"The resetting of the risk management agenda through successive capital accords has had little impact on the ability of many firms to prevent losses which raises concerns as to whether the risk calculation methods applied in the calibration of regulatory capital are fit for purpose. This has been the focus of recent public comment by global regulators, central bankers and industry commentators who suggest that excessively complex and flawed capital adequacy rules that rely on risk modeling techniques such as Value-at-Risk (VaR) were a contributing factor in the financial crisis.
We argue that the disclosure of an enterprise’s financial condition and the concomitant determination of its capital adequacy must be a function of accounting rather than financial modeling. We further argue that if accounting is to fulfill this core function, the current practice of basing accounting on fair values must be adapted such that accounting is based on the risk exposures inherent in approved transactions. In this paper we demonstrate how this may be achieved by adding risk information to the existing management information that is attached to transactions upon their registration in accounting systems. The incremental risk information enables a calculation of risk-weighted transaction values that are accounted for using a new risk abstraction - the Risk Unit (RU). In this way a comprehensive risk management system is created that is tied to the financials of the enterprise.
We further demonstrate how risk accounting aligned with management accounting can produce a system of integrated risk and management reporting by, for example, group, organisation unit, product, customer and geography which, in turn, enables the risk appetite setting process to become an integral part of the enterprise’s financial planning and budgeting cycle.
Over time, risk accounting outputs can be correlated with expected and actual losses thereby imparting a monetary value to the RU abstraction which can be used in the determination of regulatory capital requirements, the computation of risk adjusted return on capital (RAROC) and adjusting the betas in the capital asset pricing model (CAPM) thus bridging accounting with economic theory and risk management concepts."