A few weeks ago, the investigation Credit Suisse commissioned Paul Weiss to undertake into how the bank’s relationship with Archegos Capital Management went so wrong–inflicting $5.5 billion of losses on Credit Suisse and a total of $10-billion in losses across the banking system as a whole–was released. The crux of the debacle stemmed from “[Credit Suisse]’s relationship with Archegos Capital Management, the family office of Sung Kook “Bill” Hwang, a former hedge fund manager:”
Archegos, which used borrowed money from several banks to build massive equity positions, ultimately could not meet margin calls by its lenders when share prices dropped, triggering its default on March 25, 2021, costing [Credit Suisse] $5.5 billion in losses.”
This debacle for CS came fast on the heels of the early March meltdown of Greensill Capital, leaving CS holding a suite of funds nominally worth $10-billion, which bought securitized loans from Greensill, suddenly of indeterminate value. As Bloomberg summed up the mess:
Lex Greensill’s business has unraveled at a blistering pace, leaving a tangled trail of destruction all around it.[In early March,] Greensill Capital filed for administration [bankruptcy] in the U.K., capping a stunning collapse for its founder. The bank that he owns in Germany has been shut down by regulators, the funds he ran in partnership with Credit Suisse are being liquidated and his firm is in the process of being broken up with its core perhaps sold to Apollo-backed Athene Holding Ltd.
Greensill himself has lost his billionaire status, and the myriad strands tangled up in the collapse involve everything from investment funds to the steel industry to Britain’s healthcare system.
As mind-boggling as these losses are, what both Archegos and Greensill were doing were entirely routine, even boring, everyday financial transactions (albeit at huge scale), but precisely the type of transactions a bank as well-staffed and sophisticated as CS should have been capable of monitoring and controlling for risk with the proverbial one hand tied behind its back:
- Archegos was investing in widely traded and reasonably liquid securities using margin; and
- Greensill was in the “factoring” business, a type of lending that has been around for centuries (some scholars even believe the “moneylenders” of the Bible were in the factoring business)–providing supply-chain finance to firms, accelerating payments to suppliers in return for a fee.
So the question imposes itself with some urgency: What could possibly have gone wrong? How could a Credit Suisse have suffered these two massive losses within weeks of each other–but ones which arose from fundamentally garden-variety activities for a bank with the scale and resources of CS?
To understand how CS blew itself up this way, we need to introduce the concept of “complicated” vs. “complex” systems, and to delve into the unusual failure modes of the complex variety.
This may seem far afield from the more mainstream content and coverage here on Adam Smith, Esq.–because it is!–but I’m publishing this column because I believe it exposes a systematic misapprehension in how our profession conceives of, analyzes, and assigns blame and responsibility for large-scale mishaps. To be specific, our profession’s concepts and assumptions about categories like “cause,” “responsibility,” and even “reasonable [behavior]” and “notice/warning” cannot grapple with complex systems.
It’s even worse than being inadequate to the situational analysis: By applying our familiar thought patterns developed and nurtured around “complicated” systems to “complex” ones, we employ profoundly unsuitable diagnostic tools. If we cannot recognize and comprehend complex systems, we will do our clients a disservice, twist truth, and repudiate justice.
Engineers who design systems and the forensic analysts who follow when things go suddenly and massively south distinguish between “complicated” and “complex” systems, because they each have quite distinct characteristics and quite different failure modes: