Liveblogging “Financial Innovation” Week 6: New Markets

The focus for our classes on September 26 and 27 was the theme of “Financial Innovations in Markets.”  At this point, we shifted our attention from the drivers of innovation, to its manifestations—we started looking at innovations in markets, institutions, services, instruments, and innovations for social impact.  The purpose of looking at financial innovations in these various forms is to develop a critical point of view.

What do financial markets do for us?  Any critical point of view has to begin with an understanding of ideal function and goals for markets.  Such understanding is the focus of the field of market microstructure within financial economics.  In his chapter on the NYSE, Richard Sylla argued that financial markets serve several needs: they pool resources; subdivide claims for investor convenience; mobilize capital by channeling funds from savers to users; allocate capital efficiently; afford ways of managing risk and create useful economic information.  To these I would add that they afford liquidity to investors and, to the extent that markets are organized in some way, they tend to promote orderliness.

Imagine a world with no markets: we would have to search for products and buy them through some barter-like negotiation.  Shopping for the bare essentials would be enormously costly in time and money.  The modern American supermarket or big box retailer gathers thousands of stocking units under one roof and offers these goods at take-it-or-leave-it prices.  In communities large enough for two or more competitors, the prices are likely to be competitive.  The upshot is that the existence of these markets might lower our costs of search and transaction. 

We have seen examples of the benefits of financial markets this week and in prior weeks:

·        The advent of trading in options and futures contracts in Amsterdam between 1550 and 1650.  As trade in spices and other commodities from the Dutch East Indies boomed, merchants needed to limit their exposure to price fluctuations.  Initially the instruments traded were bespoke designs.  As trading expanded, the instruments became more standardized.

·        The advent of new markets in kidneys and marriage partners.  In the absence of such markets, finding a counterparty is hit-or-miss, and consequences of failure are disastrous.  Innovative markets have been created that use search algorithms to match up counterparties. 

·        Electronic trading of securities on new exchanges has dramatically lowered execution costs and possibly increased liquidity. 

·        As described in Michael Lewis’s book, Flash Boys, which we discussed earlier in the course, Brad Katsuyama’s new IEX market offers an alternative to exploitative front-running in “dark pool” markets.

·        Flip Pidot (D’02) visited our class and discussed his efforts to launch American Civics Exchange (ACE), which would enable investors to trade instruments whose value derived from outcomes of elections, legislative votes, and regulatory actions.  With Flip’s assistance, we explored, a prediction market; and we considered the change in polling percentages following a major presidential debate.  ACE and PredictIt could enable a participant to hedge risks that might stem from civic events or government actions.

Markets manufacture information.  Prices are the most important kind of information that markets produce.  Markets also provide useful information about liquidity, volatility, risk, and correlation.  Investors use this information to trade in the market as well as for decisions outside the market.  For instance, corporations use “beta” (a measure of the volatility of a firm’s stock price relative to the volatility of the stock market) in estimating the return that stockholders require from the company.  The cost of equity, combined with the cost of debt (informed by interest rates) determines the cost of capital for a company.  The market-based cost of capital is used in making a host of important corporate decisions about capital investments, acquisitions, restructurings, stock buybacks, and so on. 

Markets also can provide information about market participants.  The spreads of an issuer’s debt relative to risk-free bonds is an indication of the risk of that issuer.  The inability of some financial institutions to borrow in the repo funds market during the Panic of 2008 was evidence that investors doubted the creditworthiness of those institutions.

The market as a search engine.  Markets bring buyers and sellers together.  Markets lower the cost of finding a counterparty to do a trade.  This search-related benefit of markets is sometimes referred to as liquidity.  Larry Harris, former Chief Economist of the SEC, wrote, “Liquidity is the ability to trade large size quickly, at low cost, when you want to trade.  It is the most important characteristic of well-functioning markets.”  ((Larry Harris, Trading and Exchanges, 2003, Oxford University Press, page 394.))  Market makers, dealers, and brokers help to promote liquidity.  As the articles about the NYSE in 1792 and 1914 suggest, the absence of liquidity in one market can stimulate financial entrepreneurs to establish a new market.   

The benefits of a market depend on trading volume.  Growth in the number of trading participants tends to improve market efficiency.  With few participants, the views and behavior of any one participant will have an outsized effect on prices and trading volume.  Recall from our discussion in week 4 that market efficiency means that prices reflect relevant information about the asset underlying the financial instrument.  More market participants bring more diversity of opinion and more channels by which information can enter market prices.  An increase in the number of market participants increases the likelihood that prices will be efficient.  Higher trading volume helps price discovery.  

Of course, what matters is not just any kind of trading.  Uninformed day-traders simply add noise to the market prices.  The kind of traders who really help price discovery are informed traders—these tend to drive security prices toward their intrinsic values.  Informed traders reflect many styles: value traders estimate intrinsic values of securities from all the fundamental information they can find; news traders act on new information; technical traders respond to predictable price patterns caused by noise traders, shifts in market sentiment, or statistical aberrations (technical traders tend to rely on algorithmic trading models); and arbitrageurs simultaneously buy and sell similar instruments to exploit pricing anomalies.  More of this informed trading helps price discovery.

We considered examples of new markets that failed because of insufficient trading volume.  The case of Robert Shiller’s MacroMarkets house price derivatives showed that low trading volume during the panic of 2008-2009 doomed the attempt to launch the new instruments.  In his conversation with us, Shiller remained confident that a market in these instruments would arise eventually.  Also during this week, we discussed the Chicago Climate Exchange, which ceased its trading of carbon emissions in 2010 due to inactivity in trading for trading greenhouse gas emission allowances.  Though these instruments make sense as a device for adding the cost of pollution to the pricing of goods and services, the absence of a government mandate made the participation in this market voluntary for companies.  Trading volume remained insufficient and the market closed.   

In class, we conducted an exercise about locating the market for trading in sukuk (sharia compliant) bonds.  We considered London for its large and liquid markets, its desirable legal system, and its familiarity with Islamic finance.  Another candidate was Dubai, which was attractive for its ease of doing business and competitiveness as a business center.  The third candidate was Kuala Lumpur, Malaysia—the sukuk market settled in KL.  Malaysia is the largest sukuk issuer in the world, accounting for about 70% of total issuances.  And Malaysia requires that all debt issuances be rated.  And there is a big local demand for sukuk issues in Malaysia.  It seems that prospective trading volume attracted the sukuk bond market to KL.

Market disorder tends to lead to government intervention and rules.  We discussed the origins of the New York Stock Exchange.  Following financial panics in 1791 and 1792, the New York State legislature banned open-air auctions of securities.  It was thought that simply closing the financial market permanently would prevent future panics.  But dealers and investors and therefore gathered under a buttonwood tree in lower Manhattan to form a club that would facilitate trading, but only among members.  Membership in the club would be limited by certain entry criteria, and trading would occur on the basis of certain rules.  This is an early example of regulatory arbitrage, discussed in my liveblog post for Week 5.   

Another case of disorder and invention occurred in 1914.  We discussed the impact on market liquidity when the U.S. government closed the NYSE.  The government was afraid that Europeans would sell American financial securities at the outbreak of World War I and attempt to repatriate stocks of gold to their own countries.  A massive and sudden outflow of gold could destabilize the U.S. financial system.  Thus, the government simply closed the market.  But traders formed an informal securities market “on the curb” of the NYSE.  The article by William Silber found that securities prices in this alternative market remained relatively competitive and efficient.  Regulatory arbitrage struck again.

We also looked at an example of a benign influence of government: the advent of the 30-year amortizing mortgage.  The article by Rose and Snowden described the impact of the Great Depression on mortgage lending.  Before the Depression, house purchases were financed with interest-only balloon payment contracts.  The maturity of such loans during the depression when unemployment was high figured in the bankruptcy of many consumers.  The amortizing mortgage loan reduced the risk associated with longer terms.  The Federal Housing Administration, Federal Savings and Loan Insurance Corporation, and Home Owners Loan Corporation used their powers to motivate banks and S&Ls to adopt the amortizing mortgage model. 

Another example of government stimulation for innovation in financial markets was discussed in the article by Gerardi, Rosen, and Willen.  They found that federal deregulation of the mortgage market and of the S&L industry in the mid-1980s led to increased integration between real estate finance and other financial markets.  The mortgage securitization market boomed.  Consumers enjoyed greater tailoring in the design of mortgages.  And credit constraints relaxed, particularly for borrowers at the low end of the house value distribution.        

Questions for innovators in new financial markets:

1.      What is the problem that this new market solves?  What is being priced?  To whom is the pricing information useful?  In his chapter on “Market Designers and Financial Engineers,” Robert Shiller wrote, “Market designers, sometimes called mechanism designers, start with a problem—the need for a market solution to some real human quandary—and then design a market and associated contracts to solve the problem.”  ((Robert Shiller, Finance and the Good Society, page 69.))  Consistent with our studies over the preceding five weeks, consider how profit, risk, market incompleteness, market inefficiency, and government action might contribute to the case for this new market.   Another way to answer these questions is to consider the list of functions that markets perform: they pool resources; subdivide claims for investor convenience; mobilize capital by channeling funds from savers to users; allocate capital efficiently; afford ways of managing risk; create useful economic information; afford liquidity to investors and, promote orderliness—to whom are these benefits valuable, and why?

2.      Can this new market gain reasonable trading volume and liquidity?  Can it attract informed traders?  Markets are search engines.  For a search engine to be effective, it needs plenty of counterparties.  Try to identify a demand for services from the market.  How large and stable is the demand?

