Posts Tagged ‘Innovation’

What is COP16?

Friday, November 26th, 2010

The United Nation Framework Convention on Climate Change is an international environmental treaty that was established at the Earth Summit in Rio de Janeiro back in 1992.

A Message to World Leaders from Global Youth

Click to watch

The treaty aimed to address the rise in greenhouse gas emissions and its impact on the environment. However it never set out a specific limit for each country’s gas emissions and contains no enforcement mechanism.

Each year, members of the convention meet at the Conference of Parties (COP) to discuss progress in dealing with climate change as well as the Kyoto Protocol and starting this year, the Copenhagen accord.

At this year’s convention (COP16) 194 countries will be taking part in the negotiations at the sixteenth conference of parties in Cancun. The agenda will revolve around discussions of last year’s Copenhagen accord as well as an attempt to create a fair, ambitious and binding agreement that would see signatory countries limit their greenhouse gas emissions.

The Australian Youth Climate Coalition (AYCC) has been involved with the Conference of Parties (COP) since 2007. This year’s delegation comprises of twelve individuals selected from around Australia who will be pushing the international agenda and liaising with Australian governmental bodies to reach an agreement.

The goal is to avert the frustration and walkouts witnessed during COP15 in Copenhagen last year.

Sentiment analysis: the internet becomes a focus group

Sunday, October 31st, 2010

How does the world feel right now? In 2005 wefeelfine.org scoured the world’s blogs for the keyword ‘feel’ and, via an artful and compelling interface, presented each author’s snippets of text and images as a beautiful representation of the mood of the world. Jump forwards to April 2010 when 50,000 websites integrated Facebook ‘Like’ buttons in the first week of its availability. Now with the growth of Twitter, that flow of micro-opinions and feelings has become a torrent. Social media clearly likes to express personal opinion.

Mid way between the pure art of wefeelfine.org, and the visceral grunt of Facebook’s ‘Like’ is a grey area of mostly unquantified social thought. That’s where sentiment analysis (also known as opinion mining) resides. As its tools and techniques become more sophisticated it will reap valuable insights from the cacophony – for brands, governments and researchers to understand the feelings of the masses, and then respond to them – without the need for surveys, polling call centres, or focus groups.

The way it works is via natural language processing which uses algorithms to understand the context within which people’s opinions reside. For an in depth theoretical overview of this area, Bo Pang and Lillian Lee’s book Opinion mining and sentiment analysis has plenty to absorb, but in essence, a sentiment analysis service will rate statements as either positive, negative, or neutral, and add up the results. For example, a YouTube comment such as ‘The Social Network sucks’ is clearly negative, whilst a blog saying, ‘The Social Network is not factual, but does capture the essence of the character’, is either neutral or erring towards the positive, and someone tweeting, ‘OMG u mus c JT in #socialnetwork :-) ’ is positive but needs a lot of syntax interpretation. The most sophisticated forms of sentiment analysis are yet to come, but already the technology exists to rate the strength of feeling and weight key influencers amidst many other factors.

Since context is everything, these algorithms will inevitably have a wide reaching impact upon search engines. According to Google’s Matt Cutts, Google Search is already using Sentiment Analysis for reviews, and they filed for a patent back in 2007. Consider, for example, searching on the phrase, ‘antenna problems with the iPhone 4’. This complex question requires a fair bit of individual research and unpicking from the search results, and while the answer is interesting to a member of the public, it’s vital to the manufacturer. You can be sure Apple was listening closely to the noise on the web before they gave away US$100m worth of free iPhone 4 bumper cases.

Financial markets are also interested in turning the fuzzy into facts with companies such as Thomson Reuters exploring sentiment news in the form of Market Sentiment, but it is in the branding sector that sentiment analysis is seeing the most visible evolution. Over the last ten years the concept of customer engagement has grown due to the fragmentation of market segments and customer loyalty. The rise of social media has opened new ways to review global opinion, with Nielsen Buzzmetrics being one of the first to collate and display the user trends.

The principal is that you type in a brand name or subject and the sentiment analysis service will return a dashboard or chart analysis of the positive, negative or neutral opinions from the social web: Twitter, Facebook, Social Networks, RSS feeds, 100 million blogs.

