14/91/17: Risk, Uncertainty, Political Risks and Markets

My article on the links between political risks, financial returns and economic growth in the MFTimes: http://issuu.com/publicationire/docs/mf_august_2017?e=16572344/51951043 pages 5-7.

28/7/17: Risk, Uncertainty and Markets

I have warned about the asymmetric relationship between markets volatility and leverage inherent in lower volatility targeting strategies, such as risk-parity, CTAs, etc for some years now, including in 2015 posting for GoldCore (here: http://www.goldcore.com/us/gold-blog/goldcore-quarterly-review-by-dr-constantin-gurdgiev/). And recently, JPMorgan research came out with a more dire warning:

This is apt and timely, especially because volatility (implied - VIX, realized - actual bi-directional or semi-var based) and uncertainty (implied metrics and tail events frequencies) have been traveling in the opposite direction  for some time.

Which means (1) increasing (trend) uncertainty is coinciding with decreasing implied risks perceptions in the markets.

Meanwhile, markets indices are co-trending with uncertainty:

Which means (2) increasing markets valuations are underpricing uncertainty, while focusing on decreasing risk perceptions.

In other words, both barrels of the proverbial gun are now loaded, when it comes to anyone exposed to leverage.

20/7/17: U.S. Institutions: the Less Liberal, the More Trusted

In my recent working paper (see http://trueeconomics.blogspot.com/2017/06/27617-millennials-support-for-liberal.html) I presented some evidence of a glacial demographically-aligned shift in the Western (and U.S.) public views of liberal democratic values. Now, another small brick of evidence to add to the roster:

The latest public opinion poll in the U.S. suggests that out of four 'net positively-viewed' institutions of the society, American's prefer coercive and non-democratic (in terms of internal governance - hierarchical and command-based) institutions most: the U.S. Military and the FBI. as well as the U.S. Federal Reserve. Note: the four are U.S. military, the FBI and the Supreme Court and the Fed are all institutions that are not open to influence from external debates and are driven by command-enforcement systems of decision making and/or implementation. Whilst they serve democratic system of the U.S. institutions, they are  subject to severely restricted extent of liberal checks and balances.

Beyond this, considering net-disfavoured institutions, executive powers (less liberty-based) of the White House are less intensively disliked compared to more liberty-based Congress.

27/6/17: Millennials’ Support for Liberal Democracy is Failing

New paper is now available at SSRN: "Millennials’ Support for Liberal Democracy is Failing. An Investor Perspective" (June 27, 2017): https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2993535.


Recent evidence shows a worrying trend of declining popular support for the traditional liberal democracy across a range of Western societies. This decline is more pronounced for the younger cohorts of voters. The prevalent theories in political science link this phenomena to a rise in volatility of political and electoral outcomes either induced by the challenges from outside (e.g. Russia and China) or as the result of the aftermath of the recent crises. These views miss a major point: the key drivers for the younger generations’ skepticism toward the liberal democratic values are domestic intergenerational political and socio-economic imbalances that engender the environment of deep (Knightian-like) uncertainty. This distinction – between volatility/risk framework and the deep uncertainty is non-trivial for two reasons: (1) policy and institutional responses to volatility/risk are inconsistent with those necessary to address rising deep uncertainty and may even exacerbate the negative fallout from the ongoing pressures on liberal democratic institutions; and (2) investors cannot rely on traditional risk management approaches to mitigate the effects of deep uncertainty. The risk/volatility framework view of the current political trends can result in amplification of the potential systemic shocks to the markets and to investors through both of these factors simultaneously. Despite touching on a much broader set of issues, this note concludes with a focus on investment strategy that can mitigate the rise of deep political uncertainty for investors.

7/6/17: European Policy Uncertainty: Still Above Pre-Crisis Averages

As noted in the previous post, covering the topic of continued mis-pricing by equity markets of policy uncertainties, much of the decline in the Global Economic Policy Uncertainty Index has been accounted for by a drop in European countries’ EPUIs. Here are some details:

In May 2017, EPU indices for France, Germany, Spain and the UK have dropped significantly, primarily on the news relating to French elections and the moderation in Brexit discussions (displaced, temporarily, by the domestic election). Further moderation was probably due to elevated level of news traffic relating to President Trump’s NATO visit. Italy’s index rose marginally.