3.      Who rules, and how?  Obtaining a license to operate from most national governments typically requires sharp clarity about the new market’s governance and operations.  Norms and rules of operation will be necessary for orderly functioning.  These might address who can trade (are there conditions for entry into the market?), how trades are settled (by cash or credit? Over what time period?), disclosure of trading and the condition of traders (do they have the financial capacity to settle their trades?), and enforcement of infractions of rules (by whom?  When?)

4.      Why now?  The economic context has an immense influence on the eventual success or failure of the new market.  MacroMarkets introduced its new derivatives on house prices shortly after the Panic of 2008, when house prices had been battered down, and found few takers for its insurance.  Markets for greenhouse gas emission allowances have depended on government mandates and incentives to promote such trading.  Regulations generally have been known to stimulate innovations to arbitrage around the regulatory constraints.  And technological innovations can stimulate financial innovations, as evident in the rise of high frequency trading exchanges and the blockchain.

5.      Who or what is being displaced by the creation of this new market?  Incumbents can be tenacious competitors.  The algorithm-based market for kidneys displaced informal networks of unilateral search. displaces informal social networks, bars, and professional matchmakers.  “Dark pools” displaced slower and more transparent markets.  ACE and the Amsterdam options and futures exchanges displace self-insurance.   

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Liveblogging “Financial Innovation” Week 5: Regulation

“The major impulses to successful financial innovations over the past twenty years have come, I am saddened to have to say, from regulations and taxes…[Through tax changes} The government is virtually subsidizing the progress of financial innovation just as it subsidizes the development of new seeds and fertilizers but with the important difference that in financial innovation the government’s contribution is typically inadvertent…the role of government in producing the pearls of financial innovation over the past twenty years has been essentially that of grain of sand in the oyster…the same process can be seen at work in any financial area subject to government regulation…The pressures to innovate around prohibited types of profitable transactions, or around newly imposed or newly-become-effective interest-rate ceilings, are particularly strong but, as we have come to see lately, even what purports to be deregulation can sometimes trigger changes that go far beyond the intentions of the original sponsors….The process of adaptation and selective survival in response to tax and regulatory changes has been going on throughout recorded history.”  ((Merton Miller, (1991) Financial Innovations and Market Volatility, Cambridge: Blackwell, pages 5, 6, and 19.))

Writing in 1991, the Nobel Laureate in Economics, Merton Miller, pointed toward taxes and regulations as major drivers of financial innovation.  Merton’s message complements other drivers we studied in the two previous weeks, profit-seeking, risk management, market incompleteness and market inefficiency.  The point of our exploration in week five was to lay more groundwork for a critical appraisal of financial innovations in the weeks ahead: innovations in markets, institutions, instruments, and services. 

Why regulate?  A detailed answer could fill entire libraries.  But in the abstract, regulation seeks to promote societal values, such as stability (e.g., capital requirements for banks), honesty (e.g., anti-fraud regulations), transparency (e.g., requirements about disclosing financial performance) and fairness (e.g., laws against insider trading).  Such intentions may be found in the preamble to laws, the hearings on which those laws were based, court decisions about those laws, and in statements by public officials.  The article by Campbell et al. explained that regulations aim to correct market failures that “impede efficiency or create unacceptable distributional outcomes”—such failures include externalities, search costs, market power, information asymmetries, and complexity.  

Evidently, it’s a nasty world out there.  In fiscal year 2016, the SEC filed 868 enforcement actions dealing with fraud, issuer disclosure, management accountability, fairness among market participants, insider trading schemes, misconduct by investment advisers, market manipulation, and foreign corrupt practices.  In fiscal year 2015, the Comptroller of the Currency issued 302 enforcement actions against institutions and affiliated parties and reviewed 22, 468 consumer complaints that dealt with unfair billing practices and unfair marketing practices—the revelation in September 2016 that Wells Fargo opened some two million bank accounts without customers’ permission is the most prominent recent case.  In fiscal year 2015, the Federal Reserve completed 51 formal enforcement actions and assessed $2.2 billion in penalties; and it completed another 91 informal enforcement actions that resulted in memoranda of understanding, commitments, and resolutions by bank boards.  One could review the enforcement activity of all of the regulatory agencies, but you get the picture: bad stuff can happen.

Regulation creates incentives.  These incentives might prompt businesses to do some things or stop doing others.  For instance,

·        Usury laws set maximum interest rates for loans.  Typically, the intent of such laws is to stop extortion or predatory lending.

·        Charters, granted by governments to financial institutions create protected franchises.  By screening entrants, governments seek to promote prudence, safety, and soundness in the financial system.

·        The Community Reinvestment Act of 1977 sought to stop discriminatory lending practices (called “redlining”) and to promote the availability of credit in low-income neighborhoods. 

·        Unit banking laws prohibited branch-banking.  Popular in the 19th Century and in agricultural regions of the U.S., such laws were motivated by a belief that the unavailability of credit was due to the aggregation of savings into the money centers from bank branches in rural areas and that unit banks would help to retain capital in credit-starved regions.

·        During the Panic of 2008, the Securities and Exchange Commission (SEC) used its regulatory powers to suspend short-selling in an effort to quell the cycle of panicked selling. 

·        The Dodd-Frank Act of 2010 introduced the most significant changes in financial regulation in 77 years.  In one of its provisions, the Act mandated that credit default swaps, which are traded over-the-counter, should be cleared through exchanges.  The intent was to promote standardization and transparency.

Side-effects. The reading by Acharya et al. stated that “Regulation is a tricky business; the law of unintended consequences always applies” and pointed to the mispricing of government guarantees, acceptance of opacity of firms and markets, and a narrow focus on individual, rather than systemic risk of financial firms as creating incentives for excessive risk-taking.  Regulations may create unintended incentives that stem from the two big drivers we studied in weeks three and four: market incompleteness and inefficiency.  Consider that:

·        Usury laws (like the prohibition of drugs and alcohol) may drive transactions into the grey and black markets.  Desperate borrowers may turn to the Mafia, a clear sign of market incompleteness.

·        Charter provisions and unit banking may have led to local banking monopolies or oligopolies, and therefore higher prices for consumers.  Restrictions on market entry can limit arbitrage and therefore efficiency.  As the reading by Acharya et al. reported, the collapse of Continental Illinois Bank (a unit bank) in 1984 was due to the fact that its lending business outgrew its deposit base, causing the bank to rely heavily on wholesale funding.

·        Critics accused the Community Reinvestment Act of stimulating overinvestment in housing and lending practices that produced subprime loans—this remains a fraught contention.  But in general, government mandates to invest tend to distort market prices and liquidity.

·        Bans on short-selling interfere with price-discovery, and thus market efficiency.

·        Efforts to standardize credit default swaps and other financial instruments will tend to discourage customization and may promote incompleteness.

Many of these cases illustrate the creation of moral hazard through regulation.  The clarity of rules, the backstop of a lender of last resort, and the creation of safe franchises may stimulate aggressive behavior to earn high returns while the regulator bears the risks.

Ways in which financial entrepreneurs might respond.  They see the violations of completeness and efficiency and are attracted to exploit those market imperfections to their advantage.  The readings and our classroom discussion suggest at least four kinds of response:

·        Regulatory observance could be profitable if regulation bestows valuable privileges on a few players.  Consider an entrepreneur who gains a coveted charter to operate a financial institution: like government licenses everywhere, bank charters carry their own franchise value derived in part from scarcity.   A current manifestation of this is the “rent-a-charter” phenomenon, in which an online lender who has no charter and cannot take deposits from the public, strikes a partnership with a small chartered bank in which the online lender finds the customer and structures the loan, while the bank partner actually makes and holds the loan.

·        Alternatively, the financial entrepreneur could simply ignore the laws and regulations.  But let’s be clear that regulatory violation is illegal and plainly inconsistent with the Honor Code that UVA students should carry with them through life. 

·        Co-opting regulators.  Critics have argued that the regulatory apparatus can get hijacked by special interests looking to use government power for private benefit.  Charges of “crony capitalism” have risen to some prominence in the current election season and earlier in the protests by Occupy Wall Street and the Tea Party.  Hijacking can occur when the regulations are formed (through intensive lobbying or even bribes), or later, if regulators get co-opted by the people they regulate.  Research suggests that material self-interest (e.g., through political donations or an interest in maintaining government funding) and cultural embrace (e.g., through “revolving door” personnel policies) can result in regulatory capture.  The Fed, SEC, and CFTC have been criticized as regulators captured by their wards—the accuracy of such allegations is disputable.  The Office of Thrift Supervision was dismantled in 2011 after several of its wards failed in the financial crisis of 2007-2009, owing in part to its lax regulation.  Regulatory capture is ethically suspect if it seeks to place private interests ahead of the public interest—though ill-considered laws and regulations could prompt co-option in the public interest. 

·        Regulatory arbitrage was discussed by several authors of our readings this week.   Financial entrepreneurs will seek to carry their activities to jurisdictions where regulation is light and from jurisdictions where it is relatively heavy.  Merton Miller cited the rise of the Eurodollar bond market in the 1970s as a way for U.S. firms and individuals to invest their funds overseas without incurring the costs of repatriating funds and investing in the U.S.  Why has there been a thriving estate and trust custody business in Grand Cayman and Panama?  There, low tax rates and strong privacy laws help customers to avoid (or evade?) taxes, hide wealth from grasping relatives and the media, and launder money.  Under the Basel Accords, international treaties that aimed to harmonize regulations of bank capital, banks need to hold capital in relation to the risk of the financial assets they hold.  Simon Johnson and James Kwak argue that the advent of securitization and use of off-balance sheet entities made it possible for banks to circumvent the Basel Accord capital requirements, leading up to the Panic of 2008.  In a reading for this week, Charles Calomiris wrote, “There is no doubt that the financial innovations associated with securitization and repo finance were at least in part motivated by regulatory arbitrage.”

