Stefan Wasilewski, ceo of Contingent Capital Corporation, aims to create better performance metrics for investors by identifying practical recursive boundaries in the credit/capital markets

"I made a mistake": Alan Greenspan (Financial Times: Alan Beattie and James Politi, Washington, 23 October 2008). Such are the words of great men, for even in troubled times their self-effacing manner proves useful guidance. While Greenspan may feel this way, he is a product of his environment - one that has seen the cumulative development of financial instruments and strategies that have not been thought through as to their impact on a complex economy, mainly because risk is thought discrete and the methods used to price it flawed.

To an engineer the control of a machine is built-in and, although the economy is not a machine but an intensely connected complex of ever-emerging businesses, the process of control needs to be structured likewise. Pricing investment risk in this environment should never have been left to opaque institutions, or processes, which do not recognise the co-dependences of business and systemic functionality.

To do so is to ignore the correlation of events in a highly connected world, that these are dynamic and conditional, whose outcomes are unknowable. This does not mean unmanageable, but that the control process be built-in to businesses and government in a consistent manner - transparent yet using different parameters.

Transparent means that data, assumptions and processes need to be monitored and published in a timely fashion. As far as accounting for results is concerned, it should be recognised that budgeting and reporting to investors is founded on dynamic processes which are therefore changeable; usually out of date; and co-dependent upon others within a complex dynamic network (both internal and external to the business).

The works of Stafford Beer, Fredrick Vestor and others are examples of how to manage the internal dynamics of a business and point to a methodology that synthesises the approaches of investors such as Warren Buffett so that extreme outcomes such as the credit crunch 2008 are reduced in frequency but allow investors to 'take their risks freely'. This paper aims to compare the background processes to two extreme events in the financial arena - the 'Reinsurance Spiral of the late 1980s' and the '2008 Credit Crunch' show their commonalities - and propose methods that would improve governance.

It is believed the consequences would be that better and timelier data is created; liquidity flow is maintained in all but gross systemic failure; and investment risk more ably assessed and priced. The paper is not meant to be an exhaustive history but more a focus on the processes that brought about the current problem in both insurance and the capital markets, and how a solution may be found.

Dynamic, conditional and unknowable: a reasonable description of the management of a business?
At the heart of the capital markets, and especially credit, lies the measure of performance and longevity of earnings. The assumptions made in arriving at such 'risk prices' should therefore embody a measurement of management performance, with respect to local and regional markets.

But where is the data to support them? Time is a vital part of all pricing, regardless of contract type, but we benchmark it to a clock not the lifespan of a business.

It is not fashionable now, but it was a generally accepted belief that a business started, developed and then either morphed into another or died. During its life span the perturbations of the world would test viability, whether these are nature, accident or economic. Success or failure would be measured by its sustaining existence and cumulative growth.

We could therefore argue that a business is dynamic because it is subject to the changes wrought in production and environment; conditional because it is dependent upon structure and boundary parameters; and unknowable because the size and impact of any change cannot be foreseen, as the conditions that spawn the change operate outside of the businesses view.

No differentiation of type of business is made at this time, as the primary goal is to define an optimised business. Therefore widget manufacturers sit alongside bankers in functional and process terms: i.e. the objective of a business is to take certain resources and change and/or combine them into others for onward use.

Time plays an important part in business, being essential in the acquisition of resources, the length of time a reaction/process takes to complete or the delay in obtaining a decision through information exchange or management direction. A good business is said to exist when each component knows its place and the time it has to be there - and because most of a business consists of human components these comprise the better part of management's considerations.

A bad business may still make a profit, but the length of time it exists is directly related to how much effort it takes to recognise realities and how long this is sustained. In between, the spectrum of performance varies, but essentially the comparison will be stakeholder satisfaction and the longevity of the business. Investors will stay with a successful business, even if returns are lower, if they see it is sustainable.

In designing the Viable System Model Stafford Beer showed that all businesses have a common set of functions (as separate to processes), even though the products and their production processes may change. Essential within the model were the control and communication functions designed to learn, then cope, with events as they occurred within the whole. The absence or weakness of any component or function would have a direct effect on the rest of the business.