Overall, European Index was down at 161.6 at the end of May, showing a significant drop from April 252.9 reading and down on cycle high of 393.0 recorded in November 2016. The index is now well below longer-term cycle trend line (chart below). 

However, latest drop is confirming overall extreme degree of uncertainty volatility over the last 18 months, and thus remains insufficient to reverse the upward trend in the ‘fourth’ regime period (chart below).

Despite post-election moderation, France continues to lead EPUI to the upside, while Germany and Italy remain two drivers of policy uncertainty moderation. This is confirmed by the period averages chart below:

Overall, levels of European policy uncertainty remain well-above pre-2009 averages, even following the latest index moderation.

28/2/17: Sentix Euro Breakup Contagion Risk Index Explodes

Sentix Euro Break-up Contagion Index - a market measure of the contagion risk from one or more countries leaving the euro area within the next 12 months period - has hit its post-2012 record recently, reaching 47.6 marker, up on 25 trough in 2Q 2016:

Key drivers: Greece, Italy and France.

Details here: https://www.sentix.de/index.php/sentix-Euro-Break-up-Index-News/euro-break-up-index-die-gefaehrlichen-drei.html.

23/2/17: Welcome to the VUCA World

Much has been said recently about the collapse of ‘risk gauges’ in the financial markets, especially on foot of the historically low readings for the markets’ ‘fear index’, VIX. In terms of medium-term averages, current VIX readings are closely matching the readings for the period of ‘peak’ ‘Great Moderation’ of 1Q 2005 - 4Q 2006, while on-trend, VIX is currently running below 2005-2006 troughs. In other words, risk has effectively disappeared from the investors’ (or rather traders and active managers) radars (see chart below).

At the same time, traditional perceptions of risk in the financial markets have been replaced by a sky-rocketing uncertainty surrounding the real economy, and especially, economic policies. The Economic Policy Uncertainty Indices have been hitting all-time highs globally (see chart below), and across a range of key economies (see this for my recent analysis for Europe: http://trueeconomics.blogspot.com/2017/01/15117-2016-was-year-of-records-breaking.html, this for Russia and the U.S.: http://trueeconomics.blogspot.com/2017/01/17117-russian-economic-policy.html). In current data, Economic Policy Uncertainty Index (EPUI) has been showing extreme volatility coupled with extreme valuations. Index values are rising above historical norms both in terms of medium-term averages and in terms of longer term trends.

 Another interesting feature is the direct relationship between the EPUI and VIX indices. Based on rolling correlations analysis (see chart below), the traditionally positive correlation between the two indices has broken down around the start of 2Q 2016 and since then all three measures of correlation - the 6-months, the 12-months and the 24-months rolling correlations - have trended to the downside, turning negative with the start of 2H 2016. Since November 2016, we have a four months period when all three correlations are in the negative territory, the first time this happened since June 2007 and only the second time this happened in history of both series (since January 1997). Worse, the previous episode of all three correlations being negative lasted only two months (June and July 2007), while the current episode is already 4 months long.

Final point worth making is that while volatility of VIX has collapsed both on trend and in level terms since the start of H1 2016 (see chart below), volatility in EPUI has shot up to historical highs.

Taken together, the three empirical observations identified above suggest that the current markets and economies are no longer consistent with increased traditional risk environment (environment of measurable and manageable risks), but instead represent VUCA (volatile, uncertain, complex and ambiguous) environment. The VUCA environment, by its nature, is characterised by low predictability of risks, with uncertainty and ambiguity driving down efficacy of traditional models for risk assessments and making less valid traditional tools for risk management. Things are getting increasingly more complex and uncertain, unpredictable and unmanageable.

23/1/17: Regulating for Cybersecurity: A Hacking-Based Mechanism

Our second paper on systemic nature (and regulatory response to) cyber security risks is now available in a working paper format here: Corbet, Shaen and Gurdgiev, Constantin, Regulatory Cybercrime: A Hacking-Based Mechanism to Regulate and Supervise Corporate Cyber Governance? (January 23, 2017): https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2904749.