Regulatory discretion.  Regulators retain discretion about enforcement of laws and regulations and may be reticent to sanction every infraction.  Alan Greenspan, as Chairman of the Fed was more interested in monetary policy and less interested in regulatory enforcement.  He believed that the private sector would police itself.  Therefore, he tended to discount reports of predatory lending in the housing bubble of the mid-2000s.   Charles Calomiris wrote that “The main story of the subprime crisis…is one of government ‘errors of commission’” such as the conscious under-estimation of risk, a lax Fed interest rate policy, ineffective prudential regulation, and rules that limited bank takeovers.  We want regulators to exercise some discretion since laws and regulations cannot anticipate every possible circumstance.  Yet inconsistent enforcement may prompt aggressive action by market participants.

Regulations might reflect popular sentiment rather than economic wisdom.  For instance, the concept of free trade has attracted some lively opposition during the current election cycle.  Yet, protectionism is a tax on consumers and almost unanimously opposed by experts in the economics of foreign trade.  The infamous Smoot-Hawley Tariff of 1930 contributed to the severity of the Great Depression.  The adoption of anti-usury laws and bans on short-selling typically reflect episodes of social stress (such as financial crises).   Speculators are easy targets for an angry public.  Speculation is often condemned as an immoral activity, like gambling, and often in contrast with investing, which seems to take the high ground.  Yet the boundaries between speculation, gambling, and investing are fuzzy.  In the best overview of this, Professor Reuven Brenner assessed the history of enmity toward speculators and concluded: “Behind the apparent misunderstanding lurked suspicion, envy, and resistance to providing a channel for social mobility through which a new class of people were becoming rich.”

Principles-based regulation vs. rules-based regulation.  Bright-line rules have the advantage of clarity and transparency.  One knows exactly what is illegal.  But such rules may invite aggressive behavior: financial entrepreneurs might manage right up to the bright line, and even test its robustness.  Principles-based regulation is constructively ambiguous and often dependent on court decisions to lend illumination.  This may motivate the financial entrepreneur to behave well within the ambiguous boundary out of aversion to risk.   Simplicity (in the form of principles) can be a virtue: detailed rules can be gamed.

Regulation is hard.  The regulator must stay abreast of innovations in new markets, new institutions, new instruments, and new services or practices.  Complexity makes it increasingly difficult to draft simple and straightforward regulations.  To regulate blockchain, derivatives, OTC trading, new technology (such as HFT) requires technological sophistication.  The complexity generates information asymmetry, which frustrates transparency and accountability.  And ultimately, measuring risk and welfare outcomes is difficult.

Cycle of innovation and regulation.  The readings suggested that regulation is both a cause and consequence of financial innovation—our focus this week was on the former, how regulation might cause financial innovation.  Later, in week 13, we’ll revisit regulation to consider how it becomes a consequence.  But it is worth mentioning here because regulation and financial innovation form a cycle of activity: one stimulates the other, and then the other stimulates the one.  Merton Miller wrote,

For a variety of reasons—including especially [the] desire to blunt the force of previous successful innovations by taxpayers—governments (or more properly, the shifting coalition of interest groups, that vehicle for protection and advantage) prefer to keep changing the structure, thereby altering the internal rate differentials and creating new opportunities for financial innovation.  This endless sequence of action and reaction has been aptly dubbed the “regulatory dialectic.”  ((Merton Miller, ibid. pages 5-6.))

The process of action and reaction between regulation and financial innovation has at least two big implications:

·        Stasis is unlikely.  The desire of incumbents and regulators for stability and equilibrium has been dashed repeatedly throughout history.  Innovation in a capitalist economy is relentless—this is the gist of Joseph Schumpeter’s notion of “creative destruction”: capitalism is an engine of constant change.  Therefore, the innovation-regulation cycle seems likely to continue indefinitely.

·        It seems unlikely that regulation will gain control over the cycle.  Regulation is basically reactive.  Regulators respond to news of illegal activities, to prominent failures of financial innovations, and to civic sentiments in legislatures, the media, and the population at large.  The curbs put in place tend to respond to known regulatory gaps—in that sense, regulation is backward-looking.  Like generals who are prepared to fight the last war, governments strive to ensure that the last known problem won’t reoccur. But such preparations won’t necessarily win the next war.

Isn’t self-regulation possible?  One alternative to government intervention in the private sector would be for the private sector to regulate itself.  This month, a group of online lenders agreed to form the Innovative Lending Platform Association that would promote a standardized presentation of credit costs for greater transparency to consumers.  Examples of successful regulations in the past would include member rules at securities exchanges and bank clearinghouse surveillance, started in the mid-19th Century.  But critics allege that self-regulation amounts to inmates running the asylum.  They point to the failures of private-sector debt-rating of subprime mortgages in the mid-2000s and of self-policing of public auditing in the late 1990s.  Though the tendency of federal policy has been to experiment with private-sector self-regulation as a first step, recent criticisms by populists at both ends of the political spectrum seem likely to push for a greater role for government-based regulation.

So…is regulation pointless?  The insights this week may seem downbeat.  Regulation is reactive and never quite gets control over the disruptive attributes of financial innovation.  Regulation can be a blunt instrument with plenty of unintended side-effects.  Measuring risk and the effectiveness of regulations is difficult.  Some regulations have been prompted by popular sentiment rather than economic wisdom. Regulation can get corrupted by regulatory capture.  And regulations are skirted through arbitrage.  As regulation of financial services has grown, government has assumed a greater role in the management of risk—but how much of this do we want or need?  David Moss, in his book, When All Else Fails, documents the dramatic socialization of risk that accompanies the democratization of credit.  This creates a free rider problem: costs of regulation are spread widely (taxes to support the regulatory establishment), while benefits may accrue more narrowly.  Advocates of laissez-faire would argue that regulation is expensive and ineffective and that free markets offer the best corrective mechanism.

Even so, one recoils from the regular exposure of venality, mendacity, and incompetence in finance and business.  Does that behavior make one proud to be a financial entrepreneur?  Would one be willing to accept the risks and consequences of such behavior in a laissez-faire world?  We want regulators to inspect our restaurants for cleanliness and our airplanes for safety.  It seems that people are sufficiently risk-averse to want governments to manage risks associated with financial innovations.  The big question is how much risk are we willing to accept?

Perhaps we expect too much of regulations.  For instance, is zero the maximum amount of fraud we are willing to accept?  It seems likely that the costs of surveillance, enforcement, and other market interventions would be enormous and would violate civil liberties and norms of privacy.  Maybe “pretty good” regulation is better than perfect.      

Some implications for the financial entrepreneur:

1.      Laws and regulations are complex, ambiguous, and variously enforced.  Hire excellent legal advice. 

2.      Regulations will change.  Pay very careful attention to the timing and direction of regulatory change. 

3.      Regulation is an adaptive system: participate in the adaptive process.  Have a voice.  Consider the possibility that your regulator could be an ally in pursuit of higher aims for your product, your firm, and your market.  Work with regulators to improve regulation—and if you cannot honorably fight to improve bad regulations you might face, then leave the field.

In your response to regulatory change, take the long view: do what is consistent with the kind of society you would like to bequeath to future generations.  Don’t skate to the edge of the ice.

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Liveblogging “Financial Innovation” Week 4: Market Inefficiencies and Behavioral Finance


“Went out to dinner the other night, check came at the end of the meal as it always does.  Never liked the check at the end of the meal system.  Because money’s a very different thing before and after you eat.  Before you eat money has no value.  And you don’t care about money when you’re hungry, you sit down in a restaurant, you’re like the ruler of an empire.  “More drinks, appetizers, quickly, quickly.  It will be the greatest meal of our lives.”  Then after the meal, you know, you’ve got the pants open, you’ve got the napkins destroyed, cigarette butt in the mashed potatoes.  Then the check comes at that moment.  People are always upset, you know, they’re mystified by the check.  “What is this?  How could this be?”  They start passing it around the table, “Does this look right to you?  We’re not hungry now, why are we buying all this food?”  — Jerry Seinfeld [1]

Markets manufacture information; and prices are the most important information they manufacture.  But is that information a reliable indicator of the worth of an asset if human cognition affects the setting of prices or the way we judge prices?  Seinfeld says, “money’s a very different thing before and after you eat.”  Something about human cognition affects the way we look at transactions.  Possible market inefficiencies and cognitive biases raise tantalizing possibilities for financial innovators.  This was our focus in week 4 of the course.

A market is efficient if prices fully reflect available information.  The efficiency of prices for impounding “available information” has been tested against (a) historical price trends, (b) current public information, and (c) all public and private information—these standards are called the weak, semi-strong, and strong forms of efficiency.  Early research found that U.S. equity markets are efficient with respect to (a) and (b) but not (c)—you can make a killing by trading on inside information (and possibly go to jail for doing so).   

