Rethinking Risk Management

COMMITTED TO IMPROVING THE STATE OF THE WORLD
Rethinking Risk Management in Financial Services

Practices from other domains
Prepared in collaboration with The Boston Consulting Group World Economic Forum April 2010
The views expressed in this publication do not necessarily reflect those of the World Economic Forum USA. World Economic Forum USA 3 East 54th Street, 17th Floor New York, NY 10022 USA Tel.: +1 212 703 2300 Fax: +1 212 703 2339 E-mail: contact@weforum.org www.weforum.org REF: 110310 @ 2010 World Economic Forum All rights reserved. No part of this publication may be reproducted or transmitted in any form or by any means, including photocopying and recording, or by any information storage and retrieval system. All photographs are from www.shutterstock.com, except otherwise noted.
Rethinking Risk Management in Financial Services

Practices from other domains
Prepared in collaboration with The Boston Consulting Group
World Economic Forum April 2010
Contents
Preface Letter from the Steering Committee Executive Summary Chapter 1 1.1 1.2 1.3 1.4 Chapter 2 2.1 2.2 2.3 2.4 Chapter 3 3.1 3.2 3.3 3.4 System-Wide Perspective Introduction Drive diversity Simulate system disasters Manage fire Transparency and Information Flow Introduction Aggregate system-wide data Scrutinize complexity Innovate transparently Governance and Culture Introduction Look for trouble Value experience Empower the front line 3 6 8 11 11 11 15 18 23 23 24 28 33 39 39 40 44 47 51 52 54 54 56 56 57 57 58 58 59 60 62
Chapter 4 Conclusion References Appendices Appendix Appendix Appendix Appendix Appendix Appendix Appendix Appendix
1: 2: 3: 4: 5: 6: 7: 8:
Project Background and Approach Summary of Risk Management Lessons Summary of Risk Management Lessons Summary of Risk Management Lessons Summary of Risk Management Lessons Summary of Risk Management Lessons Summary of Risk Management Lessons Summary of Risk Management Lessons
from from from from from from from
Aviation Fisheries Management IDC Immunology Pharmaceuticals Telecommunications Wildfire Fighting
Acknowledgements Project Team
Rethinking Risk Management in Financial Services Report
Preface
The World Economic Forum is proud to release this report on the topic of Rethinking Risk Management in Financial Services, which was part of the organizing theme for the Forums 40th Annual Meeting in 2010: Improve the State of the World: Rethink, Redesign and Rebuild. This report is part of an Industry Partnership project endorsed by the Financial Services Governors community at the Forums Annual Meeting in 2009. The recent financial crisis acquired unparalleled proportions and inflicted long-term damage on economies, countries and people. As the true impact of the crisis becomes evident and the financial system stabilizes, it is critical not to let a good crisis go to waste. Internalizing the lessons learnt and making the necessary improvements now will make the global financial system more resilient and better able to handle the next meltdown, when it happens. The crisis has highlighted the need to improve risk management strategies at both the system-wide and institutional levels in the financial services industry. It has demonstrated that efforts limited to specific institutions or jurisdictions are insufficient to address a problem that is global in scope. New thinking is required to rebuild a damaged financial system. While other efforts have largely focused on improving risk management in financial services from the inside out, this report looks at it from the outside in trying to learn from practices and patterns in domains such as aviation, fisheries, wildfire fighting, immunology/epidemiology, telecommunication and pharmaceuticals. While not all of these practices are directly transferable to finance, many are and most of them provide much needed fresh perspective and thinking. Over the past nine months the World Economic Forum, in collaboration with The Boston Consulting Group, analyzed the outside domains and engaged multiple stakeholders. Input from over 100 subject experts, risk managers, academics and business leaders was sought in trying to answer the question: What can the financial services industry do to better monitor, manage and maintain the resilience of the financial system? We trust that the report will stimulate your thinking, introduce new ideas and add to the broader discussion aimed at improving the long-term stability of the global financial system. On behalf of the World Economic Forum, we wish to particularly thank the members of the Steering Committee, the Working Group, the interview and workshop participants, Project Manager Isabella Reuttner and our partners at The Boston Consulting Group (notably Duncan Martin, Kenny Pun and Rachel Hirsch) for their boundless support. Kevin Steinberg Chief Operating Officer World Economic Forum USA Gian Carlo Bruno Director and Head of Financial Services Industry World Economic Forum USA
DISCLAIMER The members of the Steering Committee and the Working Group support the recommendations and views expressed in the report. However, they do not all necessarily agree on every detailed point made herein. The opinions expressed are of a personal nature and do not necessarily reflect the stance of the companies represented by the Steering Committee and Working Group members
Steering Committee
Co-Chairs Lzaro Campos Chief Executive Officer SWIFT Axel Lehmann Chief Risk Officer Zurich Financial Services Cneyt Sezgin Member of the Board of Directors Garanti Bank Raj Singh Chief Risk Officer Swiss Re Paul Smith Treasurer State Farm Insurance Jim Webber Chief Risk Officer Aviva Tom Wilson Chief Risk Officer Allianz SE Vanessa Wittman Chief Finance Officer Marsh & McLennan Companies Inc Mark Yallop Chief Operating Officer ICAP Plc
Members Iain Abrahams Head of Liquidity, Risk and Capital Markets Barclays Capital Karl Guha Chief Risk Officer UniCredit Group Simon Levin Moffett Professor of Biology Princeton University Erwann Michel-Kerjan Managing Director Wharton Risk Management and Decision Processes Center The Wharton School, University of Pennsylvania David Rhodes Senior Partner and Managing Director The Boston Consulting Group Luke Savage Director Finance, Risk Management and Operations Lloyds of London
From the World Economic Forum: Gian Carlo Bruno Director and Head of Financial Services Industry World Economic Forum USA Kevin Steinberg Chief Operating Officer World Economic Forum USA
Letter from the Steering Committee

The financial crisis has, to put it mildly, seriously challenged our traditional approach to risk management. Consequently, a number of individuals and institutions have advanced ideas for improving not only the analytical framework, but also the status and relevance of risk management. This report, not only reacts to the most recent episode (although we indeed reference many relevant examples), it also attempts to address a deeper problem: the demonstrated inability of the global financial system to constructively mitigate and deal with financial crises. Over the past 40 years, the IMF has counted 88 banking crises. Hence, a fundamental question presents itself: Can the financial services industry benefit from experiences in other domains that, over time, have developed sound practices and successful patterns to deal with risk? We believe the answer to be an emphatic yes. This report explores both what these practices and patterns are, and how they can be applied to the financial services industry. Obviously, there are efforts already in progress to improve risk management in the financial services industry initiated by such bodies as the Financial Stability Board and the G20. Many of these efforts are highly relevant, such as the re-alignment of individual compensation with institutional and systemic goals. To avoid replication, our report will not dwell further on initiatives already underway. In contrast to other and perhaps more conventional studies, our report tries to shed new light by focussing on the lessons that the financial services industry can learn from other environments. We take an outside-in perspective, thereby differentiating this report from others that focus on improving risk management using traditional concepts, tools, and ideas that always have been and will continue to be inherent and very relevant to the financial sector. It is important to recognize that risk-taking is an integral part of many financial institutions business models. This is a crucial difference to some domains that we have examined. Also, we are well aware that outside domains may not provide ready guidance to all aspects of financial services (see Appendix). This report concentrates on stylized patterns and lessons that are potentially transferable to the financial sector while acknowledging that no domain is perfect at managing risk or indeed fully comparable to financial services. We further acknowledge that some of our commentary on the industry is by default overly generalized for reasons of brevity. We do realize that no two financial institutions are identical: relative performances during the crisis have borne that out. We ask readers to keep these caveats in mind if, at times, what we depict or suggest does not resonate with what they know from their own institutions vantage point.
Our goal is to provide food for thought rather than an off-the-shelf solution. Many of the outside practices we explore are somewhat distant from conventional thinking. We are aware that some of our ideas will be controversial. We therefore do not necessarily speak of them as recommendations. Instead, we hope that our report will inspire a fruitful discussion between those stakeholders that have an interest in a more resilient financial system: policy-makers and supra-national bodies at a global level, regulators and governments at a national level, and senior managers at a firm level. It is our intention to stimulate, provoke, and challenge and by doing so to help transition the financial system to a more resilient and less failure-prone state. The Steering Committee and the Working Group would like to thank those individuals who generously gave their time to support this project. We hope that all will find our report as stimulating to read as we found it to research, debate and write. Steering Committee Co-chairs Lzaro Campos Chief Executive Officer SWIFT Axel Lehmann Chief Risk Officer Zurich Financial Services
Executive Summary
The recent financial crisis exposed many weaknesses in risk management in financial services. Issues around incentives, governance and culture at many market participants have been well documented and need no further discussion. However, the trouble ran deeper than that: reading any account of the last years events that brought the financial sector to the brink of collapse, it is obvious that many of the actors flew blind, with neither adequate information nor preparation. Moreover, what was good for an individual firm or country in the short term was not necessarily good for the system as a whole in the long run. Regulators thought nationally, not globally, until it was too late; firm, product and trading strategies became complex yet homogeneous, leading to a stampede once positions did deteriorate. While some of the decisions made under intense pressure have so far held up to the test of time, it is hard not to conclude that things could have easily been much worse. Financial services is not the only domain with issues of system-wide stability or conflicts between the individual (short-term) and systemic (long-term) good. In this spirit, seven domains outside financial services were analyzed with the belief that their risk-management techniques might hold lessons for finance. The findings were grouped into three non-mutually exclusive areas of focus: (1) system-wide perspective, (2) transparency and information flow, and (3) governance and culture.
(1) System-wide perspective: Drive diversity. Homogeneous systems are less resilient than diversified ones. For example, in 2007, a virus killed millions of farmed Chilean salmon. The fish had been farmed at high density, treated with similar antibiotics and subjected to similar preventive measures. They were, therefore, all vulnerable to a single threat. Applying this lesson, financial institutions could encourage diverse and contrarian approaches towards modelling risk and selecting business strategies. Competitive forces would make this difficult to achieve at an institutional level. Regulators could, therefore, encourage variation in institutions risk management approaches and increase capital charges for systemically crowded high-risk/high-return business strategies (this initiative would need to be carried out with sound understanding of the strategies, rather than as a blanket measure). In promoting a level playing field one should recognize that diversity in risk management is important and complete regulatory convergence should be avoided. The overall approach towards achieving diversity in financial services should be based on broadly agreed principles as opposed to strict one-size-fits-all rules. Simulate system disasters. The World Health Organization (WHO) helps nations develop action plans activated by the global pandemic alert level and encourages simulations and real-life rehearsals to prepare for crises and to improve planning. Pilots train extensively on realistic flight simulators to prepare for emergency situations. Similarly, the financial services industry should put more emphasis on creating and rehearsing contingency plans for large systemic events across institutional and national boundaries. Such plans and simulations should be realistic and concrete and should address not only short-term operational concerns, but also longer-term strategic issues. Manage fire. Since forest ecosystems need fire to rejuvenate, some wildfires that do not endanger human lives and property are allowed to burn out. Controlled burning is also conducted selectively to reduce fuel build-up. The parallel in financial services could be that failure of some individual institutions is acceptable, even desirable, for the overall system, and therefore government guarantees should be limited. In addition, the financial services industry could consider developing fire breaks to contain incidents locally and prevent system-wide spread. One such measure, as suggested by the United Kingdom Financial Services Authority (FSA) is to require institutions to create living wills so that, if necessary, they could be wound down with minimal impact to the system.
(2) Transparency and Information Flow: Aggregate system-wide data. The aviation regulator in the US conducts a collaborative government and industry programme known as the Aviation Safety Information Analysis and Sharing programme (ASIAS), which aggregates national aviation incident reports and safety data. The programme provides a comprehensive and consistent data environment that enables systemic issue analysis and identification. This ultimately helps detect systemic issues earlier and more effectively. In financial services, large amount of data is already collected from financial institutions, but this data is not aggregated or exploited for systemic issue detection. On its own, the aggregation of data will not increase the resilience of the system. Therefore, the industry should first focus on asking the right questions in order to determine a set of critical systemic stability indicators that could contribute to an efficient early-warning mechanism. Development of these indicators should be adaptive to keep pace with technological and financial innovation, and could work alongside efforts to enhance data mining and management techniques. Scrutinize complexity. The pharmaceutical industry conducts in-depth studies to analyze the efficacy, side effects of, and interactions between new drugs .The fishery industry models the effects of fishing on the ecosystem as a whole, and restricts methods that also kill untargeted (or by catch) species. Similarly, the financial services industry could mandate deeper and broader assessments of the impact of new products and business strategies on financial markets. These assessments would look beyond the direct impact and explicitly target the second and third order effects. Regulators could then consider performing unintended consequences studies on products that breach system-wide threshold volumes, and could be empowered to restrict volumes if the products were deemed potentially unsafe to the system. Obviously, such restrictions would have to be set with a deep technical understanding of the products. Innovate transparently. In immunology, pathogens that mutate before the adaptive immune response can kick in are particularly dangerous, as the immune system perpetually lags the pathogens invasion. Moreover, if the host immune system misinterprets the nuances of the new strain, it may be deceived by apparent familiarity and gear up to fight an old strain. Similarly, financial institutions and regulators should be wary of rapidly mutating products by carefully monitoring instruments with exceptional growth and variation. They must also make sure that established risk management techniques continue to apply when new strains have developed. In the telecommunications industry, the best practice is to write simple code in discrete modules so that system-wide errors are hard to make and easy to find. The financial services domain could consider instituting a standardized modular nomenclature covering all products so that their risks could be better decomposed and understood. New products originally seen as complex and leading edge do generally become more standardized as volumes increased, suggesting that it is not impossible to break down complex products into simpler components.
(3) Governance and Culture: Look for trouble. The World Health Organization utilizes web crawlers and an extensive informal human network to seek out emerging infectious disease outbreaks, especially unfamiliar ones. This enables early detection and therefore swift mitigation. In immunology, white blood cells constantly circulate in the human body, seeking dangerous pathogens. The financial services industry should encourage and adopt a culture of actively searching for emerging threats at both the institutional and system-wide level looking for trouble and in addition respecting individuals who raise warning signals. Institutions and the industry could create dedicated teams to proactively investigate institutional and systemic risks and continuously experiment with new warning-indicators.
Value experience. Wildfire fighters value the experiences of those who have fought very large fires, and document their stories. Airline companies and regulators conduct in-depth analyses on all accidents and near-misses and convert the lessons learnt into new regulations and procedures that improve safety. Similarly, the financial services industry could emphasize the value of experienced employees (both at institutions and regulatory bodies), improve their retention, and have a cadre on call to respond when a new crisis occurs. In order to ensure that lessons from past crises are passed down, institutions should carefully analyze events and document and aggregate experiential testimony for training new generations. Empower the front line. Pilots, co-pilots, and mechanics can delay a take-off if they deem the aircraft to be unsafe. In the cockpit, co-pilots are encouraged to raise safety issues. Front-line wildfire fighters are empowered to make tactical decisions at the fire scene. Similarly, financial services institutions could consider further encouraging front-line risk managers and business-unit employees to take charge of local risk management issues, and raise alarms without fear of retribution. Since the financial services industry (in theory) already has much of this capability in place, upgrading it is more a case of reinforcing the existing framework than radically redesigning the process. As an example, senior management could explicitly reward proactive flagging and management of risk issues, improve channels for anonymous reporting, and communicate that consistent smooth sailing would be considered too good to be true. Clearly this will require an appropriate set of incentives. The adoption of one or more of the suggestions could aid in strengthening the financial services industry as a whole. In assessing appropriateness of the suggestions, it might be helpful to consider a framework that looks at the nature of a risk event (exogenous shock vs. endogenous systemic malfunction) and its consequence (large non-systemic event vs. systemic melt-down). Depending on what the reader is trying to combat, some analogies are more powerful than others. For example, many risk management practices in aviation try to avoid large non-systemic events such as plane crashes, and have limited consideration for the system as a whole (other than where events pertain to a component or process affecting many aircraft).1 While the financial system appears to be stable for the immediate future, the financial industry should pause and reflect on past risk-management practices and actively explore potential changes that could be made going forward. The following questions are critical: How can the industry make the proper trade-off between information protection and disclosure as it seeks to enable system-wide risk monitoring and management? How can the rejuvenation and safety of the financial system be balanced without either creating moral hazard or system fragility? Is the industry on the right track with the current regulatory approach? How can the benefits and vulnerabilities associated with regulatory convergence be balanced? How can the industry adapt (structurally and culturally) to new threats and innovations of the future, given that it does not yet know the products, the markets, the players, and the consumers of the future? Given that the next crisis is very unlikely to be prevented by a central controller, how can the industry resist the temptation to solve stability issues by over-centralisation and instead strengthen the resilience of individual systemic nodes? The implementation of any needed changes will neither be easy nor can it happen overnight. Some require a phased approach; others require voluntary initiatives from the private sector; yet others require regulatory mandates. Above all else, international and cross-industry cooperation and trust are crucial to achieving system-wide resilience, and it is in this spirit that this report has been researched and written. The project team thanks those who have contributed to this effort, and looks forward to the ongoing debate.
1 The Project Background and Approach section in the Appendix of this report provides a detailed framework
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Chapter 1 System-Wide Perspective