Abstract: This paper examines the impact of cybercrime and hacking events on equity market volatility across publicly traded corporations. The volatility influence of these cybercrime events is shown to be dependent on the number of clients exposed across all sectors and the type of the cyber security breach event, with significantly large volatility effects presented for companies who find themselves exposed to cybercrime in the form of hacking. Evidence is presented to suggest that corporations with large data breaches are punished substantially in the form of stock market volatility and significantly reduced abnormal stock returns. Companies with lower levels of market capitalisation are found to be most susceptible. In an environment where corporate data protection should be paramount, minor breaches appear to be relatively unpunished by the stock market. We also show that there is a growing importance in the contagion channel from cyber security breaches to markets volatility. Overall, our results support the proposition that acting in a controlled capacity from within a ring-fenced incentives system, hackers may in fact provide the appropriate mechanism for discovery and deterrence of weak corporate cyber security practices. This mechanism can help alleviate the systemic weaknesses in the existent mechanisms for cyber security oversight and enforcement.

14/1/17: Country Risks survey results for 2016

+Euromoney have published their @CountryRisks survey results for 2016: available here quoting, amongst other analysts, myself.

2/1/16: Financial digital disruptors and cyber-security risks

My and Shaen Corbet's new paper titled Financial digital disruptors and cyber-security risks: paired and systemic (January 2, 2017), forthcoming in Journal of Terrorism & Cyber Insurance, Volume 1 Issue 2, 2017 is now available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2892842.

Abstract:
The scale and intensity of digital financial criminality has become more apparent and audacious over the past fifteen years. To counteract this escalating threat, financial technology (FinTech) and monetary and financial institutions (MFI) have attempted to upgrade their internal technological infrastructures to mitigate the risk of a catastrophic technological collapse. However, these attempts have been hampered through the financial stresses generated from the recent international banking crises. Significant contagion channels in the aftermath of cybercriminal events have also been recently uncovered, indicating that a single major event may generate sectoral and industry-wide volatility spillovers. As the skillset and variety of tactics used by cybercriminals develops further in an environment of stagnating and underfunded defensive technological structures, the probability of a devastating hacking event increases, along with the necessity for regulatory intervention. This paper explores and discusses the range of threats and consequences emanating from financial digital disruptors through cybercrime and potential avenues that may be utilised to counteract such risk.

2/10/2014: IMF Report: Risk Taking Behaviour in Banks

As some of you might have noticed, I started to contribute regularly to Learn Signal Blog last week. This week, my post there covers IMF Global Financial Stability Report update released this week, dealing with the drivers for risk taking behaviour of the banks prior to and since the Global Financial Crisis: http://blog.learnsignal.com/?p=46

12/8/2014: Experience, Earnings & differences Between Economies

In the previous post, I summarised recent research paper on entrepreneurial learning-by-doing (http://trueeconomics.blogspot.it/2014/08/1082014-serial-entrepreneurship.html). Here are some other recent papers on the topic of entrepreneurship and human capital.

First paper is by Lagakos, David and Moll, Benjamin and Porzio, Tommaso and Qian, Nancy, titled "Experience Matters: Human Capital and Development Accounting" (December 2012, CEPR Discussion Paper No. DP9253: http://ssrn.com/abstract=2210223). The authors use micro-level data from 36 countries to look at evolution (over time) of ratios of experience-to-earnings. They find that the ratios profiles are flatter in poor countries than in advanced economies. In other words, experience-linked returns are flatter in poorer economies, or put differently: for each year gained in experience, poor country workers gain less in earnings than their rich countries counterparts.

The paper does not aim to explain the reasons for this empirical regularity, though the authors do say that "…composition differences [of workers (e.g., by schooling attainment or sector of work)] explain very little of the cross-country differences in the steepness of experience-earnings profiles. …Amongst other possible explanations, we note that our main finding that experience-earnings profiles are flatter in poorer countries is consistent with a class of theories in which TFP and experience human capital accumulation are complementary (i.e., low TFP in poor countries depresses the incentives to accumulate human capital)."

What the authors do, however, is look at the role that differences in experience-earnings profiles found between countries can have on levels of development. "When the country-specific returns to experience are interpreted in such a development accounting framework -- and are therefore accounted for as part of human capital -- we find that human and physical capital differences can account for almost two thirds of the variation in cross-country income differences, as compared to less than half in previous studies."

Specifically, on human capital side, "We calculate the part of human capital due to experience and show that this is positively correlated with income, and furthermore that its cross-country dispersion is similar in magnitude to the dispersion of human capital due to schooling."

