Prof Robin Matthews March 16 2017 ADAPTED May 12 2017 London DBA Presentation Prof Robin Matthews March 16 2017 ADAPTED May 12 2017 London 24/02/2019 07:11:55 robindcmatthews.com

BRIEF SUMMARY The economist Frank Knight distinguished risk and uncertainty by saying that it was possible to attach probabilities (perhaps only subjective probabilities) to risk, whereas uncertainty referred to situations that was so unexpected that calculation of any kind (including probability calculations) was impossible. He associated uncertainty with the completely unexpected events that occur in our lives and beset us. John Maynard Keynes took the same view. Events like the fall in the Berlin wall, the Arab Spring, the financial crisis of 2008 are examples of uncertainty. And there are many micro examples that affect our lives constantly; death in the family, personal loss through theft or accident, sudden illness and so. And the macro events stemming from uncertainty affect whole societies and the effect individuals. So uncertainty is part of life. The examples I’ve given you are examples of what you might call bad luck, or misfortune, but there are many examples of uncertainty that bring forth opportunities; windfall gain, sudden turn for the better, fortuitous events that benefited such as some of the macro events given above confer wins as well as losses. What might be thought of as bad luck may turn out to be all for the good. What the future holds is always unknown before the event. 24/02/2019 07:11:55 robindcmatthews.com

It is easy to rationalise the unexpected after the event and attribute causality to what happened and say ” We should have expected this or that.” But it’s just ex post rationalisation. The famous politician was once asked what worried him most; “ Events, dear boy”, he said. Slide 5 distinguishes expected value and expected utility; the impact of change depends on both its probability and the expected utility (positive or negative associated with the change. E(V), expected value values events measured by the expected money value of alternative outcomes V(a) and V(b) weighted by their respective probabilities. Expected value does the same sort of calculation but U(a) and U(b) refer to some index of utility or happiness. What both formulations emphasise is that there are two forces affecting the impact of outcomes 1. The impact on money values, or utility and 2. The probability of their occurrence. Events such as major disasters (tsunamis, global extinctions) may have a low probability but they have an enormous negative impact. Having distinguished risk and uncertainty, I began by relating risk to the enneagram mandala, slide 6 and in a linear way in slide 7. Risk enters as we move between thought and action as shown in the red line in slide 6. 24/02/2019 07:11:55 robindcmatthews.com

It is often assumed that probability is normally distributed (risk) It is often assumed that probability is normally distributed (risk). This is so in most financial analysis. But not all events have normal probability distributions. Extreme events like earthquakes or wars or financial meltdowns often have what are called fat tailed distributions or Black Swan distributions (slide 21) ; they are events that happen time and time again al though they have a very low probability as compared to milder events. The remainder of the lecture focused on financial risk stemming from the high connectivity of the financial system with the non-financial sector, ordinary businesses that continually borrow, payback and refinance their activities; slides 12 and 13. Slide 14 illustrates the impact of a shock to a bank, that reduces its assets and forces it to call in loans or refused to refinance existing loans when they come up for renewal. Slide 15 is a picture of the inverted pyramid created by too active securitisation. Slides 16 to 18 illustrate the interconnectivity of the international financial system showing how shock to part of the system can spread throughout the whole, creating mayhem as in 2008. 24/02/2019 07:11:55 robindcmatthews.com

Risk and uncertainty Risk and the enneagram Expected value and expected utility E(v) = Pa V(a) + PbV(b) E(U) = Pa U(a) + PbU(b) Risk and Uncertainty Risk associated with probability (subjective or frequentist) Uncertainty with the unexpected Sources of risk Financial political technological ecological etc. Black swans 24/02/2019 07:11:55 robindcmatthews.com

RISK GRAMMAR GRAMMAR GRAMMAR OUTER DYNAMICS 9 Evaluation, 8 reflection 1 vision, intention ADAPTATION implementation 7 2 values REALISATION SEARCH PAYOFFS 6 3 INNER DYNAMICS/ CAPABILITIES choice commitment 5 4 alternative scenarios GRAMMAR RISK GRAMMAR 24/02/2019 07:11:55 robindcmatthews.com