1.1 Introduction
Managing risk in a complex environment requires a comprehensive view of the entire system. Leading up to the recent crisis, many financial institutions had similar risk exposures, although this fact was not widely deemed important. Institutions held near-identical classes of investments, most used a high degree of leverage, and many financed themselves through short-term funding. Thus, when liquidity receded following the collapse of housing prices and subsequently of financial assets linked to mortgages, many institutions suffered losses simultaneously and sought to close similar positions. As these institutions had similar funding structures, risk-management practices, and mitigation strategies, it was as if someone had yelled Fire! in a packed theatre, and all ran to the same exit. Global regulatory uniformity also encouraged homogeneity, particularly concerning the reliance on rating agencies. Regulation in all major financial centres allowed the same solutions to reduce capital (such as through conduits and structured investment vehicles). Moreover, many practitioners relied on historical correlations of individual underlying risks to calculate diversification benefits, forgetting correlations could change in a stress scenario. In addition, financial institutions and investors had become accustomed to the idea that governments would arrest severe market downturns and, as the rescue of Long-Term Capital Management (LTCM) illustrated, intervene to mitigate the impact of failing institutions. Markets may have even assumed, rightly so to some degree, that an institution could be too big or too interconnected to fail. Some participants considered that tail risk was idiosyncratic in nature, effectively denying the existence of systemic risks. Ultimately, neither regulators nor the industry were prepared for a systemic crisis. Most regulators had failed to develop a system-wide perspective and were still figuring out contingency plans as the crisis unfolded. At the institutional level, most senior management teams had never experienced a significant crisis. They operated under the belief that a system-wide crisis would never happen. Although sound decisions were eventually made that helped bring the system back from the brink, the danger should have never been permitted to develop. How does the indu stry construct an all-encompassing, system-wide view, and enhance the resilience of the global financial system? The financial services domain could (1) drive diversity (as homogeneous systems are less resilient), (2) simulate system disasters, and (3) manage fire (to maximize system resilience).
1.2 Drive diversity

Increases in complexity did not come with more diversity. On the face of it, market participants looked more and more different in their legal status, investment strategies, and business objectives. It has now become apparent that, behind these veils of diverse colours, there was a profound uniformity in the approach to risk, its measurement, its management, as well as in the drivers of risk appetite. This uniformity had very destabilizing consequences. Jean-Pierre Landau, Deputy Governor, The Bank of France, 8 June 2009
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Chilean farmed salmon suffered from a viral disease in a homogeneous environment Chile is the second largest farmed salmon producer in the world. The industry is crucial to the economy and employs tens of thousands of people. Thus, when a viral disease hit its salmon farms in 2007, killing millions of fish, many plants had to be shut down. Thousands of jobs have been shed since the outbreak. The viral disease, infectious salmon anemia (ISA), was first detected in Chile in 2007. ISA is a highly contagious and lethal virus in the salmon population, but does not affect humans. It can cause severe anemia and haemorrhages in salmon internal organs. ISA is not a problem unique to Chile and has previously caused trouble in other countries, including Norway, Canada, and Scotland. However, the scale and speed of infection in Chilean salmon farms were unprecedented. Environmentalists have reported that Chilean salmon farms yield (on average) 25 kilos of fish per cubic meter, compared to 15 kilos per cubic meter in Norway. This over-crowding further encouraged ISA, as its transmission could be aided by sea lice that plague overcrowded farms. In addition to saturated facilities, Chilean salmon farms were characterized by close facility proximity, making disease control even more difficult.3 To combat diseases, farmers began to use a high level of antibiotic treatment.4 Yet this step made the farmed salmon as a whole more vulnerable to contagion in the long run. When the outbreak occurred, the combination of high density, close proximity and drug resistance resulted in rapid spread and catastrophic damage.
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Landau, J. Introductory remarks by Mr. Jean-Pierre Landau at the Conference on The macroeconomy and financial systems in normal times and in times of stress, jointly organized by the Bank of France and the Deutsche Bundesbank, Gouvieux-Chantilly. Bank of International Settlements, http://www.bis.org/review/r090806c.pdf, 8 June 2009. Chile Government Recommends Salmon Crisis Measures. The Patagonia Times, http://www.patagoniatimes.cl/index.php/20080609542/News/SalmonNews/CHILE-GOVT-RECOMMENDS-SALMON-CRISIS-MEASURES.html, 9 June, 2008. Salmon Virus Indicts Chiles Fishing Methods. The New York Times, http://www.nytimes.com/2008/03/27/world/americas/27salmon.html, 27 March 2008.
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Robust Systems: Heterogeneity, Redundancy, and Modularity

By Simon Levin In complex systems, strong non-linearities may lead to the magnification of disturbances, thereby to loss of robustness and to regime shifts. Examples include desertification, eutrophication, and disease outbreaks. Economic analogues include market collapses and recoveries, bank runs, and shifts in social preferences. Sudden transitions are driven by feedbacks. Positive feedbacks, which directly enhance perturbations, are clearly destabilizing. Each new case in an epidemic has the potential to cause others. Less intuitively, strong negative feedbacks, which initially correct deviations, can destabilize, as in the collapse of the dynamically unstable Tacoma Narrows Bridge. Robustness hinges on the balance between heterogeneity, redundancy, and modularity. Heterogeneity represents adaptive capacity, the ability to find new solutions in the face of change. Genetic heterogeneity is the essential ingredient on which natural selection acts. However, redundancy, which trades off in obvious ways against heterogeneity, also confers robustness, compensating for the loss of key elements. In 2004, a lack of robustness was evident when one of the major suppliers of flu vaccine to the United States
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could not deliver. Fortunately, the flu season was mild. Finally, modularity creates both barriers to the uncontrolled spread of disturbance and building blocks for recovery after disturbance. Diseases may spread rapidly within particular risk groups, like drug users, but then slow down because of the modular nature of social contacts. Forest fires are contained through fire breaks, which confer modularity. Similarly, the recent economic meltdown can be attributed, in large part, to the excessive over-connectedness of the banking system that is, to an absence of sufficient modularity as well as to the absence of heterogeneity and redundancy. Simon Levin, PhD Moffett Professor of Biology Princeton University
Application to financial services Prior to the financial crisis, many financial institutions were running similar business and risk management strategies at the product-line level. As evidenced by players relative performance through the crisis, only a few institutions were pursuing a more diversified approach. Indeed, many institutions were simultaneously building large positions in structured credit products derived from the same underlying asset classes, utilizing short-term money-market funding, and making risk management decisions with similar assumptions and techniques. Capital requirements were calculated under similar methodologies, with similar underlying models. Reliance on external credit ratings was pervasive. When the U.S. sub-prime housing bubble burst, financial institutions with the same vulnerabilities all went for the same exit door. The financial services industry needs to rethink how it can foster diversity in order to make the system more resilient. Indeed, while some measure of emotional comfort can come from herding, financial institutions should avoid crowded business strategies and vary modelling assumptions for risk management. Boards, executives and investors should think for themselves rather than implementing me-too strategies and obsessing with benchmarks. It is understandable that when everyone is judged on relative performance financial institutions should seek to compare themselves, but just copying strategies (or even trading positions) is not healthy for either the organisation or the system. As it turned out, many institutions assumed that super-senior tranches of collateralized debt obligations (CDOs) were safe based on their AAA credit rating. This view failed to account for the fact that the ratings were based on precarious assumptions about default risk, house prices, and cross-correlations among the risks of the underlying assets. Financial companies also kept large inventories on their balance sheets, and ultimately suffered substantial losses failing to recognize that there would be a penalty on homogeneity and a prize for diversity. Thus, financial institutions should seek diverse and contrarian approaches and opinions in terms of risk modelling, business strategies, and assumptions. The winners in the next crisis (as indeed in the last) will be those organizations that get these difficult calls right. Of course, when competitors are all apparently winning from a given strategy, and shareholders demand the same high level of return on equity, it is difficult for financial institutions to stand on the sidelines. It is also challenging for them to strike the right balance between building consensus in decision making and encouraging varied opinions within their organisations internally.
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Regulators should refrain from promoting complete systemic uniformity, and perhaps endeavour to encourage a larger degree of systemic heterogeneity. They could encourage institutions to manage risk with varied approaches and increase capital charges for systemically crowded high risk/high return business strategies (this initiative would need to be carried out with sound understanding of the strategies, rather than as a blanket measure). Since homogeneity leads to shared vulnerabilities, counter-intuitive as it may seem, not all practitioners should adopt the same best-practice risk management techniques, methodologies and assumptions both domestically and across borders. The trend of complete regulatory convergence is simply not desirable. Although convergence leads to benefits such as the interoperability and comparability of institutional financial health across jurisdictions, homogeneous supervisory practices create a future selection bias, exposing the financial system to as yet unknown threats. Although differences in regulatory approaches could lead to arbitrage, properly-managed diversity can help close loopholes and make the system more resilient in the long-term. Needless to say, a balkanization of regulatory regimes could be equally (if not more) detrimental to the stability of the global financial system. One of the problems leading up to the recent financial crisis was that the demarcation between various players in the financial market had become blurred Commercial banks began behaving like investment banks and hedge funds creating a large shadow banking system and certain insurers started behaving like banks. Consequently, levelling the playing field according to outdated institutional demarcation lines is inefficient and potentially a source of systemic risk. A more promising approach would be to regulate and supervise according to functional and activity lines that better reflect the fluidity in the modern financial world. In other words, regulation should emphasize a principles-based and behavioural approach over a rules-based and institutional approach.
1.3 Simulate system disasters