In the forthcoming article in the Village magazine, I challenge Thomas Piketty's interpretation of income and wealth inequality data, in part, on the grounds of his failure to reflect the role of human capital in generating financial returns. It looks like the above study provides some more support for my arguments.

10/8/2014: Serial Entrepreneurship: Learning by Doing?

We often hear references to the U.S. entrepreneurial climate whereby one's failure at the first venture is commonly rewarded with an encouragement to start again. One of the alleged reasons for this climate emergence, the popular belief asserts, is that an entrepreneur learns from failure or success of the first venture to deploy this knowledge to achieve a greater success in the second entrepreneurial endeavour.

"Serial Entrepreneurship: Learning by Doing?" (NBER Working Paper No. w20312) by FRANCINE LAFONTAINE, and KATHRYN L. SHAW, looks are whether "Among typical entrepreneurs, is the serial entrepreneur more likely to succeed?" and "If so, why?"

The paper uses "a comprehensive and unique data set on all establishments started at any time between 1990 and 2011 to sell taxable goods and services in the state of Texas. An entrepreneur is defined as the owner of a new business. A serial entrepreneur is one who opens repeat businesses. The success of the business is measured by the duration over which the business is in operation."

And the conclusions are:

• "The data show that serial entrepreneurship is relatively uncommon in retail trade. Of the almost 2.3 million retail businesses of small owners of new businesses in our data, only 25 percent are started by owners who have started at least one business before, and only 8 percent are started by an owner who is still operating at least one other business started earlier."
• "However, once one becomes an entrepreneur for a second time, the probability of becoming one a third time, or fourth time, and so on, keeps rising."
• "Moreover, we find that an owner's prior experience at starting a business increases the longevity of the next business opened, and that controlling for person fixed effects, prior experience still matters."
• "Finally, experience at starting retail businesses in other sectors (e.g. a clothing store versus a repair shop) is beneficial as well, though not as much as same sector experience, and not in the restaurant sector."

The authors conclude that "prior experience imparts general skills that are useful in running the new business."

7/5/2014: Simple vs Complex Financial Regulation under Knightian Uncertainty

Bank of England published a very interesting paper on the balance of uncertainty associated with complex vs simplified financial regulation frameworks.

Titled "Taking uncertainty seriously: simplicity versus complexity in financial regulation" the paper was written by a team of researchers and published as Financial Stability Paper No. 28 – May 2014 (link: http://www.bankofengland.co.uk/research/Documents/fspapers/fs_paper28.pdf), the study draws distinction between risk and uncertainty, referencing "the psychological literature on heuristics to consider whether and when simpler approaches may outperform more complex methods for modelling and regulating the financial system".

The authors find that:
(i) "simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions";
(ii) "simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis"; and
(iii) "when combining information from different indicators to predict bank failure, ‘fast-and-frugal’ decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate".

The authors key starting point is that "financial systems are better
characterised by uncertainty than by risk because they are subject to so many unpredictable factors".

As the result, "simple approaches can usefully complement more complex ones and in certain circumstances less can indeed be more."

The drawback of the simple frameworks and regulatory rules is that they "may be vulnerable to gaming, circumvention and arbitrage. While this may be true, it should be emphasised that a simple approach does not necessarily equate to a singular focus on one variable such as leverage… [in other words, simple might not be quite simplistic] Moreover, given the private rewards at stake, financial market participants are always likely to seek to game financial regulations, however complex they may be. Such arbitrage may be particularly
difficult to identify if the rules are highly complex. By contrast, simpler approaches may facilitate the identification of gaming and thus make it easier to tackle."

Note, the above clearly puts significant weight on enforcement as opposed to pro-active regulating.

"Under complex rules, significant resources are also likely to be directed towards attempts at gaming and the regulatory response to check compliance. This race towards ever greater complexity may lead to wasteful, socially unproductive activity. It also creates bad incentives, with a variety of actors profiting from complexity at the expense of the deployment of economic resources for more productive activity."

The lesson of the recent past is exactly this: "These developments [growing complexity and increased capacity to game the system] may at least partially have contributed to the seeming decline in the economic efficiency of the financial system in developed countries, with the societal costs of running it growing over the past thirty years, arguably without any clear improvement in its ability to serve its productive functions in particular in relation to the successful allocation of an economy’s scarce investment capital (Friedman (2010))."

