Last year we have witnessed several "extreme events" in the financial world. Large financial institutions - even the ones labelled 'too big to fail' - saw their shareholder value melt like snow in the sun. The CxO's of these institutions were totally uncapable of stopping the process. They could only undergo the extreme events. Complexity theory can help CxO's to understand and make sense of these events.
Of course financial markets are inherently uncertain. We know that bubbles can be created and that bubbles can burst. The problem is that we never know upfront whether it's a bubble or not. And if it is a bubble, we have no means to predict the timing of the burst. The analogy with earth quakes - also extreme events - is remarkable.
The creation and the bursting of bubbles is a phenomenon that appears in many complex systems, be it financial, biological or technological complex systems. Complex systems consists of large numbers of nodes or agents that are connected to one another. The overall set of these connections is called "the network".
Nodes do not connect randomly
Complexity theory states that nodes do not connect randomly. A new node prefers to connect with existing nodes that are well connected. As a result, some nodes become more important than others. In the financial system the nodes or agents are the different banks. Some banks indeed are better connected then others.
A bubble is created when suddenly one or some agents become super connected. The bubble bursts if one of the super connected agents is hit by a event that suddenly changes its reputation or role in the network. Because of the super connectedness the initially small event is enforced and cascaded trough the network, causing the burst.
CxO's should invest in understanding complexity
CxO's that deepen their insight in these complexity related insights, can better make sense of extreme events.
Reference: The Network Challenge. Strategy, Profit and Risk in an Interlinked World. Colin Crook. Wharton School Publishing, 2009