IT and Systemic Risk and its Implications for Business

Introduction: What is Systemic Risk and How Does it Affect Business

Globalization has brought the world together and the rapid spread of Information Technology or IT has made us all interconnected, networked, and always on in a 24/7 paradigm. This means that the convergence of globalization and IT has resulted in businesses being able to not only cater to clients worldwide but also have a level playing field where in the noted expert on globalization, Thomas Friedman’s words, “The World has become flat”. However, all this interconnectedness and integration has downside risks as well. When systems are bound together and integrated, a fault in one part of the system has implications for the other parts and indeed, the system as a whole.

Consider what happens if you are a manager in a global company sitting in New York and having suppliers and customers around the world. If a storm breaks out in China or India, chances are that your supply chain would take a hit as deliveries are delayed leading to cancellation of orders etc. next, consider that you are a stockbroker sitting in London. Because the global financial markets are integrated through IT and operate on a 24/7 continuous basis, a crash in say, Mumbai, would affect your portfolio as you might be owning stock of Indian companies as well as would have invested in the country’s capital markets.

The above two examples are how systemic risk is increased because of globalization. Now consider a software company located in the United States and having its subsidiaries all over the world. If an IT system in one location goes down, then the work of everybody is affected, as it is often the case that these companies work according to load sharing as well as deliverables being done piecemeal. This is the example of how IT can cause systemic risk as well.

We have seen how globalization and IT create systemic risks for the companies. We can now understand the implications of this interconnectedness by examining what happened during the collapse of the American Investment Bank, Lehmann Brothers. On Sep 15, 2008, the bank declared bankruptcy sending global markets into a tailspin as the participants in the markets were all connected in one way or the other to each other and given the fact that global markets are tightly interwoven, a risk in one part of the system affects other parts as well as the entire system.

The point that we are trying to convey here is that while the integration of the global economy has brought prosperity, it has also brought in its wake severe exposure to systemic risk as can be seen from the examples listed above. Moreover, with increasing interconnectedness, there is simply no way to gauge which part of the system is vulnerable and damage to which part causes the system to topple over.

In business jargon, these systemic risks are known as the Butterfly Defect or the Butterfly Effect that is used to refer to the theory that if a butterfly flaps its wings in one part of the world, a storm is caused in another part of the world because of the systemic nature of the world. Of course, this Butterfly Effect has been in existence even before Globalization and the spread of IT. The difference between earlier eras and now is that globalization and IT have increased the vulnerabilities of the system to failure as nobody knows how many pressure points, fault lines, and vulnerabilities exist in the global economy.

This means that one is not sure how many butterflies are around and how many of them are flapping their wings. However, this does not mean that the world is prone to collapse and systemic risk with nobody having an idea or are clueless about how to mitigate it. As we shall discuss in the succeeding sections, there are ways and means of handling systemic risk through understanding complexity, reducing vulnerabilities, and increasing vigilance over the systems. It would suffice to state in this introduction that the acknowledgement of systemic risk is the first step towards dealing with it.

Black Swans, X-Events, and Collapse

We have discussed how systemic risk affects all of us whether we realize it or not. Some of the risks have been given names such as Black Swans, X-Events etc. Black Swans refer to low probability high impact events that occur and which cannot be predicted in advance. The term is derived from the belief that Swans are only white until someone spotted a Black Swan and the completely paradigmatic conception of what was known until then was replaced by the new theory. Similarly, the global economy is vulnerable to such Unknown Unknowns wherein we are subject to a sudden crash that happens without warning and has not happened before leading to a high impact.

On the other hand, X-Events are those that are known to happen but for which we do not have adequate preparation mainly because we have not yet quantified and understood the risks. This can be events like Terrorist Attacks, IT systems being hacked by sophisticated cyber-war techniques etc. the clear implications of both Black Swans and X-Events is that they fall in the category of Known Unknowns and Unknown Unknowns which means that both ignorance as well as risk blindness plays a part in not resolving these systemic risks. However, as we shall discuss in the next section, it is not the case that we are helpless before these risks and there is indeed a way to mitigate them.

Strategies to Minimize Systemic Risk

As set out in the introduction, while we are indeed prone to systemic risk, not all is lost, as some would think by insisting that we go back to our earlier paradigm that was simpler and easier to handle. This kind of thinking blames globalization and IT for systemic risk without understanding the fact that these trends have brought prosperity to Billions of people around the world. therefore, in order not be like the Ostrich in the Sand who is oblivious of the approaching cataclysm and like the Dodo that refused to change with the times and hence faced extinction, the key to mitigating systemic risk is to understand the pressure points, the vulnerabilities, the fault lines, as well as stepping up vigilance.

As they say, technology is value neutral. It can be used for both good and bad purposes. Just like technology and IT have ensured more value addition and innovation in the global economy, they can also be used to hack into computer systems, bring down the servers, as well as lure unsuspecting people into frauds and other Ponzi schemes. Thus, we need to figure out a way in which we deal with systemic risk and the first step towards that is to acknowledge the fact that systems are vulnerable.

The key to mitigating systemic risk is through establishing early warning systems that raise flags and put out warnings in advance of the approaching dangers. Just like we learnt to forecast the weather better than our ancestors in previous eras, we can master the art of predicting the dangers. Indeed, if we look back, weather forecasting was a hit and miss affair for a long time and it is only in the later parts of the 20th century that we began to get it right.

Similarly, predicting Black Swans, X-Events, and other systemic risks can be done if we leverage artificial intelligence, ubiquitous computing, Big Data, and market sensing and market intuiting techniques. All these techniques are predictive and predicative in nature meaning that these techniques provide us with the capability to detect risks before they manifest into full-blown storms. Moreover, we can also ensure that we understand and control complexity instead of letting it take over our lives. Finally, we can put in place continuity of business strategies to ensure that if by chance , a disaster strikes, we are prepared for it.

Conclusion

Life is risky even without IT and globalization. As has been emphasized throughout this article, it is indeed the case that risk has been with us ever since humankind emerged. The difference between those times and now is that the risks have magnified because of interconnectedness as well as highlighted because of the 24/7 global media that relentlessly and breathlessly plays up the risks leading to a sort of perpetual breaking news cycles wherein it seems as though the world is coming to an end. Therefore, the conclusion is that without behaving like an Ostrich or the Dodo, we can indeed master and tame the risks and ensure that our IT systems as well as business systems are made more resilient.

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