And the final drop: clarity of simple systems and implied improvement in transparency. "Simple approaches are also likely to have wider benefits by being easier to understand and communicate to key stakeholders. Greater clarity may contribute to superior decision making. For example, if senior management and investors have a better understanding of the risks that financial institutions face, internal governance and market discipline may both improve."

Top line conclusion: "Simple rules are not a panacea, especially in the face of regulatory arbitrage and an ever-changing financial system. But in a world characterised by Knightian uncertainty, tilting the balance away from ever greater complexity and towards simplicity may lead to better outcomes for society."

2/1/2014: Risk, Regulation, Financial Crises: A Panacea Worse than the Disease?

An interesting - both challenging and revealing - piece on 'preventing the future crisis' via http://www.pionline.com/article/20131223/PRINT/312239993/preventing-the-next-financial-crisis-requires-regulatory-changes.

Few points worth commenting on:

Per article: "…Record investment management industry profits as well as record market highs belie the fact we remain truly exposed to complex financial products and services not yet fully restrained since the crisis of 2008." As a logical conclusion to this, of the "three things in particular should concern all of us who are stakeholders in the finance industry as we move into the new year" the first one is:

"…complacency that another crisis can't happen because we have fixed the gaps in regulation."

So far nothing to argue with. Financial innovation (aka a path of increasing complexity) remains the main source of margins uplift in the industry. As long as that is the case, we are going to have less transparency, lower capacity to price risks and, as the result, greater fragility of the system, especially with respect to tail events.

"Nothing could be further from reality and the list of unfinished regulatory business is long. " And the article rolls on with a brief list of reforms and changes yet to take place. Alas, desired or not, these changes are hardly going to bring about any significant change in the way the sector operates. The irony is: the article warns against complacency and then complacently assumes (or even postulates - take your pick) that implementing the list of regulations and reforms supplied will resolve the problem of 'gaps in regulation'.

Really? Now, wait a second. We have a problem of 2 parts:
Part 1: complexity of system is high.
Part 2: complexity of regulation lagging complexity of system.

Matching Part 1 to Part 2 by raising complexity of regulation can only address the problem of risk buildup if and only if Part 1 is independent of Part 2. Otherwise, rising complexity in 2 can lead to rising complexity in 1 and a race in complexity.

Still with me? That is a major problem of the financial system as we know it since at least 19th century. The problem is that rising complexity of regulation is driving financial innovation probably as much as the need for higher margins. The race to match Part 1 and Part 2 above is a loss-making game for regulators, and thus, for economies at large.

If that is at least partially true, the argument should not be about regulations that are yet to be implemented, but rather about which regulations can help reducing complexity (and increase risk management effectiveness) in both Parts 1 and 2. We are still missing that argument, having departed firmly on the path of reasoning that suggests that higher complexity of regulation = higher system ability to absorb shocks. More dangerously, we are seemingly traveling along the line of logic that suggests that higher complexity of regulation = higher ability of system to 'prevent' shocks.


The article goes on to list another major source of risk: "investment management industry overconfidence that it is back in control". Specifically, "We in the industry perceive ourselves as having rectified our inability to see building counterparty, leverage and liquidity risks, masked through Federal Reserve policy by the unorthodox government support of financial markets and the nearly 10,000-point move in the Dow Jones industrial average since the financial crisis."

In reality, "Systemic risks are still building, undetected. Transparency is not increasing and the unwillingness or inability to remove government support in the markets is unprecedented."

Guess what? If you assume that more regulation + more complex regulation = better risk management, you are going to become complacent and you are going to get a false sense of security, control. This brings us back to the first point above.


And now to the non-point point number 3: "Finally, we in the investment management profession seem totally nonchalant about the current state of our existing regulatory system. It is alarmingly outdated, under-resourced and no match for the complexity of markets in the 21st century. To be clear, we are not talking about the new regulations addressing the crisis, rather the basic requirements of our present regulatory structure."

Back to point one above, then, again…


The reason I am commenting on this article is precisely because it embodies the very poor logical reasoning that is leading us to structure regulatory responses to the crisis in such a way that it will assure the emergence of a new crisis. But the real kicker is not that. The real kicker is that the very belief that regulatory system based on matching complexity of regulated services can ever be calibrated well-enough to assure stability of the system is a belief suffering from gross over-extension of faith.

