Truly accounting for risk exposures requires…
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.
To be more specific…
Risk accounting is a specialized approach that aims to address the limitations of traditional accounting practices in capturing and reporting potential future losses associated with risk exposures. It recognizes that relying solely on historical financial data may not provide an accurate representation of a company’s true financial condition, leading to profit uncertainty among shareholders and stakeholders.
To overcome this gap, risk accounting integrates risk measurement and reporting into the calculation of economic profit. Economic profit takes into consideration both accounting profit and the opportunity costs associated with revenue generation. Unlike traditional profit measures, economic profit incorporates the potential impact of risk exposures on future profitability. By quantifying and factoring in risk, economic profit provides a more comprehensive and realistic assessment of a company’s financial performance.
To implement risk accounting effectively, a standardized system of risk measurement is established. This system employs a common risk metric, typically expressed in the form of a risk unit (RU), to quantify different types of risks faced by an organization. The risk unit represents the exposure to risk associated with specific transactions, products, or services.
By adopting risk accounting, organizations can benefit from a standardized system of risk measurement, improved risk reporting and transparency, enhanced risk mitigation strategies, and a more accurate calculation of economic profit. It enables organizations to move beyond subjective assessments and provides a quantitative basis for evaluating risks and their impact on profitability.
Furthermore, risk accounting opens doors to deeper insights into an organization’s risk culture, risk appetite, and risk-adjusted performance. It promotes a proactive approach to risk management by incentivizing risk mitigation through economic profit calculations and capital charges. This integration of risk and finance creates a unified perspective that facilitates strategic decision-making and resource allocation.
However, it is important to recognize the challenges and limitations associated with implementing risk accounting, such as data quality and availability, technological integration, and the need for industry collaboration. Overcoming these challenges requires a commitment to continuous improvement, investment in advanced analytics and technology, and industry-wide collaboration to establish standardized practices and benchmarks.
Tables and Templates…
…providing the risk-weighted factors used in the risk exposure quantification in Risk Units (RUs).
Exposure Uncertainty Factors
…or EUFs. 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.
Value Tables
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.
Best Practice Scoring Templates
…or BPSTs. 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.
Definitions
Non-Financial Risks & Unexpected Losses
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.
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.
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 |
…more from the experts
[Source: “Comments on Risk Accounting” by Henry Stewart Publications 1752-8887 (2016) Vol. 9, 4 413–420 Journal of Risk Management in Financial Institutions]
“The framework… harmonizes all quantifiable risks and valuation uncertainties into one consistent framework without getting bogged down with specific risk models, methodologies and calibrations”
“The integration of accounting and risk measures (both economic and regulatory) makes an important contribution to making risk-adjusted returns transparent”
“…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.”
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