What’s Your Credit Risk Appetite?

Developing a credit risk appetite based on sound principles is integral to demonstrating effective risk management. The PRA’s Dear CEO letter to UK Deposit takers (Jan ’23) stated the need for firms to be ready for a period of prolonged stress [1] , it also underlined the need for appropriate risk management and governance frameworks. The PRA’s Supervisory Statement on Corporate governance: Board responsibilities (SS5/16) [2] published in 2018 states “The business strategy should be supported by a well-articulated and measurable statement of risk appetite (expressed in terms that can be readily understood by employees throughout the business).”

When considering a Credit Risk Appetite, it is important to understand the essential position the credit risk appetite holds at the intersection between the top-down strategic view of risk taken at the top of the organisation and the bottom-up day-to-day management of credit risk within the bank. Where to set thresholds is a challenge many lenders grapple with. There can be a tendency to place arbitrary constraints on measures to minimise risk or possibly to anchor to historic levels. Without an understanding of the rationale behind the measures, if there is a breach, thresholds may be argued to be flexible or contingent to change. The obvious question being, if the new level is acceptable, then why wasn’t the threshold set at that level to begin with.

Understanding the organisations financial status and long-term strategic objectives should identify constraints that translate into lower-level quantifiable measures against which thresholds can be set. These constraints can come in many forms including, but not confined to; profitability, operational capacity, Expected Credit Loss (ECL), capital or reputational thresholds. An exploration of the fundamental constraints is integral to creating measures (and subsequently thresholds) that are an accurate representation of the risk appetite of the business. A robust and principle-based approach to determining the right measures and setting thresholds is required, even where there is limited data or experience. Measures should be clearly defined both in the way they are calculated and, in the role they are playing e.g. leading indicators, concentration or performance (lagged).

The dynamic nature of risk and inter-dependencies should be considered by evolving the portfolio through different scenarios, considering new business flows and changes in attrition. Informed discussions on what could cause a breach in appetite and what actions would be taken to prevent this, should form part of risk appetite development.

Taking mortgage loan to value (LTV) or indexed LTV profiles as a typical group of appetite metrics within a risk appetite statement as an example, a lender may decide that due to the optics of market reporting they want to keep the average LTV of the portfolio below 60% and have no more than 10% at a higher threshold, say 90%. In an environment of increasing house prices, they may have been booking 20% of new business at above 85% LTV. They may have been experiencing relatively high levels of attrition after expiry of high LTV 2-year products, resulting in a stable portfolio LTV. How will the dynamics of the portfolio LTV change when house prices are stagnant or dropping and retention rates increase through a movement in their acquisition mix to 5-year products and a reduction in customer’s ability to switch to competitors through affordability constraints? The ability to see how the portfolio evolves under different economic scenarios is a valuable tool in setting appropriate thresholds and identifying controls. Having a more granular set of input and calculations to simulate and project forward the whole portfolio with new business and run off under different conditions allows the firm to understand how the business plan may unfold under different conditions and to see how these impact key outcome measures such as ECL and capital risk weights.

To support long term commercial success credit risk managers should understand why thresholds are in place, how they will be monitored, and what levers can be pulled to course correct if required to utilise the appetite effectively.

4most’s industry experience coupled with modelling expertise provides the ability to create bespoke tools to support the development and monitoring of credit risk appetite.

If you would like to discuss any aspect of your organisations credit risk appetite or portfolio management, please get in touch.