ABSTRACT
MARKETUNDERMINEDSOMELONGSTANDINGVALUESANDMYTHSTOOKDOWNTHE53 AUTOINDUSTRYANDTENSOFTHOUSANDSOFDREAMSOFHOMEOWNERSHIPINDEBTED GOVERNMENTSINTOTHETRILLIONSOFDOLLARSFORAGENERATIONORTWOANDDESTROYED THERETIREMENTSECURITYOFMILLIONSOFPEOPLEDUETONOWUNCERTAINPENSIONPLANS 7HATMANYCALLTHE@GLOBALlNANCIALCRISISAFFECTSTHEENTIREBUSINESSLANDSCAPEAND THEFORMSOFPLANNINGTHATMOVEBUSINESSFORWARD4HISISPROVOKINGADRAMATIC RETHINKINGINPLANNINGMODELSBOTHINTHECORPORATESECTORANDTHEPUBLICSECTOR )NTHISCHAPTERWEREFERTOTHISSETOFEVENTSSIMPLYAS@THE#RISIS 4HE#RISISISSTILLUNFOLDING!SWEWRITETHISIN!UGUSTPOLITICIANS
SPORADICALLYREFERTO@GREENSHOOTSOFRECOVERYANDMANYPUNDITSASSERTTHATTHE WORSTMAYBEBEHINDUS-AYBETHEYARERIGHT(OWEVERITISEQUALLYPOSSIBLETHAT ITWILLCONTINUETOUNFOLDTHROUGHANDBEYONDASCONSEQUENCESCONTINUETO REVERBERATEASFACT lNDINGCOMMISSIONSREVEALTHEIRlNDINGSASNEWREGULATIONS ARETESTED)NDEED(EIFETZETALP ASSERTTHAT@THEIMMEDIATECRISIS xMERELYSETSTHESTAGEFORASUSTAINEDOREVENPERMANENTCRISISOFSERIOUSAND UNFAMILIARCHALLENGES4HISLATTERVIEWISOURSTARTINGPOINT -UCHATTENTIONHASBEENGIVENTO@SOLVINGWHATISTAKENTOBETHE@PROBLEM
4HISSOLUTIONFOCUSISUNDERSTANDABLEnBUSINESSESAREHURTING JOBSARELOST FACTORIES ARE CLOSING AND BUSINESSES ARE GOING BANKRUPT PENSION FUNDS ARE DECIMATEDHOMESAREFORECLOSEDANDPOLITICIANSNEEDTOBESEENTOBEDOING SOMETHING1UICKACTIONHASBEENNEEDED
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ENVIRONMENT4HESENEWCONNECTIONSlRSTMANIFESTEDASARUN AWAYINTHESUB PRIMEMORTGAGEMARKETINTHE53BUTHAVESINCERIPPLEDTHROUGHOUTTHEGLOBAL lNANCIALINDUSTRYANDTHEREALECONOMY&ROMTHEPERSPECTIVEOFABUSINESSTHE #RISISISANEXAMPLEOFACONTEXTUALDISRUPTIONSEE#HAPTER )TGREWOUTOFTHE MYRIADOFARRANGEMENTSnECONOMICREGULATORYlNANCIALPOLITICALIDEOLOGICAL PSYCHOLOGICALCULTURALANDSOCIALnTHATDEVELOPEDANDACCRETEDOVERMANYYEARS )TMAYTAKEALONGTIMEFOREVENTHEMAINCONTOURSOFTHOSELINKSTOBEMAPPED OUTSOTHATALTERNATIVEINSTITUTIONSVALUESBEHAVIOURSANDRELATIONSHIPSMAYBE REDESIGNED 4HISMAPPINGOUTOFTHESYSTEMICRELATIONSTHATBROUGHTABOUTTHE#RISISIS
STILLINTHEEARLYSTAGES 7ECONTENDTHATNONEWANDSAFERSYSTEMWILLEMERGEUNTILTHEOLDSYSTEMIS