Are we only as good as our weakest link? Beer did not think so, for we could optimise performance if we planned ahead to compensate for most eventualities.

Therefore audit and learning; planning and control; along with production are linked together by a communication network that would ideally overcome delays in decisions as long as the founders and then managers of the business have the vision to establish them.

Embedded within this system is a reporting process that must be clear and concise, timely in communication and held accountable at each level of operation. If the reports only reveal good news, there's a problem. All businesses have difficulties and delays; how you overcome them is the essential part.

If this self-similar functionality exists and we are in a business with several divisions spread over different geographical locations, then we say there is a 'recursive' nature to the business with each area and layer having its own set of dependencies, boundaries and parameters.

Dynamic? Yes. Conditional? Yes. Unknowable? Yes. But manageable? Yes. Only when the perturbation event is catastrophic in size would the system breakdown. But it is within the hands of management to set the boundaries at which a catastrophe is determined to exist, and it is up to management to maintain a constant awareness of the state of the business (system) in order to know whether a catastrophe looms.

The research objectives
To understand the solution we must first recognise the problem and its genesis. But why should we consider the whole, not just the capital markets? So why include insurance, as well as structured finance?

It is because structured finance uses insurance products/processes learned from insurance companies to separate and off-set component risks, often at prices that enhance the returns for the original capital market investors. Before we investigate this relationship and the end result in the credit markets, a short journey through history may help.

The second objective is to discover what the practitioners of the business think their world view is and how they go about proving it. This may be a classic approach to the ontology and epistemology of the participants in a system, but in a straw poll of senior UK banking and capital markets executives the first agreement was that there is no consensus of time, morality doesn't exist in trading and trust was the first thing out of the window in a financial crisis (as Francis Fukuyama¹ has tried to tell us time and again).

If there is no consensual perspective as to time in financial circles, we have a major problem because it is the core element in all financial calculations. In a natural financial order 'derivatives' are based upon the 'underlying instrument' and no matter what the 'greed' imperative may be, inverting the pyramid of total contract values in favour of 'derivative trades' not only destabilises the system but also removes any hope of the time element of money working.

While the capital markets, accountants and regulators continually refer to 'The System', if the above is true, then they cannot have a real view of 'a system' because their divergent views of timeframe and values put boundaries around each department - indicating that they only see emergent sub-systems unconnected to the broader economy. Communication, a vital part of any meta-system such as the economy, has been sacrificed for cost reasons and perhaps some inconvenient truths.

To have any chance of solving the credit crunch (which is badly named because it is really a leverage crisis), the participants need to recognise how the components are connected and why self-similar processes have repeated mistakes of the past. A good example in the UK is that whenever the Bank of England is removed from the trading floor, the regulatory function becomes chaotic².

To be effective: top-down and bottom-up
While we need to appeal to the senior governors of the market, we also need to get buy-in from the next generation of practitioners who have not had the experience of managing a crisis but need to know what the consequences of their actions will be. Therefore this should be a 'top-down' and 'bottom-up' approach.

The only problem here is resources. Why? It is because the people who contributed to the straw poll above have already outlined what is needed and the education of the 'credit crunch' has already begun³.

The result we aim for is a dynamic map of the various levels of marketplaces and the sustainability of a business within its marketplace, that marketplace within the economy and how resources can be dynamically allocated. We do not aim to remove existing credit and performance metrics; just augment them to account for the proper use of time.

Now we need some artists, graphic designers and a small amount of resources donated by someone with the gravitas that will open the door to those in power to listen. Volunteers, please, and be brave!

Why the title?
It is said that the natural resonant frequency of the planet is F# and that, as any musician would understand, the next thing you need to do to create good music is establish the tempo; hence the title. The natural resonant frequency will establish your key and finding out how we interlink in time to create that frequency will benchmark the tempo. You can have all forms of jazz, classic or rap, but don't disturb the beat!

Footnotes

¹Trust: Human Nature and the Reconstitution of Social Order
²Stafford Beer: A regulator must be part of the system it regulates
³George Soros: The Credit Crisis of 2008 and What it Means, Alan Greenspan: The Age of Turbulence, I.O.U.S.A: Addison Wiggen & Kate Incontrera