As the crisis developed, in too many instances supervisors () were not prepared to discuss with appropriate frankness and at an early stage the vulnerabilities of financial institutions which they supervised. Information flow among supervisors was far from being optimal, especially in the build-up phase of the crisis. This has led to an erosion of mutual confidence among supervisors. De Larosire Report to the European Commission, February 25, 2009
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The WHO sets the global alert level to activate national contingency plans On April 27, 2009, considering cases of H1N1 in the United States, Mexico, and Canada, as well as potential spread to other nations, the WHO raised its global pandemic alert level from 3 to 4. On April 29, nine countries had officially reported 148 cases of H1N1, including one death in the United States and seven in Mexico. Level 5 alertness was declared. A month and a half later, on June 11, the highest alert level, level 6, was activated as almost 30,000 confirmed cases were reported in 74 countries.6
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The de Larosire Group. The High-Level Group on Financial Supervision in the EU Report. http://ec.europa.eu/commission_barroso/president/pdf/statement_ 20090225_en.pdf, February 2009. World Health Organization, http://www.who.int/, 2009.
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The WHO is responsible for setting global pandemic alert levels, which correspond to actionable response measures based on the current degree of epidemic spread. These levels refer solely to spread of the infection, not to its severity or potential deadliness. Levels 1 through 3 indicate that the disease resides predominantly in animals with limited human infection. Level 4 indicates a sustained level of human-to-human transmission. Levels 5 and 6 indicate widespread global human infection.7 Member states are encouraged to develop specific action plans to manage epidemics in their region. These plans typically activate based on shifts in the global pandemic alert level. The WHO builds tools to support nations in developing detailed response procedures. Action-plan categories are organized by planning and coordination, situation monitoring and assessment, communication, reduction in the spread of disease, and continuity of health-care provisions. The WHO also encourages nations to test their plans, outlining three types of simulations8: (1) table-top exercises, in which major stakeholders discuss scenarios and how they should respond; (2) functional exercises, in which several entities complete simulations for a given scenario without deploying resources; and (3) full-scale exercises, in which participants enact scenarios as realistically as possible. These exercises involve all participants outlined in the plan ideally from multiple nations and regions and include deployment of resources. The lessons from these simulations can then be used to modify and improve overall crisis plans.
Pilots simulate disasters Pilots train extensively on flight simulators to prepare for multiple emergency scenarios, including severe (yet infrequent) events. These simulators vividly recreate real-life situations using visual cues, motion sensors, and actual cockpit tools. Pilots feel like they are experiencing a critical event, such as facing an engine failure in conjunction with an electrical system malfunction while attempting to land in a storm. Most commercial pilots are required to log a minimum number of simulator hours every year to stay up-to-date on procedures. In some countries, pilots must be re-evaluated and re-trained on simulators every six months in order to keep their licenses.
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WHO pandemic phase descriptions and main actions by phase. World Health Organization, http://www.who.int/csr/disease/influenza/GIPA3AideMemoire.pdf, 2009. Considerations on exercises to validate pandemic preparedness plans. WHO, http://www.who.int/csr/disease/influenza/ExerciseConsiderations.pdf, 2009.
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Source: Courtesy of Thomson Reuters
Practitioners in the Telecommunications industry develop contingency plans Telecommunications providers also make detailed contingency plans for emergency situations. These plans are tailored to specific regions since the probability of various threats especially those related to weather differ by geography. There are also generic contingency plans that providers put in place. For example, if the central control room shuts down, mobile trucks with operating equipment can be used to avoid network failure.
Application to financial services During the course of the recent financial crisis, a series of financial institutions faced bankruptcy. In each case the response of regulators and the government differed: some were bailed out while others were propelled into shotgun marriages. In September 2008 it was Lehman Brothers turn. The Federal Reserve Bank of New York called in prominent financial CEOs to figure out a plan. However, the government declined to rescue the firm, and potential suitors backed away. Lehman Brothers had to declare bankruptcy, the largest in US history. When the markets opened the following Monday, trust had disappeared and trading froze. This took market participants and regulators by surprise and almost led to the collapse of the global financial system. Reflecting on this near miss, the financial services industry could benefit from better preparation for severe events and systemic crises, utilizing detailed contingency plans based on associated simulations.
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When creating sweeping contingency plans, it is important to understand what each party is responsible for regulating, so that all angles are covered. Equally, it is also important that institutions and regulators across jurisdictions coordinate efforts. All should agree on a priori protocols concerning how to collaborate in the face of a large-scale crisis and test those through realistic simulations. At the extreme, the industry could explore the possibility of publishing these plans sanitized for corporate confidentiality where necessary to help engender trust in the stability of the system. Contingency plans need to be simulated to ensure they are applicable and implementable. Simulations should not only address operational concerns such as infrastructure failure or natural disasters but also strategic issues such as capital, buy/sell activities, and shifts in management/ownership possibly involving multiple institutions and across jurisdictions. Simulated crisis scenarios should of course be highly realistic, like flight simulations, and could be run with fake feeds when markets are closed (such as over a weekend), similar to the disaster recovery exercises that financial institutions already conduct. Such fire drills could highlight potential vulnerabilities, and increase preparedness for systemic events. The lessons learnt from such simulations would of course be incorporated into contingency plans.
1.4 Manage fire

The Governments macroeconomic framework has delivered unprecedented stability, with 62 consecutive quarters of GDP growth in the UK the longest sustained expansion on record. Gordon Brown, John Hutton, Alistair Darling, March 2008
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Wildfire fighters manage fire risk by controlling the fires environment For most of the twentieth century, full fire suppression was the official policy in the United States. After 79 wildfire fighters were killed in a fire in the Southern Rockies in 1910, the U.S. Forest Service adopted a zero tolerance policy. In 1933, after another large wildfire in Oregon wiped out three million acres of forest, the strict 10 (acres) by 10 (a.m.) rule was instituted, requiring all fires of over ten acres in extent to be extinguished by 10 a.m. the day after they had broken out. However, nature needs to burn. In fire-prone climates, fire is part of the ecosystem. Organisms have evolved not just to cope with fire, but to depend on it. Fire reduces fuel loading, clears land for new shrubs and flowers to grow, and attracts birds that do not inhabit trees to nest in burned areas. It removes forest litter that nurtures insect infestation and kills diseased trees.
Brown, G, Hutton, J, Darling, A. Enterprise Unlocking the UKs Talent, HM Treasury Department for Business Enterprise & Regulatory Reform, http://www.berr.gov.uk/files/file44993.pdf, March 2008.
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Decades of full fire suppression in the United States resulted in significantly harmful landscape alteration. Therefore, in 1978, the U.S. Forest Service revised its wildfire policy to be consistent with land and resource management objectives. Today, wildfire fighting has evolved into wildfire management. Wildfires that do not threaten human lives and property are left to burn out. Furthermore, prescribed burning igniting small fires intentionally to reduce fuel build, create fire breaks, and clear land has been affirmed as an appropriate firemanagement practice.10 Prescribed burning is highly controversial, however, and requires balancing the interests of multiple stakeholders. Wildfire is hard to control. Wind direction and weather patterns can change suddenly, spreading the wildfire and potentially causing a much larger fire than intended. Fire management politics have become more complicated as real estate development has encroached on forests that border urban areas. Prescribed burning efforts in these regions can interfere with highway traffic and make residents ill at ease.
10 Fire Ecology Eco-link, Temperate Forest Foundation, http://www.forestinfo.org/Products/eco-links/Fire-Eco2.PDF, 2002.
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Creative Destruction in Natures Economy

By Stephen J. Pyne In recent decades, the realization has grown that fire is not something that happens to biotas from the outside like a flood or an ice storm. Rather, it is an integral process that many biotas expect and need. Simply put, fire recycles nutrients, rearranges ecosystem structures, and recharges landscapes that have fallen into lethargy. It is the quintessential agent of creative destruction in natures economy. People had long recognized this fact, and had used controlled fire in domains such as hunting, foraging, herding, and farming. But industrialization, particularly when combined with colonization, shook up these ancient arrangements. Fire came to be perceived as mostly destructive, and state-sponsored conservation intervened. Officials misidentified fire, qua fire, as an agent of damage and sought to suppress it. At first, this movement seemed to succeed. Over time, however, it became apparent that burning could not be abolished and that even the attempt to do so was disruptive and led to even greater damage. Successful programmes have thus shifted from fire suppression to fire management. Agencies appreciate that they cannot just shut down fires, nor can they simply stand by and let a transcendent nature have untrammelled sway. Accordingly, many agencies fight fires only when wildfire threatens life and property. They allow fires some room to roam when flame and smoke do not pose hazards to people or hard assets. They deliberately start fires to stimulate ecological benefits and to compensate for past suppression programmes. Also, they seek to shape the general landscape so that whenever fires occur whether by accident, arson, or lightning they will have properties that promote fires benefits and lessen its costs. Its a tricky business, to be sure. But the concept that techniques must be mixed and that fire cannot be removed from land management overall provides a strong analogy to the economic crises of recent years. Stephen J. Pyne, PhD Regents Professor School of Life Sciences Arizona State University
Author of over 20 books including Year of the Fires: The Story of the Great Fires of 1910 and Tending Fire: Coping with Americas Wildland Fires.
Application to financial services While many banks have failed in the past, this reality was far from the public mind in the years leading up to the recent crisis. Recent government intervention, including explicit and implicit bailouts such as LTCM and Bear Stearns, made many financial practitioners believe that the government would bear the consequences of poor institutional risk management. In order to change this perception, it is essential that governments and regulators allow institutional failure or creative destruction as part of a necessary, rejuvenating process.
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Simply put, national governments could actively manage financial fires that are burning. Of course, it is also important to try to contain fires locally and prevent broader spread. A potential example of such a fire break is a living will, as suggested by the FSA.11 If all else fails, a living will can be activated to minimize the impact of an institutional failure on the financial system as a whole. In order to be effective, such a will would need to be updated regularly to reflect the pace of business change among successful industry participants. Regulators would need to set incentives (such as capital relief) to ensure that institutions take preparation efforts seriously. In the spirit of a level playing field, they also need to watch out that transparency around such living wills does not unfairly penalize some institutions, for example via reduced credit ratings. On the other hand, just as fire breaks restrict the size of forest fire, taken to the extreme, this could mean some entities too big to fail need to shrink which should be evaluated on a firm-by-firm basis, taking into account its management structure and capabilities. Extreme care needs to be taken around defining an appropriate time horizon for such changes. If unchecked, such side effects could lead to the very type of destabilizing shock that the measures aim to prevent. What is more, arbitrage within the legal framework could help identify vulnerabilities in the system. It could weed out weak practices and players that could potentially contribute to another systemic crisis. Allowing arbitrage (even of the regulatory kind) is analogous to a small fire, and can be systemically helpful as long as appropriate monitoring is in place and quick counteraction available if needed. In other words, small fires are essential to the overall health of the financial system. Indeed, the absence of small institutional failures in a certain business niche could be seen as cause for concern rather than evidence of stability. Of course, it will at times be difficult to differentiate what is truly a small fire from a situation that could degenerate into a systemic event.
11 FSAs Turner backs living wills for banks. The Financial Times, http://www.ft.com/cms/s/0/d67f2976-9805-11de-8d3d-00144feabdc0.html, 2 September 2009.
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Chapter 2 Transparency and Information Flow

2.1 Introduction
In finance, information advantage often translates into profit opportunities. However, when the pendulum swings too far, asymmetric information can create conditions for systemic meltdown and catastrophic value destruction. Prior to the recent crisis, simple products were packaged into complex structured products (such as single mortgages into CDOs, and from there into CDO-squared). This was often done with good reason, and solved genuine risk-management problems for clients. However, in the absence of necessary transparency, such complex instruments made traditional risk assessment and portfolio aggregation more difficult. For example, a specific individual mortgage will, over its lifetime, behaviourally and dynamically select which tranche of the CDO it is part of. Although product specifications were documented, few customers, practitioners, or regulators could truly understand the details involved even if they had taken the time to read them. Thus, institutions had difficulty managing the associated risks, and some institutions did not even know their own risk exposures. Securitization was originally intended to spread risk across the financial system to institutions that were willing and better able to hold the risks. However, when the usage of some structured products mutated from their original intent (e.g., from risk management to yield enhancement), complexity grew - blurring the boundaries between risk origination and risk ownership and complicating accountability for risk management. Few could understand where the risks truly resided in the system. Packaging complex products as off-balance-sheet, special-purpose vehicles exacerbated the problem, hiding ultimate liabilities from the market. Investors and regulators could no longer discern institutional risk exposure. Moreover, different accounting standards, regional exemptions for capital treatment (e.g., domestic lending portfolios), and a large, less-regulated shadow banking sector made it nearly impossible to get a consistent, system-wide view of overall risk. Thus, in the period leading up to the financial crisis, there was insufficient transparency in the financial system; no one was really aware of the aggregate system-wide risk (e.g. total credit derivative exposure, overall leverage, counterparty interconnectedness). The industry did not or could not fully understand institutional and product interactions. What started off as the bursting of the sub-prime housing bubble in the United States evolved into a global, system-wide liquidity problem and ultimately turned into a solvency crisis for some financial institutions. The speed and ferocity of this evolution caught most industry practitioners and regulators by surprise. The lack of transparency and insufficient consideration of complex interactions prevented virtually everyone from fully comprehending cascading effects at the systemic level. Regulators did not see the need to intercede earlier or knew how best to address the situation when they did react. Also, adaptations in regulations, along with the processing of information relevant for supervisors, significantly lagged behind innovation and industry evolution. How does the industry increase transparency, thereby reducing the odds of a systemic meltdown? The financial services domain could (1) aggregate system-wide data, (2) scrutinize complex products (considering second- and third-order systemic effects), and (3) innovate transparently.
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2.2 Aggregate system-wide data

