Against the backdrop of financial crisis, a distinguished group of academics and practitioners discusses the contribution of financial management and innovation to corporate growth and value, along with the pitfalls and unintended consequences of such innovation. The main focus of most panelists is the importance of a capital structure and risk management approach that complement the strategy and operations of the business. Instructive examples are provided by Judy Lewent, former CFO and head of strategic planning at Merck, and Lakshmi Shyam-Sunder, director of finance and risk management at the International Finance Corporation.

But if these represent successful applications of finance theory, what about the large number of cases where the use of derivatives and other innovations has led to high leverage and apparent risk management failures? Part of the current trouble, as pointed out by Andrew Lo, can be attributed to the failure of risk managers and their models to account for highly improbable events—the so-called fat tails of the distribution. But, as Robert Merton suggests in closing, there is a more comprehensive explanation for today's problems: the tendency of market participants to respond to potentially risk-reducing financial innovation by increasing their risk-taking in other areas. "What we have here," says Merton, are two partly offsetting effects of innovation—one that is reducing the risk of companies and their investors, and another that is encouraging greater risk-taking. From a social or regulatory standpoint, the goal is to find the right balance between these two effects or forces.

This paper proposes a new approach to improve the way central banks can analyze and manage the financial risks of a national economy. It is based on the modern theory and practice of contingent claims analysis (CCA), which is successfully used today at the level of individual banks by managers, investors, and regulators. The basic analytical tool is the risk-adjusted balance sheet, which shows the sensitivity of the enterprise's assets and liabilities to external "shocks." At the national level, the sectors of an economy are viewed as interconnected portfolios of assets, liabilities, and guarantees-some explicit and others implicit. Traditional approaches have difficulty analyzing how risks can accumulate gradually and then suddenly erupt in a full-blown crisis. The CCA approach is well-suited to capturing such "non-linearities" and to quantifying the effects of asset-liability mismatches within and across institutions. Risk-adjusted CCA balance sheets facilitate simulations and stress testing to evaluate the potential impact of policies to manage systemic risk.