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The Evolution of Risk Accounting

Understanding Basel II: The Basel Committee's Challenge to Banks on Operational Risk

As financial institutions grew more complex and global in the late 20th century, the Basel Committee on Banking Supervision recognized the need for a robust framework to manage the increasing risks within the banking sector. This led to the development of Basel II, a set of international banking regulations that aimed to strengthen the global financial system by setting new standards for risk management, particularly in the area of operational risk.

In this article, we’ll explore the goals and challenges of Basel II, the shortcomings of the banking sector’s response to it, and how these experiences paved the way for the development of risk accounting.

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About the BIS and BCBS

The Bank for International Settlements (BIS) was established in 1930, making it the world’s oldest international financial institution. Initially created to facilitate reparations payments following World War I, its role evolved to support central banks in managing monetary and financial stability. The BIS became a forum for cooperation among central banks and provided banking services to them.

The Basel Committee on Banking Supervision (BCBS) was formed in 1974 by the BIS in response to growing concerns over financial stability following the collapse of several international banks. The BCBS develops global regulatory standards for banks, including the Basel Accords, which set minimum capital requirements to ensure banks can absorb losses and maintain stability.

The Basel I Accord (1988), Basel II (2004), and Basel III (2010) are key milestones, each addressing different aspects of financial risk management and resilience. The BIS and BCBS continue to play crucial roles in global financial regulation.

The Origins of Basel II

The Basel Committee on Banking Supervision was established in 1974 by the central bank governors of the G10 countries, following disruptions in international financial markets. Its primary goal was to enhance financial stability by improving the quality of banking supervision worldwide. Over time, the committee has introduced several key frameworks, known as the Basel Accords, to guide banking regulation.

Basel II, introduced in 2004, represented a significant evolution in these efforts. It was designed to address the limitations of its predecessor, Basel I, by focusing not just on credit risk but also on market and operational risks. The central premise of Basel II was that banks should hold enough capital to cover their risks, with the amount of required capital being determined by the risks a bank took on.

Operational risk, in particular, was given much greater emphasis under Basel II. This category of risk includes losses due to failures in internal processes, people, systems, or external events. The Basel Committee recognized that as banking activities became more complex, the potential for significant operational losses increased, making it essential for banks to manage these risks more effectively.

The Basel II Challenge on Operational Risk

One of the key challenges Basel II presented to banks was the requirement to “devote the necessary resources to quantify the level of such risks and to incorporate them into their assessment of their overall capital adequacy.” In other words, banks were expected to not only identify their operational risks but also to quantify them in a way that would allow these risks to be integrated into their capital requirements.

However, this was easier said than done. Quantifying operational risk is inherently difficult because it often involves factors that are not easily measurable, such as the potential impact of a system failure or the likelihood of a human error leading to a significant loss. Despite these challenges, Basel II set the expectation that banks would find a way to meet this requirement.

The Industry’s Response: Risk & Control Self-Assessment (RCSA)

In response to Basel II, the banking industry widely adopted a method known as Risk & Control Self-Assessment (RCSA) to manage operational risks. RCSA involves assessing risks and controls within an organization, typically by using a color-coded system (red, amber, green) to indicate the severity of risks and the effectiveness of controls.

While RCSA provided a structured approach to identifying and assessing risks, it fell short in several key areas. As Peter Hughes noted, “colors can’t be aggregated or compared, which severely impedes risk oversight and governance.” This means that while RCSA could help banks understand where their risks lay, it did not provide a clear way to quantify these risks or compare them across different parts of the organization.

The lack of a standardized method for quantifying operational risks led many banks to develop their own internal models. These models, collectively known as the Advanced Measurement Approach (AMA), were designed to analyze historical loss data and estimate the potential for future losses. However, the AMA proved to be highly complex and difficult to compare across institutions, leading to criticism and eventual withdrawal from the regulatory framework.

The Shortcomings of the Advanced Measurement Approach (AMA)

The AMA was initially embraced by Basel II as a sophisticated method for calculating operational risk capital requirements. It allowed banks to use internal models to determine the amount of capital they needed to hold against potential operational losses. However, over time, the AMA became a source of frustration for both banks and regulators.

The complexity of the AMA models, coupled with their lack of comparability, made it difficult for regulators to assess the true level of operational risk within the banking system. Moreover, the reliance on historical loss data meant that these models were backward-looking, focusing on past events rather than providing a forward-looking assessment of future risks.

In 2017, the Basel Committee decided to phase out the AMA, citing these inherent weaknesses. This decision highlighted the need for a more effective and standardized approach to managing operational risks — an approach that could offer greater transparency and comparability across the industry.

The Need for a Paradigm Shift

The challenges and shortcomings associated with Basel II and the AMA underscore the need for a new approach to risk management — one that can more accurately quantify and report risks.

 This is where risk accounting comes into play.

As discussed in previous articles, risk accounting offers a way to integrate risk measures directly into financial statements, providing a forward-looking view of a company’s risk profile. By quantifying and aggregating risks, risk accounting allows for better oversight and governance, addressing the very issues that plagued the RCSA and AMA methods.

Furthermore, risk accounting can help overcome the limitations of the Basel II framework by providing a standardized method for measuring and reporting operational risks. This would not only improve the comparability of risk data across institutions but also enhance the ability of regulators to monitor and manage systemic risks within the financial system.

How Risk Accounting Can Help

Risk accounting can address many of the shortcomings of Basel II and the AMA by:

  1. Standardizing Risk Quantification: By providing a consistent method for quantifying operational risks, risk accounting allows for better comparability and transparency across the banking sector.
  2. Enhancing Risk Oversight: Risk accounting integrates risk measures into financial statements, enabling more effective oversight and governance. This helps address the limitations of methods like RCSA, which struggle with aggregation and comparison.
  3. Improving Regulatory Frameworks: Risk accounting offers a forward-looking approach that can complement existing regulatory frameworks, providing regulators with more accurate and timely information about the risks facing the financial system.
  4. Facilitating Better Decision-Making: With a clearer understanding of their risk profile, banks can make more informed decisions about capital allocation, risk management, and strategic planning, ultimately leading to a more resilient financial system.

A Brief Introduction to Risk Accounting

For those new to the concept, risk accounting is an innovative approach that combines traditional accounting practices with advanced risk management techniques. It involves identifying, quantifying, and aggregating risks across an organization and incorporating these measures into financial statements. This provides a more comprehensive and transparent view of a company’s financial health, helping to prevent future financial crises.

Conclusion

The challenges faced by the banking sector in responding to Basel II highlight the need for a new approach to managing operational risks. Risk accounting represents that new approach, offering a way to quantify and report risks more effectively, thereby enhancing financial stability.

As we continue this series, we’ll explore further aspects of risk accounting and how it can be applied to address the most pressing issues in the financial industry today. For those interested in learning more about risk accounting, additional resources are available to deepen your understanding of this critical innovation.

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