Search Choice CONCEPTUAL Implementation EVENTS Adaptation strategic decision process Search Intentions, aspirations, vision of the future imagining/analysing alternatives, deciding according to values norms and desired payoffs Conceptual stage Imagination/analysis Algorithms Mind sets CONCEPTUAL Choice Commitment to chosen alternatives. RISK AND UNCERTAINTY; from potential to actual Dynamics ensure that intentions are never fully realised Implementation Implementation of chosen alternatives. Monitoring events and comparing actual with desired outcomes. EVENTS Actual payoffs occur. Algorithms for implementation; systems structures cultures architectures path dependence Monitoring and control, algorithms comparing actual events to intentions. Adaptation stage Change evolution as elements of the meta model change Adaptation Adaptation to changes in outer dynamics, inner dynamics and grammar, or miscalculations, unexpected events and disappointing payoffs. 24/02/2019 07:11:55 robindcmatthews.com

payoffs Outer dynamics grammar Payoffs to stakeholder groups Tangible and intangible Assets (including Reputation) payoffs Competitors and co-operators Outer dynamics Inner dynamics Global macro conditions grammar Rules, laws, regulations, structures, architectures, routines; Mindsets, culture, norms, values, habits, moods; Intelligence rational and emotional; Formal and informal, Inner and outer; Hard and soft systems. 24/02/2019 07:11:55 robindcmatthews.om

payoffs Inner dynamics Outer GRAMMAR SYSTEM STATE 24/02/2019 07:11:55 robindcmatthews.com

GLOBAL POSITIVE FEEDBACKS FINANCIAL REVOLUTION Flexible exchange rates Deregulation New asset pricing models TECHNOLOGICAL Investment funds Shorter product cycles Pressure to reduce costs Outsourcing GLOBAL DEMAND FDI Consumption Investment Asset prices Sovereign wealth funds Securitization GLOBAL POSITIVE FEEDBACKS 1980 – 2006 (circa) 24/02/2019 07:11:55 robindcmatthews.com

Yin (dark) Yang(light) Eventually balance sheets recover Current account deficits financial deficits fallacy of composition Bubble bursts Asset prices ↓ Balance sheet Recession Deleveraging Govt’s, Firms, Households Deficient demand U ↑ G ↓ Contagion Fiscal policy works Risk aversion Liquidity trap Inflated asset prices Hubris New asset bubble Contagion Speculation, leveraging, securitization Monetary policy works Excess demand U↓ G↑ Govt’s, Firms, Households Increase demand Eventually balance sheets recover 24/02/2019 07:11:55 robindcmatthews.com

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The financial tower of Babel: 21ST century CDO’s CDC’s CDW’S SWF’S SPV’’s SPE’s CONDUITS IPO’s PRIVATE EQUITY FUNDS HEDGE FUNDS DERIVATIVES/OPTIONS SHADOW BANKING SYSTEM REGULATED BANKING SYSTEM CORPORATE BONDS GOVERNMENT BONDS LIQUID ASSETS CASH unregulated regulated 24/02/2019 07:11:55 robindcmatthews.com

Haldane (2009) 24/02/2019 07:11:55 robindcmatthews.com

Haldane (2009) 24/02/2019 07:11:55 robindcmatthews.com

Haldane (2009) 24/02/2019 07:11:55 robindcmatthews.com

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From Bettis RA, Hitt MA. 1995. The New Competitive Landscape. Strategic Management Journal 16 : 7-19. 24/02/2019 07:11:55 robindcmatthews.com

Evolution and change distinction TYPES OF SYSTEM CHANGE TTYPES OF ypest Random no pattern Normal distribution Bell shaped or approximately so Fat tailed distributions change on all scales possible; Black Swans Deterministic predictable iff imformation perfect Chaotic Deterministic but CDIC Catastrophic Singularity and great extinctions Self ordered criticality Attraction to tipping points; major (phase) transitions. TYPES OF SYSTEM CHANGE distinction change Evolution 24/02/2019 07:11:55 robindcmatthews.com