A lot of big brands are already using these services from the larger players. We see Paypal, Nokia, Skype, Xerox and Ogilvy using Alterian; The Economist using Jodange; AT&T, Barnes & Noble and Playstation are using Lithium; Nokia, Roche and HSBC are with Sysomos; Adobe, National Geographic, 3M and Dell with Radian6 ; Wiley, Vodafone and T-Mobile with Attensity; AOL, Nissan and Marriott with Clarabridge; and The Body Shop are with Brand Watch.

Smaller solutions are also available, such as Chatterscope which allows you to monitor sentiment changes via simple alert messages. And Evri has released their Vibology widget which can be embedded in any web page to show a similar rating meter.

These products are already mature enough to use standardised processes for harvesting, cleaning, processing, and delivering results to sophisticated analytics dashboards. The more developed sentiment analysis companies (above) are correctly perceiving this is vital for Customer Relationship Management, and that they need to provide the correct tools to Marketing Managers who will want to tailor their campaigns based on the results they uncover.

However, it is also an emerging technology, one which requires a lot of artificial intelligence inspired computing to glean relevance – not only from languages other than English, but also from emoticons, acronyms and social media grammar – without which a lot of Twitter would be unreadable. Until these issues are fully resolved, the biggest caveat is therefore on accuracy, and the efficacy of the ratings.

Pull: The power of the semantic web to transform your business

Wednesday, October 6th, 2010

The internet is changing. It’s becoming driven by structured data, and as the databases connect, computers will be able to make rule-based assumptions and take action on our behalf, as individuals, and businesses. This interconnection is often referred to as ‘the semantic web’, and one of the features of it is a seeming ability for the web to use our information and draw in other relevant connections. At Business21C we’re calling this phenomenon The thinking web.

David Siegel’s book Pull: The power of the semantic web to transform your business, offers a perspective on the impact and potential behind this shift. His key message is that the internet has grown up as a push-based system: a ‘search for and get sent’ model in which a person looks online; finds a match; the business checks their stock; calls a supplier; and sends it to the user. This will now become pull-based. Driven by the information we upload, things will come to us automatically. Siegel calls this The Performance Economy – a world of ‘getting what we need when we need it’. As he says, ‘Pull leads to performance. Just as pulling metadata aligns your customer’s data with yours, in the performance economy, your company’s economics are aligned with your customer’s. While the push economy is based on process, the performance economy is based on outcomes.”

In the ‘push’ model a delivery item is ordered, then addressed and sent to a specific location; tax returns are completed and filed. But with ‘pull’, if the shelves are nearing empty the replacement products are automatically ordered; a delivery item is told our identity and it seeks us out through co-operative delivery networks; and our tax returns become live transactional data exchanged with the tax department.

Privacy and security are clearly massive concerns for this vision of the future. But Siegel sees these issues being solved by the creation of personal data lockers. Stored online, Identity 3.0 lockers hold everything there is to know about us and our preferences and possessions. And amidst this ‘personal ontology’ are our privacy settings, which let medical practitioners alone see our health story or the online car market to see our desired new vehicle.

Inevitably Siegel embarks on some futurology to illustrate the potential that he’s explaining. He speculates that we are only one percent along the path to this transition, and that US$1 Trillion of inefficiency each year could be removed from the US economy. And he feels that it paves the way for revolutions in health reform, self-building legal frameworks, Fair Tax, and totally new business practices and customer relationships.

“Pull” (the book) is an informative and highly accessible read for such a complicated set of ideas about our technological future. Siegel is not only passionate and committed to the idea, but even uses the book as a call for like-minded people and investors to help him make it happen.

David Siegel
Pull: The power of the semantic web to transform your business
Hardcover: 288 pages
Publisher: Portfolio Hardcover; 1 edition (December 31, 2009)
Language: English
ISBN-10: 1591842778
ISBN-13: 978-1591842774
http://www.amazon.com/Pull-Power-Semantic-Transform-Business/dp/1591842778

Creative Innovation 2010, the wrap

Friday, October 1st, 2010

What kind of man walks onto a stage in a foreign city – where he has few acquaintances and fewer friends – and declares the newly opened public building in which he is standing an architectural mish mash? What kind of a speaker at a creativity conference declares the ‘chucking around of paint around should be confined to nursery schools and universities but the bit in the middle is about learning what needs to be learned’.

