Risk accounting and risk management for accountants

Risk Accounting and

Risk Management

for Accountants

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AMSTERDAM • BOSTON • HEIDELBERG • LONDON • NEW YORK • OXFORD

PARIS • SAN DIEGO • SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO

CIMA Publishing is an imprint of Elsevier

Risk Accounting and

Risk Management

for Accountants

Dimitris N. Chorafas

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CIMA Publishing is an imprint of Elsevier

Linacre House, Jordan Hill, Oxford OX2 8DP, UK

30 Corporate Drive, Suite 400, Burlington, MA 01803, USA

First edition 2008

Copyright © 2008, Dimitris N. Chorafas. Published by Elsevier Ltd. All rights reserved

The right of Dimitris N. Chorafas to be identified as the author of this work has been

asserted in accordance with the Copyright, Designs and Patents Act 1988

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A catalogue record for this book is available from the Library of Congress

ISBN: 978-0-7506-8422-4

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Contents

Preface ix

Part 1: Risk and the Accounting Profession 1

1 Volatility, Uncertainty and Non-traditional Risks 3

1. Risk defined 5

2. Non-traditional risks 7

3. Volatility patterns 11

4. Financial derivatives 14

5. Risk is a cost 17

6. The science of risk management 19

2 Risk Management and the Accountant 23

1. Beyond classical accounting 25

2. Thinking out of the box 27

3. Case studies: GE and Amaranth 30

4. Newton’s principles in analytics 32

5. A risk protection strategy 34

6. Pareto’s law in management accounting 37

7. Using the cash account for risk control 40

3 Duties and Responsibilities in Risk Accounting 43

1. The accountant’s mission in risk control 45

2. Creative accounting 47

3. Business risk 51

4. Business risk factors: an example 54

5. Monitoring assets and liabilities 57

6. IFRS, accounting standards and transparency 61

7. Personal accountability 64

4 Accounting for Total Exposure: A Case Study 67

1. Understanding total exposure 69

2. A real-life case study on total counterparty risk 73

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3. Understanding where the risks really lie 75

4. Correlation coefficients 78

5. Correlations are specific to the institution 82

6. Confidence intervals 84

7. Dynamic financial analysis 90

Part 2: Risks to be Kept Under Close Watch 93

5 Credit Risk 95

1. Credit risk defined 97

2. Counterparty risk 100

3. Counterparty risk with hedge funds: a case study 103

4. Credit policy 106

5. Corporate lending and collateral 110

6. Credit and other limits 113

7. Stress tests for credit risk 116

8. SPD, SLGD, SEAD 118

6 Credit Risk Mitigation 123

1. Concepts underpinning credit risk transfer 125

2. For and against credit derivatives 128

3. Exposure associated with credit risk transfer 130

4. Collateralized debt obligations 133

5. Credit default swaps 137

6. The market for credit derivatives and its liquidity 140

7 Market Risk 145

1. Market risk defined 147

2. Trading book risk 149

3. Challenges to valuation of the trading book 153

4. Interest rate risk and organizational risk 156

5. Interest rate risk and foreign exchange risk 159

6. Stress tests for market risk 162

8 Position Risk 165

1. Position risk defined 167

2. Credit risk concentration 169

3. Market risk concentration 172

Contents

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4. Position risk with debt instruments 174

5. Position risk with equities 177

6. Risk appetite 181

7. Risk of ruin 184

9 Beyond Credit Risk and Market Risk 189

1. Liquidity risk 191

2. Event risk 194

3. Legal risk 196

4. Longevity risk: a case study 200

5. Payments risk 203

6. Risk must be controlled intra-day 205

Part 3: Risk, Regulation and Management Control 211

10 Basel II and the Accountant 213

1. The Basel II framework 215

2. Competitive impact of Basel II 217

3. Accounting-based indicators 220

4. Tier-1, Tier-2, Tier-3 capital and the hybrids 223

5. The high risk of too little capital: a lesson from QIS 4 and QIS 5 227

6. Innovation in risk management: market discipline and

operational risk 232

7. Return on investment from Basel II would be better governance 236

11 Risk-based Pricing 241

1. Counting the odds 243

2. Primary and consequential risks 245

3. Pricing risk 248

4. Mispricing credit risk 250

5. Marking to market 254

6. Marking to model 256

7. Beyond valuation models 258

12 Board of Directors and Risk Management 263

1. Risk control requires unconventional thinking 265

2. The board’s responsibilities in macroeconomics 268

3. A devil’s advocate in risk management 272

Contents

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4. Risk management is like pre-trial preparation 275

