Introducing Risk Accounting
Risk Accounting is a new and revolutionary method and system that identifies, quantifies, aggregates and reports exposures to non-financial risks.
The breakthrough thinking in Risk Accounting is the definition of a new, additive, standard unit of measurement, designed specifically for non-financial risks, called the Risk Unit or RU. That means that all the diverse exposures to non-financial risks in financial institutions can now be validly expressed through a common, additive metric, the RU.
The Portfolio View
A portfolio is a composite of like exposures that provides the essential foundation for risk control and analytics:
- granular content is aggregated and verified against official accounting records;
- techniques such as trending, ranking, modelling, limit-setting, limit usage monitoring and bench-marking provide risk transparency;
- models produce insightful risk exposure and probability analytics from a controlled source of risk exposure data; and
- groundbreaking technologies such as AI, FinTech and RegTech are enabled.
Portfolio management techniques applied to the financial risks inherent in, for example, credit, investment and trading portfolios, have evolved to a very high degree of effectiveness. But risk managers have not yet found a way of transporting these techniques to non-financial risks.
Now they can. Risk Accounting is the first ever solution that provides an accurate and comprehensive portfolio view of non-financial risks.
“…represents a sizeable step forward in the search for a practical global solution to enterprise risk management (ERM)”
“…the London Whale trading loss… Here, the (method) would bloom”
“…a very useful conceptual framework that could serve as a baseline for fulfilling the needs of BCBS 239, with a relatively simple to implement approach”
“…the first mechanism proposed to integrate the major components of risk in a large institution”Julian Williams, PHD
“The integration of accounting and risk measures (both economic and regulatory) makes an important contribution to making risk-adjusted returns transparent”Robert Mark, PhD
“The framework… harmonizes all quantifiable risks and valuation uncertainties into one consistent framework without getting bogged down with specific risk models, methodologies and calibrations”Mark Abbott, MA
“…(the) approach could be a meaningful way of establishing a common metric for operational risk, an area in risk management which, after many years, is still lacking analytical rigour”Madelyn Antoncic, PhD
“…(the) proposed framework is both novel in addressing the limitations of existing ERM risk measurement frameworks and practical in adapting the control and reporting frameworks that already exist in accounting and general ledger systems”Roger Chen, CFA, PRM
“…I think it is a good way of thinking about the operational risk associated with different underlying risk classes but, as the authors point out in the paper, it is not intended to be a substitute for capital at risk.”Adam Litke, PhD
Risk managers have adopted a number of terms to describe the risks inherent in the operating environments of financial institutions. The most widely used are ‘operational risk’ and ‘enterprise risk’. More recently, a further term has emerged… ‘non-financial risk’. These three terms are essentially synonymous. Accordingly, Risk Accounting has adopted the term ‘non-financial risk’ to mean all the risks inherent in the operating environments of financial institutions, including operational and enterprise risks.
Risk Accounting: Definitions
Exposure to non-financial risks exists where a financial institution fails to adequately plan, organise, manage and control its internal risk-mitigating activities and processes. In contrast, exposure to financial risks exists where a financial institution intentionally creates external financial exposures with customers, intermediaries and counterparties for a projected return.
Unexpected losses are financial outcomes associated with a financial institution’s failure to accurately identify, quantify, aggregate and report its accumulating exposures to financial and non-financial risks and, consequently, cannot know whether such exposures are within risk appetite limits approved at the Board level. In contrast, expected losses are stochastically determined accounting estimates of projected financial outcomes associated with accepted financial and non-financial risks where the amount of accepted risk has been accurately quantified and is within risk appetite limits approved at the Board level.
In the recent past, most notably during the financial crisis of 2007/8, financial institutions of all sizes around the globe suffered material, sometimes catastrophic unexpected losses. These were invariably due to their inability to effectively identify, quantify, aggregate and report their internal exposures to non-financial risks. In many instances, the result was extreme accumulations of unidentified and unreported exposures to non-financial risks that eventually turned into losses. In contrast, external exposures to financial risks have intrinsic monetary value that can be readily identified and quantified in natural currency, aggregated and reported. In short, a financial institution’s amount of exposure to external financial risks is typically known whereas its amount of exposure to internal non-financial risks is typically unknown.
Risk Accounting - An Overview
The Risk Accounting method generates three core risk metrics applied to the reporting categories typically used in management accounting including by organization, legal entity, product, customer, location and risk type.
The three core risk metrics are:
- Inherent Risk… the amount of non-financial risk in RUs accepted by a financial institution before considering the effects of internal risk mitigation activities and processes (represents maximum possible loss)
- Risk Mitigation Index (RMI)… a measure of the effectiveness of a financial institution’s internal risk mitigating activities and processes on a scale of zero to 100
- Residual Risk… the amount of non-financial risk in RUs that remains after reducing a financial institution’s Inherent Risk by its RMI (represents probable loss)
The first step in risk accounting is to identify the primary risk types to which each industry is exposed. For example, in banking these are deemed to be processing, lending, trading, funding, interest rate and selling.
The risk types and the objective of the
related risk-mitigating activities and processes are shown below:
|Risk Type||Risk Mitigation Objective|
|Processing||…transactions accepted for processing are properly approved and processing is complete, accurate and timely|
|Lending||…in the event of an assumed default, a liquidation price for underlying collateral can be realized in a reasonable time-frame and without incurring exceptional losses|
|Trading||…in the event of an assumed unwinding of a trading risk position, a liquidation price can be realized in a reasonable time-frame and without incurring exceptional losses|
|Funding||…stable sources of funding are available to fund immediate and foreseeable operating needs|
|Interest Rate||…in the event of unusual interest rate movements, interest rate sensitive assets and liabilities can be extinguished, replaced, extended or renewed in a reasonable time-frame and without incurring exceptional losses|
|Selling||…positive customer outcomes are achieved, and customers are treated fairly|
The diagram below shows how risk and operating factors are combined to generate algorithms used to calculate risk accounting’s three core metrics (inherent risk RUs, risk mitigation index and residual risk RUs) for each risk type triggered by the product in question:
The tables and templates that provide the risk-weighted factors used in the RU calculation are:
1. Exposure Uncertainty Factor (EUF) Tables
There is an EUF table for each Risk Type. They provide risk-weights (EUFs) according to the risk characteristics of each marketed product graded by criteria such as the value retention properties of collateral, complexity, availability of market prices, method of trading, degree of straight-through processing (STP), whether the product is sales incentive linked, and many others.
2. Value Table
A basic assumption in Risk Accounting is that there is a positive correlation between exposure to processing risk and the volumes and values of transactions accepted for processing. Transaction values from accounting records are mapped to the Value Table which assigns a Value Band Weighting (VBW) to value band ranges. The Value Table recognises that, as processing volumes and values increase, the rate of change in risk decreases due to enhanced operational sophistication that occurs primarily through automation.
3. Best Practice Scoring Templates
A Risk Mitigation Index or RMI is calculated for each business component (department) and associated operational processes that interact with the product along its end-to-end processing cycle. The RMI is determined by mapping the actual status of each business component’s risk-mitigating activities and processes relative to industry consensus best practices and extracting the applicable scores which are prorated on a scale of zero to 100.
Maintaining & Improving the Risk Accounting Standards - SERRAQ
The global standards setting organisation for Risk Accounting is SERRAQ. SERRAQ hosts the Risk Accounting Standards Board comprised of leading industry practitioners and academics.
For details of how to apply for membership to SERRAQ, click here. Members have free access to SERRAQ’s Knowledge Centre comprising approved Risk Accounting standards and implementation guidelines and expert technical support and training.