The event was Creative Innovation 2010, hosted by leading members of Melbourne’s art and business community, headed by leading Soprano and social entrepreneur, Tania de Jong.

The speaker was Austin Williams, Director of the Future Cities Project, in the UK and author of The enemies of progress, (Societas, Exeter, 2008). For the first hour of deep conversation during which he shared a stage with Edward de Bono and Rufus Black, Rhodes Scholar and Master of Melbourne University’s Ormond College, the audience would have been forgiven for thinking Williams had walked on to the wrong stage at the wrong event.

‘Excuse me, sir, the conflict resolution course meets next door.’

I would venture to argue that Williams was in exactly the right place at exactly the right time, and indeed cleverly placed by the conference organisers.

Why? Well let’s start with the words ‘creativity’ and ‘innovation’. Put the two together, add the name of just about any industry, and you’ve got the title of at least ten conferences in Australia alone, this year – back of the envelope calculation, granted.

We’ve had creative innovation in design, in accounting, in management consulting, in education, in health, we’ve had regional innovation events, skills creativity events, innovation for the young, the old and the young at heart. Business21C can put its hand up for hosting its own creative and innovative event this year, innovatively disguised ‘funky thinking’.

In fact, there’s been so much talk about creativity and innovation since the GFC undermined our belief in the financial system, that quite possibly the least creative thing you can do right now is host an event with either of those words in the title.

But de Jong and her colleagues recklessly put the two words together and staged an creative innovation extravaganza at Melbourne’s newly built Recital Hall, last month. And they pulled it off with style.

CI2010 worked. More than that, in places it was fabulous. One session even got a standing ovation – and that doesn’t happen often when there’s a management consultant on the platform. I have been trying to fathom why. It was not the impressive list of speakers. After all, in 2010 event organisers have to compete with the likes of TED.com who provide brilliant speakers 24 hours a day to a broadband connection near you. It wasn’t the musical interludes that punctuated the proceedings gracefully, either. It was, I believe, how the speakers were put together on stage: the brilliant and the brilliantly bolshie, the creative and the critical. And kept there. Panel sessions were up to two and a half hours long. No whack-up-your-powerpoints,-say-your-piece-and-sneak-off. Speakers spoke, and the audience drilled. Uncompromisingly, sometimes less than coherently, but relentlessly, for three whole days.

During that time, more than 30 speakers covered topics as diverse as pig farming, mental health, responsible design, irresponsible design, education, play, meditation, neuroscience and brand building for cities. And, in some miraculously found moments between all that content, we were entertained and soothed by a variety of artistic pursuits rarely associated with business discussion, from cartooning to piano, singing and painting.

But why are innovation and creativity taking up so much airtime in business discourse?

Either we are determined to become socially and environmentally responsible all of a sudden, or developed economies are waking up to the thought that they have to come up with new ideas to remain globally competitive. (After all, Australia, you can’t keep digging stuff out the ground and flogging it on, forever.)

The two schools of thought on this go something like…

  1. Western economic nations have painted humanity into a tight corner with their focus on growth, consumption, more growth, more consumption. We are running out of just about everything we need to survive as a species: space, water, fuel, food, clean air. This is a big thorny problem, one that some say can only be tackled by new kinds of thinking.
  2. It’s a matter of economic competitiveness. Take a look at statistics on patent registration around the world. Now compare them to those on national economic growth. There is a correlation. China, India and Korea have shown five, three and two and a half fold growth in the number of patents registered per capita of population in recent years. In developed nations, patent registration is slowing. In the UK and in Japan there’s negative growth. It seems, perhaps, new ideas are drivers of economic growth.

Whatever the reason, creativity and innovation are without doubt the new business black. But does the constant picking over of what creates creativity and sparks innovative thinking work? Or is it mid-life crisis navel gazing of mature economies in search of meaning?

