Monday, July 13, 2009

Complexity, Predictability, and Cascade Effects

Duncan Watts has a great piece in the The Boston Globe titled, “Too Complex to Exist.” I love the illustration:


Some excerpts:

ON AUG. 10, 1996, a single power line in western Oregon brushed a tree and shorted out, triggering a massive cascade of power outages that spread across the western United States. Frantic engineers watched helplessly as the crisis unfolded, leaving nearly 10 million people without electricity. Even after power was restored, they were unable to explain adequately why it had happened, or how they could prevent a similar cascade from happening again - which it did, in the Northeast on Aug. 14, 2003…

Traditionally, banks and other financial institutions have succeeded by managing risk, not avoiding it. But as the world has become increasingly connected, their task has become exponentially more difficult. To see why, it's helpful to think about power grids again: engineers can reliably assess the risk that any single power line or generator will fail under some given set of conditions; but once a cascade starts, it's difficult to know what those conditions will be - because they can change suddenly and dramatically depending on what else happens in the system. Correspondingly, in financial systems, risk managers are able to assess their own institutions' exposure, but only on the assumption that the rest of the world obeys certain conditions. In a crisis it is precisely these conditions that change in unpredictable ways.

In the article Watts proposes some regulatory steps to limit the complexity of financial systems. I am not optimistic; it is very hard to restrict activities until a problem is obvious (see my post “Rising Markets Create Lender Losses” for more on this). I think a more pragmatic route is for institutions to create firewalls within the organization so that the failure of one business line doesn’t take the whole institution down (e.g., AIG’s CDS operation pulling down the insurance business).