- Complicated systems contain many components and dynamic, ever-shifting relationships among those components; they can operate across, potentially, an extremely wide range of circumstances, but their behavior is ultimately predictable (given XYZ set of inputs, the system will perform to the corresponding parameters designed into it for those inputs). And, if a complicated system fails, the cause can be tracked down and identified with confidence. In other words, with hindsight, the precise cause of failure can be pinpointed and an effective “fix” designed in. A high-performance jet engine is complicated, but the ways in which it can fail are not mysterious.
- Complex systems, by contrast, can shift from “normal” performance to a disastrous mode for no immediately apparent reason. A power plant, say, or a large hospital is complex.
A decade ago The Harvard Business Review wrote about this topic in the business context: Learning to Live with Complexity. They define complicated systems in a sound and straightforward way:
Complicated systems have many moving parts, but they operate in patterned ways. […] Practically speaking, the main difference between complicated and complex systems is that with the former, one can usually predict outcomes by knowing the starting conditions. In a complex system, the same starting conditions can produce different outcomes, depending on the interactions of the elements in the system.
Global commercial banks are squarely “complex” systems, as the HBR article recognizes in the context of Citi’s near-meltdown at the onset of the GFC:
It is very difficult, if not impossible, for an individual decision maker to see an entire complex system. … Many have argued that Citigroup’s near collapse, in 2008, stemmed from an organizational design that locked people into silos; employees with information about the consequences of the bank’s involvement in subprime lending were not connected to those making strategic decisions. It didn’t help, of course, that the CEO at the time, Chuck Prince, conspicuously chose to ignore any warning signs of excessive leverage, as a now-famous remark to the Financial Times in 2007 demonstrates. “As long as the music is playing, you’ve got to get up and dance,” Prince said, adding, “We’re still dancing.”
The daunting challenge is that our minds are designed to think in terms of complicated and linear systems which conform to a Gaussian (bell) curve of behavior, and not in terms of complex or exponential systems where the “power curve” of behavior means extremely rare events take on outsize, even overwhelming, importance. As HBR puts it:
In complex systems, events far from the median may be more common than we think. Tools that assume outliers to be rare can obscure the wide variations contained in complex systems. In the U.S. stock market, the 10 biggest one-day moves accounted for half the market returns over the past 50 years.
With that groundwork laid, let’s return to Paul Weiss” executive summary of what happened at CS vis-a-vis Archegos, and hold the thought in your mind that CS is a complex system:
The Paul, Weiss team ultimately found no evidence of fraud or illegal conduct by individuals or the bank. Nor, the report concluded, was this a situation where the architecture of risk controls and processes was lacking, or the existing risk systems failed to operate sufficiently to identify critical risks and related concerns. Instead, the report found that senior managers persistently failed to address risks connected with trades made by Archegos. The losses “are the result of a fundamental failure of management and controls in [its] investment bank,” Paul, Weiss wrote. “The business was focused on maximizing short-term profits and failed to rein in and, indeed, enabled Archegos’ voracious risk-taking.”
Among the key conclusions in the report, the Paul, Weiss investigation found a failure to effectively manage risk in the investment bank’s prime services business by both the first and second lines of defense, as well as a lack of risk escalation. In the same business, it also found a failure to control limit excesses across both lines of defense as a result of an insufficient discharge of responsibilities in the investment bank and in risk, as well as a lack of prioritization of risk mitigation and enhancement measures, such as dynamic margining.
In other words, not only was there no illegal or even manifestly improper behavior, but the “architecture of risk controls, processes, and systems” was sound. The failures were compound ones of shirking or short-changing responsibilities at multiple levels in what became a disastrous cascade. The Wall Street Journal succinctly describes the escalating leeway CS extended to Archegos in retrospectively-chilling terms (“Credit Suisse Failed to Act on Archegos Risks, Report Says”):
Credit Suisse began waiving risk protections related to Mr. Hwang well before Archegos collapsed. In 2017, changes in Mr. Hwang’s trading prompted a 10% margin call, a common request by a bank to post more cash to back up positions as they became riskier. Credit Suisse waived the requirement and created a “bespoke weekly monitoring of Archegos.”
Then in 2019, Archegos asked to lower its margin requirement, saying competitors were offering a better deal. The margin on the stock-linked derivatives he liked to invest in, known as total return swaps, dropped to 7.5% of the total invested from around 20%.
In return, Archegos agreed to give Credit Suisse more power to close out its positions with little notice. But the report says these protections were “illusory, as the business appears to have had no intention of invoking them for fear of alienating the client.”
The litany of omissions and neglect is a lengthy one:
- In September 2020, a credit risk manager escalated concerns about the trades to his supervisor; nothing was done.
- Early in 2021, credit risk managers cut Archegos’s internal credit rating citing the firm’s “high performance volatility, concentrated portfolio, and increased use of leverage.” CS “discussed” asking Archegos for more margin but never did.
- In March, the counterparty oversight committee again discussed Archegos, by then the prime brokerage unit’s largest client in terms of position size. The committee decided Archegos would be moved to a dynamic margining system within the next couple of weeks, This never happened because–seriously–Archegos kept cancelling calls CS had set up to discuss the change.
- Credit Suisse returned $2.4 billion in margin collateral to Archegos between March 11 and March 19.
What are we to make of these high-level findings (Paul Weiss) and timeline (the WSJ)?