The accountant’s mission in risk control

Marco Venuti2013

Risk and Accounting

Risk definition

Risk management

The accountant’s mission in risk control

Risk Classification

Types of risk

Agenda

Pagina 2

Risk definition

• Risk is an abstract term (we are all faced with risk in our everyday lives)

• Risk is the chance of injury, damage or loss • Pure and speculative risk• Risk is often related to the volatility of future value of a position due

to changes in creditworthiness, market behaviour or uncertain events, unexpected happenings and other outliers

• The risk lies in how variable our costs and revenues really are • The measure of variance around an expected value is the

quantitative expression of risk

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Risk definition

Risk and uncertainty

Risk: variability that can be quantified in terms of probabilities

Uncertainty: variability that cannot be quantified at all (F.Knight,1921)

“We can’t measure uncertainties, but we can still assess and risk-manage them through worst- case scenarios, risk transfer, and so on” (M.King, Bank of England, 2004)

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Risk definition

- Expected loss

- Unexpected loss

Example: To quantify an unexpected loss, a bank risk manager first identifies the risk factors that seem to drive volatility in any outcome (volatility of stock price for equity investment). But the number of risk factors varies considerably depending on both the problem and the sophistication of approach.

Then the risk manager uses statistical analysis to calculate the probabilities of various outcomes for the portfolio under consideration. This probability distribution can be used in various ways: for example, the risk manager might pinpoint the area of distribution (extent of loss) that the institution would find worrying, in the case of a probable loss.

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Risk definition

• Type of risk: – traditional risk (such as credit risk, liquidity risk, market risk and

insurance risk)– non-traditional risk (such as stategic and business risk, event

risk and legal risk, reputational risk)

• All risks concerning an entity must be identified, measured, evaluated and managed

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Risk definition

• Once we have put boundaries around our risk by naming and classifying them, we can also try to quantify them

• While assigning numbers to risk is incredibly useful for risk managers and risk transfer, it is also potentially dangerous

• Introducing sophisticated models to calculate risk is one way to solve this problem but this has its own dangers (VaR models work well under normal conditions but they may produce a misleading results in abnormal markets, …)

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VaR

• VaR = Value at risk

→ the worst loss that might be expected from holding a security portfolio over a given period of time, given a specified level of probability (known as confidence level).

→ Example: if we say that a position has a daily VaR of euro 10 million at 99% confidence level, we mean that the realized daily losses from the position will on average be higher than euro 10 million on only one day in every 100 trading days

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Risk definition

• Measuring, monitoring and controlling risk are key activities in accounting and in auditing

• innovation, leverage, volatility, liquidity and their lack combine to increase the risk of major exposure, which has the potential to destroy a financial institution or any other entity

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Risk management

• “the science of risk management, if not practised beforehand, cannot be gained when it becomes necessary. Nor indeed can the athlete bring high spirit to the contest, who never has been trained to practise it” (Roger of Hourden)

• “Risk management and risk taking are not opposites, but two sides of the same coin” (M.Crouhy, D.Galai, R. Mark, 2005)

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Thinking out of the box

It is necessary that:

• accountants improve their ability to calculate additional risk factors that exist outside the immediate trading and back-office functions;

• board of directors improve their understanding of risk management;

• firms introduce continuous effective risk control based on: rigorous auditing, better performance measurement, appropriate capital allocation and realistic pricing of financial products.

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What accountants should do:

• learn risk management

• calibrate tools to analyse risk and to register risk exposure

• apply value differentiation provided by traders, loans officers, risk managers, senior executives

• use accounting practices that respond to the need to focus on every signal connected to exposure

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The accountant’s mission in risk control

• to develop risk accounting and cost accounting based on both qualitative and quantitative criteria, for which metrics must be provided

• to develop appropriate standards to analyze risk exposure and to present this information

• to develop comprehensive internal controls with activities such as authorizations, compliance checks and follow-ups of non compliance clearly defined at every level of activity

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The accountant’s mission in risk control

• To develop systems and procedures that:

– clearly delineate risk elements

– allow efficient management of the limits system,

– monitor counterparty and financial market risks,

– manage assets and liabilities in a consistent and secure manner – apply stress testing (as a defensive weapon) in risk accounting

to help identify what is wrong and what may happen in future if some fundamental variables change.

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Situations that must be analyzed by accountants

• Uncertainty (frequency and impact of expected and unexpected events)

• Volatility (and correlation between markets and instruments)

• Liquidity (of market and of firms)

• Solvency (also default point characteristics)

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Risk Classification

• Pure risk – (people, goods, responsability)

• Speculative risk – (business risk and derivative risk)

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Types of risk

• Business and Strategic risks

• Financial risks

• Insurance risks (e.g.: Longevity risk)

• Operational risks

• Other risks:

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Business and strategic risk factors: examples

• Decline in earning or capital arising from incorrect business decision

• Incorrect allocation of resources

• Unstable sales level and lack of current profitability

• Average sales prices have declined

• If customers fail to meet their financial obligations to the firm

• Intellectual property rights are not adequately protected

• Top management defines risk taking area: risk appetite and risk tollerance

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Credit risk

• Credit risk is the risk that a counterparty (borrower or participant in trading or in other types of transaction) is unable or unwilling to meet its financial obligations.

• Credit policy consists of a number of policy decisions, rules, procedures and controls put in place to govern the operations of loans officers and diversification when necessary

• Stress test for credit risk

• Strictily connected to Credit risk concentration

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Market risk

• Risk of potential loss arising from adverse effects due to changes in interest rates, currency exchange rates, equity prices and other relevant market variables (The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices.

• VAR is sometimes not sufficient to capture market risk

• It is necessary for better valuation methodologies to achieve closer interaction with new accounting standards (stress test for market risk)

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Market risk

• Market risk comprises three types of risk: currency risk, interest rate riskand other price risk

• currency risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates.

• interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates.

• other price risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market.

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Operational risk

• Operational risks is the risk of loss arising from inadequate or failed internal processed , personnel or system, or from external events.

• Operational risk includes:

- operational efficiency and effectiveness,

- financial reporting risk,

- compliance risk.

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Other risks

• Liquidity risk (may not have the financial resources needed to face the current obligations…)

• Event risk (unforeseeable risks that suddenly reduce the credit quality of corporate borrowers and the value of fixed income securities)

• Real estate risk

• Legal risk (legal dispute, changes of law, ..) is strictily connected to other risks (business and strategic risk, operational risk).

• Contagion risk (contagion effects in a group) and reputational risk (deterioration of reputation) are strictily connected to business and strategic risk

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