To Austin Williams our potential to innovate is massively restricted by risk averse, precautionary parameters about what innovation should look like: sustainable, responsible, socially acceptable, for starters. Creativity, he says is stifled from birth.

But that’s just what he says. Thirty other speakers gave their insights and thoughts on creative thinking and innovative thinking practice over the three days of Creative Innovation 2010. Some agreed with Williams, some didn’t. But it was the diversity of thought and the opportunity to challenge that set CI2010 apart. Without critical thought and the confidence to challenge, can there be true creativity or meaningful innovation?

Short summaries of some of speakers key points are below. Videos will be online shortly and we’ll link to them as soon as they are. Have a browse, and see what you think.

Professor Jonathan West, Australian Innovation Research Centre, The innovation myth

The myth of innovation is that it arises from creativity. Innovation results from a lot of hard work over a long time, testing, creating and commericialising. Innovation is about changing the system into which the innovation plays. The 3 most important innovations of 20th century are: fixing energy into nitrogen, the atomic bomb, and containerisation (the container system for transport). In common they have the creation of a large scale and complex system to support them. For containerisation, it was a matter of reengineering a whole international infrastructure: ships, ports, dockers, trains, trucks and so on, but once achieved, global trade exploded.

We live in a complex world, with complex systems. Innovation is inefficient because it is about system change and we design our systems to be impossible to change.

Andrew MacLeod, CEO, Committee for Melbourne, Melbourne Innovative City

Presented the concept that the branding for the city of Melbourne should be the new paradigm in internatonal aid – to foster private and public sector development for investment, and for Melbourne to become to private sector investment and administration of international aid, what Geneva is to public sector investment and administration of aid.

Edward de Bono, Rethinking the future

Climate change is not the biggest problem facing humanity – the poor quality of our thinking is. And the fact that we don’t understand just how poor it is. Creative thinking has been trained out of us, because it hasn’t been valued. Now we need a Palace of Thinking where new ideas can be looked at and explored. Only by improving our thinking can we improve the ways we deal with some of the big issues facing us.

Michael Smith, CEO, ANZ Bank, Innovation and the rise of Asia – new opportunities, new risks

The rise of Asia offers new opportunity and new risks for business. ANZ Bank is one of fastest growing banks in Asia. Any large business that does not have a strategy that engages in Asia is exposing itself to risk. Successful strategies to compete in the Asian market must be innovative.

What do you need to innovate:

  • Shared mindset
  • Shared logic
  • Shared discipline (how to collaborate and create new knowledge accross organisations, not just recreating existing knowledge.

Claire Penniceard, Pork farmer, Failure, farming and food security

Claire Penniceard bred and raised hardy independent self managing beef cattle, on a zero input enterprise – no supplements no hay, no fertilizers. She bred grand champions but it was not economically or environmentally sustainable. She was the best, but the best was not good enough.

Having explored issues of dietary energy and food security around the world within parameters like environmental sustainability and animal friendliness, she walked off her successful beef farm to go into pig farming. It takes 74 of best beef farms to equal in production what one great pig farm does. Now she produces nine million dollars worth of export quality pig. They are housed and managed to enact all their natural life.

Dr Peter Farrell AM, CEO, ResMed, Innovation and entrepreneurship, the engines of economic growth

Entrepreneurs are often considered to be risk takers. They are not. They are opportunity seekers. Innovation is not creativity but requires it. Innovation occurs when a concept is anointed by the marketplace, when someone writes you a cheque. When we apply a new technology to something we know it’s called productivity, but when we apply it to something new it’s called innovation.

Stefan Cassomenos, Pianist, conductor, composer, From improvisation to composition

Failure is part of the creative process, and Cassomenos believes his entire process of composition depends on failure in some way before creativity is born.

Professor Patrick McGorry, Executive Director, Orygen Youth Health, Australian of the Year, Mental health and mental wealth

Australia’s health is its greatest natural resource, yet mental health is seriously neglected. It effects four to five million Australians and is the greatest killer in Australians under the age of 40.

Yet in terms of mental health care, an apartheid system exists: compare the facilities provided, staff numbers, visitors even flowers delivered to a patient with breast cancer, to those someone hospitalised for a mental health problem receives.

