Monday, 22 July 2013

Beyond the concepts of Risk and Risk Management

The current economic crisis indicates that conventional risk assessment, rating and management techniques don’t perform well in a turbulent and global environment. AAA-rated companies and banks have suddenly failed, demonstrating the limitations of not only risk management techniques but also the need to re-think the expensive and sophisticated Business Intelligence and Corporate Performance Management infrastructure that modern corporations have relied on. But what are the origins of the financial meltdown that is spilling over into the real economy? Why is the economy increasingly fragile? We identify three main causes: excessively complex financial products, globalized financial markets that lack regulations and usage of subjective computational models that are naturally limited to less turbulent scenarios.

Models are only Models. No matter how sophisticated, a model is always based on a series of assumptions. More sophistication means more assumptions. Classical risk evaluation models, because of their subjective nature, are inherently unable to capture the unexpected and pathological events that have punctuated human history, not to mention the economy. But there is more. Conventional Business Intelligence is unable to cope with the hidden complexity of a modern global corporation precisely because it thrives on unrealistic mathematical models. Once defined, a model is condemned to deliver only what has been hard-wired into its formulation. However, a difficulty in analysing our inherently turbulent economy and, more specifically, financial instabilities, lies in the fact that most of the crises manifest themselves in a seemingly unique manner. Life very rarely follows a Gaussian distribution and the future is constantly under construction.


Excessively complex financial products have spread hidden risks to every corner of the globe. Their degree of intricacy is such that they are often beyond the control of those who have created them. Derivatives of derivatives of derivatives …. The speculative use of such products creates an explosive mixture. Because of the global nature of our economy, and due to its spectacular degree of interconnectedness, such products are an ideal vehicle for creating and transmitting uncertainty.

Uncertain and global economy. It is because of the laws of physics that our economy is increasingly uncertain, unstable and interconnected. This means that it is becoming increasingly complex and turbulent. Conventional methods that rely on mathematical models are unable to capture and embrace this complexity, not to mention predict crises. The increase of complexity is inevitable and globalization is an inevitable consequence of the growth of complexity.

Complexity is a fundamental property of every dynamical system. Like many things, it can be managed provided it can be measured. As for most things in life, when managed, complexity becomes an asset. When ignored, it becomes a liability, a time bomb. Because of the laws of physics, the spontaneous increase of complexity in all spheres of social life is inevitable. Like for most things in life, every system possesses its own maximum level of sustainable complexity. Close to this limit, known as critical complexity, it becomes fragile, hence vulnerable. This is the fundamental reason why each corporation should know its value of complexity, as well as the corresponding critical value.

Complexity can be measured. Ontonix is the first company to have developed and marketed a radically innovative and unique technology for rational quantification and management of complexity. Introduced in 2005, OntoSpace™, our flagship product, is the World’s first complexity management system. While others struggle with definitions of complexity, we have been measuring the complexity of banks, corporations, financial products, mergers, or crises already since 2005. Our complexity measure is objective. It is natural. No fancy mathematics, statistics or exotic models. A 100% model-free approach guarantees an objective look at a corporation.

Hidden and growing complexity is the main enemy of a corporation. A corporation may still be profitable but close to default. Highly complex systems are difficult to manage and may suddenly collapse. Excessive complexity is the true source of risk.
Critically complex systems become almost impossible to manage, hence are vulnerable and greatly exposed to both internal and external sources of uncertainty.  

Complexity X Uncertainty = Fragility™. This simple yet fundamental equation has been coined by Ontonix and establishes the philosophy and logic behind our technology and services offering. The bottom line is simple: a complex business process, operating in an uncertain environment, is a fragile mix. Since the uncertainty of the global economy cannot be easily altered, in order to operate at acceptable levels of fragility one must necessarily reduce the complexity of the corresponding business model. Based on this logic Complexity Management goes beyond Risk Management and establishes a new underlying paradigm for a superior and holistic form of Business Intelligence. A technology of the Third Millennium.

Conventional techniques provide insufficient to insure against all future contingencies.
There are numerous recent examples of AAA-rated corporations that have suddenly defaulted or are in serious difficulty. The collapse of the Lehman Brothers Bank is a prominent case.  Based on the financial highlights of the bank in the period 2004-2008, our analysis has indicated how a quickly increasing complexity provided crisis precursors, hinting more than a year before default that the system was in difficulty. Evidently, the management was unaware that complexity was sky-rocketing as it is invisible to conventional methods. 

The bottom line: manage complexity.