The task of a systemic regulator will be superhuman without the transparency and tools to instil market discipline. The trouble with the old system is it is too easy for institutions to deny problems that allow systemic risks to fester and grow. This denial contributed significantly to the distrust that froze the system. Lloyd Blankfein, CEO, Goldman Sachs, 13 October, 2009
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Aviation aggregates incident data to enable systemic safety analysis Aviation is a highly complex system. Since plane crashes can cause many deaths, there is zero tolerance for safety risk in aviation. Over the past 50 years, practitioners have greatly improved safety by intensely focusing on improving technology and learning from past incidents. As accident rates began to plateau in the 1990s, the industry has looked for new methods to continue to improve safety in the new millennium. In the U.S., many agencies collect aviation safety data, including, for example, the Federal Aviation Administration (FAA)s Aviation Safety Action Program (ASAP) and NASAs Aviation Safety Reporting System (ASRS). These programmes rely on voluntary reporting of incidents and near misses by commercial airlines and by individual aviation professionals; they have processed around one million incident reports to date. To encourage reporting, all reports submitted are de-identified so that names of individuals and carriers are secure. At the individual airline level, many operators also collect and analyze flight operation data, or what is called Flight Operation Quality Assurance (FOQA) data, to improve aviation safety. Nevertheless, since multiple independent efforts are involved, the data are often fragmented and not very effective at unravelling deep and complex systemic issues. Therefore, to address this problem, the FAA developed the Aviation Safety Information Analysis and Sharing (ASIAS) programme in 2007.
12 To avoid crisis, we need more transparency. The Financial Times, http://www.ft.com/cms/s/0/3de2aab8-b78f-11de-9812-00144feab49a.html, 13 October 2009.
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The ASIAS programme is a collaborative government and industry initiative allowing national aggregation of existing aviation safety data from different data sources. It also complements incident and flight operation data with contextual information on weather, terrain and air traffic control. By combining isolated data sources, the ASIAS programme provides a comprehensive and consistent data environment that enables systemic issue analysis and identification. Additionally, the ASIAS board a mix of public and private constituents including the FAA, NASA, engine and airframe manufacturers, airlines and pilot unions flags specific issues and employs analysts to dive into data in search of answers. Ultimately, through more extensive data sharing and better safety information extraction from the data, the goal is to more effectively detect potential systemic safety issues before they occur and to mitigate them.
13 Basehore, M. National Transportation Safety Board, FAA Presentation - ASIAS. National Transportation Safety Board, http://www.ntsb.gov/Dockets/Aviation/CEN09MA142/426930.pdf, 23 September 2009.
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ASIAS Programme
By Margaret Gilligan Aviation is one of the safest human endeavours, yet the industry is always looking for ways to identify risk as well as to eliminate, mitigate, and manage it. Because commercial aviation accidents are so rare and random, we cannot wait for the risk to manifest itself in a system failure. We have to find ways to identify emerging risks before they cause catastrophes. An industry/government initiative has been forged to collect safety data across the aviation community. Named the Aviation Safety Information Analysis and Sharing (ASIAS) initiative, it integrates data from many sources to accomplish several objectives. First, data can help determine whether a risk that occurs at one operator is common to other operators. Then, safety professionals can fashion mitigations that improve the entire system. Second, data can measure whether the safety initiatives have been implemented and are having the intended effect of improving safety. Ultimately, data analysis can uncover risks that no one has yet identified and allow the community to develop safety improvements. It has been said that ASIAS is the closest thing to a crystal ball that the aviation safety community will ever have. While this initiative is just getting underway, we have already seen its potential. It enables analyses that integrate pilot reports as well as data collected on aircraft, routes flown, air-traffic procedures, and topography. It has shown that we can improve pilot training, aircraft automation, and air-traffic practices to enhance safety. It is a multidimensional solution that has addressed potential risk in many ways. Margaret Gilligan Associate Administrator for Aviation Safety United States Federal Aviation Administration
Application to financial services There are clear differences between aviation and financial services from a risk management perspective. Most pertinently, taking risk is undesirable in aviation, whereas it is a vital part of the business model in many areas of financial services. However, both industries generate large amounts of data in their operations and rely on it to manage risk. Financial services firms already process significant data volumes and share them with their regulators and other parties (e.g., market and pricing providers). Similar to the aviation industry pre-ASIAS, this information is currently for the most part fragmented and not consistently structured, ultimately preventing a coherent view of risk across the system. During the recent crisis, it was therefore not possible to get a precise system-wide reading on key parameters of systemic stability, such as leverage, liquidity and counterparty connectedness.
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The direct ASIAS analogy in financial services would be to create a complete system-wide database of transaction level data for every trade made to monitor risk. While such a deep and detailed data repository in the financial system is neither feasible nor desirable, the broader analogy has some merit, particularly with regards to how the aviation industry uses the aggregated data. We, therefore, propose a two-step approach for consideration: 1. Through a working group between regulators, experts from research institutions, and industry participants, determine a framework of critical systemic stability indicators for which ongoing collection of data would be beneficial (i.e. identifying the right questions to be asked). A starting point for discussions, based on lessons from the recent financial turmoil, could be indicators including the following:
Indicator Connectedness of counterparties Leverage Liquidity Significant changes in transaction volumes Concentration of exposures
Rationale Measure of potential for contagion Key ingredient in most financial crises Expression of viability of systemic nodes Potentially linked to product mutations and crowded trading strategies Monitoring the knock-on effects from price or valuation volatility
2. For those indicators, aggregate the relevant (which does not necessarily mean most granular) data to both monitor ongoing systemic risk, and allow deep-drill analyses in case of near misses. The exact nature of a near miss is harder to define in financial services than in aviation, but could include hedges that did not work as intended, or losses in single product lines that, while significant, did not bring down the house. The data would have to be at a level of granularity appropriate for each indicator (e.g., aggregating the embedded leverage in many derivative products). While ultimately the analyses need to be anonymous for competitive reasons, the data should be available to the analysing body on a named basis wherever relevant for measuring system connectedness. To ensure that this effort is targeted it should apply to all financial institutions where systemic risk is accumulated rather than to specific types of institutions (e.g., insurers or banks). This will ultimately allow treatment of similar operations in the same way, while not trying to fit a solution to institutions where it does not apply. It should be noted that while building such a data collection will not be trivial, a lot of the data already exist (e.g., with exchanges, regulators, BIS, market data providers), and it will often be only a matter of improved coordination and common taxonomy between data sources, rather than building systems from scratch. The move towards centralised clearing for many products should also make this endeavour easier. Some regulators are already going down this route in certain instances e.g., the UK FSA is mandating near-live reporting of banks liquidity. The Financial Stability Board is engaging in an exercise that is similar in spirit to what is described here.14 By getting the indicators (the questions to ask) right and moving away from blanket data dumps, it is our hope that such efforts can be made both less cumbersome and more effective.
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Ultimately, the information should be gathered and monitored at a global level, due to the global nature of financial markets. But starting the effort at a national level with all relevant institutions (particularly collecting near misses in a systematic fashion) will be initially more feasible and still be an improvement from todays situation. The practical details of such a scheme need to be further worked through and the industrys concerns over implementation need to be addressed. However, the experience in aviation (and that of the recent financial crisis, where system-level data were often unavailable at crucial moments) suggests strongly that such a repository, if properly constructed, will be of great value to maintaining systemic stability in financial services. When doing this, it needs to be understood that simple product-level data composition will not enhance stability on its own the data need to be complemented with systemic understanding (as expressed in asking the right questions). It could be argued that crashing an individual plane is unlikely to cause a systemic issue in aviation, whereas failure of a single financial institution can more easily be systemic (as proven by Lehman). So the ASIAS analogy needs to be applied carefully it is relevant where it identifies common components or procedures that, if left faulty, could cause a plethora of crashes and thus destroy confidence in air travel. In that spirit, the near miss concept in particular is very pertinent. Finally, this report does not propose that financial services and aviation should converge to an identical regime of supervision and monitoring.
2.3 Scrutinize complexity

The shortcomings of the originate-to-distribute model can be attributed mainly to the failure of individual players to develop a holistic view on the risks due to excessive focus on their narrow, individual perspective, losing sight of system-wide drivers of risk and interdependencies. 78th Annual Report, Bank of International Settlement, 30 June 2008
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The pharmaceutical industry seeks out adverse drug effects Taking Paracetamol while drinking large quantities of alcohol could cause liver failure. Mixing some formulations of Warfarin (used to reduce blood clots and prevent heart attacks and strokes) with Naproxen could lead to serious gastro-intestinal bleeding. Drugs are used to treat diseases or alleviate symptoms. However, many also come with adverse (side) effects, some of them serious or even lethal. According to the U.S. Center for Disease Control (CDC), nearly 20,000 Americans die each year because of unintentional drug poisoning, usually the result of harmful drug mixes. Such mixtures are now the second-leading cause of accidental death in the United States, after automobile crashes.16
14 The Financial Crisis and Information Gaps Report to the G20 Finance Ministers and Central Bank Governors, http://www.financialstabilityboard.org/publications/r_091107e.pdf, 29 October 2009 15 78th Annual Report. 30 June 2008. Basel: Bank of International Settlement. 16 Paulozzi, L. CDC Congressional Testimony: Committee on Energy & Commerce, Subcommittee on Oversight & Investigations, United States House of Representatives. Centers for Disease Control and Prevention, http://www.cdc.gov/washington/testimony/2007/t20071024.htm, 24 October 2007.
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Drugs may have natural side effects (second-order effects) and also react differently when in contact with other drugs or environmental factors (second- and third-order effects). Pharmaceutical companies conduct extensive clinical trials to try to understand side effects and interactions by gradually increasing the sample size so that small or rare effects and interactions are detected. However, since drug effectiveness is measured on average across a population (rather than for a particular individual), individual patients with particular health or disease traits may react differently. Some researchers now conduct pharmacogenomic studies which examine individual genetic variability in response to a drug with the hope of enhancing the effectiveness of drug reactions and one day personalizing medicine. Post commercial release, the sample size is much bigger (the entire consuming population) and the environment is not controlled, so unknown interactions will surely occur. Pharmaceutical companies work with regulators to detect this (post-marketing) and change labelling information if needed. Regulators have begun requiring companies to develop ex-ante risk management plans prior to product launch for certain new drugs deemed particularly capable of producing side effects. Since drug consumption can potentially be lethal, regulators have a critical role to play in product approval. Indeed, regulators are engaged at an early stage in the drug development process which typically lasts eight to fourteen years and are the ultimate arbiters on whether a drugs benefits outweigh its risks. Once a drug is approved, regulators impose strict labelling rules to ensure that potential adverse effects are clearly communicated. Nonetheless, there have been cases in which drugs were withdrawn after launch because companies and regulators discovered adverse side effects. For example, Vioxx, an anti-inflammatory drug administered to millions of consumers for five years, was believed to have caused between 88,000 and 139,000 heart attacks, of which about one-third proved fatal, before the drug was taken off the market.17
17 Graham, D., Testimony of David J. Graham, MD, MPH. United States Senate Committee on Finance, http://finance.senate.gov/hearings/testimony/2004test/111804dgtest.pdf, 18 November, 2004.
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Fisheries management considers the overall ecological system When a fishing vessel retrieves its net, along with the target species, other types of fish, or by-catch, often get caught in the web. In 2005, the Food and Agriculture Organization of the United Nations noted that the average proportion of the global catch discarded between 1992 and 2001 was 8%.18 Apart from being a sheer waste of resources, by-catch can include endangered species such as sea turtles, sea lions, and dolphins. Similarly, when fishermen use certain deep-sea trawling techniques, they can damage the ocean floor and uproot coral reefs. In order to avoid such second or third-order consequences to the ecological system, fishery management agencies explicitly restrict certain fishing activities and techniques. For example, they require fishing nets to be of a certain type and length with specifically-sized holes. In addition, scientists model fish stock levels and predict species behaviour as inputs to management decisions. Certain species such as blue fin tuna are more commercially valuable than others and naturally attract more research. While scientists initially used single-species models, they gradually realizing the importance of the predator-prey relationship began utilizing ecological models that consider all species in a given area.
18 Kelleher, K. Discards in the worlds marine fisheries An update. 2005. Rome: Food and Agriculture Organization of the United Nations.
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Recognizing that fish are part of a larger ecological system, and especially after several fish-stock collapses, some fisheries are gradually learning the importance of sustainability. Indeed, over-fishing is a risk that needs to be managed. Thus, in some fishery regions, an annual threshold called total allowable catch limits the overall yield for each species. The goal of this limit is to ensure that the population rejuvenates and sustains itself over time.19 In some countries, within certain restrictions, quotas can be bought, sold, or leased to competing fishermen an interesting analogy to the recent cap and trade schemes for carbon emissions.
The immune system screens out antigens that target self One of the wonders of the human adaptive immune system is the astonishing variety of antigens that it can produce. The immune system generates around a hundred million antibodies housed in the body at any one time that can respond to the many variants of pathogens. However, some antigens mistakenly identify human cells as pathogens. Therefore extensive self/non-self screening is performed so that only antibodies that do not target self are released in the body. This prevents the second order effect of the body attacking itself.
Non-Linear Models: A Paradigm Change

