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

WHAT IS RISK ACCOUNTING?

Risk Accounting is a new and revolutionary method of identifying, quantifying,
aggregating and reporting exposures to non-financial risks including
operational, cyber, model, conduct and fraud risks. It introduces a new,
additive common metric – the ‘Risk Unit’ or ‘RU’ – that is designed to express
all forms of non-financial risk.

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AN OVERVIEW OF THE RISK ACCOUNTING METHOD




INTRODUCING THE ‘RISK UNIT’ OR ‘RU’

The ‘Risk Unit’ or ‘RU’ is the new additive metric, unique to the Risk
Accounting method, that is used to quantify and report exposure to operational
risk using three core metrics:

 * Inherent Risk: The amount of operational risk in RUs before considering the
   effects of internal risk mitigation activities and processes (represents
   maximum exposure to operational risk)
 * Risk Mitigation Index (RMI): A measure of the effectiveness of internal
   operational risk mitigating activities and processes on a scale of zero to
   100
 * Residual Risk: The amount of operational risk in RUs that remains after
   reducing Inherent Risk by the RMI (represents actual exposure to operational
   risk)

CALCULATION OF INHERENT RUS

RiskBox calculates Inherent RUs based on two factors: (1) Exposure Uncertainty
Factor (EUF), and (2) Value Band Weighting (VBW):



PORTFOLIO VIEW OF OPERATIONAL RISKS

RiskBox generates algorithms that convert EUF, VBW and RCSA (Enhanced) inputs
into a portfolio view of operational risk exposures in RUs encompassing:

 1. The reporting and analysis of granular and aggregated exposures by multiple
    categories including group-wide, business line, business organisational
    component, product, and customer.
 2. Direct comparisons of exposure to operational risk through benchmarking and
    ranking within and between enterprises (assuming the above tables and
    associated risk factors are uniformly applied).
 3. Identification and prioritization of risk mitigation action plans with a
    calculation of the projected risk reduction impact of each plan in RUs.
 4. The setting of operational risk budgets and risk operating limits in RUs
    across all vertical and horizontal dimensions of the enterprise with the
    potential for real- or near real-time monitoring of accumulating exposures
    to risk vs. risk budgets and limits.

RISK ACCOUNTING SOFTWARE

RiskBox is Risk Accounting’s calculation engine.

Once determined and approved, product risk factors (EUFs), new-business scaling
factors (value table) and RCSA activity and control effectiveness factors and
best practice benchmarks require minimal maintenance. These tables, risk factors
and benchmarks are set up in RiskBox.

There are two variables that require periodic input:

 1. The daily amount of new business booked.
 2. Changes in the operating status of risk mitigation activities and controls.

RiskBox is designed to have maximum operational flexibility and be readily
adaptable to the highly complex requirements of large financial institutions.
Its modules can be implemented either as a standalone end-to-end solution
incorporating risk and control self-assessment (RCSA) or integrated within an
existing information infrastructure. The key component is the RU calculation
engine which can be integrated in solutions offered by third party technology
providers, configured using existing platforms or through a de novo in-house
development.

RiskBox can be easily positioned between the data integration layer and the
presentation layer (reporting, analysis, dashboarding and alerting tools). It
can be deployed in-house, in a third-party cloud, as a physical hardware device
or a virtual device on a variety of operating systems and connectivity options.
Implementation options vary depending on the complexity of the existing
infrastructure, the results that need to be obtained, and time and budget
constraints.



