Archive for category Risk & Stability

Date: September 20th, 2012
Cate: Finance, Risk & Stability, Systems

Organizationally induced catastrophes by Charles Perrow

Charles Perrow is an excellent and original systems thinker.  Perrow’s book Normal Accidents should be required reading for engineers, designers and anyone responsible for the safety and risk management of a large system, physical, financial or social.

Perrow’s understanding of tight coupling, contingency, complexity and hidden paths in systems is top notch. He uses real world examples to bring these concepts to life.  One thesis posited by the paper is that as small systems integrate and become tightly coupled they form a larger discrete system which becomes prone to collapse and catastrophe than the original smaller isolated systems. Integration of this type in pursuit of economic efficiency, power and influence leads to the ultimate collapse of a large system.

The implicit argument is that decentralized (federated/discrete) systems are longer term stable and resilient than monolithic systems.  Historical and contemporary study of overly centralized homogenous governments, banking and social systems tightly coupled acting in unison provide numerous examples of this critical failure thesis.

My personal concern is the global unified banking risk system known as Basel 3.

Here is a paper Perrow posted many years ago. Some other of his papers can be found here.

Date: August 3rd, 2012
Cate: Risk & Stability, Systems

Geoffrey West gets complexity.

This is a great video, for those who have a little complexity background.  I just wish West would mention constructal theory.  Constructal theory talks about the structural changes required for various scaled flow rates.  I mention structural flow changs and innovations in my new book.

If someone can tie biology and constructal theory into the Fiegenbaum constant, that would totally rock.  It would be a nice systems theory for biology and evolutionary process. Most likely it could be incorporated with an entropy and dissipation model factor model.  Biology could become like a fuzzy form of physics both some homestatic and homeorhetic fuzzy boundaries and trajectories. Sweet!

If you dig this video, check out West’s TED talk. He definitely has a lucky “talk” shirt which serves him well in both presentations.

Date: July 24th, 2012
Cate: Risk & Stability, Systems
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A great paper on how networks become brittle due to interconnection

This is a rare document which understands how networks function and how things are interconnected.  My own opinion is that the network of society is more resilient than illustrated and will bounce back, but the reality of cascading failures and overly centralized architecture are very valid.

This is a great document using the correct language of degraded performance, cascading failure and resiliance.  It is worth the read and highly educational.  Copyright warning, I have posted this is scribd, hoping it gets a larger audience. It is the work of Feasta.

Date: July 24th, 2012
Cate: Finance, Risk & Stability, Systems

Excellent video on complexity in finance and systems. relates CDS to oil rigs and normal accidents.

Ht to Farnam Street

An excellent introduction to tight coupling, feedback and systems.  The piece also includes normal accidents, safety systems leading to normalized risk and hidden paths in systems that induce risk.

Date: July 16th, 2012
Cate: Finance, Risk & Stability, Systems
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Non-normality and financial risk

Andrew Haldane at the Bank of England often presents information in very clear forms.  Here he attacks the normality assumptions found in many financial models.  The systems thinker will not be surprised.  Enjoy the paper, it is very good.

Date: May 1st, 2012
Cate: Finance, Risk & Stability

Clarity of thinking and risk: 20 lessons forgotten from 2008 (Seth Klarman)

Seth Klarman manages an estimated $23 billion for his hedge fund Buapost group. He has an excellent sense of risk and an ability to convey his thoughts. Here is an excerpt:

Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

Full text with all 20 lessons is available here at the top notch blog, Farnam Street.

Date: April 18th, 2012
Cate: Finance, Risk & Stability

When central bank balance sheets go boom.

As liquidity disappeared in 2008, central bank’s balance sheets as a percentage of GDP exploded as the public/private central banks stepped into the liquidity breach buying everything in sight while simultaneously lowering rates. The interesting lack of inflation during this period of monetary expansion/creation is a serious indication of the destruction of money and credit that went on in the private sector.

With corporate balance sheets groaning with cash and liquidity appearing to have returned, the question remains; what next? Low rates and massive balance sheets for the next few years, or try to deflate central bank balance sheets.  Current interest rate levels and swollen balance sheets indicate central banks believe the crisis to be far from over. Or, perhaps like Japan the dominance of  central banks in the debt markets is now fashionable. It all feels quite uncomfortable and the Spanish party hasn’t even started yet.

Date: January 13th, 2012
Cate: Finance, Risk & Stability, Systems
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Equity drawdowns 1871-2011, the long wait.

People experience risk as a visceral reaction in the form of anxiety, anger and depression related to a sense of loss. The drawdown is a graphic way of showing this experience. The peak to trough drawdown is shown by plotting the last high water mark of a data series as 0 and showing how declines unfold before equalling or creating a new high water mark.

The drawdown tool only makes sense with an ever increasing time series.  Quantitative analysts use volatility to express risk, but many decisions are made based on perceptions. Drawdown is a good way of understanding those perceptions and the patience that may be required with paper loss experience. Being a value investor helps some people to ignore price fluctuations while they focus on intrinsic value.

Plotting a drawdown series is also a good way to understand what holding an asset may feel like. 20 years can seem like a long time to get up to break even. The graph below doesn’t include dividend payments or the impacts of inflation on purchasing power of the asset.

The graph below is taken from a full article available on Seeking alpha entitled The trillion dollar trading system 1871-2011.

S&P 500 peak to trough drawdown 1871 to 2011

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