By George Sugihara Most models utilize idealized linear, stable equilibrium dynamics. These are acceptable in engineering applications where linear approximations around an equilibrium point are reasonable. This works, for example, for springs and transistors. According to this view, systems can be decomposed into their parts, and their dynamics are statistically stationary. The fit of a model to the underlying observations (post hoc correlation) is its main measure of merit. However, what works for springs and transistors will not necessarily work for natural systems. Recently this paradigm has been challenged by the behaviors of non-engineered systems, such as the catastrophic collapse of some fisheries and financial markets. Such non-linear behavior cannot come from stable linear systems. Moreover many natural systems can show bursts of volatility that look anything but stationary, much to the chagrin of fisheries and financial risk managers. Fields ranging from finance to environmental science are now recognizing that many real world phenomena of interest are more accurately viewed as being part of a complex web of interacting parts that are fundamentally nonlinear i.e., non-equilibrium, unstable, and non-stationary in their dynamic behavior. At the leading edge of research nonlinear state space models describe multiple attractors instead of single equilibrium points. These models use the accuracy of real-time prediction as their measure of merit, in place of simple post hoc fitting or correlation. It is hoped that these models will not only be more useful in real-world applications, but also give insight into a whole class of general metrics that can tell whether a system risks transitioning into an unstable or catastrophic state. The benefits for monitoring systemic stability and enabling early counter-measures could be immense.
19 It is worth pointing out that in many countries, catch limits are determined by fishery councils incorporating inputs (including scientific inputs) from multiple stakeholders and experts. The catch limits are specified at maximum sustainable yield (MSY), a fixed equilibrium concept that stipulates the level at which the fish stock can replenish itself continuously.
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Reflections on Cooperative Hierarchical Networks Cooperative networks are common in nature, a classic ecological example being plants and their pollinators. While both plants and animals compete for resources within their respective groups, they also obtain mutual benefits across groups (nectar rewards for competing animals, pollination services for competing plants). Such cooperative-competitive networks also exist in the financial world e.g., hedge funds and prime brokers, or retail stores and payment systems. In cooperative ecological networks, hierarchies between generalists and specialists develop in which new specialists associate with generalists (rather than other scarce specialists). Such nested specialization has been shown to decrease overall competition in the system, thus allowing a larger number of species to co-exist than could happen otherwise. This results in a self-reinforcing mechanism in which the existing generalists gain more connections/size with every new specialist entering the system. The system grows larger as competitive feedback declines. In biology, cooperative hierarchical networks can collapse if a generalist species dies out, thereby increasing the competitive intensity of the many specialists that are affiliated with it. This is the equivalent of a systemically relevant institution collapsing in finance. Cooperative hierarchical networks can also, due to the abundance of species they support, reach a level where they become too big for their environment and collapse dramatically the equivalent of a global systemic crisis in finance. These analogies suggest that viewing finance as an ecosystem and applying some of the associated scientific modelling such as identifying networks of counterparty risk and keystone institutions whose removal could cause systemic collapse might well have merit for risk managers. George Sugihara, PhD Professor of Biological Oceanography McQuown Chair Professor of Natural Science Scripps Institution of Oceanography University of California, San Diego
Application to financial services The crisis has shown that many financial institutions created complex and opaque products because such products were usually associated both with higher margins and deeper client relationships through bespoke solutions. However, by their very nature, these offerings are difficult for general mainstream practitioners to understand. Many financial professionals thus had trouble managing the associated risks. It can be argued that the side effects of complex derivative structures were high leverage and opaque counterparty exposure, and that these elements were unclear to many stakeholders. At the institutional level, it is critical that senior managers mandate deeper and broader assessment of new-product business strategies on financial markets beyond the products direct impact. Senior managers should question high-order effects that products may have on other business units even those that appear completely unrelated, such as retail or wealth management as well as on customers and on the system as a whole, via a committee of all product representatives in a firm.
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Of course, individual institutions cannot necessarily see the impact of their products on the overall system. In order to allow for the possibility of such a systemic examination, it would be beneficial if the industry had a better coordinated data environment, as suggested earlier. This could lay the foundation to enable the analysis of systemic second- and third-order effects that cannot be easily carried out today. As discussed above , pharmaceutical companies actively examine side effects and involve regulators early in the product-design stage on a sign-off basis. Although pharmaceuticals and financial services are different industries, the latter can in our view leverage the lesson of involving regulators early in the product-development process to help identify systemic second- and third-order effects. However, to preserve the financial services industrys speed of innovation, this needs to happen on an informational rather than a sign-off basis. Regulators will likely need to upgrade their staffing levels and capabilities to engage meaningfully, but this would be a small cost compared to that of a full-blown crisis. Financial services regulators could perform unintended consequence analyses of complex new products once they have reached pre-determined aggregate volume thresholds. Equally, if a product is deemed systemically critical, it could be subjected to increased regulatory scrutiny. While the term systemically critical needs to be defined by the industry, once a class of products reaches this status, regulators could proactively examine its potential aggregate effect on the system. This could include regulators tracking where the potentially risky products reside, whom the products could impact in case of adverse market conditions, and how interactions between product sets and market dynamics might play out. Furthermore, as in the example of fisheries management, financial-services regulators could (in principle) be empowered to limit product activities that are deemed to pose excessive systemic risk. The caveat mentioned in aggregate system-wide data applies here also simply looking at product-level analyses without a systemic view is unlikely to be helpful or successful. To enable a renewed and true working relationship for assessing side-effects, trust between regulators and practitioners is essential. One way to jump start the process is by creating more public and private dialogue around how to best create positive transparency as opposed to excessive intrusion into the industrys operations to merely appease some parties desire for tighter supervision for the sake of it.
2.4 Innovate transparently

The cash flowing from mortgage payments into a single CDO had to filter up through several layers. Assets were bundled into a pool, securitized, stuffed into a CDO, bits of that plugged into the next CDO and so on and on. Each source of a CDO had interminable pages of its own documentation and conditions, and a typical CDO might receive income from several hundred sources. The Economist, 22 January, 2009 The immune system is vulnerable to rapidly mutating pathogens Some of the most dangerous pathogens, such as certain variants of plasmodium, the parasite that causes malaria, are those that mutate faster than the human body can initiate an adequate, specific immune response. In these cases, the adaptive immune system perpetually plays catch up, producing antibodies for an old version of the pathogen even as a new one launches a round of infection. Rapid change conceals a threat.
20 In Plato's cave. The Economist, 22 January, 2009
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Other pathogens exploit a related loophole in our immune response: antigenic memory. After an infection by a pathogen, the immune system will retain memory in the form of the cells that generated the specific antibodies required to fight it. This allows rapid response should an identical infection occur in the future. However, some pathogens, such as the influenza virus, exploit this feature by emerging with slight variations each season. If these differences are sufficiently slight, the immune system may not process and communicate the nuances of the new strain. White blood cells adapted to the old strain of the virus will reproduce and attack the intruder, but with diminished effect. This is known as the original antigenic sin, in the sense that the original antigen is the template for fighting future infections. Thus, the immune system must be vigilant. Not only does it need to constantly watch for foreign intruders, some of them rapidly mutating, but once a threat is recognized the immune system must initiate an appropriately customised response. Public health authorities can assist as an external immune system with the latter process by developing and distributing vaccines customised to the most recent variant of the virus. However the punch line is the same: Mutations pose problems for any immune system.
Telecommunications engineers keep it simple to increase transparency The telephone system was originally an analogue network. Connections were point to point, routed through physical exchanges by physical operators. Amplifiers were needed to boost signal strength periodically over long distances. Since then technology has evolved and Voice Over Internet Protocol (VOIP) is replacing the traditional network. Analogue voice signals are now digitized and data is transmitted in packets as 0s and 1s. There is no longer a simple signal route connecting geographies of the connected parties. Partly as a result, the network is now truly global.
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In writing the programmes that enable the new digital network, one important strategy that practitioners have developed is to keep it simple and modularize. This is necessary since the extent and complexity of the system means that programmes will often end up functioning in an environment unimagined by the original programmers. Since the environment mainly consists of largely unconstrained virtual machines rather than physical ones i.e. software not hardware this is an everyday occurrence. Even small errors can have unexpected consequences when far from home. As a result, best practice is to write programmes in small, easy-to-understand chunks. This helps programmers avoid errors in the first place, and detect or fix them more easily if they do occur. In addition, users distant in time and space can more easily read and understand the programme. Keeping it simple and modular increases comprehension and makes error-detection quicker, helping to reduce development costs. Simplicity and transparency co-exist.
Aircraft engineers use modular design Like computer programmers, aircraft engineers also design in modules. Most aircraft components can be detached individually for maintenance and can be tested independently. Components can also be reused as they are more flexible and installation is quicker and easier. From the system-wide perspective, if there is a problem identified with a modularized component, the component can be easily identified in all aircraft and if needed, substituted. Reusing tried and tested modular components in new designs reduces the risk of unexpected consequences.
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The pharmaceutical industry conducts drug testing with gradually increasing sample sizes to understand behaviour in broader populations Drug development is a long process involving sequentially expanding sample populations in order to examine and understand the system-wide risks and benefits of a drug. The process is staged into well defined modules, each of which is carefully and transparently documented. Development begins with in silico (i.e. in a computer) and in vitro (i.e. in a test tube) experiments to characterize chemical structure and drug activities. Testing proceeds to cell cultures and then to animals where scientists learn how the drug interacts with natural biological systems. Afterwards, multiple stages of clinical trials involving humans are conducted with increasing sample sizes. Phase I involves dozens of people, and trials gradually expand to several thousand people. Testing is conducted carefully to assess drug efficacy and side effects, while not exposing the entire population to uncertainties all at once. At any phase, if the testing process reveals adverse side effects or interactions that outweigh the calculated benefits, the drug development programme ends and the drug will not go to market.
Information Management in Biology: A Model for Financial Systems

By Harvey Rubin Integrated and efficient information flow and management is essential for living systems. Bacteria, for example, are far from being vulnerable tiny creatures. They have a robust, adaptive regulatory system that optimizes the growth of the colony given any external and internal set of conditions. They adapt to the composition of the growth media, the temperature, acidity, and salinity of the environment, the presence of damaging radiation, attack by other organisms that produce toxins or even antibiotics, and many other colony-threatening conditions. Growth and division of healthy human cells are strictly controlled or premature cell death may occur, or unregulated cell-growth malignancies may arise. Successful adaptation depends on sensing the environment in combination with regulatory mechanisms that are built into the system itself. Control engineers call this supervisory control, where controllers share certain information and communicate with each other as well as with a supervisor that can switch between local controllers based on other information flows. Robustness of the system in unpredictable environments is directly related to the success of the controllers. Much like these complex engineering systems, control in living systems works over a range of temporal and spatial scales, can be autonomous or central or both, and works only if relevant information is sensed, processed, and distributed to the components of the system that need it. It is important to note that not every component of a complex system needs every bit of information for the system to work optimally. In fact, quite the opposite is true. Complete sharing of information in biological systems, where every molecular receptor would recognize and respond to every signal, is not compatible with life. Biological systems are replete with exquisitely specific molecular receptors tuned to respond to very specific signals and information and no others. Breakdown of the specificity can leads to disease or death. In nature, innovation exists even in regulated and tightly controlled systems.21 Indeed, controllers allow innovation to emerge through selection for fitness in an evolutionary sense. It all depends on assiduous and appropriate information flow and management. Harvey Rubin, MD, PhD Professor of Medicine, Microbiology and Computer Science Director, Institute for Strategic Threat Analysis and Response (ISTAR) University of Pennsylvania
21 Regulation in biology refers to changes in the frequency, rate or extent of a process that generally leads to a more robust living system.
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Application to financial services In financial services, opaque products and markets often translate to increased short-term profit but also longer-term system instability. For example, leading up to the recent crisis, complex products were created largely at the customers request, it should be noted that were hard to understand in and of themselves, let alone at a systemic level. Customers and institutions had difficulty managing the associated risks of many products, especially when they mutated beyond their original intent of spreading risk across institutions and/or were deployed in quite different environments. For example, numerous variants of risk management products were extensively deployed for speculation or yield enhancement. This opacity also reduced the industrys overall understanding of the aggregate risks in the system. The mutation of financial products and their uncontrolled environmental spread either through unexpected volume growth, proliferation to unintended clientele, or use for different purposes can pose issues for systemic stability. Similar to how the immune system detects pathogenic nuances to adequately respond to a specific strain, risk management departments need to understand how products have evolved over time. While there is no natural central intelligence in the immune system to speed up or direct detection, financial institutions can bolster risk monitoring to detect mutations. Product transparency is crucial in detecting these mutating instruments. Institutions and regulators should be especially concerned with product volume increases that seem out of line with growth in the underlying target market. Once potential threats are identified, institutions need to ensure that measurement and control frameworks remain effective in managing the associated risks, and adapt risk management strategies if needed. At the system-wide level, innovations or mutations often exploit loopholes in the regulatory framework. If the loopholes identified are properly addressed by altering risk management techniques, system stability can be strengthened. However, regulators should consider rethinking the process and pace of updating regulatory requirements to address gaps in a timelier manner. Several years are too long in a market that innovates monthly. To further increase risk, transparency and understanding and following the lead from telecommunications institutions could keep things simple when crafting new products. This could mean breaking them down into recognizable modules with appropriate documentation. In fact, new products that are originally seen as complex and cutting-edge do generally become more standardized. This suggests that it is possible to create bespoke risk-management products aimed at addressing unique client needs by breaking down complex products into simpler components. However, since transparency often makes life easier for copy-cats, many institutions might not be able to fully mandate this on their own. Regulators should therefore encourage simplicity and modularization in product design. One technique for regulators to consider is to institute a standard nomenclature framework that institutions could use to describe their products and the associated risks. It could be beneficial to have a common language for the buy-side, sell-side, regulators, and consumers who are not necessarily aware of a product, to be immediately able to codify the risks and rewards a product embeds. Such a framework could help consumers better understand risk/reward trade-offs and help regulators better monitor system-wide risk exposures. The framework would be effective only if it could fit all new products and meaningfully describe them. Since there is a fine line between standardization and homogeneity, it would be critical that the nomenclature describes, not restricts, product innovation. The framework should fit the products, not dictate product design. Regulators could also consider lowering capital and compliance requirements for new products that consist of existing, well-understood modular components, similar to the modularity principle in aircraft design. This would increase transparency, and hopefully help the financial services industry better understand component interactions that could be dangerous to the system. In addition, once a component or a collection of components is deemed unsafe, it can be identified and managed throughout the system.
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Chapter 3 Governance and Culture