1. EXPOSURE UNCERTAINTY FACTOR (EUF) TABLE

EUFs are scaled to a value between zero and 20 reflecting each product’s
operational complexity and the consequent process burden it imposes on the
enterprise. EUFs relative to the activities below, where applicable, are
assigned according to the risk criteria and associated risk factors set out in
the EUF tables and summed for each product:

 * Processing: number of operational touchpoints along the product’s end-to-end
   processing cycle.
 * Lending: the relative time and effort required to liquidate collateral in the
   event of a credit default with reference to the value retention properties
   and price stability of underlying collateral.
 * Trading: the relative time and effort required to unwind a trading position
   with reference to the availability and reliability of market prices and
   rates, and the manner in which the product is traded, e.g., electronic,
   floor, OTC etc.
 * Treasury: the relative time and effort required to fund a product and manage
   associated liquidity and interest rate risk with reference to:
   * Banking book: interest rate type (fixed or floating) and maturity.
   * Derivatives: relative degree of complexity.
   * Transactional and trading book: assume marginal Treasury involvement.
 * Selling: whether the product is…
   * an investment product involving the holding of customer monies;
   * directly linked to a sales incentive scheme; and
   * bundled with other products (e.g., a loan with an interest rate swap);
   * …and the product’s relative degree of complexity from a customer
     perspective.
 * Environment: the product’s relative toxicity, combustibility, and
   biodiversity.

2. THE VALUE TABLE

Ascending $ amounts of daily operational throughput, for each product, are
assigned a Value Band Weighting (VBW).

The value bands plotted against the VBWs produce a logarithmic curve that
depicts how the rate of change in risk decelerates as operational throughput
accelerates, primarily due to enhanced automation that naturally occurs as
production volumes and values increase. 



3. CALCULATION OF RISK MITIGATION INDEXES (RMIS) AND RESIDUAL RUS

Two variable inputs are periodically input into RiskBox to produce RMIs and
Residual RUs by multiple reporting categories including group-wide, business
line, business component (cost center), customer, product, legal entity, and
location. 

 1. The amount of operational throughput, being daily new business transacted
    relative to each product, which can be captured either manually or via
    automated interfaces with accounting systems.
 2. The status of risk mitigation gathered from across the enterprise via risk &
    control self-assessments (see below) captured at pre-selected organizational
    levels, e.g., process, production team, department, division etc.

Z

RISK & CONTROL SELF-ASSESSMENT - RCSA (ENHANCED)

The traffic light ‘RAG’ assessments typically used in RCSAs to report the status
of risk mitigation activities and processes are replaced either by a binary
‘yes/no’ input indicating the presence or absence of compliance with an industry
consensus best practice or through gauging the degree of compliance by reference
to a set of predetermined benchmarks. RCSA enhanced inputs are used by RiskBox’s
algorithms to calculate risk mitigation indexes (RMIs) and residual RUs.



AUDITABILITY

An important feature of Risk Accounting is that RiskBox inputs via EUF and VBW
tables and enhanced RCSAs are auditable:

 1. EUFs are set and approved during the product approval and review process.
    Auditors can independently verify that EUFs have been appropriately
    documented, approved, and consistently applied.
 2. Operational throughput and mapping to the Value Table can be independently
    verified by auditors against accounting records.
 3. Given that enhanced RCSAs require either a ‘yes/no’ response or the
    selection of a benchmark from a multiple-choice dropdown box, an auditor can
    independently verify whether responses are appropriate as there is only one
    acceptable response.




WHAT EXPERTS SAY?

[As published in the “Comments on Risk Accounting” by Henry Stewart Publications
1752-8887 (2016) Vol. 9, 4 413–420 Journal of Risk Management in Financial
Institutions]

“…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

Durham University Business School

“The integration of accounting and risk measures (both economic and regulatory)
makes an important contribution to making risk-adjusted returns transparent”

Robert Mark, PhD

Black Diamond Risk Enterprises

“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 Guardian Life Insurance Company of America

“…(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

Principal Global Investors

“…(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

New York Life Insurance Company

“…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

Bloomberg

Z

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.

s

NOTE

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.

 



MAINTAINING & IMPROVING THE RISK ACCOUNTING STANDARDS - RASB

Risk Accounting Standards Board

The global standards-setting organisation for Risk Accounting is RASB.  The
Board is comprised of leading industry practitioners and academics with a keen
interest in risk exposure quantification solutions research.

For details of how to apply for membership to RASB, click here. Members have
free access to RASB’s Knowledge Centre comprising approved Risk Accounting
standards and implementation guidelines and expert technical support and
training.


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