Market inefficiency can drive financial innovation.   More recent research found persistent inefficiencies, both within and across markets.  These findings are well summarized by Andrei Shleifer in his book, Inefficient Markets: An Introduction to Behavioral Finance.  Inefficiencies arise because of what economists call “limits to arbitrage.”   Arbitrage involves the matched buying and selling of assets in order to exploit different prices for essentially the same asset.  Here are some examples:

Ø  In a perfect world, a ton of grain would command the same price everywhere; economists call this the “Law of One Price.”  Suppose that communication problems prevent traders in a distant market from being fully informed about grain production and demand across the world.  The difference could motivate arbitrageurs to buy a ton of grain in the low-priced market, ship it to the high-priced market, sell it there and pocket the difference between the two prices. 

Ø  In a perfect world, a McDonald’s “Big Mac” hamburger would command the same price everywhere, since it is made to uniform specifications.  Yet, as the Economist magazine reports each year in its Big Mac Index, prices vary around the world.  In theory, you could buy lots of Big Macs in low-price countries and transport them for sale in high-price countries.  And in theory, doing so should drive up the price in the low-price country and drive down the price in the high-price country.  (I’ll get to the limits to this in a moment.)

Ø  In a perfect world, a dollar of earnings produced at one hotel chain (say, Hilton) should be worth as much as a dollar of earnings at another very similar hotel chain (say, Marriott).  Where the earnings multiples deviate, you could buy shares in the low-priced chain and sell short shares in the high-priced chain, which would tend to equilibrate the prices of the two hotel chains.

And so on…

But I kept qualifying my examples with “In a perfect world” which is economistspeak for a world of competitive, well-informed, and frictionless trading.  Prices can differ across markets because of:

·        Frictions:  An “arb” (slang for arbitrageur) needs to see a return on a trade commensurate with the risk the arb foresees.  Structural factors such as regulations, slow information technology, transportation problems, margin requirements, taxes, and possible delays in closing the trade increase the costs or uncertainty of a trade.  Government intervention in currency markets would be a prime explanation for the fact that McDonald’s Big Macs sell for different prices around the world.  In most markets, there are usually many low-risk, low-return investment opportunities—but these won’t get the arb’s attention because of the cost of frictions or the arb’s high opportunity cost on her time and attention.  Across markets, there will be a host of smallish deviations from the Law of One Price.

·        Limits to arbitrage: If you perceive an over-pricing of oil paintings by the old Dutch Masters, you decide to sell all your old Dutch Masters paintings and buy…what?  Modernists?  Arbitrage can be limited where it is difficult to find a comparable asset with which to complete the trade. 

·        Cognitive biases.  Humans are fallible.  They lazily project recent experience into the future.  They are more averse to losses than happy about gains.  They overreact to news (out of overconfidence or fear).  They can move in herds of sentiment.  They introduce “noise” into market prices.  Noise traders are the bane of professional arbitrageurs and behave socially by trading on rumors and imitating the behavior of others.  In contrast to the theory of market efficiency and rationality, in which the trading of erratic individuals cancels out, noise traders move in herd-like fashion and don’t cancel each other out. 

Financial innovators seek to exploit market inefficiencies or to protect market participants from the adverse effects of their own cognitive biases.  Consider some examples:

ü  High frequency trading—as described in Michael Lewis’s book, Flash Boys: A Wall Street Revolt—exploits delays trading.  By observing demand, supply, and other trading signals, and by front-running before other trades get to the market, the innovator exploits a consistent advantage versus other traders.  The inefficiency here is that not everyone is equally well-informed at every moment in time.  In the case of high frequency trading, the difference in time might be a matter of a few milliseconds.   Lewis describes Brad Katsuyama, an innovator who developed the IEX Market and sought to prevent such front-running by eliminating the inefficiency.

ü  Life-cycle investing.  Individual investors tend to get stuck in a rut: they manage their own wealth in ways that past experience proved to offer some success.  Typically, one invests in stocks when young and then enjoys a sizeable build-up of wealth over the decades.  The problem is that one’s tolerance for market risk declines by one’s retirement years, causing investors to hang on too long to past strategies.  In response to this problem, financial innovators developed life-cycle investment plans that would automatically shift the investor’s portfolio from risky stocks to less risky fixed income securities as the investor approaches retirement.

ü  Democratization of financial news.  It used to be that to become well-informed about asset prices meant that you needed to pay expensive commissions to brokers and/or expensive subscriptions to financial publishers.  Now, the world is awash in low-priced financial information.  Expert discovery and interpretation of the financial news helps to separate the important signal from market “noise.”  Ratings agencies and the financial press were founded in the 19th Century to help discover and interpret the meaning of news—today, such interpretations are available virtually free on the Internet.  More often than not it can be fairly said that if you don’t know what’s going on, you aren’t paying attention.

ü  Digital awareness.  Today, various apps and online platforms help to awaken the attention of investors to price movements through warnings and alerts.  Social media, such as Twitter, enable one to follow trending sentiments

What do inefficiency and cognitive biases mean for financial innovators?

1.      Financial innovations may help to reduce market inefficiencies and correct cognitive biases.  Underlying many innovations is an arbitrage of some kind.  Arbitrage helps to drive prices into alignment, or parity, or “fairness.”  Therefore, a key question is, what are the limits to arbitrage in your market?

2.      It is hard, if not impossible to “beat the market” with any consistency if the market is efficient—this is the gist of Burton Malkiel’s famous book, A Random Walk Down Wall Street.  He argues that for the typical individual investor, a passive investing strategy of buying-and-holding a well-diversified portfolio of stocks (such as in an index fund) will dominate a strategy of active trading.  Large institutional investors help to produce efficiency.  They trade in high volume and have very sophisticated information infrastructure.  Dick Mayo, a visitor in our course, has described how Jeremy Grantham (a financial innovator) invented the concept of the index fund to enable investors to buy and hold a diversified portfolio at low transaction cost.  The most important implication for financial innovators is that “noise trading” won’t pay.  Don’t be a noise trader.

3.      How efficient is the market you aim to serve?  We discussed the differences in efficiency among the markets for U.S. Treasury bonds, shares in General Electric, gold, and old masters paintings.  The market in U.S. Treasury bonds is highly efficient: it is the biggest and most liquid financial market in the world.  News is impounded almost instantaneously and seems to reflect expectations about inflation, interest rates, economic growth, and currency exchange rates fairly well.  The market for shares in GE is also pretty efficient.  Gold is subject to irrational swings in value and bouts of mania or depression.  The market in old masters paintings is characterized by low liquidity, the mania of collectors, and the occasional fraud.  Housing markets are hugely influenced by local factors that one would discern only by on-the-ground research—these factors could drive important pricing inefficiencies.  Across the wide variety of assets, it may be safest to assume that every market is inefficient to some extent.  The key questions are how inefficient, and why?

4.      What do you know that the market does not know?  And vice versa.  You may think that you’ve discovered that Hilton is priced too high relative to Marriott and other hoteliers.  But before you trade on that belief, dig beneath it with research. It may be too good to be true.  Good questions to ask: is your belief based in facts or is it just an opinion?  Could your belief be tainted by your own cognitive biases?

5.      In inefficient markets, be alert to predators.  The predators may not think of themselves as predators: the HFT front-runners in Flash Boys liked to believe that they were bringing added liquidity and efficiency to the stock market.  Payday lenders make a similar argument.  But see point #1: inefficiencies and cognitive biases present profit-making opportunities; righteousness might cloak avarice.  To be safe, check who is driving what inefficiency at whose expense.  Warren Buffett said that “any player unaware of the fool in the market probably is the fool in the market.” [2]  As the course goes forward, we should discuss more fully what we mean by “predation.”

At the end of Jerry Seinfeld’s skit, he said,

“I’m not an investor.  People always tell me, you should have your money working for you.  I’ve decided I’ll do the work.  I’m gonna let the money relax.  You know what I mean, ‘cause you send your money out there working for you—a lot of times it gets fired.  You go back there, “What happened, I had my money, it was here, it was working for me.”  “Yeah, I remember your money, showing up late, taking time off.  We had to let him go.” [3]

Seinfeld bids for our sympathy because he is uninformed—putting your money to work is a very good thing to do.  Being uninformed (“I’m not an investor”) and nursing a cognitive bias (“a lot of times it gets fired”) are the root causes of market inefficiency.  Financial innovation can help people with these problems. 

  1. Jerry Seinfeld, The Seinfeld Scripts: First and Second Seasons, page 127 []
  2. Quoted in Michael Lewis, Liar’s Poker. []
  3. Seinfeld, ibid. page 152. []
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Liveblogging the Presidents: Gerald Ford


“We’re taught Lord Acton’s axiom: all power corrupts, absolute power corrupts absolutely. I believed that when I started these books, but I don’t believe it’s always true any more. Power doesn’t always corrupt. Power can cleanse. What I believe is always true about power is that power always reveals. When you have enough power to do what you always wanted to do, then you see what the guy always wanted to do.”  — Robert Caro, The Guardian, June 10, 2012.


Power always reveals—that is the premise for a year-long seminar that I’m guiding to draw leadership lessons from the autobiographies, biographies, and principal speeches of the post-Watergate Presidents (i.e. those from 1974 to the present).  These Presidents are closest to the reality of today’s MBA students and rose to the position through an incredible selection gauntlet.  Their styles and actions are minutely documented, making it possible for us to see them in detail.  If Robert Caro is right, the clarity about these seven Presidents should help us to understand the use of power and execution of leadership.  What leadership insights might their use of power reveal?  Most generally, what meaning might we make of the story of any leader?


Our seminar convened on September 1 to discuss the biography and memoir of Gerald Ford, [1] who served as the 38th President, from August, 1974 to January, 1977.  That was an inauspicious moment in history at which to start a study of leadership.   