3.1 Introduction
In many domains, the threat of personal harm, especially physical harm, creates a healthy fear of taking risks and creates a strong risk-sensitive culture. By contrast, this type of threat does not exist in finance: no matter how bad things get, nobody dies. Moreover, the financial-services industry is in many instances highly asymmetric where risk taking is concerned. The potential for windfall personal compensation from institutional risk-taking creates a culture that is more sensitive to reward than to risk. Much commentary on the recent crisis has frequently, and rightly, pointed to issues with governance and culture in the industry which includes regulators as well as practitioners. In addition to asymmetry, a focus on relative performance prior to the recent crisis encouraged herd behaviour. This homogeneity and lack of contrarian voices was a key cause of the accumulation of similar risks across the system, as well as to a synchronized run for the exit when those risks started to become apparent. The implied view, that an absolute loss was acceptable as long as it was less than that of the competition, collided with the reality that an institutions capital does not tolerate absolute losses above a certain magnitude. Furthermore, it is fair to say that an industry so heavily focused on relative performance would find it difficult to listen to cautious voices. Looking for trouble is not something that comes naturally in this environment. One highly-publicized illustration of this point is the Bernard Madoff scandal. The few who had long claimed that the performance of Madoffs investments was technically impossible were ignored by the many because the returns, and the marketing, were so attractive. In some corners of the finance industry, arrogance took hold, particularly when it was supported by such apparent financial success. This undermined the effectiveness of controls set by institutional risk departments and regulators. Finally, a culture of specialization often meant that staff operated in silos with little sense of responsibility for the overall business. In cases where the silos were linked, the linkage was often through processes or technology neither of which created a sense of empowerment or ownership. In areas where the linkage was personalized frequently only at the senior management level there was typically not enough detail to spot some of the risks in very technical products.
How can the industry instil risk-sensitivity into its governance and culture? The financial services domain could more proactively (1) Look for trouble, (2) value experience, and (3) empower the front line.
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The Tragedy of the Commons

By Glenn Reed Until the latter half of the 20th century, over-harvesting of ocean fish was popularly thought to be impossible. Culturally, many people had and in some places continue to have a strong belief that access to this common publicly owned resource was a birthright. One consequence of this attitude has been that even when fishermen could see resources declining, they would continue to harvest at unsustainable levels. They knew that if they didnt harvest the fish, someone else would. The term race for fish was used to describe this self-destructive behaviour. Yet it was recognized that the continued treatment of the seas as a common resource would lead to additional problems unless a management regime could be devised to prevent it. Attempts to control fishing through restrictions such as license limitation programmes, in which the number of fishermen is limited, have proved difficult. Iceland and New Zealand have had greater success by creating privatized fisheries through government regulation, and have become models for more recent programmes in the United States. In this privatization model, also called rationalization, the tragedy of the commons is replaced by allowing fishermen to own a tradable share of the former common resources. Once the resource is owned by fishermen, or other stakeholders, it becomes as asset to be protected over the long term and not overexploited for short-term gain.22 Each fisherman has a share of the total allowable harvest, and must stop fishing when that limit is reached. Rationalization and quota-based management approaches can only flourish after a change in culture. Once in place they are usually embraced, as illustrated, for example, by the economic benefits of privatization. An additional benefit in a rationalized sea environment is that fishery managers and industry have greater ability to minimize negative impact to ocean habitat. Glenn Reed President Pacific Seafood Processors Association
3.2 Look for trouble

Why was this allowed to happen? At a deep level, I believe that the problem was ideological: [] committed to the view that the market is always right, [practitioners] simply ignored the warning signs. Dr. Paul R. Krugman, Professor of Economics and International Affairs, Princeton University, and recipient of the 2008 Nobel Memorial Prize in Economics, 3 December 2007. 23
22 It is worth pointing out that Dr. Elinor Ostrom, the 2009 co-Nobel Prize winner in economics, has made an important contribution to our understanding of how the tragedy of the commons can be avoided by exploring public and private ownership. See: Scientific Background on the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2009: ECONOMIC GOVERNANCE. The Royal Swedish Academy of Sciences, http://nobelprize.org/nobel_prizes/economics/laureates/2009/ecoadv09.pdf, 2009. 23 Krugman, P. Innovating Our Way to Financial Crisis. New York Times, http://www.nytimes.com/2007/12/03/opinion/03krugman.html?_r=1, 3 December 2007.
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The WHO looks for trouble In the 1990s, the World Health Organization, mandated to provide leadership on global health matters24, principally performed passive infectious disease pandemic surveillance. Member nations reported outbreaks to the WHO, which in turn generated responses. However, national reporting was slow and often incomplete, and as a result, so was the WHOs response. The latter part of the decade brought increasing number of epidemic outbreaks. For example, pneumonic plague broke out in Surat, Gujarat, India, in 1994 and Ebola hit Kikwit in the Democratic Republic of the Congo in 1995. Many people died; panic ensued; the idea that infectious disease had been conquered receded. Consequently, the WHO concluded it needed to improve response times and therefore detection speed. The WHO went looking for trouble: they turned their approach on its head and switched to active surveillance (with the support of technology), and linked it to assistance and response. The Global Public Health Intelligence Network (GPHIN) was developed and launched by Health Canada in 1999. Today, in its second generation, GPHIN crawls through the web in search of news items that might indicate potential disease outbreaks around the world. It automatically and continuously scans and translates articles in seven languages. Canadian public health officials aggregate and screen the data, then send them on to the WHO. A WHO team meets daily to discuss the reports and decide which incidents need verification from WHO country offices. Moreover, the International Health Regulations, in effect as of June 2007, empower the WHO to further investigate informal leads in some circumstances in order to mount an actionable response and assist nations in need.
24 The role of WHO in public health. World Health Organization, http://www.who.int/about/role/en/index.html, 2009.
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The WHO can now detect and respond to potential disease outbreaks quicker. Today, it uses additional epidemic intelligence services to constantly look for trouble. The WHO also engages its offices in 144 countries, as well as affiliated laboratories and non-profit organizations, to investigate unusual events and patterns. In response, member countries have raised their game and are increasingly the first to report incidents themselves. This is encouraged by the provision of practical and rapid assistance.
The immune system is constantly responding to new invaders In the face of constant threats, the human immune system is constantly monitoring and adapting to identify and fight new pathogens. Molecular pattern recognizers throughout the body continuously scan for generic signs of the presence of pathogens. When they encounter a hostile pathogen, they secrete signalling molecules asking for specialized help even as they initiate a first wave of generic defence. Specialized and numerous white blood cells circulate constantly throughout the body. Upon picking up these distress signals, they hone in on the origin. When they detect the specific target pathogen, they lock on and destroy it.
Aviation regulators also look for trouble Over the past decade, aviation regulators have also begun to look more avidly for trouble. One of the purposes of FAAs ASIAS programme, which aggregates system-wide data, is to search for unrecognised patterns in near-miss incidents to help detect and fix small problems that have the potential to lead to bigger systemic issues.
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Application to financial services Leading up to the recent crisis, senior management, business units, and risk-management functions in many financial services institutions were often not actively looking for emerging new threats. Monitoring and reporting functions were performed routinely, by-the-numbers, without going beneath the surface to sniff out potential problems. As long as the dashboard glowed green, everything was thought to be just fine. As a result, many institutions failed to spot or worse, ignored warning signs that a systemic crisis was lurking and were underprepared when it hit. To better detect such signals, financial institutions and regulators should actively look for trouble. The industry should constantly search for new patterns that might indicate problems at both the institutional and system-wide level. Even though there will inevitably be some false alarms, the overall result will be worth the effort especially given the consequences that ensue when the system does break down. The few institutions that have thrived though the crisis tended to be those that acted on a nagging feeling that something was not quite right, dug deep to find its causes, and restrained their risk-taking as a result. To this end, financial institutions and regulators could consider dedicating teams to conduct proactive examinations and analyse unusual patterns. At the system-wide level, better coordination of relevant data, as suggested earlier in this paper, could facilitate such analyses. But being a vigilant watchdog is not enough. The sector should also respect and embrace dogs that bark the contrarians. Practitioners should have an inquisitive nature to follow evidence trails and imaginative personalities to generate creative scenarios. At the institutional level, firms could consider rotating practitioners through business and risk departments to broaden their perspectives and encourage diverse views. Some institutions already do this successfully today. Once dedicated teams uncover risk-management concerns, those teams should work with corporate risk management functions and business units to develop contingencies and adapt strategies in response. Moreover, institutions need a channel to escalate and adequately discuss such issues, and a shift in culture such that warnings are heard and acknowledged. Senior managers and Board members should expect to see risk reports with problems highlighted. A uniformly rosy outlook should prompt concern, not comfort. Institutions and regulators should also be in constant pursuit of effective metrics that signal emerging stress, and be aware that existing metrics inevitably become less effective over time.25 Regulators could thus consider experimenting continuously with new warning indicators such as excessive leverage, crowded strategies, counterparty concentration, or funding source concentration to measure system stability. By making this process dynamic, the industry will hopefully be able to find and employ metrics to signal the next crisis rather than the previous one. Of course, while a culture of vigilance and supportive mechanisms can help detect risks, experience is necessary to give context and understanding to the search.
25 It is worth pointing out that Goodharts law, first stated in 1975, suggests that some observed statistical metrics in the context of macro-economic policy control tend to lose their effectiveness once regulators decide to use them. See Goodhart, C. Monetary relationships: a view from Threadneedle Street, Papers in Monetary Economics, Reserve Bank of Australia, 1975.
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3.3 Value experience

