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Thinking: how can the financial services industry improve its approach to risk management?

Document Cited in Related
Vincent
AuthorHughes, Peter
PositionINFORM

Ever since the 2007-08 financial crisis, firms have been asking their accountants to discuss key risks, including those unrelated to financial reporting. Even so, more recent crises affecting financial services companies strongly suggest that these firms and their auditors, investors and regulators still weren't aware of the scale of the accumulating risks until it was too late.

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It's clear that we need a better measurement framework for risk exposure. One proposal, which has been tested in financial services firms, is to measure risk using a common unit of exposure. Basically, this new method, which we call risk accounting, adapts the management accounting system so that the information typically attached to a transaction when it's registered in a bank's system (product, customer, market segment etc) is complemented by information on risk that's triggered when the transaction is accepted. In this way, a calculation of risk-weighted transaction values may be enabled and accounted for.

To create a risk accounting system, an organisation's risk managers work with operational staff to come up with scores denoting each department's exposure to risk and the effectiveness of its risk mitigation procedures in every process for which it's responsible. In doing so, they use three sets of standardised tables relating to the three "risk drivers" that are present in all business processes:

* The risk characteristics of the relevant products.

* The amounts accepted for processing in accordance with accounting records.

* The effectiveness of the operating environment at mitigating risk.

A risk mitigation index for each process is then derived using best-practice templates. The risk weights assigned to each transaction are used in the calculation of its exposure to risk using a new metric, the risk unit. The resulting scores and weightings are applied in a scorecard under which operational metrics are computed, consolidated and aggregated.

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