Non-Financial Risks: Developments in Accounting

We intuitively understand accounting measures such as profit or equity. The corporate world places great reliance on them. For example, they are used to communicate and evaluate a firm's financial performance and condition; they determine the extent to which firms can enrich investors, employees and the public purse through dividends, discretionary bonuses and taxes; and they are the primary input to regulators' assessments of whether a bank is appropriately capitalized and can operate safely.

The preparation of accounting measures starts with the transactions registered in accounting systems. All transactions carry a monetary value according to the contractual obligations entered into and the amounts payable or receivable emanating from such obligations. If the foundation of accounting measures is registered transactions, it follows that they are primarily concerned with what has happened in the past, not what is likely to happen in the future. Consequently, the usefulness of accounting measures is limited if they do not reflect the risks a bank accepts to increase shareholder returns, given such acceptance invariably introduces the probability of incurring future losses.

The non-consideration of the likely financial consequences of accumulating exposures to risk constitutes a significant gap in GAAP (generally accepted accounting principles), and one that the international accounting standards-setting bodies have begun to address.

Expected and Unexpected Losses

In the case of credit risk, it is accepted that a stochastically modeled probability of default can be estimated with relatively high precision. A generally accepted accounting principle is that revenues and expenses are recognized in the accounting periods in which they are incurred. It follows that, if a theoretical probability of default is present in every credit instrument and can be estimated with reasonable precision, then the associated expected loss should be recognized in each accounting period that it is unsettled.

Accordingly, international accounting bodies overhauled the treatment applied to asset impairment and, since 2018, banks are required to make accounting loss provisions for expected credit losses.

However, material credit losses can also be a consequence of accumulating exposures to non-financial risks such as operational, model, cyber, conduct and fraud risks. The presence of these risks in a bank's internal lending activities and processes creates exposure to additional credit losses, given the heightened probability that loans may be approved for poor-quality borrowers in the belief they are good-quality, or the failure to perfect claims on alternative sources of repayment through guarantees, collateral and credit derivatives in the event of default.

Credit losses within this context are deemed “unexpected,” as the amount of credit related non-financial risk exposure in monetary terms is unavailable and, consequently, modeling probability of default is not possible.

Accounting measures still need to address this remaining gap in GAAP.

Financial Abstractions

Arguably, non-financial risk is a financial abstraction. Making financial abstractions observable through accounting measures is what accountants do.

For example, a primary task of a cost accountant is to calculate product profitability. A web of cost allocation tables and operating statistics are combined to plot how each step in a product's manufacturing process proportionally consumes fixed, variable and overhead costs. The result is the “unit cost” of a product that provides vital information on the composition of product profit margins that is used to manage costs and optimize production efficiency.

Unit cost is a financial abstraction, but one that is accepted and relied upon across all industries, including financial services. Transforming it into an accounting measure makes something that is essentially unobservable, observable.

Whereas the primary concern of a manufacturing enterprise is the cost and efficiency of its production, the primary concern of a bank is the management and mitigation of risk. Accountants have solved the manufacturing challenge through cost accounting; academics have researched and are proposing risk accounting as a new branch of accounting to resolve the risk challenge.

A Common Metric

Academics and practitioners have long argued for a common additive risk metric to express all forms of non-financial risk. It follows the simple but compelling logic that the quantification and aggregation of atomic non-financial risk exposures needs a non-financial metric. Accordingly, academics defined one and called it a Risk Unit, or RU.

RCSAs and Op Risk Databases

Banks have universally adopted risk and control self-assessment (RCSA) as the primary method of managing exposure to non-financial risks. They also routinely register operational risk loss events in accordance with criteria established in Basel II. These information sources have been identified by academics as primary inputs to risk accounting.

Analogous to the web of cost allocation tables used in cost accounting, RCSAs have been adapted to represent a “web of risk allocation tables” for risk accounting. Their adaptation involves replacing the traffic-light assessment metric, typically used in RCSAs, with a system of risk-weights complemented by product risk factors and accounting values. These inputs are used in a calculation engine to generate algorithms that calculate atomic exposures to non-financial risk in RUs that can be validly aggregated.

Academics believe that by statistically correlating RUs with realized losses registered in operational risk loss databases, over time a monetary value can be assigned to the RU. Once valued, a monetized RU could provide the basis for determining non-financial risk expected loss provisions.

Testing of the theoretical risk accounting model and the program for validating the RU's feasibility are ongoing. If the RU is proven to be truly representative of accepted non-financial risks, academics believe it will potentially enable the systematic risk-adjusting of financial performance and condition through expected loss accounting provisions, provide an alternative basis for operational risk capital adequacy determination and add analytical rigor to the management of non-financial risks.

Peter Hughes (peter.j.hughes@durham.ac.uk) is a visiting fellow and advisory board member of the Durham University Business School's Centre for Banking, Institutions and Development (CBID). He was formerly a banker with JPMorgan Chase. His previous contributions to GARP Risk Intelligence included Enterprise Risk: Academics Probe New Methods.