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A test of the inherent predictiveness of the RU, a new metric to express all forms of operational risk in banks

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journal contribution
posted on 30.04.2021, 09:00 by Peter Hughes, Mahmoud Marzouk
In 2016 Allan D. Grody and Peter J. Hughes proposed a method and system termed ‘Risk Accounting’, an integrated financial and risk accounting framework. Risk Accounting incorporates a novel operational risk exposure quantification technique based on the Risk Unit (RU), a new common additive metric designed to express all forms of operational risk in banks. In this paper, we report on initial tests of the inherent predictiveness of the RU. The test focused on the period leading up to the global financial crisis of 2007-8 and involved the restatement into RUs of publicly available accounting data in the United States relative to a subset of large US banks. We contend that the RU’s inherent predictiveness could be concluded if it is demonstrated that an accelerated increase in trended operational risk RUs and subsequent material unexpected losses are positively correlated. We further describe how a monetary value can be stochastically derived and assigned to the RU over time. The inclusion of valued RUs in accounting systems will potentially enable the systematic adjustment of financial performance and condition relative to accepted nonfinancial risks to complement the accounting treatment already applied to financial (credit and market) risks. The resulting harmonisation of the accounting treatment applied to both financial and nonfinancial risks based on stochastic modelling will enable risk-adjusted economic profit to be adopted as the primary business performance metric and economic capital as the primary method of determining both operating and regulatory capital requirements. The real-time or near-real-time production of portfolio views of operational risk exposures based on the RU adds analytical rigour to their management and causes risk mitigation to become both a risk reduction and a profit optimisation initiative. The more effective management, oversight and governance of exposures to operational risks is the anticipated outcome.

History

Citation

Journal of Risk Management in Financial Institutions, 14 (2), 173-194 (2021)

Author affiliation

School of Business

Version

AM (Accepted Manuscript)

Published in

Journal of Risk Management in Financial Institutions

Volume

14

Issue

2

Publisher

Henry Stewart Publications for Professional Risk Managers' International Association

issn

1752-8887

Copyright date

2021

Available date

01/06/2021

Language

en