For most of us, this is uncharted territory. Inflation has been the predominant concern of policy makers in the U.K. for well over 50 years and almost nobody alive in the U.K. has had any experience of deflation Tim Besley, former Member of the Bank of Englands Monetary Policy Committee, 21 December 2008 26
Wildfire fighters value experience Wildfire fighters make life-or-death decisions. At times they have only minutes to make the call between fight and flight. They must therefore maintain what they call situational awareness constantly watching for and evaluating changing conditions. The only way to gain such awareness is through experience. Although wildfires are complex, involving interactions among weather, vegetation, and terrain, most are limited in size and severity. Yet large and uncontrollable mega-fires occasionally break out that defy conventional efforts to extinguish them. In addition to their sheer size, mega-fires are dangerous because most wildfire fighters have never experienced one, and hence their situational awareness is limited.
26 MPC man: 'We are in uncharted economic territory'. The Daily Mail, http://www.thisismoney.co.uk/markets/article.html?in_article_id=461555, 21 December, 2008.
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Passing fire fighting experience to new generations to prepare them for mega-fires is crucial. To this end, many countries emphasise the retention of experienced fire fighters, on both a full-time and on-call basis, to ensure that their experience of fighting mega-fires is available. In addition, fire strategists have attempted to capture and codify their experience electronically. After each event, a full account including what triggered the fire, the evolution of its path, the methods used to extinguish it, the damage incurred, and the lessons learnt is carefully recorded. Over time, a body of knowledge is established documenting the complete fire history of a region. These data are critical both for training junior fire fighters and for ongoing fire management. As a last resort, on-call experienced fire fighters are drafted to the scene of a mega-fire to bring their experience to bear.
Aviation learns from post-accident analysis In 1989, the U.S. National Transportation Safety Board reported 0.144 fatalities per 100,000 departures in the United States. Almost twenty years later, in 2008, the NTSB reported only 0.019, 77% fewer than in 1989.27 How was the industry able to improve safety so dramatically from what was already a low base? Nicholas Sabatini, Associate Administrator for Aviation Safety at the FAA describes aviations diagnostic approach as follows: We lose one. We investigate. We learn what happened. We make corrections. 28
27 Aviation Safety Statistics. National Transportation Safety Board, http://www.ntsb.gov/AVIATION/Table5.htm, 2009. 28 Sabatini, N. Downward Pressure on the Accident Rate. FAA, http://www.faa.gov/news/speeches/news_story.cfm?newsId=7170, 2006.
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Aviation has mastered the use of post-accident analysis. When an incident occurs, the regulator, operator, manufacturer, and even competitors conduct investigations. This can take anywhere from several months to several years depending on the incident and the exact parties analyzing it. But these parties do not just passively record the causes of accidents. They learn from them and make changes to their operations, whether it means grounding a certain type of aircraft with a potentially dangerous component, changing maintenance protocols, or revising a flight manual. This flight manual, updated as new lessons and experiences are recorded, contains documentation on procedures for all known scenarios. The manual is sometimes used in live situations by pilots to help determine their actions.
The immune system logs memory on past incidents After fighting a pathogen, the human immune system maintains a population of memory cells - white cells tailored to fight the specific intruder. The next time this pathogen re-enters the body, these cells can be very quickly activated, providing protection and often immunity (memory cells are the basis for vaccinations).
Application to financial services Practitioners in financial services, like wildfire fighters, need to take advantage of situational awareness to sense danger and mitigate risk. Such awareness comes with learning from experience. Yet the industrys workforce, particularly in trading businesses, is often so young that very few people have had hands-on experience of extreme conditions. The financial services industry needs to ensure that it can leverage its more-experienced employees both at institutions and regulatory bodies. In addition to the teams actively looking for trouble, as previously described, this could be achieved by setting up specific on-call crisis task teams made up of experienced former employees. Following the reserves concept in the military, these teams would be called into action only in the event of an emergency. Perhaps most importantly, institutions should consider recruiting board members who have lived through major financial events or other catastrophes. Of course, to be effective, they must also understand financial products and recent innovations. Indeed, if financial institutions could capture personal accounts of past events, they could better transmit important lessons to new generations and build enhanced risk management capabilities. Like wildfire fighting, financial services companies could create an experience logbook readily available to all employees made up of first-hand narrative accounts of past incidents. These narratives could include video accounts highlighting the most severe moments. Such vivid, first-person accounts help history come alive and keep the memory fresh.29 These accounts could be used in internal training and regulators could consider mandating their use for senior management training.
29 Ariely, D, Carmon, Z. Gestalt Characteristics of Experiences: The Defining Features of Summarized Events. In Journal of Behavioral Decision Making, 2000, 13:191-201.
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Moreover, in wildfire fighting, experienced practitioners are retained to build knowledge in the squad even if they have made honest mistakes in the past. In the financial world, leaders are often dismissed if they are linked to an incident, sometimes regardless of whether they were responsible personally or not a convenient scapegoat response that eliminates the need for a full post-mortem and allows the organization to move on without introspection. While it is obviously important to hold individuals accountable for their actions, financial institutions need to investigate incidents in depth to truly understand the causes before attributing blame. Following the fire fighting example, the financial services industry could consider changing the balance between finding scapegoats and learning from mistakes. Accordingly, the industry needs to improve its culture of investigation, as has already been pointed out in look for trouble.
3.4 Empower the front line