MUCHBETTERUNDERSTOODCONSIDERINGTHATALARGEPARTOFANYNEWSYSTEMWILLOVERLAP WITHASPECTSOFTHEOLDONEANDWILLINSOMEWAYEMERGEFROMIT4HISIMPROVED UNDERSTANDINGREQUIRES ABODYOFTHEORYTHATPUTSTHECURRENTPHENOMENA INANAPPROPRIATELYCOMPLEXCAUSALCONTEXTAND ASETOFTOOLSTOPROBETHE UNCERTAINTIESOFTHEFUTURETHATAIMTODELIVERIMAGESINSIGHTSANDPERSPECTIVES FROMTHEFUTURE4OGETHERTHESETWOTHINGSWILLENABLEUSTOUNDERSTANDTHECONTEXT OVERALONGERTIMEHORIZONTHANTHATWHICHTHESOLUTIONFOCUSTYPICALLYAFFORDS 4HEOUTLINEFORTHISCHAPTERISASFOLLOWS&OLLOWINGASHORTHISTORYOFTHE#RISIS
SOFARWElRSTRECAPTHEMAINTHEMEOFTHISBOOKNAMELYTHAT#44PROVIDES ACONCEPTUALRATIONALEFORTHEUSEFULNESSOFSCENARIOPLANNINGASAWAYTOTHINK RATIONALLYANDEFFECTIVELYABOUTTHEFUTURE.EXTWEDESCRIBEHOWTHISKINDOF FUTURETHINKINGHASENABLEDUSTOEXPLAINTHEUNDERLYINGDYNAMICSOFTHE#RISIS AFTERITBROKEOUT7EARGUETHATTHESEDYNAMICSCONSISTOFADRAMATICFAILUREIN RISKASSESSMENT7ETHENSHOWTHATTHISEXPLANATIONREVOLVESAROUNDSYSTEMICRISK ASDISTINCTFROMDIVERSIlABLERISK ANDTHERELATEDDISTINCTIONINFUTURETHINKING BETWEENPLAUSIBILITYANDPROBABILITY4HESEINSIGHTSPOINTTOWARDSSCENARIOSASA REMEDY .EXTWENOTETHEREPORTSOFTHEUSEOFSCENARIOPLANNINGINTHElNANCIAL
SERVICESINDUSTRY"UTWEOBSERVETHATWHERETHISHASBEENTRIEDITHASNOTLEDTO SIGNIlCANTLYDIFFERENTDECISIONMAKINGFROMTHERESTOFTHEINDUSTRY!NALYSING WHYTHISISTHECASEWEHIGHLIGHTHOWSCENARIOPLANNINGINTHATINDUSTRYHASOFTEN BEENMADESUBSERVIENTTOTHEPROBABILISTICAPPROACHTORISKANALYSIS7ETHEN DESCRIBEARECENTPROJECTINWHICHSCENARIOSAREUSEDINADIFFERENTWAYTOSEARCH FORPLAUSIBILITYANDTOCHALLENGEBASICASSUMPTIONS&INALLYBASEDONTHISCRITIQUE WEOFFERSUGGESTIONSFORHOWTOUSESCENARIOPLANNINGMOREEFFECTIVELYSOTHAT CORPORATEEXECUTIVESANDPUBLICPOLICY MAKERSMIGHTINFUTUREAVOIDTHEKINDOF DECISIONMAKINGTHATLEDTOTHECURRENTCRISIS
)NSHORTWEBELIEVETHATTHEREVIVEDINTERESTIN#44ORIGINALLYDEVELOPED BY%MERYAND4RISTASABRANCHOF/PEN3YSTEMS4HEORYISTIMELY4HATBODY OFTHEORYPROVIDESINSIGHTSTOHELPUNDERSTANDBETTERHOWTHE#RISISDEVELOPED ASITDIDANDOFFERSTOOLSTODESIGNMORERESILIENTSYSTEMSOFVALUECREATION4HE PURPOSEOFTHISCHAPTERISTOSUBSTANTIATETHESEPOINTS