Ford’s Presidency: Brief Highlights


Ford’s administration began at the nadir of popular support of the presidency, a moment of a profound crisis of trust.  President Nixon resigned in disgrace in August, 1974, having been accused of obstruction of justice in investigations about the break-in at the Democratic National Headquarters in the Watergate in 1972.  Earlier, Vice President Spiro Agnew had resigned following a charge of corruption.  Ford was part of a difficult leadership episode in American history.  During the two decades of leaders from 1960 to 1980, no one served two full terms, owing to loss of reelection (Ford and Carter), drop out of re-election (Johnson), resignation (Nixon), or assassination (Kennedy).  Ford was the only President in U.S. history not to enter the White House by means of a national election as President or Vice President.  One poll found that over 80% of the people believed that Ford did not have the ability to run the country.  He was mocked as the “accidental President.”


Nor was the rest of his incumbency easy.  Ford dealt with the withdrawal from Vietnam, the economic aftershock of the OPEC oil embargo, Congressional investigations on domestic intelligence abuses, rising inflation, the Mayaguez incident, budget deficits, the Swine Flu scare, Middle East tensions, relations with China, the Turkish invasion of Cyprus, and the Indonesian invasion of East Timor.  Ford himself survived two assassination attempts. 


Ford has been described variously as “a decent man,” a team-player, ego-less, steady, dependable and a centrist.  As a star athlete at University of Michigan, he learned the virtues of self-discipline, practice, and sacrifice for the team.  His lifetime of service in the U.S. House of Representatives developed his skills of coalition-building and negotiation with political opponents.  As Republican Whip and the House Minority Leader, he grew to value cohesion and loyalty to the party.  Ford described himself as an economic conservative, social moderate, and internationalist.  Military service in World War II led him to believe that security of the nation depended on active engagement and leadership in the global community—this was a marked turnaround from isolationist views he held before the war.


Upon rising to the Oval Office, Ford immediately sought to set a tone of “healing” to address the crisis of trust (the title of his memoir conveys this dominant tone, A Time to Heal).  “Our long national nightmare is over,” he declared in his inaugural speech.  He pledged candor and openness, sought to create national unity in the face of partisanship, initiated a program by which Vietnam War draft resisters could achieve a presidential pardon, and pardoned Richard Nixon for the obstruction of justice.  He sustained Nixon’s international policies and retained Nixon’s presidential staff and Cabinet, notably Henry Kissinger.  For his pardons and retention of Nixon’s staff, he was vilified in the press and by both the left and right of the political spectrum.  To respond to mounting inflation, he announced a program to “Whip Inflation Now” (WIN), a program of voluntary belt-tightening aimed at reducing demand and married with tax increases on corporations and wealthy individuals. All this occurred within Ford’s first three months in office.  The unpopularity of these actions prompted a resounding defeat for Republicans in the mid-term elections of November 1974.  The Democrat-controlled House and Senate that returned to Washington in January 1975 challenged Ford for the rest of his incumbency. 


Ford’s style as an administrative leader marked a break from Nixon.  Where Nixon relied on a strong Chief of Staff as a gatekeeper, Ford wanted to be more accessible at the center of a hub-and-spoke administrative system with little staff filtering.  Later, recognizing the overwhelming volume of issues and interests that came to the White House, Ford eventually acceded to stronger staff intervention.  But throughout his career, Ford proved to be a “big picture” leader, who relied on others to master details—this non-mastery proved to be a critical part of his defense of his pardon of Nixon (i.e., that Ford had no prior knowledge of Nixon’s obstruction of justice) or of CIA improprieties.


Ford’s execution of his own policies drew more criticism.  He recruited Nelson Rockefeller as his Vice President and later dropped him when running for re-election.  Ford appeared to “flip-flop” on budget-cutting: at first, his WIN program sought to cut expenses and balance the budget; soon he abandoned that policy in the face of a recession and overwhelming Congressional pressure and signed a deficit-expanding budget.  He was unable credibly to shake allegations that he had accepted some kind of deal to pardon Nixon.  He went to Helsinki to negotiate a ground-breaking agreement with the Soviets on human rights, only to face a barrage of criticism upon his return home.  He proved to be a lackluster communicator on TV and stumbled in debate with Jimmy Carter. 


Ford’s was the second-shortest incumbency in the 20th Century and the fifth-shortest in U.S. history.  Short tenure in office is bound to affect one’s impact and legacy.  With the exception of Kennedy and possible exception of Ford, the ten shortest-tenured Presidents left rather empty legacies. 


U.S. Presidents, Shortest Days in Office and Rank in Poll of Historians



William Henry Harrison



James A. Garfield



Zachary Taylor



Warren G. Harding



Gerald Ford



Millard Fillmore



John F. Kennedy



Chester A. Arthur



Andrew Johnson



John Tyler




A recent ranking of Presidents by historians puts Ford in the second quartile from the bottom.  Historians tread carefully in discussing Ford’s presidency but their sentiments echo the rankings (“unique” “obstructed,” “stalled,” “mediocre,” “tarnished,” “cautious.”) 


With the passage of time, critics relented and even reversed their judgment of Gerald Ford.  The John F. Kennedy Foundation gave Ford its 2001 “Profile in Courage Award” for pardoning Richard Nixon.  Ted Kennedy, one of Ford’s leading adversaries in the 1970s, said, “I was one of those who spoke out against his action then.  But time has a way of clarifying past events, and now we see that President Ford was right.”


In sizing up a President, what questions should we ask?


Our seminar discussion chewed over the details of Ford’s presidency.  Five “buckets” of concerns seemed to matter in our assessment:

·        Circumstances.  Stuff happens to any leader: crises, changes in the economy and political environment, the prevalence of urgent issues to deal with, and the strength (or weakness) of the mandate with which one assumes leadership.  Ford parachuted into a maelstrom.  The first step in assessing a presidency is to appraise the special circumstances that the President faces.

·        Character.  What a leader brings to the office matters.  As Aristotle said, “Character is destiny.”  “Character” serves as an umbrella for a range of personal attributes such as values, priorities, life experience, ideology, personality and purpose.  In his classic book, Leadership, James MacGregor Burns wrote that:


“Essential in a concept of power is the role of purpose….[Transformational leadership] occurs when one or more persons engage with others in such a way that leaders and followers raise one another to higher levels of motivation and morality…Their purposes, which might have started out as separate but related, as in the case of transactional leadership, become fused.  Power bases are linked not as counterweights but as mutual support for common purpose.  Various names are used for such leadership, some of them derisory: elevating, mobilizing, inspiring, exalting, uplifting, preaching, exhorting, evangelizing.  The relationship can be moralistic, of course.  But transforming leadership ultimately becomes moral in that it raises the level of human conduct and ethical aspiration of both leader and led, and thus it has a transforming effect on both.” (pages 13 and 20). 


Character (purpose) plays a vital role in leadership.  In the assessment of historians over time, Ford’s character (his decency, steadfastness, and moderation) is the defining attribute of his legacy as a leader: “healer” President.  A second step in assessing a presidency is to inquire how a President’s character stands out, while in office and changes over time.

·        Choices.  The President cannot escape from making hard decisions.  Those choices are the tangible footprints of leadership.  Our seminar paid particular attention to the tone that Ford sought to set for the nation, the prioritization of issues and agenda, the organization of the White House staff, and preparation of the budget.  A third avenue of inquiry is to discern which choices proved to be pivotal in the President’s incumbency.

·        Execution.  Implementation of the President’s program is another weighty indicator of leadership: how is it done, and how well?  For instance, in his book, Soft Power, Joseph Nye has distinguished between using “hard power” (coercion through threats, force, and money) and “soft power” (persuasion, attraction, and appeal).   The President must choose the kind of power to wield, and how to use it.  Skills of communication and negotiation are crucial.  The recruitment of talented and effective staff and of allies and coalition partners is indispensable as well.  The President cannot only take; he or she must also give: judging where and when to compromise is vital.  Fourth, how well did the President implement the agenda?

·        Outcomes.  Our seminar gave considerable attention to what we might mean by “success” and “failure” in the presidency.  Some defined success as the ability to achieve the policy agenda, to win elections and Congressional passage of legislation, and to create a legacy of high esteem.  At several points in our discussion, students noted the tension between “legacy” and other measures of presidential success—maybe by doing the right thing (pardoning draft resisters and Nixon) one loses elections.  Any discussion of a presidency invites two final questions: did the President succeed?  And by what standards do we measure success?


The elements of Presidential leadership seem interdependent.


The presidency of Gerald Ford suggests that circumstances, character, choices, and execution are related to outcomes, but in a non-obvious way.  It is too simplistic to say that if you have one kind of input, you’ll get a certain kind of result as President.  When one takes into account the evolution of a presidential administration over time, these five buckets seem interdependent.  Circumstances, character, choices, and execution affect outcomes as well as each other.  We should not look at a President’s leadership as static.  The interdependence of the buckets becomes vivid as the President’s leadership plays out over time. 


As circumstances change, the President must adapt character, choices, and execution–or fail.  World War II prompted Ford’s conversion from isolationism to internationalism.  For much of his career, Ford was a Cold War hawk—yet he also sought a nuclear disarmament treaty with the Soviets and presided over the withdrawal from Vietnam without victory.  Ford was a consummate legislative leader who was unable to translate that skill into a successful legislative program once he occupied the Oval Office. 


Of course, the interdependence can work in other directions as well.  Ford gambled that his choices about healing, openness, and pardons for the accused would temper the popular distrust of the presidency—yet for the balance of his incumbency, it inflamed the distrust.  Execution can affect choices: Ford’s maladroit TV addresses and debates diminished his popular support and narrowed his range of political flexibility.