When I was head of group regulatory risk at HBOS, I certainly knew that the bank was going too fast (and told them), had a cultural indisposition to challenge (and told them), and was a serious risk to financial stability (what the FSA call maintaining market confidence) and consumer protection (and told them). Paul Moore, former HBOS Head of Group Regulatory Risk, HBOS, 10 February 2009 30
30 HBOS whistleblower statement. BBC News, http://news.bbc.co.uk/2/hi/uk_news/politics/7882581.stm, 10 February 2009.
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In aviation, front line crew and maintenance workers are encouraged to raise safety issues On March 27, 1977 a KLM 747 aircraft and a Pan American 747 collided on a runway in the Canary Islands. None of the 234 passengers or 14 crew members on the KLM flight survived the accident. Of the 16 crew on board the Pan Am plane there were 9 fatalities, and only 61 of the 317 passengers survived. This has been considered one of the worst plane crashes of all time. One of the causes attributed to the accident in the official report was cockpit hierarchy. The KLM pilot was very senior. While it is apparent that both the co-pilot and the flight engineer questioned his decision making, once the senior pilot emphatically said that all was okay, neither of them probed further. The crash occurred 13 seconds later.31 Since this incident, the aviation community has aimed to de-emphasize cockpit hierarchy. One of the roles of the co-pilot is to help manage risk, and he or she must be empowered to raise safety issues. This input must be valued by the pilot. Aviation has now standardized this modus operandi, termed crew resource management 32. In commercial aviation, those on the front line are empowered to raise aircraft safety issues. Mechanics and flight deck crew can ground an aircraft if they deem it or the flying environment unsafe before take-off. During flight, if pilots notice any issue from restroom leaks to engine failure they log it. Unless a qualified maintenance person signs off on corresponding repairs after landing, the plane cannot fly again.
Physicians are empowered to make front-line decisions In Infectious Disease Control (IDC), disease diagnosis and management protocols are set by the WHO and national authorities. But often individual practitioners, who are empowered to make decisions locally, can have dramatic influence. For example, during the SARS outbreak in 2003, Dr. Wing Hong Seto of Queen Mary Hospital in Hong Kong vigorously reinforced performing the basic procedures of hand washing, wearing masks, and disposing of wastes. Only two healthcare workers at Queen Mary Hospital suffered SARS infections, compared with at least 87 at the nearby Prince of Wales Hospital.33
31 Joint Report KLM-PAA. December, 1978. Madrid: Ministerio de Transportes y Comunicaciones. 32 Crew Resource Management was coined in a 1979 NASA safety workshop 33 Abraham, T. Twenty-First Century Plague: The Story of SARS. Hong Kong: Hong Kong University Press, 2004, 2005.
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There is no central governor managing an immune response The human immune system is an interesting perhaps unique risk-management model because decision making is completely decentralized. There is no master authority dictating where resources should be transferred or which area of the body gets the highest priority. Rather, each individual immune-system cell is equipped to fight a specific pathogen and is responsible for fighting any it encounters. The accumulation of these individual actions leads to effective system-wide pathogen population control.
Fire fighters on the front line are empowered to make tactical decisions In wildfire fighting, frontline staff are empowered to make on-the-scene decisions because they are best equipped to leverage situational awareness. The central command is responsible for managing the overall decision-making process and strategic resource allocation, but not for individual tactical decisions. Under the U.S. incident command system, when a wildfire breaks out, the first responder on the scene assumes command until a higher-ranking fire fighter arrives. Decisions must be made swiftly because a delay could allow the fire to spread further.
Application to financial services Leading up to the financial crisis, relatively few front-line worries filtered up to senior management at most institutions. Communication channels were inefficient, and many senior management teams did not encourage the raising of difficult issues. Risk concerns were therefore mentioned infrequently, and when brought up they were largely ignored. As a result, senior management teams at many institutions did not detect the crisis early on and were not prepared when it hit. The financial services community should become more willing to solicit and consider responsible input from employees at all levels, especially when the input concerns risk management. Institutions could start by reinforcing the importance of front-line staff reporting their views and then supporting them when they do, whether senior management agrees with the offered viewpoint or not. Furthermore, senior management should communicate that consistent no issues or problems declarations would be considered too good to be true and mean it. For example, if a junior staff member feels compelled to raise a difficult issue, he or she needs to feel confident that no penalty or prejudice will ensue. In fact, institutions could consider rewarding junior staff for such behaviour. Both business units and the risk-management function could jointly contribute to the equivalent of a pilots log on risk. Any persistent absence of such contributions by one of the two parties would be cause for concern and reflected in performance reviews. That said, the fundamental separation of duties in business and risk-management functions is essential, and the latter should continue to occupy a control function over the former. Mutual understanding and ultimate alignment with the institutions goals can be achieved through mechanisms such as training and staff rotations that do not compromise organizational integrity. Some organizations already do this between infrastructure and business areas. Following the aviation example, institutions could try to instil in their front-line employees the notion that managing risks for the institution is in their hands. Indeed, personal responsibility could be repeatedly emphasized during training and coaching, and during formal appearances by institution leaders. Also, junior employee incentives should be aligned with institutional goals through appropriate compensation systems. Ultimately, front-line and central functions can be synergistic. The front line can leverage situational awareness, and the central function can see a larger, holistic picture of institutional and systemic risk.
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Chapter 4 Conclusion
Through examining domains outside of finance, nine potentially transferable risk management lessons were identified for the financial services community to consider. They fall under three focus areas: (1) system-wide perspective, (2) transparency and information flow, and (3) governance and culture. Consistent with the point on the importance of internalizing past lessons, financial services policymakers, regulators, and practitioners could engage in further dialogue to discuss how best to incorporate these findings into future policy, regulation, and practice. The overall aim is to increase the resilience of the global financial system. While the financial system appears to be stable for the immediate future, the financial industry should pause and reflect on past risk-management practices and actively explore potential changes that could be made going forward. The following questions are critical: How can the industry make the proper trade-off between information protection and disclosure as it seeks to enable system-wide risk monitoring and management? How can the rejuvenation and safety of the financial system be balanced without either creating moral hazard or system fragility? Is the industry on the right track with the current regulatory approach? How can the benefits and vulnerabilities associated with regulatory convergence be balanced? How can the industry adapt (structurally and culturally) to new threats and innovations of the future, given that it does not yet know the products, the markets, the players, and the consumers of the future? Given that the next crisis is very unlikely to be prevented by a central controller, how can the industry resist the temptation to solve stability issues by over-centralisation and instead strengthen the resilience of individual systemic nodes? The implementation of any needed changes will neither be easy nor can it happen overnight. Some require a phased approach; others require voluntary initiatives from the private sector; yet others require regulatory mandates. Above all else, international and cross-industry cooperation and trust are crucial to achieving system-wide resilience, and it is in this spirit that this report has been researched and written. The project team thanks those who have contributed to this effort, and looks forward to the ongoing debate.
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Managing Risks in Civil Aviation: A Review of the FAAs Approach to Safety. September 2008. Washington DC: Independent Review Team. Managing the Risks from Medical Product Use, Creating a Risk Management Framework, Report to the FDA Commissioner from the Task Force on Risk Management. U.S. Department of Health and Human Services, Food and Drug Administration, May 1999. Martin, D. Managing Risk in Extreme Environments. London: Kogan Page, 2008. Medicine Safety Education. Pfizer, http://www.pfizer.com/health/medicine_safety/medicine_safety_education.jsp, 2009. Meister, A. The New Zealand Experience with Fishery Management: Lessons Learned: Economy and Environment Program for Southeast Asia. http://www.idrc.ca/eepsea/ev-8324-201-1-DO_TOPIC.html, 2002. Michaels, D. Maxon, T. Some question FAAs oversight strategy in light of Southwest incident. The Dallas Morning News, http://www.dallasnews.com/sharedcontent/dws/bus/stories/031608dnbusFAAfolo.3a08159.html, 2008. Morgan, P., Hardy, C., Swetnam, T., et al. Mapping fire regimes across time and space: Understanding coarse and fine-scale fire patterns, International Journal of Wildland Fire, 2001, 10:329-342. Murawski S. Ten myths concerning ecosystem approaches to marine resource management, Marine Policy, NOAA / NMFS, 2007. National Multi-Agency Coordinating Group: Preparedness Strategy 2009. National Interagency Fire Center, http://www.nifc.gov/nicc/administrative/nmac/strategy/Preparedness_Strategy_Introduction.pdf, June 2009. Navigating the Council Process A Guide to the Pacific Fishery Management Council, Second Edition. Pacific Fishery Management Council, 2007. Pandemic Influenza Preparedness and Response, A WHO Guidance. World Health Organization, www.who.int/csr/diseases/influenza, 2009. Rauscher, K. Protecting Communications Infrastructure. Bell Labs Technical Journal, 2004, 9(2): 14. Roos, R. WHO may redefine pandemic alert phases. Center for Infectious Disease Research & Policy, http://id_center.apic.org/cidrap/content/influenza/swineflu/news/may2609phases-jw.html, 2009. Sabatini, N. Downward Pressure on the Accident Rate. FAA, http://www.faa.gov/news/speeches/news_story.cfm?newsId=7170, 2006. Sompayrac, L. How the Immune System Works, 2nd Edition. Malden: Blackwell Publishing, 2003. Southern California Fires 2007: What we learned, how we worked, Wildland Fire Lessons Learned Center, 2007. Stimpson, E. McCabe, W. Managing Risks in Civil Aviation. AeroSafety World. November, 2008:11-14. http://www.airlines.org/NR/rdonlyres/755F5E03-F457-41BC-A453-ED38F7F375B7/0/ManagingRisksinCivilAviation.pdf. Testimony of Michael Sissenwine, Chief Science Advisor, NOAA / NMFS on Data Programs for Fisheries Management Purposes before the Sub-committee on Fisheries Conservation, Wildlife and Oceans Committee on Resources, US House of Representatives, 2004. The de Larosire Group. The High-Level Group on Financial Supervision in the EU Report. http://ec.europa.eu/commission_barroso/president/pdf/statement_20090225_en.pdf, February 2009. The Final Eight Minutes. PBS, http://www.pbs.org/wgbh/nova/planecrash/minutes.html, 2006. The State of World Fisheries and Aquaculture, 2008, Food and Agriculture Organization of the United Nations, 2009. The Sunken Billions The Economic Justification of Fisheries Reform, The World Bank, 2009. Thomson, I. FBI warns of VoIP spoofing threat. Secure Computing Magazine, http://www.securecomputing.net.au/News/130880,fbi-warns-of-voip-spoofing-threat.aspx, 2008. United States Pharmaceutical Product Liability: Current Trends and Risk Management, BioInsights, Biotechnology & Life Sciences Practice Group, August 2006. World Health Organization, http://www.who.int, 2009.
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Appendices
Appendix 1: Project Background and Approach
The project was launched in the aftermath of the recent credit crises as an industry partnership initiative mandated by the Forums Financial Services community at the World Economic Forums Annual Meeting in Davos in January 2009. Recognizing that many non-financial-services disciplines have a high potential for risk management lessons that are applicable to the financial system, the working group began by selecting nine domains for further research based on their track records in managing risks within complex systems. These domains were fisheries management, wildfire fighting, pharmaceuticals, aviation, telecommunications, immunology, infectious disease control (IDC), chemicals, and logistics. However, the working group then decided to concentrate on the first seven and filter out chemicals and logistics. Although there are certainly lessons to be learned from the latter two domains (including for example, the use of safety valves, built-in redundancy, and rigorous contingency planning) the working group felt that such lessons were not necessarily unique and could be captured elsewhere. In order to capture the best ideas from the other domains, the working group undertook an independent, multidisciplinary effort. Academics, industry practitioners, and regulators from each domain were engaged through workshops and interviews. Some of the ideas of selected experts are included as sidebars in this report. The risk management lessons gathered from many expert interviews and secondary research in each domain are summarised and included in the appendix. Some of these lessons are further synthesized in the body of the report, while some remain solely in the appendix, as there was limited direct transferability to financial services. As a framework for examining how lessons from other domains can apply to financial services, the working group chose to focus on three areas 34: (1) system-wide perspective, (2) transparency and information flow, and (3) governance and culture. (1) System-wide Perspective: System-wide perspective looks at the compilation of interconnected local-level risks with a holistic lens. This contrasts with local-level perspective, which examines localized risk management practices in terms of transactions and specific entities. (2) Transparency and Information Flow: Transparency and Information Flow refers to the mechanisms through which information is exchanged within an organization and across a larger system. It addresses how risk signals are detected, reported, and escalated. It concerns how decision makers receive the best available information in a timely manner. (3) Governance and Culture: Governance refers to the rules and oversight of all activities related to risk ownership and responsibility. It includes the following five topics: why decisions are made, how they are made, how they are escalated, who makes the decisions, and the processes for monitoring these decisions. Governance is underpinned by an organizations risk culture the set of shared attitudes, values, goals, and practices that characterizes an institution, organization, or group. A risk-sensitive culture is one in which individuals are willing to voice risk-based concerns without potential negative consequences.
34 Originally, when analyzing risk management lessons in the seven domains, the working group also looked at Decision Tools and Processes as a fourth focus area. However, the translation of these learnings to Financial Services was not deemed as relevant or innovative and was therefore not featured in this report (although the related domain lessons remain in the Appendix).
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Finally, it is important to note that the explored domains are very different in nature. Major differentiators include: Evolved versus designed, and social versus engineered systems Tolerance to risk (accepting risk is core to the financial-services business paradigm) Clear definition of the enemy in certain domains (e.g. pathogens can cause disease, whereas in financialservices products, depending on their nature, can turn from good to bad) The distinction between risk and safety in some domains The outside domains examined may not be entirely relevant to all aspects of the financial services realm. This report focuses on potentially transferable lessons while acknowledging that no domain is perfect at managing risk or indeed fully comparable to financial services. When thinking about transferring lessons, readers should consider the following framework, where the shaded quadrants denote the primary focus of the report.
Effect Large, non-systemic event Exogenous shock to system Cause Endogenous unstable state of system [2] [3] [1] Systemic damage or meltdown [4]
By reference to the recent crisis (which was systemic), the report when focused at the financial system addresses quadrants [3] and [4] with priority over the other quadrants though some of the other domains have different priorities in their handling of risk. Aviation is a good case, where the possibilities for systemic damage are less numerous than those for large non-systemic events, such as plane crashes. However, by way of example, a design flaw in an altimeter initially resides in quadrant [2], but can easily migrate into [4] should it remain undetected and affect large numbers of commercial aircraft that are simultaneously vulnerable due to specific circumstances (e.g., weather). Quadrants [1]/[2] and their associated analogies from other domains will still be relevant to readers who are in charge of large institutions, and therefore domain stories are emphasised in order to spur creative thinking and for readers to draw some of their own conclusions beyond what is outlined directly in the report.
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Appendix 2: Summary of Risk Management Lessons from Aviation
Appendix 3: Summary of Risk Management Lessons from Fisheries Management
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Appendix 4: Summary of Risk Management Lessons from IDC
Appendix 5: Summary of Risk Management Lessons from Immunology
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Appendix 6: Summary of Risk Management Lessons from Pharmaceuticals
Appendix 7: Summary of Risk Management Lessons from Telecommunications
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Appendix 8: Summary of Risk Management Lessons from Wildfire Fighting
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Acknowledgements
This publication is a synthesis of ideas of many individuals from financial services and other domains. The Rethinking Risk Management in Financial Services project team would like to thank everyone involved for contributing so generously their time, energy and insights. The project team would also like to offer its special gratitude to the members of the Steering Committee for their guidance, and to the Senior Project Advisors and the members of the Working Group for their contributions through workshops, idea generations, and document reviews. Their devotion is critical to the shaping of this report.
Steering Committee Iain Abrahams, Head of Liquidity, Risk and Capital Markets, Barclays Capital Lzaro Campos, Chief Executive Officer, SWIFT Karl Guha, Chief Risk Officer, UniCredit Group Axel Lehmann, Chief Risk Officer, Zurich Financial Services Simon Levin, Moffett Professor of Biology, Princeton University Erwann Michel-Kerjan, Managing Director, Wharton Risk Management and Decision Processes Center, The Wharton School, University of Pennsylvania David Rhodes, Senior Partner and Managing Director, The Boston Consulting Group Luke Savage, Director, Finance, Risk Management and Operations, Lloyds of London Cneyt Sezgin, Member of the Board of Directors, Garanti Bank Raj Singh, Chief Risk Officer, Swiss Re Paul Smith, Treasurer, State Farm Insurance Jim Webber, Chief Risk Officer, Aviva Tom Wilson, Chief Risk Officer, Allianz Vanessa Wittman, Chief Finance Officer, Marsh & McLennan Companies Inc Mark Yallop, Chief Operating Officer, ICAP Plc Gian Carlo Bruno, Director and Head of Financial Services Industry, World Economic Forum USA Kevin Steinberg, Chief Operating Officer, World Economic Forum USA
Senior Project Advisors Michael Drexler, Managing Director, Head of Strategy & Planning, Barclays Capital and Barclays Wealth Duncan Martin, Partner and Managing Director, The Boston Consulting Group Philippe Morel, Senior Partner and Managing Director, The Boston Consulting Group David Rhodes, Senior Partner and Managing Director, The Boston Consulting Group
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Working Group Philippe Carrel, Thomson Reuters Herv Geny, ICAP Plc Anwarul Hasan, Swiss Re Daniel Hofmann, Zurich Financial Services Ltd Henry Johnson, Lloyds of London Ajay Junnarkar, Marsh & McLennan Companies Inc Gottfried Leibbrandt, SWIFT Nancy Leveson, Massachusetts Institute of Technology Ebru Ogan, Garanti Bank David M. Rowe, SunGard Data Systems Inc Leo M. Tilman, L.M.Tilman & Co., Inc Javier Torres, Grupo Santander
Other contributors In addition, the project team would like to thank all workshop and interview participants for contributing their insights and time. These individuals were (in alphabetical order): Sebastian Bonhoeffer, Institute of Integrative Biology, ETH Zurich Nicolas Boutin, The Boston Consulting Group John S. Carroll, MIT - Sloan School of Management Andrew Cassels, World Health Organization Marc Castelnou, Direcci General dEmergncies i Seguretat Civil, Departament Interior, Catalonia, Spain Mike Deimler, The Boston Consulting Group Patrick Driscoll, United States Military Academy Frank Edelblut, Control Solutions International Asaf Eliakim, The Boston Consulting Group Laurie Garrett, Global Health, Council on Foreign Relations Lee Garvin, JetBlue Airways Corporation John Geanakoplos, Yale University Margaret Gilligan, U.S. Federal Aviation Administration Robin Gisby, Network Rail Sian Griffiths, The Chinese University of Hong Kong Ray Hilborn, University of Washington Udo Jung, The Boston Consulting Group Sujit Kapadia, Bank of England Robert Kella, Qantas Simon Kennedy, The Boston Consulting Group Thomas B Kepler, Duke University Medical Center Jrg Knizek, Lufthansa
Martin Koehler, The Boston Consulting Group Gerald Kopp, California Emergency Management Agency Nick Landauer, Safety Regulation Group, UK Civil Aviation Authority Natalie Lvova, ICAP Plc William O. McCabe, The McCabe Group, LLC Allison McGeer, Mount Sinai Hospital Angela McLean, University of Oxford David K. A. Mordecai, Risk Economics Limited, Inc Michael Osterholm, University of Minnesota George J. Pappas, University of Pennsylvania Alan S. Perelson, Los Alamos National Laboratory Marc Powell, The Boston Consulting Group Stephen J. Pyne, Arizona State University Andy Quick, Pfizer Inc Karl Rauscher, Alcatel-Lucent Inc Glenn Reed, Pacific Seafood Processors Association Roland Regoes, Institute of Integrative Biology, ETH Zurich Harvey Rubin, University of Pennsylvania Michael J. Ryan, World Health Organization Paul de Sa, Federal Communications Commission Carlos Schnapp, World Economic Forum Martin Silverstein, The Boston Consulting Group Michael Sissenwine, formerly National Marine Fisheries Service, National Oceanic and Atmospheric Administration, US Department of Commerce Mark Sobolewski, United Parcel Service, Inc Paul Stang, Johnson & Johnson Pharmaceutical Research and Development, LLC George Sugihara, University of California, San Diego Adrian Thomas, Johnson & Johnson Pharmaceutical Research and Development LLC James Tiller, BT Global Services Dror Topf, The Boston Consulting Group Michael Tortorella, Assured Networks LLC Paul Tranter, The Boston Consulting Group Raj Varadarajan, The Boston Consulting Group Tom von Oertzen, The Boston Consulting Group Michael Walfish, The University of Texas at Austin Carl Walters, University of British Columbia Scott T. Weidman, National Research Council Wayne Williams, USFS Smokejumper Base, Missoula Keith Williams, Praxis High Integrity Systems Ltd Janet Woodcock, U.S. Food and Drug Administration
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Project Team
Authors (in alphabetical order) Rachel Hirsch, Consultant, The Boston Consulting Group Kenny Pun, Project Leader, The Boston Consulting Group Isabella Reuttner, Project Manager, Financial Services Team, World Economic Forum USA
Contributors Abhishek Kapur, Consultant, The Boston Consulting Group Bryan Stone, Formerly Associate Director, World Economic Forum USA
Production Editors Philip Crawford, The Boston Consulting Group Nancy Tranchet, World Economic Forum Creative Design Kamal Kimaoui, World Economic Forum
From the World Economic Forum Financial Services Teams Yvonne Betlem, Associate Director Trudy Di Pippo, Associate Director Abel Lee, Senior Community Manager Lisa Donegan, Community Manager Tom Watson, Project Manager Nadia Guillot, Senior Coordinator Michal Richardson, Coordinator
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The World Economic Forum is an independent international organization committed to improving the state of the world by engaging leaders in partnerships to shape global, regional and industry agendas. Incorporated as a foundation in 1971, and based in Geneva, Switzerland, the World Economic Forum is impartial and not-for-profit; it is tied to no political, partisan or national interests. (www.weforum.org)

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Rethinking Risk Management in Financial Services

Rethinking Risk Management in Financial Services

Prepared in collaboration with The Boston Consulting Group

World Economic Forum April 2010

from from from from from from from

Aviation Fisheries Management IDC Immunology Pharmaceuticals Telecommunications Wildfire Fighting

Acknowledgements Project Team

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Letter from the Steering Committee

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Chapter 1 System-Wide Perspective

1.2 Drive diversity

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Robust Systems: Heterogeneity, Redundancy, and Modularity

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1.3 Simulate system disasters

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Source: Courtesy of Thomson Reuters

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1.4 Manage fire

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10 Fire Ecology Eco-link, Temperate Forest Foundation, http://www.forestinfo.org/Products/eco-links/Fire-Eco2.PDF, 2002.

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Creative Destruction in Natures Economy

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Chapter 2 Transparency and Information Flow

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2.2 Aggregate system-wide data

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2.3 Scrutinize complexity

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Non-Linear Models: A Paradigm Change

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2.4 Innovate transparently

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Information Management in Biology: A Model for Financial Systems

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Chapter 3 Governance and Culture

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