Accounting and Systemic Risk

Professors Trevor Harris and Doron Nissim and Executive-in-Residence Robert Herz discuss their new paper on accounting's role in reporting, creation, and reduction of systemic risk at financial institutions and across the financial system.

The onset of the financial crisis in 2008 brought greater attention to the need to understand systemic risk — the risk that weaknesses in one firm or sector of the economy will set off domino-style, successive failures in connected sectors, sending the broader economy reeling. While measures such as value at risk, or VAR, a technique used to assess the risk of loss on any given set of assets, are available to monitor risk at individual firms, such measures are limited. especially for assessing system-wide risk. And regulators and investors use their own means of interpreting firm financial reports to learn what they can about risk. But the usefulness of financial reports is moderate at best, and can add to the spiral of uncertainty driving the systemic risk at worst, when considered in the context of an individual firm and particularly when interpreted by nonspecialists depending on formulas and ratios to explain risk and a firm’s financial position — let alone across the whole financial system.

In a new paper, Trevor Harris, Doron Nissim, and Bob Herz recommend a more robust approach to assessing systemic risk, in which they use the details of JPMorgan’s financial statements as a high quality sample firm. Line by line, they show how the financial reports and accounting system aids or abets systemic risk during economic crisis, such as how infeasible it is to unearth all the counterparties including other financial institutions that are intertwined with the original firm’s business. In a special conversation with Ideas at Work, they discuss the challenges of assessing systemic risk, how accounting can and cannot help in that assessment, and what’s at stake for our financial system.

See full Article: http://www4.gsb.columbia.edu/ideasatwork/feature/7228593/Accounting+and+Systemic+Risk#