7HENTHE53@HOUSINGBUBBLEBURSTINnITUNDERMINEDCONlDENCE INTHEMORTGAGE BACKEDSECURITIESTHATBANKSTRADEDWITHEACHOTHERASWELLAS THEDERIVATIVESTHEYTRADEDTOHEDGETHEIRPOSITIONSONTHOSESECURITIES0ROBLEMS INCOLLATERALIZINGTHOSESECURITIESREDUCEDTRUSTINTHEINTER BANKMARKETLEADING BANKSTOREDUCELENDINGlRSTTOEACHOTHERANDTHENTOBUSINESSESANDHOUSEHOLDS 4HISLEDTOTHESO CALLED@CREDITCRUNCH !SCREDITBECAMELESSAVAILABLEALLKINDSOF@LEVERAGEDACTIVITIESTHOSElNANCED
WITHHIGHDEBTTOEQUITYRATIOS lRSTEXPERIENCEDLIQUIDITYPROBLEMSFORWHICH EXTRABORROWINGWASUNAVAILABLETHISLEDTOTHESO CALLED@lNANCIALCRISISINMID &ORINSTANCEINTHE5+THEBANK.ORTHERN2OCKWHOSEBUSINESSMODEL WASTOBORROWMAINLYFROMTHESHORT TERMINTER BANKMARKETTOlNANCEITSLONG TERMLENDINGTOINDIVIDUALHOUSEHOLDSWENTUNDERANDWASNATIONALIZED)NTHE 53THEGIANTQUASI PUBLICMORTGAGEENABLERS&ANNIE-AEAND&REDDIE-ACALSO HADTOBEEFFECTIVELYNATIONALIZED 3EVERAL@0ONZI TYPEFRAUDSWEREUNCOVEREDDURINGTHISPERIODASTHECREDIT
CRUNCHCAUGHTOUTTHEIROPERATINGMODELNOTABLYTHEHUGEFRAUDULENTINVESTMENT SCHEMEOF"ERNARD-ADOFF4HIS LEDMANYSCEPTICSTOVIEWTHEWHOLEOFTHE lNANCIALSERVICESGAMEASCROOKED4HISFURTHERUNDERMINEDPUBLICTRUSTNOTONLY INBUSINESSBUTALSOINTHEPOLITICIANSWHOOVERSAWTHEREGULATORSWHOHADFAILED TOREGULATEPROPERLY 4HEINVESTMENTBANK,EHMAN"ROTHERSINSPITEOFHAVINGHADBILLIONIN
LIQUIDASSETSONA&RIDAYWAS@ALLOWEDTOGOBANKRUPTONTHEFOLLOWING-ONDAY 3EPTEMBER,EX 'IVENITSSIZEANDMOREIMPORTANTLYTHECOMPLEXITY OFITSLINKSWITHOTHERlNANCIALINSTITUTIONSITSBANKRUPTCYWASATIPPINGPOINT THATSPARKEDMUCHHIGHERINSURANCEAGAINSTDEFAULTS4HISINCREASEDTHECOSTOF BORROWINGVERYSHARPLYACCELERATINGTHE#RISIS -ANYlNANCIALINSTITUTIONSNEEDEDTOCOVERLOANSTHATHADBEENCALLEDIN
BUTWEREUNABLETOBORROWATNEWHIGHERCOSTS4HEYASWELLASTHOSESEEKINGTO RElNANCETHEIRHIGHLYLEVERAGEDPOSITIONSBECAMEINSOLVENT4HISAFFECTEDNOTONLY lNANCIALSERVICESINSTITUTIONSBUTALLKINDSOFBORROWERSnBUSINESSESHOUSEHOLDS ANDEVENGOVERNMENTSSUCHAS)CELANDS4HESEBORROWERSDISCOVEREDTHEYWERE OVER STRETCHEDLOSTCONlDENCEANDPULLEDBACKCONSUMPTIONTOIMPROVEBALANCE SHEETS2EDUCEDDEMANDSTRETCHEDTHEBALANCESHEETSOFMANYBUSINESSES4HIS WASTHE@ECONOMICCRISIS
