Professional Documents
Culture Documents
Books Taber
Books Taber
What does this concept mean for risk manage- Whether it is Daiwa Bank, Sumitomo Bank, Kidder
ment in the corporation? Imagine that the CEO of Peabody & Company, or Barings Securities, now,
a corporation has been given an omniscient view of the catastrophic risk can easily be described in one
the world, so he can see all possible sources of risk. or two sentences (and described without resorting
Armed with this knowledge, he is then allowed to to Greek letters or statistics). That the risks are
design an approach to risk management but with obvious after the fact is not surprising; after all,
one constraint: Although aware of the all the risks every loss can be explained ex post. It is tempting to
that the company has not identified, the CEO is not think “they should have known” or “how could
permitted to convey any information about these anyone run a firm like that!” But simple as the
risks to others in the company. That is, he can create events turn out to be—and simple as the changes
a structure to address both the seen and the unseen in management or oversight needed to eliminate
risks, but he cannot open up the unseen to view. He the problems—new events continue to catch us
can use full information to create the structure, but unaware.
the resulting structure cannot convey information The root of the problem is not the complexity
that would not otherwise be known. How will the of the unseen risks. The unforeseen events turn out
risk-management structure he designs differ from to be simple. The root of the problem is the com-
the structure he would design if he were never plexity of the organization. This relationship
afforded this omniscient view? between organizational complexity and risk is well
If he follows the lessons from the biological understood in two industries in which a risk-man-
world, he will move resources away from dealing agement failure is measured in lives rather than in
with details of the known risks and reconfigure the dollars: airlines and nuclear energy.
risk-management structure for better response to The airline industry has three categories of
the risks that remain unknown. Knowing that the accident, and each of these categories has a coun-
structure cannot address all the risks, he will terpart in investment management and trading
streamline and simplify formal processes and pro- organizations.2 The first category, procedural acci-
cedures because some of those procedures will dent, covers accidents arising from mistakes in fol-
obscure the unseen risks. He will decide that it is lowing obvious procedures, such as piloting
better to spend less time focusing on detailed inves- without adequate sleep or flying without the req-
tigation of the known risks and more time thinking uisite reserves of fuel. On the trading floor, proce-
and reacting to the unknown risks. Similarly, he dural errors tend to be operational ones, such as an
will simplify the risk-management models and incorrect input or miscommunication of an order.
analyses. Specialized analysis, although important Among the standard procedures for addressing
in providing perspective for what is known, can these sorts of risks are coding buy and sell orders
only coincidentally do the same for the unknown. in different colors and communicating orders in
Coarse measures will be more likely to indicate— full detail.
although perhaps not fully elucidate—areas of The second category, engineering accident,
unanticipated risk. And by being more concise, comprises accidents stemming from structural
these measures will be easier to discuss and analyze problems that, in principle, should have been dis-
intuitively than specialized measures. He will covered during flight tests or routine checks but
reduce the organizational complexity and hierar- were not. On the trading floor, engineering-type
chy of responsibility. This complexity, although accidents lie largely in the realm of market risk and
perhaps effective in a specific environment, will range from model misspecification to incomplete
obscure unidentified risks that fall across organiza- representation of risk factors.
tional lines and slow the company’s ability to The last category, system accident, covers acci-
respond to events that are beyond the intended dents that could not be anticipated and addressed
design and function of the risk-management sys- through detailed procedures or engineering. They
tem. In short, this CEO will eschew pinpoint laser are born from the confusion and interrelationships
targeting of the observed risks in favor of lower- inherent in complex organizations and systems.
resolution, 360-degree radar that is more likely to They have been termed “normal accidents”
capture the unobserved risks. because they are the inevitable, unavoidable “toxic
The unanticipated events that are catastrophic waste” that comes with building and running com-
for a species are not difficult to understand after plex systems (Perrow 1984).
they have happened. We can see that a species was The dilemma of normal accidents is this: Oper-
simply not designed to anticipate and react to cer- ate with a given level of complexity, and over time,
tain events. As recent history has shown, the same you will observe a given number of normal acci-
is true of catastrophic risks in the financial world. dents; add safeguards to try to reduce these acci-
March/April 1999 19
Financial Analysts Journal
dents, and you add complexity that will increase ity and obscurity. Because increased complexity
them. Indeed, the safeguard itself may become the increases the likelihood of normal accidents, this
source of the accident. The ValuJet crash occurred, response will be counterproductive. Indeed, the
for example, because oxygen generators, a required conventional response to the unforeseeable events
safety back-up, were being removed to comply will produce a system “risk cycle” that will lead to
with yet other safety requirements. The near-disas- better and better control of the identified risks but
ter at Three Mile Island occurred because the safety an upward spiral of surprise events.
system was so complex it became oppressive and
The dollar cost of the increase in controls will
was, accordingly, ignored. The Chernobyl disaster
be immediately evident. The costs that will not be
occurred because of runaway events triggered by a
mandated safety test. evident at first (indeed, may never be evident) are
The recent mergers in the financial industry those born of increased complexity and the reduced
have moved system complexity several steps up “survivability” of the organization in the face of the
the scale. The lesson of the cockroach becomes that unforeseeable risks. If these costs were recognized,
much more germane. The finely tuned approach to a normal accident would not simply change the
dealing with risk—the approach that would seem controls in the risk-management structure; it
optimal in any one world—may in the long run would change the risk-management structure
prove suboptimal. Given the complexity and fun- itself. That is, the realization that risk management
damental unpredictability of nature, an approach may fail in an unanticipated way provides informa-
that is coarse and less complex may be the best tion that is beyond the scope that new controls
long-term risk-management strategy. The lesson alone can address. The unforeseeable events pro-
for the corporation or investment firm is even more vide information about the incomplete nature of
pointed: Unlike the biological world, in the busi- any particular risk-management paradigm. The
ness world, the more complex risk-management knowledge that risks beyond the scope of the
rule may actually make the situation worse, leading
model remain should lead to a reconsideration of
to greater complexity rather than simply a less-
the information used for monitoring risk and to a
than-ideal response.
Once a normal accident occurs, it comes broader, not a more detailed, response.
through the veil and is open to view. It is then
manageable, and controls can address recurrences.
But if a system is already at a level of complexity This article is based on presentations given to the Berke-
where normal accidents are common, adding one ley Finance Symposium and the Federal Reserve Bank of
control after another will simply increase complex- Atlanta Risk Management Conference.
Notes
1. The analysis of optimal animal behavior under extended seeable changes in the environment are considered.
uncertainty is presented in Bookstaber and Langsam (1985). 2. The delineation of the categories and a general discussion
The article provides more examples of behavior that of the limitations of assuring safety in a complex system
appears to be suboptimal given the animal’s view of the such as the airline industry are presented in Langewiesche
world but that is superior to a fine-tuned rule when unfore- (1998).
References
Bookstaber, Richard, and Joseph Langsam. 1985. “On the Langewiesche, William. 1998. “The Lessons of ValuJet 592.”
Optimality of Coarse Behavior Rules.” Journal of Theoretical Atlantic Monthly, vol. 281, no. 3 (March):81–97.
Biology, vol. 116:161–193.
Perrow, Charles. 1984. Normal Accidents. New York: Basic Books.