Risk appetite is commonly defined as the level and type of risk a firm is able and willing to assume in its exposures and activities, given its business objectives and obligations to stakeholders. Oftentimes, the extent of the exposures is defined through quantitative financial and non-financial metrics. A risk opportunity framework defines the boundaries of strategy, policies, procedures and systems of an organization. It also forms the basis for establishing limits, controls and mitigation measures. It is normally determined as a fraction of available capital, liquid assets and borrowing capacity.
When private banks set their risk appetite framework, there is focus on avoidance of areas that they consider fraught with uncertainty. Thus, we see small loans being rationed out, leading to a funding gap where the demand for loans from small and medium enterprises (SME) is not adequately met. The same is true in the agricultural sector as reports from the Bangko Sentral ng Pilipinas indicate non-compliance with the mandated lending requirements. The risk appetite of private banks for lending to these areas is at the low end given the perceived volatility of the sector. Unless there are specific incentives for lending to happen, like a friendlier SME and agriculture environment or a more tolerant regulatory regime, very little improvement can be expected in these sectors’ access to credit.
Properly functioning financial systems are central to the growth of the economy, creation of wealth and the stability of everyday life. Aside from stimulating growth, finance helps fight poverty. The system should help small firms start up and get through difficult periods, promote the growth of medium-sized companies, and ensure the efficiency of large firms, lest they be displaced. But relying on competition in the private sector may not be enough, precisely because of their constrained risk appetites. This leads to market failure. One cannot leave everything to the market because the market unfortunately can be ruthless. It is thus necessary for development finance institutions to join the fray.
Development banks help solve market imperfections that would leave unfunded either profitable projects or projects that generate positive externalities (positive consequences to third parties). According to some experts, without public participation, the lack of trust among creditors and debtors will inhibit the deepening of credit markets. Private banks that are reluctant to extend credit because of perceived risk will leave value-enhancing and socio-economically sound projects unfunded.
It is for these gaps that countries have set up public finance institutions. In the developing world, it is the poor and underprivileged that are hardest hit by multiple economic disruptions that affect lives, assets and social cohesion. Development finance institutions are necessary to intervene and bring about security and future prosperity. Development banks are important builders of bridges between the unbanked/under-banked and the resource providers of the country. Their task is not only to protect the poor, but to unlock opportunities for better development outcomes from other socially concerned partners that are investing in the country’s priorities.
Development bankers must view the world from a different set of lens. They cannot simply be regular bankers as we understand the term generally. Development bankers must have a wider perspective and a more open attitude toward certain outcomes. They must be willing to engage not just in traditional approaches, but in more creative, non-traditional modes of financing that are designed to improve the delivery of public service and meet the needs of modernizing Philippine enterprises.
Development bankers must be effective risk-takers driven by a need to achieve overarching goals demanded by their stakeholders. Having zero tolerance for failure, or adopting the private bankers’ wealth creation mind-set, cannot attain the broader goals. The best solution is not necessarily the least risky solution that may end up the least relevant to the stakeholders. Allowing a healthy tolerance level, especially in the early stage of program development, may even be an ingredient for success.
Given this scenario, the regulatory environment must also be cognizant of the mission and cannot be too tight.
The more the grip is tightened, the less effective the outcome. What the structure needs is a balanced control system that accepts the failures that comes with successes. Innovation often calls for going into the unknown, and a wider latitude must be given to lead to optimal decision-making.
Development finance institutions must strive to ensure their decision processes follow a model aligned with their mandates. If the organization restricts its processes and people, the path to the development outcomes may become stagnant. Profits or financial returns to compensate for risk are not the primary goals of development finance. Thus it is important to develop a strong and well-communicated risk management framework that addresses the public service mission of the institution. It is critical to have a good monitoring and evaluation system that measures the outcomes that matter.
Benel D. Lagua is executive vice president at the Development Bank of the Philippines. He is an active Finex member and a long time advocate of risk-based lending for SMEs. The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as Finex.