7ITHREDUCEDCONSUMPTIONANDMOREEXPENSIVECREDITlNANCINGINVESTMENT STALLEDANDECONOMICGROWTHTURNEDNEGATIVE INMANYCOUNTRIES7HENTHIS EXTENDEDTOTWOCONSECUTIVEACCOUNTINGQUARTERSA@RECESSIONWASDECLAREDIN MANYCOUNTRIESAROUNDTHEWORLD#ENTRALBANKSLOWEREDINTERESTRATESTOALMOST PERCENTTOENABLECREDITTOBECOMESUFlCIENTLYCHEAPAGAINFORPEOPLEAND BUSINESSESTOBEABLETOBORROWONCEMORE(OWEVERTRUSTAMONGBANKSWASSO LOWTHATTHEYDIDNOTPASSONTHECENTRALBANKSLEADONDECREASINGTHECOSTOF MONEYTOEACHOTHERORTOTHEIRCUSTOMERS4HISEXACERBATEDTHECREDITCRUNCH !SSETPRICESSUCHASEQUITYVALUESOFCOMPANIESSLIDBYMORETHANHALFOVER
AONE YEARPERIODANDHOUSINGPRICESSHRANKFROMPERCENTTOALMOSTPER CENTINTHEMOSTAFFECTEDMARKETSSUCHASPARTSOFTHE533OUTHERN#ALIFORNIA &LORIDA 3PAINAND)RELAND4HISTAKESUSBACKTOTHEAPPARENTSOURCEOFTHE#RISIS INTHEHOUSINGASSETBUBBLE)TISAPOSITIVEFEEDBACKLOOPTHATTHREATENSTOBECOME ADOWNWARDSPIRALTHATWOULDBEDIFlCULTTOREVERSE )TISOFCOURSEIMPOSSIBLETOPREDICTHOWTHE#RISISWILLUNFOLDGOINGFORWARD
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Responses, in brief
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ADDRESSTHE#RISISASASOCIETYCANNOTCONTINUETOOPERATEWITHOUTFUNCTIONING BANKS3TABILIZATIONEFFORTSBEGANINLATEANDTOOKVARIOUSFORMSBANKBY BANKSECTORBYSECTORCOUNTRYBYCOUNTRYANDINTERNATIONALLY @"AILINGOUTBANKSANDLARGEINSURANCECOMPANIESINVOLVEDIN@BANCASSURANCE
ACTIVITIESHASBEENANINITIALANDIMPORTANTREACTIONTOTHE#RISIS"AILINGOUT BASICALLYMEANSEITHERLENDINGATVERYFAVOURABLERATESNATIONALIZINGMERGING BYlATORSOMECREATIVECOMBINATIONOFTHESEOPTIONS-ANYOFTHESEMOVES WEREREACTIVERUSHEDTHROUGHWHENTHEINSTITUTIONINQUESTIONWASABOUTTOFAIL .ORTHERN2OCK("/3AND2"3INTHE5+-ERRILL,YNCHAND!)'INTHE53 &ORTISIN"ELGIUM.ATIXISIN&RANCE(YPO2EAL%STATE(OLDINGIN'ERMANY0RE EMPTIVE@STRESSTESTSOFTHEASSETSABANKMUSTHOLDTOSURVIVEINADVERSElNANCIAL CONDITIONSWERECONDUCTEDINTHE53INFORALLMAJORBANKS 6ARIOUSCOUNTRIESHAVEINJECTEDMASSIVELIQUIDITYINTOTHElNANCIALSYSTEM
INANATTEMPTTOGETCOMPANIESTOLENDANDBORROWFROMEACHOTHERAGAIN4HIS HASINVOLVEDMARKETINTERVENTIONSBEYONDBAILOUTSINCLUDING CREATINGNEW MONEYWHICHWASCALLED@QUANTITATIVEEASING CREATINGSPECIALACCOUNTSIN THECENTRALBANKSFROMWHICHlNANCIALINSTITUTIONSCOULDBORROW MASSIVELONG TERMBORROWINGBYGOVERNMENTSTHATFUTUREGENERATIONSWOULDHAVETOPAYFOROR WHICHINmATIONWOULDINmATEAWAY BUYINGUP@TOXICASSETSUN SELLABLEASSETS WITHUNKNOWNMARKETVALUES FROMSOMEINSTITUTIONSANDPUTTINGTHEMINTO
