Daniel Buenza, a Professor at Columbia University Business School (my alma mater), focuses his research on the social studies of finance. In a recent article he describes his research over the last three years on the derivatives trading desk of a major bank. The period examined included the recent financial crisis and the bank came through unscathed, i.e. no huge losses or need for a capital call. Before we get to Dr. Buenza's conclusions on why the bank avoided the errors of their peers, lets first examine this new concept of social studies of finance. At least it is new to me and hopefully of interest to you--my respected readers.
Basically the social studies of finance examines the role of technological artifacts and mental models in capital markets. Technological artifacts are artificial human constructs that provide knowledge. (More on this subject here.) Wikipedia defines a mental model as "an explanation of someone's thought process for how something works in the real world". In summary, the social studies of finance involves the study of the role of technology-based and "pure thinking" models in capital markets. Obviously the two types of models can interact on the same problem. In a simple Excel model, you change the assumptions and the company cash flow changes. This would be an example of the two models interacting. Program trading would be an example of technology-based modeling where the model basically trades the position. Playing Texas Hold'em would be an example of the pure thinking model.
The unscathed, unnamed bank that Buenza studied managed to avoid catastrophe by a principle called reflexivity. Reflexivity is nothing more than the ability to reconsider your position on an issue. In finance terms, it would be to reconsider your assumptions. In other words the mental model is reexamined, thereby leading to a change in the technology (computer model) which governed the trading strategy.
The particular bank in question had a very collegial atmosphere, free exchange of information between colleagues and no superstars to upset the flow. This culture allowed traders to gather much more data and to change their mental models more easily, thereby avoiding the current financial disaster. When trading model driven positions, there is a tendency to over rely on the model and be slow to realize the model is no longer trading profitably. Excessive positions and a slowness to realize that the trading models were no longer working properly is a large part of the cause of the current financial crisis.
Most of us do not trade derivatives, but Buenza's study of the bank points out the importance of maintaining a culture that is conducive to changing assumptions. Most air crashes are due to pilot error and in most of those cases the co-pilot remained silent while knowing the pilot was making a terrible mistake. It is not easy to maintain a culture where reflexivity is the practice, but it may help you avoid disaster in your business.