This BIS initiative, while never fully implemented, is at the base of the EBA’s consultative document “Consultation on draft Implementing Technical Standards on Pillar 3 data hub”. The RASB response to the consultative paper can be found here.
Sources:
Grody, A. D., & Hughes, P. J. (2016). Risk accounting - Part 1: The risk data aggregation and risk reporting (BCBS 239) foundation of enterprise risk management (ERM) and risk governance. Journal of Risk Management in Financial Institutions, 9(2), 130–146.
Grody, A. D., & Hughes, P. J. (2016). Risk accounting - part 2: The risk data aggregation and risk reporting (BCBS 239) foundation of enterprise risk management (ERM) and risk governance. Journal of Risk Management in Financial Institutions, 9(3), 224–248.
Main Themes:
Limitations of Current Risk Management Practices: Traditional accounting standards (IFRS, GAAP) and risk management practices are insufficient to capture the complex and interconnected nature of risks in modern financial institutions. They fail to accurately identify, quantify, aggregate, and report risks, leaving the system vulnerable to unexpected losses.
Need for a Unified Risk Measurement Framework: The authors propose "Risk Accounting" as a methodology to address these shortcomings. It introduces a common risk metric, the "Risk Unit" (RU), applicable to all forms of risk, facilitating standardized measurement and aggregation of risk data.
BCBS 239 as a Catalyst for Change: The Basel Committee on Banking Supervision's principles for effective risk data aggregation and risk reporting (BCBS 239) mandates robust controls over risk data, akin to those applied to accounting data. The authors argue that Risk Accounting provides a practical framework to achieve BCBS 239 compliance.
Most Important Ideas/Facts:
1. Flawed Capital Adequacy Regime:
The authors criticize the prevailing capital adequacy regime based on Value at Risk (VaR), deeming it inherently flawed and overly complex. They highlight concerns raised by regulators regarding the reliability of internal models used by banks for calculating regulatory capital.
"It is close to impossible to tell whether results from them are prudent." - Haldane (as quoted in Grody & Hughes, 2016a)
Current approaches, especially for operational risk, rely heavily on qualitative assessments (e.g., RAG ratings) which lack comparability and aggregatability.
2. Risk Accounting as a Solution:
Risk Accounting leverages existing accounting systems and controls, adapting them to incorporate risk measurement. This allows for the integration of risk data with financial data, providing a comprehensive view of a firm's risk profile.
The Risk Unit (RU) offers a standardized and additive metric for measuring various risk types, enabling valid aggregation and comparison of risk exposures.
"The adoption of a non-financial metric in universal accounting and reporting systems will challenge the sensibilities of many." (Grody & Hughes, 2016b)
3. Key Metrics in Risk Accounting:
Inherent Risk (RUs): Represents the maximum potential loss associated with a transaction. Calculated using Value Band Weightings (VBWs) based on transaction value and Exposure Uncertainty Factors (EUFs) specific to each risk type.
Risk Mitigation Index (RMI): A dynamic measure (1-100) reflecting the effectiveness of risk mitigation practices compared to industry best practices. Derived by mapping business components and processes to standardized Best Practice Scoring Templates (BPSTs).
Residual Risk (RUs): The remaining risk after applying mitigation measures, calculated as Inherent Risk * (1 - RMI/100).
4. Benefits of Risk Accounting:
Enhanced Risk Reporting: Supports comprehensive and accurate reporting for ERM, BCBS 239 compliance, risk appetite setting and monitoring, and capital management.
Improved Risk Culture: The RMI serves as a tangible metric for assessing risk culture, enabling benchmarking and incentivizing positive changes within the organization.
Increased Transparency: Provides stakeholders with a clearer understanding of the firm's risk profile, fostering trust and confidence.
5. Alignment with BCBS 239:
Risk Accounting directly addresses key principles of BCBS 239 by:
Implementing robust controls over risk data through a standardized measurement framework and audit trails.
Creating a single authoritative source of risk data linked to the general ledger.
Enabling precise, timely, comprehensive, and adaptable risk reporting.
Quotes:
"If accounting and control systems are not ‘risk adjusted’ relative to the exponential growth in risk concentrations, the systems required to report accepted risks, including their monitoring against approved levels of risk appetite, will not meet their dual objectives of controlling risk behaviour and minimising unexpected losses." (Grody & Hughes, 2016a)
"This monovalent concept must now be applied to ‘risk adjusting’ these same accounting transactions to embody a single and universal risk-adjusted value denominated in a common risk metric for all forms of risk." (Grody & Hughes, 2016b)
Conclusion:
Grody and Hughes advocate for a paradigm shift in risk management, proposing Risk Accounting as a practical and comprehensive solution. By adopting a unified risk measurement framework based on the Risk Unit, financial institutions can address the limitations of current practices, comply with regulatory requirements like BCBS 239, and foster a more robust risk culture.
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