Professor Stephen Heppell, Director, ULTRALAB, Playful learning and why we all need cheering up

Play in learning is joyful, it surprises, challenges and engages. It teaches us to cope with the unexpected. Yet we lose sight of playfulness on our learning journey through life. We have to put play back into the centre of learning if we are going to be flexible thinkers, able to cope with change and with the unexpected.

Professor Peter Shergold, AC, The Centre for Social Impact, Empowering communities to transform democracy

Exciting and innovative stuff happens at the margins often on poorly funded pilot programs, where needs are greatest. The challenge for Australia is to become a hot bed of social innovation – political innovation and community innovation, drawing on a history of such initiatives as bush nursing.

Mark Scott, Managing Director, ABC, Building the digital town square

Fifty people in rural Australia are taking production skills and facilities to the communities, teaching people to put their stories online. If we can collaborate and share our stories we will understand each other more and have a real national conversation recognising the choice and expertise of the community is just as interesting as anything the ABC has to offer.

The experience of the Q&A audience which is growing every week has shown the value of audience led current affairs.

The future is not a place we are going is a place we are making.

Austin Williams, Director, Future Cities Project, Constructing communities, a contradiction in terms?

What is it about communities that politicians are trying to capture and bottle and sell back to us as the elixir of new ways of living? Why is it the community motif which means local and parochial is becoming central to national agenda? Three key elements of a healthy community are: voluntarism, purposefulness and autonomy. Initiatives like the big lunch which funded neighbourhood lunch events in the UK, are corrosive and insular. Is the world around you your neighbourhood or is it a bigger place? Communities are things of flux and change and should transcend the merely local. We are being taught to be good citizens rather than to be educated citizens – but through education comes citizenship.

David Rock, CEO, Results Coaching Systems, The neuroscience of creativity

We have a very small capacity for solving problems in a linear way. Most of the problems we solve at work are too big for our conscious resources so we have to access the unconscious which, relative to the conscious area of the brain is like tapping into the Milky Way.

The neuroscience of insight is the culmination of five years of study on how we can have more insights.

The four faces of insight are:

1. Awareness of an impasse, you need to stop and focus on what is not working.

2. Reflection reflection is required for insight to occur, because insight requires low electrical activity. Insights like the ring of a quiet mobile phone at loud party. Anxiety stops insights because it creates electrical signals which can drowned out the quiet electrical signals of insight.

Reflection is internally focussed. It’s relaxed and low effort.

You only need about 2 seconds of quiet to have the insight

Even a tiny threat can inhibit problem solving and insight.

3. Insight, at the moment of insight, dopamine-like substances are released. Having an insight changes the brain and packs a lot of positive energy.

4. Action, insight brings short term urgency for action. Action increases attention density. Attention density deepens insight.

Michael Rennie, Managing Partner, McKinsey and Co, Necessity is the mother of invention

Working at McKinsey and Co is working with the crack troops of western capitalism. Yet Managing Partner, Michael Rennie talked about bringing love to business – a place where there is more likely to be fear. There are two parts to innovation – the creative idea and and making the idea useful and applied. We are all creative. We don’t allow for reflection at work and most of our insights don’t happen at work.

Business21C was a sponsor of Creative Innovation 2010.

The data mining revolution

Tuesday, September 14th, 2010

We’re generating terabytes of data every minute. Figuring out what it all means will be the next gold rush, says Daniel Poon.

One of my clients, a large US conglomerate, had just acquired and integrated several gardening-equipment businesses. Due diligence had been undertaken and due process followed, but it wasn’t until much later the company discovered that thanks to product misclassifications, it was now the proud owner of no less than four million plastic planting pots, stacked in warehouses across the country.

Another case: a telco giant, while analysing calls data, discovered rampant misuse of an unlimited calling plan through calling cards. When it looked a bit closer, it found that the Mexican mafia was using the product to wholesale telephone capacity to retail customers at substantial discounts. Then, when it came time for them to pay their bills, they disappeared.

These are just two examples of the major opportunity and challenge for large organisations today: how to sort and analyse the increasingly large volumes of data they collect in ways that reveal the company’s real situation.

