Risk measurement has been part of the regulatory agenda in financial services since the first Basel Capital Accord was introduced in 1988. This and subsequent capital accords presumed that the disciplines developed to report on regulatory capital through the Basel lens would, in turn, spawn innovation towards embedding a risk culture and engendering a thoughtful understanding of risk appetite in financial firms. However, these ambitions have remained largely unfulfilled as evidenced by the global financial crisis that materialized even though the evolved discipline of risk management was all about its prevention.
The resetting of the risk management agenda through successive capital accords has had little impact on the ability of many firms to prevent losses. This raises concerns as to a possible disconnect between the risk calculation methods applied in the calibration of regulatory capital and the risk exposure measurement and management systems implemented by firms. These concerns are further compounded by the continued absence of a standardized, dynamic, aggregatable and replicable risk exposure measurement framework.
Our research addresses these concerns by proposing a risk accounting solution and introduces a new risk metric abstraction, the Risk Unit (RU). The risk accounting method is designed to risk-weight the notional values of transactions destined for posting to the accounting records of the firm. In this way it provides an empirical means of directly tying the accounting records and related financial performance metrics to dynamic measurements of exposure to risk expressed in RUs.
The direct alignment of financial metrics and risk exposure metrics proposed in the risk accounting method enables the risk appetite setting process to become an integral part of the financial planning and budgeting cycle. Over time risk exposure metrics can be correlated to expected and actual losses thereby imparting a monetary value to the RU abstraction, and can be used for capital provisioning and to compute risk adjusted return on capital (RAROC) calculations and, further, to risk adjust the betas in the capital adequacy pricing model (CAPM) thus bridging economic theory with risk management concepts.
Our Risk Accounting research paper will be published shortly. Details will appear here.