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In a recent article on the CNN website, dated October 28-th, 2008, we read as follows:
(Fortune Magazine) -- If you visit Lehman Brothers' website today, more than a month after the investment bank's plunge into bankruptcy, you can still find the following words: "The effective management of risk is one of the core strengths that has made Lehman Brothers so successful." That boast now reads like a bitterly ironic epitaph. But there was a time not so long ago when such a statement was widely believed to be true - not just for Lehman, but for Wall Street in general. News accounts in 2007, for example, routinely described Bear Stearns as being "known for its tough risk controls."
While it is true that "victory has a thousand fathers, but defeat is an orphan", we sustain that in the endless list of causes of the global crisis, some misconceptions about numerical models, mathematics, computers, as well as a few very basic human instincts, play a key role. Here they are:
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Greed.
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The mini-max principle: the desire to maximize one's gains in the shortest possible time, with the smallest possible risk and with the smallest possible investment. This is called optimization. The gateway to fragility. Another form of greed.
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The philosophy whereby wealth manipulation is preferred to wealth generation. Speculation instead of hard work.
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The belief that super-sophisticated computer models, run on huge expensive computers, represent correctly reality and can predict the future.
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The belief that we live in a static world. In reality, the world is uncertain, definitely non-linear, and the future is always under construction.
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The belief that if you have N components, they can be treated (e.g. optimized) separately then glued together to solve the big problem. This form of thinking is known as reductionism. We favor holism - looking at the global picture, see the image below.
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The belief that A + B is always equal to B + A.
One of the consequences of the above is injection of huge amounts of entropy (uncertainty) into the economy. But high entropy in the economy puts computer models under increasing pressure. Decisions based on such models are increasingly less reliable, pumping further entropy into the system. In a globalized economy the effects of bad decisions, fraud or defaults spread very quickly to all the nodes of the global network. This network - also known as the ecosystem - is tremendously dynamic and cannot be understood, not to mention analyzed, employing conventional techniques. Below we illustrate a corporation as it interacts with its own ecosystem.
Classical computer models focus on the corporation, without taking into account the ecosystem in which it operates. In our work with our customers we are finding that a substantial part of the increase in corporate complexity is of exogenous origins. In other words, the genesis of the problems lies outside of the company! The management may be smart but it is the ecosystem that drives the corporation (sometimes into the ground). Our recipe to cope with the situation is as follows:
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Assemble a global (holistic) model of your business.
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Obtain the corresponding Complexity & Risk Map - similar to the one above. Understand its structure, its hubs, weak points.
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Measure and track the complexity - pay attention to sudden changes as these are never a good omen.
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Keep your business at a safe distance from critical complexity.
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Go beyond conventional risk management. Do complexity management instead.
In a tightly interconnected (globalized) and turbulent economy, risk management doesn't apply. It's a thing of the past. Those who understand how Computational Fluid Mechanics (CFD) works, know the consequences of using laminar flow methods to analyze turbulent flow.
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