At the moment, business sits at the bottom of the business intelligence curve. The technology for gathering and storing data has accelerated over the past decade. Examples of the tidal waves of data engulfing the business world are abundant: Walmart handles more than one million customer transactions each hour and its databases are estimated to contain 165 times the information contained in America’s Library of Congress. Facebook is home to 40 billion photos and counting. Decoding the human genome involves analysing three billion base pairs; the first time it was done, in 2003, it took 10 years. Today it takes a week.

We can now store more data than we ever imagined possible, and our analytical capabilities are way beyond where they were just five years ago. The problem for organisations is mobilising those capabilities into actionable intelligence. We have solved the scaling problem – how to store terabytes of data in easily accessible, classifiable ways – but solving the intelligence issue is an ongoing project with huge implications for the efficiency of business.

Multiple versions of the truth

Most organisations haven’t got to square one with an integrated data management and analysis strategy, or what is known as master data management (MDM). At a basic level, MDM seeks to ensure that an organisation does not use multiple (potentially inconsistent) versions of the same master data (eg, product definition, business unit hierarchy, cost-centre business rules and the like) in different parts of its operations.

A simple but common example of poor MDM is when the chief financial officer asks a simple question: ‘What is the year-to-date product revenue of our company?’ The corporate controller at headquarters reports $12.1 million. The vice-president of sales reports $14,001,234 and the regional controller reports $10,800,678.

How could there be three such different answers?

The answer lies in the fact that each finance group is measuring results in a different way. The corporate controller may have reported a rounded GAAP (generally accepted accounting principles) number prepared for the Securities and Exchange Commission (SEC). The vice-president of sales’ figure included intercompany revenue, which should be eliminated. The regional controller took into account some of the deals that will be closed for the quarter but in which product has yet to be shipped. Although a single of version of the truth is assumed, it rarely exists. Reality depends on perspective and context:

  • Varied sources: product revenue may be reported from the booking or order entry system as opposed to the billing or invoicing system.
  • Varied business rules: business entities are rolled up differently. For example, headquarters often roll up entities differently than the functional business.
  • Varied assumptions: different groups tend to include or exclude certain business events, therefore generating different information.
  • Varied time of reporting: information reported at different times can produce different results.
  • Varied accuracy: not all information is measured at the same level of granularity.

As a result, while data quality at data-entry level may be relatively easy to control, interpretation and analysis of the information provided by different groups without any common guidelines leads to incorrect reporting and, eventually, incorrect decisions. MDM will be a hot topic for the coming decade.

The development of business processes that actually enable analysts to gain useful insight from the mountains of numbers sitting in our data warehouses remains in its infancy. The evolution of data mining will be one of the great productivity revolutions of the next decade.

It will first take the form of an expansion in the number of standard-use cases from which companies will be able to draw. Back in the 1980s, if you wanted to analyse what your gross margin, divisional profitability or overhead attributable was in relation to a particular product line, the project might take weeks or months. Today, it is done at the press of a button.

Other more complex queries, such as profitability per customer, may still take weeks or require a complex project of their own to answer. Very soon, however, even the most complex business analysis will be standardised, with the information scraped out of the data warehouse and put together by business intelligence bots that come standard with any of the major enterprise systems.

Already, web-based business dashboards, combined with social networking tools and strategic communication technologies, are spreading business numeracy and stimulating people who wouldn’t otherwise be thinking about business intelligence to develop queries and refine their business strategies using real data.

But there is still much to be done and huge productivity potential remains. The business intelligence revolution is here.

From the specific to the general

Tuesday, September 14th, 2010

The causes of the GFC are complex and interrelated. Although regulators across the globe are addressing many issues, they are paying little attention to at least three of the major ones, reports Professor Erik Schlögl.

‘Ban them!’ was the cry from commentators and regulators as the Global Financial Crisis subsided and scapegoats were sought. Fingers pointed at practices such as short-selling, credit derivatives and mortgage securitisation – the direct causes of many symptoms of the crisis. Yet by focusing regulatory efforts on these innovations, policymakers are at best restricting some of the transmission mechanisms of the recent crises, leaving the underlying causes unaddressed and the next crisis to manifest itself through other channels. They are, in other words, shooting the messenger.

