Risk Accounting and the Predictive Power of the Risk Unit (RU)

The original paper can be found here.

Main Themes

1. Limitations of Current Operational Risk Management: Current methods like Risk and Control Self-Assessment (RCSA) are effective at identifying risks but lack quantitative aggregation capabilities. This hinders real-time analysis and portfolio management of operational risk.

2. "Whereas RCSA is effective in identifying operational risk exposures, the use of colour-coding, typically RAG (red/amber/green), to gauge their likely financial impact disenables risk exposure aggregation."

3. Need for "Risk Accounting": The authors propose "Risk Accounting," an integrated framework that quantifies operational risk exposures using the Risk Unit (RU). This approach aims to complement financial accounting with risk values, enabling calculation of risk-adjusted financial performance and better risk management.

4. "The Risk Accounting method proposed by Grody and Hughes offers a solution in the form of an integrated financial and risk accounting framework."

5. Expected Loss Accounting for Operational Risk: Building on the expected credit loss accounting introduced in IFRS 9 and CECL, the authors argue for recognizing expected losses related to operational risk in audited financial statements. This would provide a truer picture of a bank's financial health and incentivize proactive risk mitigation.

6. "If a bank creates a risk in its pursuit of increased shareholder value, it also creates a probability of loss. If that probability of loss can be reasonably estimated, sound accounting practice would be to account for the expected loss upon the creation of the associated risk."

7. Predictive Power of the RU: The authors present a test examining the correlation between the trend of operational risk RUs and subsequent unexpected losses. The test, based on publicly available financial data of 15 US banks leading up to the 2007-8 financial crisis, suggests a strong positive correlation, indicating the potential predictive power of the RU.

8. "The test revealed an increase of 58.1 per cent in exposures to operational risks over the eight-year period. […] A primary contributor to the increase in operational risk RUs in this period was the creation of the subprime mortgage market that relied on interlinked securities and derivatives."

Key Findings

• The financial crisis exposed the inadequacy of existing operational risk management frameworks in quantifying and managing complex risks.

• The RU provides a quantifiable, aggregatable, and comparable metric for operational risk, enabling portfolio management and trend analysis.

• Statistical correlation of RUs with historical losses can facilitate assigning a monetary value to the RU, paving the way for incorporating expected operational risk losses in financial statements.

• The test conducted suggests a positive correlation between rising operational risk RUs and subsequent material losses, showcasing the potential predictive capability of the RU.

Implications

• Implementing Risk Accounting could significantly enhance operational risk management and risk-adjusted financial reporting in the banking industry.

• Regulatory bodies might consider integrating the RU and Risk Accounting principles into their supervisory framework to improve systemic risk monitoring and oversight.

• Further research and testing are necessary to validate the RU's predictive power and refine its methodology for broader adoption.

Quotes of Note

• "Arguably, operating a bank without effective risk accounting should be equally unthinkable [as a manufacturing concern operating without cost accounting]."

• "[The test] provides an initial indication of the inherent predictiveness of the RU. Such results, however, cannot be considered conclusive given the limited scope of the test."

• "If it does become widely accepted that the RU possesses predictive properties that are truly representative of all forms of operational risk, the rewards are potentially significant."

Conclusion

This research highlights the critical need for improved operational risk management in the financial industry. The proposed Risk Accounting framework and the RU metric offer a promising approach to address existing limitations and enhance risk-sensitive decision-making. While further validation is required, the potential benefits of integrating risk and financial accounting through the RU are significant and deserve further exploration.