TEMPORARY@BADBANK TYPEACCOUNTSWHICHTHE3TATEHOPESTOBEABLETOSELLPERHAPS EVENFORAPROlTINTHELONGERTERMFUTURE MASSIVE+EYNESIANINVESTMENTSBY THE3TATETOUPGRADEINFRASTRUCTUREANDCREATEJOBSAND REVIEWINGREGULATION TOPREVENTAREPEATOFTHEEXCESSESTHATHAD@SUDDENLYSPRUNGUP 4HESHEERSIZEOFTHEINTERVENTIONSANDTHEEXPOSURESFORGOVERNMENTSnIN
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BILLION4ROUBLED!SSET2ELIEF0ROGRAM4!20 WHICHTHE534REASURY3ECRETARY INSTIGATEDIN/CTOBERWOULDNOTSUFlCETOSTABILIZETHE#RISISINAGLOBALIZED WORLDWITHDENSEANDCOMPLEXLINKAGES'OVERNORSOFTHEMAJORCENTRALBANKS ARRANGEDANUNPRECEDENTEDLEVELOFCOORDINATIONBYLOWERINGALLTHEIRRATESBY PERCENTTHESAMEDAYIN/CTOBER!TANEXTRAORDINARYMEETINGOFTHE' IN!PRILTHELEADERSAGREEDTOTRIPLETHESIZEOFTHE)NTERNATIONAL-ONETARY &UNDSLENDINGCAPACITYANDBETTERCOORDINATEPOLICY4HEYALSOUNDERTOOKTO DEVELOPMOREEFFECTIVEGLOBALREGULATIONOFTHElNANCIALMARKETSANDTOATTEMPT TOTACKLESOME TAXHAVENS "EYONDTHESESTABILIZATIONEFFORTSSOMEWORKBEGANTORETHINKTHEROLEAND
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ITISNOWBROADLYUNDERSTOODTHATHEDGEFUNDSANDSIMILARlNANCIALACTIVITIESWILL NEEDTIGHTERREGULATIONANDTHATTHEREPEALOFTHE'LASS 3TEAGALL!CTIN THE53THATHADSEPARATEDCOMMERCIALBANKINGFROMINVESTMENTBANKINGSINCE THES WASAMISTAKE-OREBROADLYTHE4HATCHERITE 2EAGANITE@FREEMARKET APPROACHTOGLOBALCAPITALISMISNOLONGERBROADLYADJUDGEDTHEUNQUALIlED STANDARDTHATTHEFALLOF#OMMUNISMHADIMPLIEDFORIT3OMEBELIEVETHISSIGNALS AMAJORRETHINKINGOFVALUES 'IVENTHEVARIETYANDFORCEOFTHESERESPONSESTHEPROGNOSISHASREMAINED
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EFFECTSINTHE#RISIS7EHAVEOBSERVEDASERIESOFBOOMANDBUSTCONDITIONSlRST INTHEHOUSINGMARKETTHENINCREDITTHENINCONlDENCEINTHEBANKINGMARKET THENINTHEECONOMYATLARGETHENINGOVERNANCESYSTEMSANDSOON)NEACHOF THESESECTORSWESEEADEVELOPMENTUPWARDSTHENASHORTMOMENTOF@QUIETBEFORE THESTORMFOLLOWEDBYARUNAWAYDEVELOPMENTINADIFFERENTDIRECTION4HISIS EXACTLYAS0RIGOGINEWOULDPREDICTFORBEHAVIOURINADENSE,TURBULENTlELD )NMOREPLACIDENVIRONMENTS,CONNECTIONSARERELATIVELYWEAKANDNOTAS