The question is not, as former Federal Reserve Board chairman Paul Volcker asks: ‘How many other [recent] innovations can you tell me that have been as important to the individual as the automatic teller machine, which in fact is more of a mechanical than a financial one?’ Strong arguments can be made against Volcker’s implicit suggestion that financial innovation has been of little use (or worse) to society. More importantly, however, there are at least three significant issues with the way the financial markets operate that are not being addressed adequately by the policy measures currently under consideration in countries with developed financial markets.

Bad incentive structures

It is the nature of limited liability that it encourages risk-taking, and in many areas of entrepreneurial activity, this is certainly desirable. In the case of financial institutions, however, there has been too much willingness to take on risk, exacerbated by remuneration systems based on upside participation in the form of bonuses and a downside limited by an implicit government bailout guarantee. It’s a worn cliché, but in the GFC, we have seen a privatisation of gains followed by a socialisation of losses on an unprecedented scale.

Given the systemic importance of functioning financial institutions and the consequent necessity of explicit or implicit government guarantees, it would be naive to expect ‘the market’ to supply a solution to this problem without regulatory intervention. Risk, in particular the cost to the economy as a whole of the external impact of financial institutions’ excessive risk-taking, simply has not been priced correctly, leading to a classical case of market failure.

Through more stringent capital requirements, particularly for derivatives transactions, regulators have an instrument to impose a higher price for risk. However, there must also be closer oversight of banks’ internal systems to ensure that risk is priced consistently through the entire chain, from front office to back office, and that regulatory (or economic) capital requirements are taken into account, from the start – in the price calculations prior to entering into a transaction – to the end, when performance should be measured in terms of realised return on regulatory/economic capital.

With the right regulatory framework and proper accounting for risk, one would also expect financial institutions to shift resources – including in quantitative analytics – from front office/trading to risk management, which to date has been seen more as a cost (eg, through regulatory compliance) than as offering a potential for profit through an optimal use of economic capital.

Excessive use of leverage to enhance yields

The second issue that played a central role in the GFC and one that continues to be of concern is that hedge funds (or banks acting like hedge funds), having identified small inefficiencies in the market, seek to exploit these through highly leveraged positions. This works well in theory – in fact, the theory of efficient markets relies on inefficiencies being immediately exploited and the market thereby being returned to equilibrium – but in practice, it leads to major exposure to ‘model risk’ (ie, the risk that the assumptions underlying the trading strategies no longer hold) and is a primary vector for contagion between markets in a crisis.

Even though hedge funds are not banks, nor are their investors small depositors who need to be protected by the government, the high degree of leverage means that their activities potentially pose a systemic risk to the financial system. This is a lesson that should have been learned from the failure of Long-Term Capital Management in 1998, yet this historic hedge-fund failure and subsequent bailout had few regulatory consequences.

Feedback loops and ‘death spirals’

The hedge-fund-driven contagion between subprime mortgages and the equity market also illustrates the third burning issue: successful quant strategies, be it ‘statistical arbitrage’ prior to the GFC or ‘portfolio insurance’ prior to the 1987 stock-market crash, are quickly imitated, leading a significant portion of market participants to follow similar trades. This breaks the underlying assumption of these strategies – that the trades they prescribe will not move the market – and potentially leads to a disastrous feedback loop, causing the market to spiral ever downwards. Extreme market moves suddenly become far more likely.

This needs to be taken into account by regulators in their assessment of banks’ risk-management systems. Isolated analysis of each financial institution is not enough – the question that needs to be asked is how will the major market participants react in a given scenario of market stress, and what happens if they all react the same way?

Regulating to address the causes rather than the symptoms

The global financial system will remain vulnerable to further crises unless these underlying causes are addressed: regulators must impose improved capital requirements that enforce a correct pricing of risk in financial institutions, limit the leverage that these institutions and their major clients can employ, and take into account that risk-management strategies typically fail when they are pursued by a large proportion of market participants simultaneously. Banning one or another of the transmission mechanisms of the last crisis will not prevent the next one – which, given the increase in high-frequency and automated trading, may unfold in the course of minutes and seconds rather than at the relatively sedate pace of the GFC.