Tuesday, December 21, 2010

The Assumption of Independence in the Financial Systems Failure

I have been spending a lot of time recently reading some of the plethora of books that have been published which either provide inside accounts of the 2008 failures in the banking sector (Lehmans and Bear Stearns) or have tried to analyse the causes of this failure. Though I’m not an economist by any stretch of the imagination, having studied financial strategy I have developed something of a morbid fascination for this topic, a little on the lines of an episode of Columbo where you know the outcome but the interest comes from finding out how Colombo will prove the perpetrators guilt. In the case of the 2008 crash it is common knowledge that it was caused by bankers taking risks purely to maximise their own bonuses isn’t it?

Going beyond the superficial mass media level reveals something slightly more interesting. There was certainly unjustifiable risk taking but this in itself ought not to have caused the systemic failure that occurred. One of the early failures which triggered the collapse of the dominoes was the collapse of two hedge funds dealing in derivatives run by Bear Stearns. Right until the point at which these funds were liquidated the fund managers were maintaining that the funds were diversified so their expose to subprime mortgages was limited. However subsequent investigation proved in fact over 70% of the cash invested in these funds had been spent on mortgage-backed derivatives. This is important as it is a key tenet of investment strategy that funds should be diversified so that losses in one area are compensated by gains in other areas. Diversification fails as a strategy when losses in one area trigger losses in another area i.e. even though a portfolio may be diversified there may be dependencies between them. This is what happened in 2008: losses in sub-prime triggered losses in other areas leading to large scale failures in supposedly resilient diversified funds.

So why bring this up in a blog supposedly devoted to technology? Having the memory of an elephant this reminded me of a couple of papers that were published in the 80s. The first paper The N-Version Approach to Fault-Tolerant Software looked at how software risk could be massively reduced by copying the idea of hardware redundancy in software, a technique know as n-version programming. Basically the idea was that for a high integrity system the software should be independently written multiple times and then control logic would execute all three versions in parallel, following the majority vote at each decision point. This was followed up by another paper An Experimental Evaluation of the Assumption of Independence in Multi-version Programming which challenged the hypothesis at the heart of n-version programming – that a failure in one programme would be independent of a failure in another programme. This is a reasonable assumption in hardware since failures are typically caused by physical characteristics rather than common design flaws. However this latter paper demonstrated empirically that this was not a safe assumption for software and therefore n-version programming was dead.

Fast forward 25 years and what do we see? The 2008 crash was effectively the result of dependent failure in a system which assumed failures were independent. Spooky eh? Normally software mimics life but in this instance software technology seems to have go there first!

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