SALIENTASINATURBULENTlELD"ECAUSEELEMENTSOFTHEENVIRONMENTARENOTSTRONGLY INTERLINKEDINMOREPLACIDSITUATIONSTHELAWOFLARGENUMBERSAPPLIESDAMPENING THECONSEQUENCESOFTHEOCCASIONALDISTURBANCEANDAVERAGESPRODUCESTABILITY 0HENOMENACANBEISOLATEDINORDERTOCONTROLTHEM)NTHOSEENVIRONMENTAL TEXTURES THE CONTEXT FOR ANY SYSTEM SUCH AS A BUSINESS FIRM IS STATISTICALLY PREDICTABLETHElRMSDECISIONMAKERSCANAPPLY'AUSSIANMATHEMATICALMODELS BASEDONBEHAVIOURINTHEPASTINORDERTOFORECASTTHEFUTURE "UTINTHETURBULENTlELDTHISNOLONGERAPPLIES(EREAVERAGESBECOMEUNSTABLE
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OF THE CONDITIONS UNDERWHICH CONVENTIONAL INTERPRETATIONS OF UNCERTAINTY ANDRISKAPPLY4HEYWORKDIFFERENTLYINATURBULENTCAUSALTEXTURETHANINTHE DISTURBED REACTIVETYPE))) TEXTUREINWHICHTHOSEAPPROACHESWEREDEVELOPED 4HEMISUNDERSTANDINGLEDTOAFAILURETOANTICIPATEBIFURCATIONSANDRUN AWAY BEHAVIOURINATURBULENTlELD7HENTHE#RISISBEGANTOUNFOLDBUSINESSESAND GOVERNMENTSWEREUNPREPAREDANDRESERVESWEREDISMALLYINADEQUATEREQUIRING MASSIVERESCUEOPERATIONS)NORDERTOUNDERSTANDHOWTHISCOULDHAPPENITIS HELPFULTOMAPOUTPEOPLESATTITUDETOTHEFUTUREANDCONSIDERWHAT#44HASTO SAYABOUTTHIS )NRECENTTIMESGREATSTRIDESHAVEBEENMADEINTHElELDOFRISKASSESSMENT
ANDRISKMANAGEMENTTHROUGHTHEUSEOFMATHEMATICALALGORITHMSANDCOMPUTING POWER!SSESSMENTOFRISKHASBECOMEHIGHLYDEPENDENTONSUCHTOOLS(OWEVER ASWESTATEDABOVE#44ASSERTSTHATINATURBULENTlELDSTATISTICALMATHEMATICAL MODELSCANNOTCOMPREHENSIVELYDESCRIBETHEFUTURE)NFACTTHISISNOTANEW MESSAGEFORTHElNANCIALSECTORnTHE#APITAL!SSET0RICING-ODEL#!0-ARISK ASSESSMENTTOOLTOPRICECAPITALHASBEENAROUNDFORMANYYEARS 4HE#!0-THEORYSUGGESTSTHATTHECOSTOFCAPITAL ISDETERMINEDBYTHE
LEVELOFRISKASSOCIATEDWITHTHESPECIlCPROJECTBEINGCONSIDEREDBUTONLYTHAT PARTKNOWNAS@SYSTEMICRISK3YSTEMICRISKISCAUSEDBYCONNECTEDNESSINTHE ENVIRONMENTTHEGREATERTHECONNECTEDNESSTHEHIGHERTHESYSTEMICRISK4HE PARTOFRISKKNOWNAS@DIVERSIlABLERISKDOESNOTBYDElNITIONADDTOTHECOSTOF CAPITALBECAUSEITCANBEDIVERSIlEDAWAY)N#!0-TERMSTHENON DIVERSIlABLE COSTELEMENTISEXPRESSEDAS@BETAWHICHSPECIlESTHEEXTRAPERCENTAGEPOINTSTOBE ADDEDTOTHEBASERATERISK FREECOSTOFMONEYSOASTOARRIVEATTHEEFFECTIVECOST OFCAPITALINASPECIlCSITUATION"ETADEPENDSONLYONSYSTEMICRISKDIVERSIlABLE RISKDOESNOTAFFECTIT )NATURBULENTlELDSYSTEMICRISKDOMINATESDIVERSIlABLERISK3YSTEMICRISKIS
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