A constant race to increase complexity of the system will lead to system collapse. 

27/4/2013: ECR latest league table for ECE

Handy sovereign risk summary via ECR for Eastern and Central Europe. Note changes over time:

Interestingly, Cyprus - default event took place - is still ranked higher than a number of non-default states. Another interesting bit: Latvia, Hungary, Romania are ranked in 4th tier - low quality sovereign risks, all are EU countries, while Croatia is barely above Cyprus and Bulgaria is below - one is accession state another is the member of the EU. For much talk about 'heterogeneity' not being a problem, with differences between the US states evoked often to support this proposition, I doubt there is such a divergence between individual states in any function federal or near-federal structure anywhere... not even in Italy or Spain...

18/11/2012: Innovation, Professionalization of Risk, Stagnation?

The recurrent theme in forward thinking nowdays is the decline of technological 'revolutions' cycle. I wrote about this on foot of earlier research (here) and in recent weeks there has been another - most excellent - article on the same topic from Garry Kasparov and Peter Thiel (link here).

Two quotes:

"During the past 40 years the world has willingly retreated from a culture of risk and exploration towards one of safety and regulation. We have discarded a century of can-do ambition built on rapid advances in technology and replaced it with a cautiousness far too satisfied with incremental improvements."

The irony has it that in our collective / social pursuit of certainty, we have surrendered risk pricing and risk taking to the professional class of the 'bankers' who proceeded to show us all that they are simply incapable of actual investing. The delegation of risk authority to them, compounded with over-taxing risk taking via tax systems and strict bankruptcy regimes, has meant that real equity and real investment have been replaced with financial instrumentation of debt and financial instrumentation of creativity.

"Many investors practise a fake form of long-term thinking. Portfolio managers see the returns of the 20th century and project those far into the future. Tomorrow’s retirees are betting their fortunes on the success rates of yesterday’s companies. But the vast wealth registered by modern capital markets came from technological feats that cannot be repeated. If nobody takes the risk to invent products that produce new industries and new profits, then analysing historical returns from the 20th century will be no better guide to our future than researching crop yields from the 10th century. Without innovation, faith in the stock market is a kind of cargo cult."

We are no longer thinking - as a society - in terms of risk as an input into production of new goods, services, value-added in the economy, but see it as both as a negative utility good (something to avoid and reduce) and as a fertile ground for taxation (a logical corollary in the world where risk is a matter of 'professional' fees collection, and not an input into innovation). The social structures of modern democracies in the West are now wholly committed to reducing risk impact on households - the Nanny State - and thus taxing risk returns.

"Above all the future will be created by individuals. Those with the most liberty to take on risk and make long-term plans, young people, should consider their options carefully. ...The coming generation of leaders and creators will have to rekindle the spirit of risk. Real innovation is difficult and dangerous but living without it is impossible."

Note: beyond 'professionalization' of risk, there also remains the issue of 'financialization' of risk. While Kasparov and Thiel clearly focus on the latter aspect, my comments focus on the former. But the two are not, in fact, separate - the financialization is impossible without professionalization, and vice versa.

28/10/2012: Long term investor risk perceptions

Blackrock research on risk attitudes of long-term investors:

So within 1year we have a massive flip on perceptions concerning pensions decisions, amidst a relatively robust markets performance.

Economics 16/10/2010: Organizational systems and uncertainty

I came across this very interesting, and to me - far reaching - paper on the effects of organizational structures on the organization's ability to cope with uncertainty and change. Karynne L. Turner, Mona V. Makhija. “Measuring what you know: an individual information processing perspective” (April 15, 2010). Atlanta Competitive Advantage Conference 2010 Paper (here).

According to the information processing perspective, the organization’s ability to draw upon and utilize information is dependent on the relationship between structure and the ability of individuals to process information, facilitated by specific organizational aspects of the firm. The study considers the effect of two types of structure, organic (integrated or systemic) and mechanistic (siloed), on individuals’ ability to gather, interpret and synthesize information, and their problem-solving orientation. Evidence shows that individuals develop more information processing capability under organic than mechanistic structures, which in turn creates more problem solving orientation in individuals.

In short, the study lends support to the premise that better integrated, more diversified across skills and less siloed organizations produce more effective and efficient gathering, processing and interpreting of information, as well as better problem solving.