Interdependence and feedback suggest a richer way to think about presidential power and leadership.  Actions or positions taken in any of the five elements in the system feed back to other parts of the system.   The following figure gives the general idea: each arrow indicates one path of the feedback.  Obviously, this can get complicated.  But the chief implication is that simple explanations about the success or failure of a President are probably incomplete, incoherent, and/or wrong.




Our exploration of leadership in the presidency of Gerald Ford offers many possible insights.  Several of them warrant more discussion over the year ahead:

1.      Five buckets.  We seemed to collect our thinking around circumstances, character, choices, execution, and outcomes.  Do these buckets suffice?  Are there more? 

2.      A presidency is dynamic, not static.  An assessment of the president at one moment in time may be overshadowed by the next moment, as the volatility of polling results shows.  How shall we take into account dynamism and mutability as we assess the President’s use of power and implementation of leadership?

3.      Feedback matters.  Let’s reflect on how one dimension of presidential leadership affects the other dimensions as time progresses.  Maybe good leadership is about managing well the interactions among the buckets.   As we consider the record of a leader, where and how does feedback among leadership elements prove consequential?

4.      If feedback matters, then performance of a leader is contingent, because the impact of feedback is uncertain.  For instance, we can’t just say that “if the President has a strong majority in Congress, a strong character, or excellent communication skills, then success will happen.”  At best, you can say, “it depends.”  Therefore, perhaps we should try to step into the President’s shoes and re-create the odds of success that underlay the President’s choices.

5.      Learning matters.  If a leader is inundated with feedback among these components, then paying attention and adapting well is important.  The foundation for doing this is a learning mindset.   (For more on this, see Carol Dweck’s book, Mindset: The New Psychology of Success.)  Of course, the President could be motivated to be bold and self-confident, to take charge, and give orders, all of which militate against listening well, reflecting, and tolerating dissent.  Therefore, perhaps we should consider how well the Presidents listen and learn.


“Power always reveals,” said Robert Caro.  I think he got that right.  Our reading of Gerald Ford reveals a host of insights about power and leadership.  There are more to come as we turn to Jimmy Carter and his successors.


  1. Time to Heal, by Gerald Ford and Gerald Ford, by Douglas Brinkley []
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Why ask students to teach?

I guess you could say it’s an experiment.  But that would imply something less than the strong intention I have.  The question (in the title) was posed by a student who observed that in all three of the courses I’m teaching this semester, every student will have an opportunity to lead some of the classroom discussion.  “Do you always lead a course this way?” the student asked.  Perhaps the student wondered why I wasn’t doing the teaching.  In fact, coaching the discussion leaders before class, writing feedback to the leaders after class, and then liveblogging about the class takes more time and effort than just teaching the class on my own.  What was I thinking?  Let me explain.


In earlier posts (such as here and here) I’ve argued that:

·        You learn best that which you teach yourself.  This is my one-sentence argument for why learning by the case method is so effective.  But I can go even farther: you learn very best that which you teach others.  This is a secret that teachers the world over have discovered: if you really want to master something, try to explain it to someone else.  Thus, if the teacher really cares about student learning, then asking students to explain, teach, question, and guide the learning of others follows naturally.

·        How we teach is what we teach.  The format of the classroom experience is hugely important in shaping the capabilities of students.  If you teach by asking students to sit silently and take notes, they will become better and better at that.  But is note-taking what business leadership is about?  Active learning builds capabilities that are valuable in professional life.  Asking good questions is among the most valuable capabilities.  Therefore, I structured by classes accordingly this fall.

·        You can run a business by asking questions.  In one style of business management, leadership is command-and-control; the leader gives orders; and the employees are order-takers.  What this breeds is a passive organization of people who are drones, who work-to-the-rules, who adopt a checklist mentality and bring less initiative, personal investment, or willingness to question authority.  Such organizations are bureaucratic, slow, unresponsive to the needs of customers or other stakeholders, and dreary.  In the new style of management, the leader asks rather than tells.  Through questioning, the leader frames a problem or challenge, helps the followers to grow in awareness, and solicits their thinking.  The followers who are closer to the front-line of action are bound to have more clarity about the problem.  And the process of group discussion tends to build alignment within the group and commitment to a course of action.   Businesses really need such alignment and commitment so that authority can be delegated and action taken promptly and nimbly.  Good management starts with good questioning.  Our alumnus, George David, the former CEO and Chairman of United Technologies Corporation, had a practice that he called “fifty questions.”  When he visited a manager or a plant, he didn’t settle to listen passively to a set-piece presentation.  Instead, he actively engaged his managers in a curiosity-driven process.  Darden teaches you not to be shy about questioning.  The Chinese have a proverb: “He who asks a question is possibly a fool for a moment; but he who does not ask a question remains a fool forever.”

·        Growth as a leader depends on growth in asking good questions and in listening well.  I want my students to grow as leaders.  Therefore, the assignment to them of leading discussions is an exercise in leadership development. 

·        Teachers also must learn—this was the mantra of a mentor of mine (C. Roland Christensen at HBS).  Though I have mastered the subjects I’m teaching, there is a lot more I want to learn about them.  In virtually every class this fall, student discussion leaders raise some unexpected insights. 


So far, the students are rising nicely to the challenge.  And the coaching I give them seems to help.  A week before they teach, I meet with the student discussion leaders to shape expectations—I don’t tell them what to do or say.  Instead, through questioning I try to help them understand what a good class discussion looks like and what they can do to achieve it. 

1.      Success starts with clarity about two or three important learning goals for the class meeting.  What are they?  And how do they link to previous classes and set the stage for class meetings to follow?  I refer the students to the readings assigned for that week and brief them on my aims for the course and on the importance of their class meetings to the course objectives.  In the coaching meeting, we discuss the strengths and weaknesses of the readings and their relevance to the students.  Within broad parameters, I insist that the students develop the specific learning goals for the class meetings that they will lead.

2.      A teaching plan using the “ask, don’t tell” approach might look like a series of questions with rough time allocations next to them.  I emphasize that a discussion is a process, an unveiling of insights and ideas.  Therefore, the questioning should aim to structure the unveiling in a way that arrives at a good destination.  Trying to start at the destination usually results in disaster.  Also, I urge the students to pay close attention to the exact way they ask questions: those that start with “what,” “where,” and “when” will typically generate a short reply and less energy.  But questions that begin with “how” and “why” elicit richer replies and more energy.   And asking students to make a decision or take a stand may generate tension, and emulates the business world.

3.      I encourage the discussion leaders to develop mini-cases, games, simulations, debates, or competitions for use right in the classroom.  These give hands-on exercises that deal with the concepts of the day.  The resulting experiments have generated real energy in the classroom.  So have short and provocative video clips available from the Internet helped to challenge or reinforce student insights.

4.      Based on past experience, most students can summon up some attributes of a successful class discussion.  These might include breadth of engagement, energy, excitement or points of tension, and valuable insights.  There is always the temptation to close a discussion with a pronouncement by the leader of “here’s what this class meeting was about.”  It’s better to close by asking rather than telling: “in summary, what are some key points that you take from our discussion today?”

5.      Finally, I encourage flexibility.  Rarely does a class meeting go precisely according to plan.  To some extent, the discussion leader should follow the energy of the students: about what are they enthusiastic or troubled?  But a few outspoken students can lead the class far afield.  A key judgment of the discussion leader is when and where to guide the discussion back to the goals for the day.  One can’t explore every nook and cranny within the time constraint of a class period.  Anyway, open issues or questions are great fodder for student reflections outside of class. 


At Darden’s graduation in 2007, I said:


Learning and managing well are fundamentally about self-discovery.    The secret to learning is not to wait for someone to tell you the answers, but to figure things out for yourself.  What we teach at Darden is how we teach, a process of questioning and challenge, of debate and persuasion, of dealing with ambiguity, of running up and down blind alleys—because all of that is part of the essential experience of personal discovery. 


Great teachers ask a lot and tell little.  They ask a lot in the sense of stretching their students and they ask a lot in the sense of inquiring rather than telling.  …The minute that you unshackle yourself from the expectation that someone else is going to lay out the meaning of things for you, you become much more effective and compelling.  You enable all of the attributes of leadership: the ability to recognize threats and opportunities; to shape a vision; to enlist others; to communicate; and to take action.  Once you realize that learning is about self-discovery, you are ready to give the gift to others. 


The big implication is this: you should manage others in the same way you have been taught at Darden.  Like your professors, you should ask a lot and tell less: guide, help, goad, irritate, stimulate, and question.  Expect that your employees will explore, inquire, experiment, and analyze.  The greatest managers don’t tell; they engage others to learn.  The day of the corporate command-and-control generalissimo is past; in the best practice organizations today, groups of professionals work together like learning teams to figure things out.  Make knowledge important wherever you go; state problems and encourage pragmatism and experimentation. 


Conversation is transformational.  The leadership of conversation is radically transformational.  By my work with students this fall, I hope to strengthen them radically. 


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Liveblogging “Financial Innovation” Week 3

“[K]nowledge advances when striking real-world events and issues pose puzzles we have to try to understand and resolve. The most important decisions a scholar makes are what problems to work on. Choosing them just by looking for gaps in the literature is often not very productive and at worst divorces the literature itself from problems that provide more important and productive lines of inquiry.”
– Professor James Tobin, Essays in Economics, Vol. 4


This post continues a series of postings related to my course, “Financial Innovation: Opportunities and Problems.”  We devoted classes on September 5 and 6 to discussing some important drivers of innovation, such as profit-seeing, risk management, industrial change and incomplete markets.  And we had a video visit from Nobel Laureate in Economics, Robert Shiller, who is a professor at Yale.  At the end of the second day, this famous quotation by James Tobin (another Nobel Laureate) came to my mind.  Tobin basically says, “If you’re going to spend your time, don’t work on trivial problems”—this applies to business professionals as much as it does to scholars.  More on that in a moment.


