Econophysics1, Nonlinearity2 and Complexity Theory3 have emerged as established approaches in the study of both organizations and markets. Unfortunately, during the last thirty years, most research about Financial Stability, systemic risk and aspects of sustainable growth (economic, social, urban and environmental sustainability) has focused on the financial sector and macroeconomic issues (i.e. correlations, systemic risk, monetary policy, volatility, derivatives, etc.), and has neglected the real sector, microeconomics (industrial organization; and analysis and failure of companies, households and individual financial institutions; etc.), online social networks and psychology issues (human biases; group-decisions; organizational psychology; etc.). However, in many developed, developing and under-developed countries, the linkages between the real and financial sectors remain strong and are increasing (e.g. loans/mortgages; over-drafts; insurance; LOCs; Swaps/options; Credit-Chains; securities investments and retirement portfolios; regulations; etc.) and crises in the real sector has often been one of the root causes of financial crises in the financial sector. See the comments in Bruneau et al. (2012). A financial or economic crisis (in the financial or real sectors) is usually characterized by one or more of the following factors: (i) significant balance sheet problems (of households, financial intermediaries, companies and/or governments); (ii) reduced ability (of households, financial intermediaries, companies and/or governments) to raise capital; (iii) substantial changes in credit volumes and/or asset prices; (iv) reduced output and productivity (of participants in the economy); (v) decline of Aggregate Demand; and (vi) large scale government interventions—usually in the form of new regulations (including the ability to postpone the recognition of losses), and/or government financial support and/or nationalizations and/or subsidization. Examples of crises in the real sector that have affected the financial sector include (but are not limited to) the automotive industry crisis of 2007–2010 in the US and Europe; the housing industry crises and asset-bust of 2007–2010 in the US and Europe; the failure of the agriculture industry in Portugal in the 1970s/1980s; the retail industry crisis in Germany during 2009–2011; the retail industry crisis in the US during 1999–2001; the oil industry crisis of 2014–2016 in the US (failures of oil/gas firms); the energy crisis of 2006–2008 in the US (high oil prices); the Oil/Gas industry crisis of 2014–2016 in Nigeria (declines of oil prices which affected both real estate and the banking industry); the property bubble burst of 1990–1991 and an overcapacity of the industrial/manufacturing sector during 1990–1992 in Japan; the rise in corporate bankruptcies/failures during 1996–2000 in Japan (which led to failures of Japanese banks that made loans to, and owned equity stakes in companies); the global steel industry crises and severe glut of 2015–2016 (which has badly affected China); and the over-capacity problem in the aluminum, chemical, cement, and steel industries in China during 2013–2016. Credit Chains, inefficient contracts and incentives (e.g. standardized franchise contracts, mortgage contracts, supply chain contracts and employment contracts), human-biases and ineffective institutions (e.g. land titling systems) in the real sector are or can be major causes of financial crises. Appendix 3 herein and below lists some of the major financial and economic crises in the world during the last few centuries (measured by monetary impact or the number of persons affected) and a review indicates that many of those crises were caused and/or defined by: (i) risk perception issues especially about political economy shocks, economic/financial contagion and activities/moves of competitors; (ii) nonlinear risk that could not be timely identified or managed with then-existing economic/financial models and strategies (e.g. immediate-cause-and-delayed/extended-impact, or delayed/extended-cause-and-immediate-impact, or small-cause-and-large-impact, or large-cause-and-divergent/collateral-impact; etc.); (iii) divergencies in opinions in markets that is mostly attributable to disclosure/accounting issues, risk perception and political economy shocks; (iv) significant changes in the mental states and psychology of investors and ordinary adults (i.e. mass hysteria; anxiety; optimism; Regret; noise; depression; etc.); (v) behaviors, biases and issues that pertain to declining prices of assets (e.g. stocks; residential real estate; currency bonds/loans; exchange rates; commodities; etc.) or bubbles or the sudden increase of prices of a key asset (e.g. oil-price shocks) or the sale of assets; (vi) the limitations and evolution of forms of corporate entities (i.e. the nature, powers and evolution of corporate entities); (vii) housing bubbles and mortgage-related problems; and (viii) intangible assets in the banking industry (e.g. human capital; brand equity; etc.)—banks’ historical compensation costs are about 40–60% of their annual revenues.
The approaches used in this book include “Qualitative Reasoning” (See Forbus (2019), Halpern (2003), and Bredeweg and Struss (Winter 2003)), Algorithms, “Perception Dynamics Theory” (a new approach introduced in this book), Mechanism Design Theory and Complex Systems Theory.
Risk perception is critical in corporate entities and for government regulators and overall social welfare; and it has been analyzed from various perspectives such as financial risk4 (including psychology5 and corporate governance), operational risk (i.e. reliability-engineering/systems-engineering6; safety-science,7 and operations research8), computer-science/HCI9 and physics.10 The commonalities among these different pe...