Measuring Systemic Risk: Network Theory Meets Finance Meets Accounting?

One of the main issues the financial crisis brought up is how little we know about measuring systemic risk. Finance and accounting theory can tell us quite a bit about the riskiness of various firms, but very little about the riskiness of a particular industry.

Given that the financial sector in this country at one point accounted for about 40% of the country’s GDP – it’s clear that this industry bears a little more scrutiny than most – but even the best regulations could leave us flat-footed again – and will. If we could somehow measure the riskiness of the industry in real time (or near real time) we might just be able to prevent or minimize future calamities. But how?

Sean Safford over at orgtheory.net brings ups 3 questions that get to the heart of the problem. I’ll mention some ways I think these questions could be answered.

1. First, measurement: How would one measure the network connectedness of companies in a way that could adequately inform policy? Many a network analyst would give up a limb in return for a government mandate requiring companies to provide network data of this kind. But which network ties are the most relevant when it comes to robustness? Cross-holdings? Joint ventures? Insurance instruments

At the most simplistic level, flows between firms can be measured by looking at their Accounts Payable (AP) and Accounts Receivable (AR) data. Most often these transactions can be used to setup a social network because most accounting software links individual transactions back to a supplier or client which in turn has a unique federal id number. Using this federal id number you could create a solid maps of dollar flows between companies.

Besides dollar flow data between firms, the average AP and AR days can tell you a lot about how a company is positioning itself. If the average AP days jump from 30 to 42 days, there would be good reason to believe that the company is trying to conserve cash. If AR jumps from 30 to 40 days that could mean that a company’s clients are starting to have issues making a payments. Both of these scenarios could be describing increased riskiness in a firm. By pulling together real time financial data like this, one could see the interactions between firms and potentially see system wide trends before they cascade into real problems. While accounting data doesn’t say much about the riskiness of financial instruments or insurance instruments, it could be a step in the right direction.

2. Would the act of publicly measuring these network ties change the network structure? Could simply collecting the data and educating people on what they mean be enough to influence tie formation? Could doing that achieve robustness more effectively than regulating against being “too central to fail”? In what ways might doing that pervert the “organic” process of network formation? What unintended consequences might result?

Honestly, this information could be easy obtain under the right circumstances. If I were the FED, I would require every financial firm to send it raw accounting data on a monthly basis to be analyzed for systemic risk. I would not make this data or the results of this data publicly available. If the FED began seeing warning signs of systemic risk they could summon the relevant firms and regulatory agencies to try to hedge this off. All of this would be behind closed doors. Making this information and the proceedings publicly available would be like inviting children to couple’s counseling – it’s a bad idea.

3. Lastly, a general question concerning the relationship between networks and institutions. Is it a problem of a particular network structure which introduces too much systemic vulnerability? Or is the problem a complex of rules that are too obscure to allow actors to take rational action?

My feeling on this is that there is no set of rules – no matter how simply crafted or wonderfully presented that can anticipate problems to prevent them – sometimes they actually just make things worse. I don’t mean to say there shouldn’t be any rules – but just that trying to control for all possible scenarios is not feasible or even desirable. As I mentioned in my answer to question (2) above, I think it would be much better if the FED or some other institution worked with industry to jointly problem solve on how to mitigate risk. Making such deliberations public would certainly change the behavior of firms and possibly increase risk and uncertainty because folks would get scared (both the firms and the public) and they could make irrational decisions before the issues could be understood and resolved.

via systemic risks: too big, too complicated or too central? « orgtheory.net.