5. Helping board members to understand risk and return 278

6. The risk management committee of the board 281

7. The board’s responsibility for reputational risk 284

Index 289

Contents

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Preface

The champions of tennis tournaments are those who play every point as if it is a

match decider. If we were to describe in one brief sentence the core functions of

risk accounting and of risk management, then this is it.

This book has been designed and written for accounting professionals who are

increasingly confronted with challenges associated with the control of exposure.

The text is based on extensive research in the United States, England, Germany,

France, Italy, Switzerland and Sweden. Its orientation is practical; therefore, it

includes plenty of case studies, which help in guiding the hand of the reader in

the new realm of accounting functions.

Because the best weapon one has against any type of risk is knowledge of what

is happening in business today, the text starts with two fundamental factors

underpinning risk: volatility and uncertainty. Then, in a comprehensive way, it

presents how and why accounting, auditing and risk control correlate.

The themes covered in Part 1 include what the accountant needs to know

about risk and risk management, as well as duties and responsibilities associated

with risk accounting. One of the focal points is business risk; another is a com￾prehensive presentation of correlation coefficients, confidence intervals and

dynamic financial analysis – enriched with case studies.

The text outlines the reasons why risk accounting and risk management are

forward accounting functions, whose exact design varies with their implementa￾tion. Therefore, they must be examined within the perspective of each company’s

business challenges.

The themes included in Part 2 are credit risk, stress testing of credit risk, credit

risk mitigation through credit derivatives and swaps, market risk, stress testing of

market risk, position risk, and issues beyond credit risk and market risk. The lat￾ter include liquidity risk, event risk, legal risk and payments risk.

The reason for taking this holistic view, which has been a deliberate choice, is

that risk accountants and risk managers must look for smoke at many areas of

operations – and they should do so almost at the same time. If smoke indicates

fire, then delays in damage control may confront them with a four-ring alarm

blaze. Risk management is not child’s play.

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Part 3 addresses Basel II, risk-based pricing, and the need that members of the

board of directors understand and appreciate risk accounting. The models promoted

by Basel II are, in essence, risk accounting tools, expressed in a general form, and

need to be personalized by every institution because averages are very bad advisors.

The text critically examines the results of recent quantitative impact studies

(QIS 4 and QIS 5) and finds them wanting. It also focuses on the aftermath of cur￾rent mispricing of credit risk, and on problems connected to marking to market

and marking to model. With this background, it emphasizes the guidelines top

management needs to establish, and the role of internal control in assuring that

limits to exposure are observed:

● With any trade or investment

● With any counterparty

● At any time, and

● Anywhere in the world.

One of the challenges present in every company, and most particularly a finan￾cial institution, is that most directors are not intimate with the issues connected

to a galloping exposure due to novel derivatives and risk-mitigation instruments.

This issue is addressed by the last chapter of the book, with advice given on how

to be a devil’s advocate through risk accounting facts and figures.

Unlike fishermen who talk about the one that got away, risk accountants and

risk managers prefer stories about the risks they landed. Risk control is not a mat￾ter of avoiding exposure. If so, it would resemble suicide for fear of death.

Instead, the very core of risk accounting and risk management is to be at all times

in charge of exposure.

I am indebted to a long list of knowledgeable people, and of organizations, for

their contribution to the research that made this book feasible. Also to several

senior executives and experts for constructive criticism during the preparation of

the manuscript.

Let me take this opportunity to thank Mike Cash for suggesting this project,

Claire Hutchins for seeing it all the way to publication and Geoff Crane for the

editing work. To Eva-Maria Binder goes the credit for compiling the research

results, typing the text, and preparing the camera-ready artwork and index.

Dimitris N. Chorafas

Preface

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Part 1

Risk and the Accounting

Profession

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Volatility, Uncertainty and

Non-traditional Risks

1

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