The case for “Complexity Analysis”: Blind faith, Greek philosophy and risk
Wednesday, 24 February, 2010 1 Comment
Unless you have been living in a cave you WILL be aware that the global financial sector has FAILED. It is “shot”! The models upon which the largest institutions and corporations quantified risk are discredited as are the rating agencies who wield such power over entire nations.
No-one could have seen it coming. Right?
WRONG. ABOUT AS WRONG AS YOU COULD BE!!! The warnings were out there. Not from fortune-tellers, soothsayers, prophets of doom and mad men. They, like those that relied upon their own intuition, would probably been marginalised or dismissed. But when warnings came from economists and academics you would have thought that the stakes were sufficiently high, to, at least, listen to what they had to say. NOPE. The most popular course was to ridicule what has since been shown to be the “inconvenient truth”.
So when “the shit hit the fan”, particularly, in such spectacular fashion, one might have imagined that the High Priests of money would “cast out the false idols”, openly embrace new wisdom and means of worship with humility. WRONG AGAIN. Keep the (illusion of) faith.
Despatch the elders to gather in further financial offerings from the worshippers who, after all, have shown themselves so (gullible) reliable when faced with past tests (crises) of faith. The message: tell them it is down to “a temporary disturbance in the force” or whatever you need to, to keep the money rolling in.
Reassure worshippers of the power of prayer. Divert and distract with debate about new (more effective and inclusive) forms of worship…but maintain the status quo. As we can no longer do away with “heretics” deal with them as you did in at the time of past crises.
Serve us well and you will be rewarded with elevation to the Priesthood with the promise of power and riches.
PROBLEM: The game is up. Worshippers are better informed, willing and able to communicate their disquiet and to co-ordinate to bring about much needed change. The very ability to share concerns and to collaborate on solutions gives an unprecedented power of “the crowd”. Power that institutions would do well to recognise because the crowd (WE) can and will determine if an old faith still has relevance. Who is to say, that with a righteous cause, leadership and tools, a group of “heretics”, can’t form a cult…or a new religion!?
Risk and rating models that rely solely upon historical (and incomplete) “class” data are not adequate for an increasingly inter-connected and complex world.
The data can and does lie!
A man says that he is lying. Is what he says true or false?
We may have moved on from the 4th century in many ways. And on many occasions business has been successfully conducted irrespective, even inspite, of statements (or data) being false. That does not make it right and, as we already know, in an inter-connected, globalised, world can we still work on this basis? The following, from Nassim N Taleb & A Pilpel (in Risk & Regulation Magazine, 2007) sums it up better than I ever could:
“This is a problem of self reference…since a probability distribution is used to assess the degree of truth – but cannot reflect on its own degree of truth and validity. And, unlike many problems of self reference, ones related to risk assessment have severe consequences”.
“If one needs data to obtain a probability distribution to gauge knowledge about the future behaviour of the distribution from its past results, and if, at the same time, one needs a probability distribution to gauge data sufficiency and whether or not it is predictive of the future, then we are facing a severe regress loop”.
Let’s not be fooled…the data is not the only problem!
Please take a look at an excellent presentation “Paradigm Shift from Risk to Uncertainty” from Jason Jones, of Jones Consulting. Some much needed common sense on issues that too many in the industry appear all too ready to, at best defer or, at worst ignore.
SO WHAT WE NOW KNOW, EVEN FROM THESE FEW PIECES OF INFORMATION, IS THAT THE INSURANCE INDUSTRY (AND BROADER FINANCIAL SECTOR) NEED TO “GET OUR OWN HOUSE IN ORDER” BEFORE WE CAN EVEN ATTEMPT TO TACKLE THE CHALLENGE OF REBUILDING TRUST.
THE “MISSING PIECE” OF THE JIGSAW IS: HOW TO RELIABLY MEASURE THE ROBUSTNESS OF AN ENTITY OR SYSTEM? THE DREADED CONVENTIONAL WISDOM TELLS US THAT “YOU CAN’T MANAGE WHAT YOU CAN’T MEASURE”.
WITH THE DEVELOPMENT OF A MODEL-FREE COMPLEXITY MANAGEMENT SOLUTION COMES THE ABILITY TO MEASURE AND MANAGE SO MUCH MORE THAN HAS EVER BEEN POSSIBLE BEFORE SO THE NEW WISDOM STATES THAT “YOU CAN’T MANAGE WHAT YOU DON’T MEASURE”.
I WILL BE INTRODUCING THESE, PATENTED, CAPABILITIES INTO UK IN THE NEAR FUTURE AND WOULD BE HAPPY TO SPEAK TO ENLIGHTENED INDIVIDUALS WITHIN THE INSURANCE, BANKING AND CREDIT SECTORS ABOUT WORKING TOGETHER TO ANALYSE EXISTING PORTFOLIOS AND TO DEVELOP YOUR COMPETITIVE ADVANTAGE THROUGH JOINT CREATION OF COMPLEXITY BASED PRODUCTS AND SERVICES.
Conventional ratings, such as those issued by rating agencies, focus on the financial aspects of a business. While this is important, it is not sufficient to provide a global idea of the overall state of health of a corporation.
We recognise essence of Zadeh’s Principle of Incompatibility – highly complex systems cannot be described precisely.
Complexity-based ratings are stratified into five levels (below). Complexity-based ratings focus entirely on structural aspects of a business not on its financials or financial performance. Excessive complexity of a business is a fundamental source of its risk exposure as it points to a structure that is fragile and, therefore, vulnerable to both endogenous and exogenous risk sources. Since excessive complexity is a “disease” which is invisible to conventional techniques, the idea of a complexity rating is to establish a marker which can expose it. Moreover, high complexity is undesirable because it may lead to surprises and unexpected behaviour.
1-Star: The business is globally close to its critical complexity. Its structure is weak. The business is unsustainable and very fragile. Exposure is very high and the business is highly inefficient and very difficult to manage. It is impossible to make forecasts and define realistic goals.
2-Star: The business is highly complex and difficult to manage and control. Exposure is high as well as inefficiency. The structure of the business is fragile, hence vulnerable. It is difficult to make forecasts.
3-Star: Business complexity is moderately high but its structure is fairly robust. Predictability is acceptable. Exposure is moderate.
4-Star: Low complexity points to a robust business structure. Predictability is high, exposure is low. Business sustainability is quite high. The same may be said of efficiency.
5-Star: Very low complexity indicates a very strong business structure as well as very low exposure. The business is manageable and it is possible to make credible forecasts. The business is potentially highly sustainable and efficient.