Here are some points from the week that may seem obvious at first, yet are quite subtle and warrant some of your time to reflect upon:

1.      Financial innovation pays.  This is the main finding of research by Lisa Scholar, Bernd Skiera, and Gerard Tellis.  It’s good to know that financial entrepreneurs get a reward for their labors.  Following the Global Financial Crisis, it seemed that all we heard about were innovations that blew up and cost their inventors, customers, and investors a lot of money.  But looking beyond the recent episode at a lot of innovations over a longer time period yields a conclusion at variance with the popular schadenfreude. But why would it be a surprise that innovation pays?   As we saw in earlier classes, the evidence is that financial innovation is a fairly steady ongoing phenomenon (with some peaks and valleys).  Would innovation occur without the financial incentive that success affords?  Probably not.  But our discussion of this paper summons two questions:

a.      Does it pay commensurate with the risks?  The study focused on innovations commercialized by established financial institutions.  What’s missing are those start-ups that fail and ideas hatched within larger companies that never go to market.  It’s nice that innovation pays; but does it pay enough?

b.      Does financial innovation create value?  It’s nice that innovation pays, but are we all better off because of the innovation or did the innovation just transfer wealth from the pocket of Peter to pay Paul?  This was the gist of Paul Volcker’s famous claim that he hadn’t seen a worthy financial innovation since the ATM—“worthy” as he went on to discuss, meant that it would increase national productivity (i.e., create wealth).  It’s a worthy research question, probably better tackled at the level of individual case examples rather than large-sample research. 

2.      Look for opportunities to “complete” markets.  The demand in most markets is not satisfied with “one size fits all.”  Some consumers want tiny Smart cars; others want big SUVs.  So much of the artistry in business consists of recognizing unmet demand and tailoring products and services to meet that demand—this is called “completing” the market.  Advanced techniques, such as conjoint analysis that one learns in an MBA program, help to identify segments of the market and the extent to which they are completed.  Many of the fintech pitches one hears today, and of the financial innovations in history have at their core a proposition to complete the markets.  One reason we should want to promote the completion of markets is that we are all better off to the extent it occurs—this is the insight of two Nobel Laureates in Economics, Kenneth Arrow and Gerard Debreu.  In theory, a general equilibrium (a world of complete markets) is pareto efficient or “as good as you can make it” without enhancing the welfare of one person by reducing the welfare of another.  But the practical businessperson is probably much less interested in the theoretical case of perfectly complete markets and much more interested in the instance of incomplete markets, in which we find ourselves today.    That markets are incomplete pleads a few questions:

a.      Where are the gaps?  Big data, advanced analytics, A/B testing, and machine learning can help one answer this question.

b.      How big are the gaps?  Arrow and Debreu hypothesized a global economy so segmented that each person represented his or her own market segment.  That may be a nice thought experiment, but if the demand in a certain gap has a population of one, it won’t be large enough to sustain an innovation effort (unless that person is someone like Warren Buffett or Bill Gates).

c.      Why do the gaps exist?  Perhaps the economics in that segment of the market really stink.  Or maybe there are regulations or patents that get in the way.  Analyzing the barriers to entry to a market is by now an advanced art-form

d.      If you enter that gap, what competitive reaction might that elicit?  Big players on the edge of a market segment are unlikely to sit still if you penetrate that segment.  Dreams of big rewards might evaporate as the market gap suddenly fills.  Fintech entrepreneurs often fail to answer this question adequately.

3.      So many segments, so little time.  In class, we discussed the case of MacroMarkets, a firm founded by Robert Shiller and that brought to market in 2009 a kind of insurance against falling house prices.  Shiller noted that for most families, the home is the largest asset they own and a significant, if not dominant percentage of wealth.  People insure against illness, fires, and auto accidents—why not insure against a decline in the value of one’s home?  So he got to work and through a process of experimentation with others developed a succession of product designs over time—the case illustrates, again, that financial innovation is most often a process of incremental advance.  Eventually, he brought his perfected innovation to market, but was hampered by market conditions (Global Financial Crisis), the aversion of most people to dwell on the downside likelihood, and generally, marketing.  The new instruments failed to gain the trading volume and liquidity and were withdrawn from the market.  It seemed to consumers that buying the house value insurance really was considered a bet “against” one’s home.  The implication for many students was that even if you have a market-completing innovation, regulations and poor market conditions can prevent a successful roll-out.  And we listed a range of issues that challenge the success of new financial products and services: consumer myopia, regulation, non-standard assets (e.g. houses), institutional momentum, tangibility, emotion, moral hazard, and cost.  Robert Shiller seemed unfazed by the outcome.  He said, “A lot of things have slow beginnings.  Life insurance was first offered in ancient Rome and grew very slowly until it took off in the 20th Century.  I’ve made my peace; I brought this idea to the world; its time will come.”  In his writings (see especially his Finance and the Good Society) Shiller argues that financial innovation can address substantial problems facing society, such as wage inequality, pension shortfalls, and volatility in home values.  By example and exhortation, he encourages us to work on consequential needs in the world.


All of this brings us around to James Tobin’s remark that the most important decisions one makes are what problems to work on.  Financial entrepreneurs face a blizzard of market gaps.  So, work on the worthiest problems.  These might be defined by potential scale and scope, and by social impact.  How do you define “worthy?”


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Liveblogging the Great Depression: Lords of Finance

This post begins some commentaries on readings about the Great Depression.  Richard A. Mayo and I are conducting a year-long seminar to look at this complicated and overshadowing episode in economic history.  We will drill into readings that are classic and/or new.  I have decided to liveblog about these readings in order to give to our students some added perspective and criticism on the slant that writers take on the Great Depression—and on comments made in our seminar discussion.  This is not a Cliff’s Notes summary of what we read and discussed, but collects, rather, some ideas that rattle around in my mind.  I hope that our students (and any other readers) will find these reflections helpful.


The Great Depression vastly influences the way we think about business cycles (especially troughs), financial crises, and government intervention in markets.  And it represents a massive pivot in American politics as well, away from laissez-faire and toward socialization of risks and returns, centralization of economic policy-making, and the regulation of economic life.  Thus, mastery of the Great Depression is a very worthy goal for the development of MBA students.   As the generation with any personal memory of the Great Depression passes away, and as we approach the 10th anniversary of the Panic of 2008, now seems like the right time to help the rising generation make some meaning about it.   


On August 25th, the seminar commenced with a discussion of Lords of Finance: The Bankers Who Broke the World by Liaquat Ahamed.  Few books about central banking have gained the plaudits of this one.  It has figured among the “must-read” recommendations of prominent executives and critics.  And the book has taken some stiff criticism from Stephen Schuker (historian at UVA) for Ahamed’s neglect of important source material, or “of fiscal politics, evolving industrial structure, or the prerequisites for a growth-oriented entrepreneurial culture.”  Ahamed (a hedge-fund manager) might fairly be indicted for practicing history without a license.  Yet Lords of Finance remains a valuable portal into a multi-disciplinary study of the Great Depression for raising a number of important themes and stimulating critical thinking about that period of time.  Here are six such points:


1.      Financial and economic crises have long ancestry.   How far back in time must one go to tell the story of the Great Depression?  The popular view is that the story begins with the stock market crash of October, 1929: “greedy speculators created a bubble, which burst, and imposed economic hardship on everyone for ten years.”  But it’s not that simple.  Ahamed advances the view that the Great Depression had its origins in the First World War and especially the Versailles Treaty of 1919.  The developed economies exhausted themselves fighting and financing the war.  Reparations and the payment of war debts, combined with an ill-advised return to the gold standard created a brittle and unsustainable economic system.  This repeats an argument made by luminaries such as John Maynard Keynes and Herbert Hoover.  Therefore, if one is interested in getting to root causes of a financial crisis, one must look farther back in time than the obvious onset. 

2.      The cycle of debt-deflation is the foundational economic phenomenon of the Great Depression.  Debt-deflation entails a pernicious feedback spiral in which the pressure for repayment of debts triggers the effort to sell assets by debtors.  The effort to liquidate assets drives asset prices downward.  Declining prices (deflation) worsen the adequacy of collateral underpinning other credits in the economy, which triggers more pressure for repayment of debt and/or for demanding more collateral for loans—in other words, “the more the debtors pay, the more they owe.” [1]  The increased pressure triggers more liquidation of assets.  As the debt-deflation spiral worsens, economic output plummets, workers are laid off, and bankruptcies (corporate and personal) and social distress rise.  This stimulates hoarding of money, which worsens liquidity in the economy and threatens the stability of the financial system.  The debt-deflation spiral ends either with the return of confidence from some powerful surprise (such as government intervention through debtor relief or fiscal spending) or when no assets remain to be sold in the effort to liquidate debt obligations.  The theory of debt deflation was originally formulated by Irving Fisher in 1933, in response to the onset of the Great Depression.  Significantly, Fisher rejected the view that markets were generally and always in equilibrium.  In response, mainstream economists argued that deflation wasn’t so dangerous, since in Fisher’s model, value was merely transferred from debtors to creditors, with no impact on the overall economy.  But in 1995, Ben Bernanke (another student of deflation) counter-argued that a sufficiently severe debt deflation cycle would produce adverse effects on output and employment, both of which could produce depressions.  The deflationary process that caused so much hardship, especially in 1930-1934, spanned most sectors of the economy and appeared sporadically early in the 1920s, notably in agriculture.  Orthodox thinking held that deflation was a temporary adjustment following a period of inflation.  Yet economic history suggests that the US has sustained some extended periods of deflation.  Some sectors, such as agriculture, experienced deflation for much of the 1920s and 1930s.  Why might this be?  Maladroit monetary and fiscal policies are standard explanations.  An added candidate would be technological innovation.  Technological change is generally deflationary.  Alexander Field, in his book Great Leap Forward offers some evidence to suggest that the displacement of steam-based power by electro-motive power in American manufacturing during the 1920s had a depressing effect on prices.  Deflation is much in the minds of central bankers today: what are the parallels between the twenty-teens and the 1920s?    

