Strategic Risk Management

APPENDIX B

How to Determine Risk Capacity and Risk Appetite

In chapter 3, we outlined the principle of understanding a firm’s risk capacity and risk appetite, two terms that are often confused with each other. Returning to the poker player analogy we used earlier, risk capacity is the maximum loss that our player can absorb but still leave the game able to return and play another day. Sustainability as a going concern sets the upper bound on risk capacity. Risk appetite, on the other hand, describes the betting limit for any individual hand. The most critical relationship between these two elements is that risk appetite should never exceed risk capacity.

This is simple to see in the case of a poker player in a single game, but imagine if she ...