42

FINANCIAL RISK MANAGEMENT

cases, to also serve as protection against litigation. Note that the need to
ensure the suitability of transactions to clients and the need to provide
clients with evaluations that the trading firm can certify as reliable limit
a trading firms ability to simply serve as a credit intermediary between
two counterparties using backtoback derivatives.

3.4

ACCOUNTING RISK

Accounting risk can be viewed as a form of reputational risk. When a firm

makes serious accounting errors, requiring the restatement of past earnings, it does not lead to any net loss of cash to the firm, as in cases of fraud,
operations errors, or incorrectly drawn contracts. However, it can damage
investor, creditor, and regulator confidence in the accuracy of information
that the firm supplies about its financial health. This loss of confidence can
be so severe that it threatens the firms continued existence, as the Kidder
Peabody financial disaster, discussed in Section 4.1.2, illustrates.
Measures to control accounting risk are similar in nature to those needed to control legal risk. Instead of needing knowledge of legal issues and
precedents and how courts tend to interpret the law, knowledge of generally accepted accounting principles (GAAP) and how accounting boards
of standards and regulatory authorities tend to interpret these principles
is needed. The need for specialized knowledge by accounting jurisdiction
is similar to the need for specialized knowledge by legal jurisdiction. The
need to obtain independent accounting opinions and avoid opinion shopping parallels those considerations for legal risk. The need for thorough
documentation showing that accounting rules are being followed parallels
the need for thorough documentation of contractual understandings. The
need for limits on exposure to accounting policies open to interpretation
parallels the need for limits on exposure to legal interpretation.

3.5

FUNDING LIQUIDITY RISK

Funding liquidity risk should be clearly differentiated from the liquidity risk
we discussed as part of market risk in Section 1.2, which is sometimes called
asset liquidity risk.
Funding liquidity risk has two fundamental components:
1. The risk that investors perception of the firms credit quality will become impaired, thereby raising the firms funding costs relative to the
costs of competitors across all funding sources utilized.