Effective management of knowledge is the basis of firms’ ability to compete (Zander and Kogut, 1995; Nonaka, 1994). This is achieved through organizational design (Teece at al., 1997) that underlies “the means by which firms acquire, disseminate, interpret and integrate organizational knowledge”.

Organizational structure embodies a number of key elements, such as control and coordination or management mechanisms, and human capital management that allocate tasks to work units and individuals, and coordinate them in a way that achieves organizational goals. The manner in which this is done is critical due to problems created by

• External uncertainty associated with suppliers, competitors and consumer demand (Gresov and Drazin, 1997; Sine, Mitsuhashi and Kirsch, 2006), or
• Internal uncertainty, due to the complexity of internal coordination, measurement difficulties and changing processes (Habib and Victor, 1991).
  

Uncertainty reduces the effectiveness of pre-established routines, technologies or goals, and increases the importance of problem solving (Becker and Baloff, 1969)). The more work related uncertainty increases, the greater the need there will be for information processing (Turner and Makhija, 2006 and Tushman, 1979).

One way in which an organization addresses uncertainty is by assigning specific responsibilities to specialized subunits, which collect, process and distribute information acting as “a set of nested systems” (Daft and Weick, 1984).

Literature distinguishes two types of organizational structures, mechanistic and organic. These structures differ in the distribution of tasks, the flow of information among individuals and across units, and the extent to which there is interaction with the environment (Shremata, 2000; Gibson and Birkinshaw, 2004).

Mechanistic forms of organization are characterized by hierarchical division of labor, in which communication tends to be in one direction – top to bottom. Individuals develop deep expertise in their own designated jobs, which tend to be clearly specified and specialized in individual knowledge. The mechanistic structures do not allow for much flexibility (Parthasarthy and Sethi, 1993).

Organic forms of organizations are based on horizontally-administered teams, in which all members participate in management decisions (Baum and Wally, 2003), allowing for worker autonomy, responsibilities adaptation. Team members developing competence across multiple tasks, thus diversifying their skills and knowledge sets. Individuals have broader unit-level knowledge rather than just one job and develop greater flexibility.

The structural differences between mechanistic and organic organizational forms are likely to influence the development of information processing capability in organizational members, reflected in organization’s ability to gather, interpret and synthesize information. Turner and Makhija (2010) consider the impact of different types of structures on each of these three aspects of organizational members’ information processing capability.

Turner and Makhija (2010) postulate a set of testable hypotheses all of which are confirmed:

H1: Organic structures lead to more gathering of information than mechanistic structures.
Implication: uncertainty is reduced in organic (integrated or more horizontal) structures through reduced information asymmetries vis-à-vis external environment.

H2: Organic structures lead to more similarly interpreted information than mechanistic structures.
Implication: information asymmetries are reduced across the broader range of the organization structures in the organic setting.

H3: Organic structures lead to more synthesized information than mechanistic structures.
Implication: organic systems are better capable of integrating information of various types.

H4: More gathering of information is associated with greater problem solving orientation.
Implication: organic systems are better able to cope with converting uncertainty into manageable risks systems.

H5: More similarly interpreted information is associated with greater problem solving orientation.
Implication: better information processing in organic systems results in better problem solving, so information is used more effectively.

H6: More synthesized knowledge is associated with greater problem solving orientation.
Implication: individuals also tended to synthesize, or understand the interrelationships among different types of information, much better than individuals working in mechanistic structures.

H7: Information processing capability mediates the relationship between organizational design and problem solving orientation
Implication: the effects of individuals’ information processing on their problem solving orientation is greater in the organic structures, reflecting their comfort with problem situations in their work.

Turner and Makhija (2010) research shows that, when operating in two different types of structures, individuals process information differently in all three respects: gathering, interpreting, and synthesizing information.

These findings have several far-reaching implications for the organizational structures found in Ireland.

Firstly, it is clear that hierarchical and fixed systems approach to public services provision – characterized by the lack of communications between vertically-integrated public sector departments and organizations leads to their inherently lower ability to absorb, process and implement informational processes that manage uncertainty.

Secondly, this shows why successful entrepreneurial ventures are horizontal in nature and less siloed.

Third, it shows that our political system – with disproportionate powers allocated to the executive, as opposed to more uniform distribution of powers between the executive, legislative and judiciary – is similarly to the public sector less equipped to handle uncertainty.