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.
This presentation addresses these concerns by introducing a risk accounting solution based on a new risk metric abstraction, the Risk Unit. Risk accounting 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 empirical means of directly tying the accounting records and related financial performance metrics to dynamic measurements of exposure to risk expressed in Risk Units.
The direct alignment of financial metrics and risk exposure metrics 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 Risk Unit abstraction, and can be used to risk-adjust betas in Capital Asset Pricing Models’ expected return assumptions thus bridging economic theory with risk management concepts.
