Dynamics of Information Flow Before Major Crises: Lessons from the Collapse of Enron, the Subprime Mortgage Crisis and O
The analysis of the two largest financial disasters in the USA so far in the first decade of this century—the collapse of Enron in 2001 and the subprime mortgage crisis of 2007–2008—suggests that the huge scale of these disasters stemmed from a lack of ti
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ial crises Information concealment Complexity Resilience Risk management
Early warning
D. Chernov D. Sornette (&) ETH Zürich, Zurich, Switzerland e-mail: [email protected]; [email protected] © Springer International Publishing Switzerland 2016 A.J. Masys (ed.), Disaster Forensics, Advanced Sciences and Technologies for Security Applications, DOI 10.1007/978-3-319-41849-0_8
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D. Chernov and D. Sornette
1 Introduction The private sector actors and policy makers are all interested in developing and fostering innovations and industry developments that can provide higher profits, growth and employment. But there is always a trade-off between unbridled innovations that may lead to serious negative externalities (pollution, accidents, crises) and full-fledged regulatory control that can stifle innovation. This belongs to the general principle-agent issues, where the size of the subsequent impacts can reflect amplifying externalities. In this article, we review three financial crises (Barings, Enron and subprime crisis), one mixed financial-industrial disaster and three industrial catastrophes, and identify the role of seriously missing information in generating the accident. The lacking knowledge resulted from both inadequate transmission between involved actors and direct concealment of risk information. We find that regulators and representatives of these industries had a mutual interest in the weakening of any existing regulation to facilitate the launching of innovative development. So the budgets of government oversight bodies were reduced, preventing them from hiring qualified and experienced inspectors who understood the innovations; the authorities demanded less reporting from industries as they brought in the now deregulated innovations; and ultimately regulators lost the comprehensive understanding of the challenges involved. In the absence of strict government control to protect the long-term interests of society, private industries were free to choose the most effective way of implementing innovations to maximize dividends to shareholders, growth of capitalization and bonus plans to motivate executives—all which served short-term interests. Their solutions for introducing innovation, while serving their own interests very well, were less effective in protecting the interests of society. During the early stages of a new development, it seems to executives and regulators that the expansion of innovations is going well because, in the wake of deregulation measures, nobody fully understands all aspects of the development. Sometimes, they realize some of the shortcomings of the innovations. But previous poor decisions, an unwillingness to believe that the worst could happen, and an industry culture of risk concealment, which prevents the transmission of timely information about existing risks and the adequate assessment of potential ones—all of these lead to a misplaced confidence among executives that the present state of the innovation process is sound, when in reality it is moving towards ca
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