The New Era of Global Risk Management

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The New Era of Global Risk Management

The recent financial crisis has forced us all to come to grips with a fundamental reality of managing risk:  You can only expect to receive exceptional returns if you are willing to take exceptional risks.   As a number of recent books and articles have shown, the standard practice of assuming a "normal distribution" of independent risks is often not prudent.  What appear to be very rare, but totally cataclysmic events, occur far more frequently than most people want to admit, and those risks tend to cluster in ways that few take seriously beforehand.

The 2009 World Economic Forum in Davos, Switzerland1 focused heavily on this reality and on new ways of thinking about risk management on a global basis.  As the attendees learned, individuals, firms, and countries need to think not only in terms of isolated risks, but in terms of interdependent risks.  That is, planning for the ways risk factors often interact like a set of dominoes; one triggers others, and those trigger still more. 

A word about "tightly-coupled systems" is in order.  In his landmark 1984 book, Normal Accidents,2 Yale sociologist Charles Perrow coined the term "system accidents."  In his analysis, certain types of accidents were found to be inevitable in systems that were complex enough and whose components were tightly coupled — that is, the various components could influence one another strongly.  The large number of components and their strong influence on one another meant that no one could predict the outcome of all their interactions.  While Perrow was seeking to explain accidents in systems such as the space shuttle, airliners, and nuclear reactors, his theory has also been applied broadly to systems like markets and economies. 

Markets and economies have many tightly-coupled components that influence one another strongly.  As a result, unexpected interactions can occur among the components.  For example, selling by one group of people in a market can influence others to sell, producing a market crash.  Small forces can set such a reaction in motion, and to use Perrow's words, "processes happen very fast and can't be turned off… recovery from the initial disturbance is not possible; it will spread quickly and irretrievably for at least some time… What distinguishes these interactions is that they were not designed into the system by anybody."

This is a good description of the present economic crisis and suggests that the way we manage risk needs to be improved dramatically...

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