3.      Determinism versus personal agency: shall we study economic leadership?  Ahamed could have focused his book on policies and larger trends.  But by focusing on four central bankers, Ahamed seems to argue for the significance of human agency in the unfolding of great events.  Economists don’t spend much effort studying individual leaders and instead focus on aggregate flows of money and resources.  Historians, on the other hand, don’t like to attribute big outcomes to the decisions of individuals because big outcomes have many causes and theories about free will and the “Great Man” of history are out of fashion.  Determinism flourishes in much of the writing about the Great Depression: because of pre-existing conditions, the economy was bound to collapse, regardless of what individuals might choose to do.  Yet it is important for us (at a professional school) to study the relation among individuals, their decisions, and the outcomes that follow as a way to learn about leadership.  By focusing on individuals in history, we better understand their motives and consequences of their choices, thus better informing our own choices going forward.  As much of the behavioral research in economic decision-making has shown, biases and preferences of individuals matter enormously—so do ideologies, incentives, and interests; for such reasons, the study of economic leadership is valuable.

4.      Keynes, the looming presence.  Nominally, Lords of Finance is about four central bankers.  But a fifth person, John Maynard Keynes, overshadows the episode.  From the start, he decried policies that ultimately led to catastrophe (his criticism of the Versailles Treaty, The Economic Consequences of the Peace, is worth reading in 2016—and I commend Margaret McMillan’s Paris 1919: Six Months the Changed the World).  Historians of the Great Depression generally cleave to Keynesian economics in their interpretation of the awful downward spiral of 1929-1934.  Perhaps this is with benefit of hindsight: Keynes’s General Theory of Employment, Interest, and Money was published in 1936 and reflected his critique of economic orthodoxy of the day, classical economics, which held that the cure of a depression was a process of “liquidation” like a cold or a case of the flu—and the risk of such a cure was deflation (see point 2, above).  It was in this regard that Keynes wrote, “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”  The “defunct economists” and “academic scribblers” were the classical economists whom Keynes would eventually displace.  Keynes’s demand-side stimulus-oriented policy recommendations offered a provocative alternative.  Yet Keynes had less to say about possible structural barriers to economic recovery from a crisis.  The alternative narrative to Keynes, neoclassical economics, adds that supply side inflexibilities such as entrenched labor unions, “sticky wages,” heavy regulation, trade barriers, and the like can limit the speed of an economic recovery.  But as of the 1920s, the central bankers in Lords of Finance had little consciousness of either demand-side or supply-side narratives.  An important lesson of the that era is that economic and financial crises spawn new ideas.  I leave it for our students to surmise what new ideas are arising from the Global Financial Crisis and Great Recession.

5.      Author’s purpose.  The thrust of Lords of Finance is to explain why and how the axis of monetary orthodoxy shifted profoundly between 1919 and 1939.  Not a pretty process and one fraught with poor choices and inept actions.  I surmise that Ahamed wanted to offer a cautionary tale to current and future economic leaders.  Did he succeed in this?  Much as one may enjoy a good yarn, there is no thoughtful reading without criticism: Where were YOU persuaded?  Where not?

6.      History matters.  Henry Ford famously said, “History is bunk,” words that he later ate when, in penance, he established a wonderful museum of industrial history, Greenfield Village.  History matters for practical people as a way to make meaning about what is happening right now and how the future might unfold.  The Great Depression has cast a very long shadow.  At the nadir of the Global Financial Crisis, some pundits prophesied the onset of another Great Depression.  But things didn’t turn out exactly that way.  Why and how that happened will be an underlying topic in our seminar.  Suffice it to say, as Mark Twain said, “History doesn’t repeat itself, but it rhymes.” 


  1. Irving Fisher, (1933) pages 344-346. []
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Liveblogging “Financial Innovation” Week 2

This continues a running commentary that parallels a new course that I’ve started at Darden, “Financial Innovation: Opportunities and Problems.”  On August 29-30, we explored several important themes in articles by James Van Horne, Josh Lerner, Antoin Murphy, Robert Shiller, and Scott Frame and Lawrence White.  We studied the case history of John Law’s meteoric rise and fall in 1720 with the bursting of the Mississippi Bubble.  And on August 30th, we heard a presentation from Pascal Bouvier, a fintech venture capitalist.  What are we to make of all of this?

1.      “Revolutions” in financial innovation do occur, and should be assessed with caution.  At the close of class the previous week, we debated the extent to which the blockchain “revolution” was substance or hype.  James Van Horne took us back to 1985, when he described a recent wave of financial innovation and warned that it can lead to “excesses.”  The problem with frothy episodes of financial innovation is that they can advance meaningless and ephemeral new products and services, inflate bubbles in asset valuations, and promote outright frauds.  There are many cautionary examples in history; the story of John Law is an iconic example.  A financial genius, Law is credited with strengthening the concept of a central bank, organizing one of the earliest international trading conglomerates, commercializing the concept of financial options, organizing an options market, and arguing that shares in an enterprise were effectively another form of “money”—in the early 18th Century, any one of these would have been a big deal; altogether, they were “yuuuuge.”  And Law was a master practitioner of co-opting the state: with patronage from the King of France, he amassed monopolies on foreign trading rights in return for which he proposed to restructure the national debt of France.  Law’s problem was that some worthy ideas gave way to excess.        

2.      Momentum strategies always end in tears.  In order for Law to succeed with is audacious plan, he needed to raise more capital, and at higher share prices.  To justify higher share prices, Law extolled the promising growth of trade with the Mississippi Valley and other regions.  The buoyant expectations soon turned to speculation and then a massive bubble.  In the summer of 1720, investors awoke to the realization that real growth of trade with the Mississippi Valley or even real growth of the entire French economy would never warrant the lofty share values.  Thus, the bubble collapsed; John Law fled the country; and financial innovation in France was suppressed for decades.  Nevertheless, the model of momentum growth is a hardy weed in the business garden.  Examples such as Enron, Boston Chicken, and the dot-com bubble of 1998-2000 speak to its durability.  The following figure illustrates the “self-reinforcing cycle,” as systems analysts call it: each new infusion of capital fuels more growth, which justifies higher prices for the next infusion of capital.  But momentum growth strategies always fail because of declining returns to scale: eventually firms run out of enough promising assets necessary to justify the high growth expectations.  Stated alternatively, the Mississippi Company couldn’t grow indefinitely faster than France and its colonies without eventually owning it all!  The lesson for budding practitioners in law, business, and public policy: learn to recognize a momentum strategy and call it out.




3.      Who innovates?  John Law illustrates one other point: Financial innovation seems likely to come from the periphery, rather than the center, of a field; from entrants rather than incumbents.  The articles by Josh Lerner and by Frame and White helped to illustrate this.  In a world of only big firms and oligopolistic competition, it seemed that only big firms (incumbents) would have the capital and incentive to innovate—this was the thesis of Joseph Schumpeter, one of the great economists of the mid-20th Century.  Iconic examples such as Bell Labs (of AT&T) and Xerox PARC (of Xerox) seemed to prove Schumpeter’s thesis.  But thanks perhaps to deregulation and technological change, the pattern in the financial sector seems to be that players on the periphery innovate and that big, established incumbents imitate, quickly.   To be clear, “the periphery” means different things to different researchers.  Josh Lerner describes it as “small firms,” “less profitable firms,” “older, less leveraged firms located in regions with more financial innovations.”  Frame and White tell us that “the early issuers were those that tended to be higher risk and also tended to be banks and thrifts (which had relatively liquid assets that could be placed in over-collateralized special funding vehicles).”  The research suggests that the prominent incumbents in the financial sector are likely to be followers and adopters of innovations, whereas players closer to the periphery are likely to be the innovators.  John Law is an extreme example of the outsider-innovator: a Scotsman who fled to France from England, an alleged murderer, and a “gambling dandy” and bookmaker entrusted with the national fisc.  In obvious ways, Law is not a life example for students to follow.  So we looked at Bond Street, an online lender to small and medium-sized businesses, and asked why big banks aren’t imitating that model?  Students pointed to the tendency of big banks to emphasize economies of scale: make only big loans to big firms and watch those clients closely.  In short, John Law, Bond Street and academic research suggest that if you want to look for the source of innovation in finance, you should look toward the periphery. 

4.      Fintech is booming.  Perhaps the biggest illustration of innovation-from-the-periphery is the growing mass of fintech startups, some 18,000 of them in the world, according to Pascal Bouvier, a venture capitalist, CFA, Darden MBA (1992), and blogger in fintech.  We hosted Bouvier for a class session.  He quoted Marc Andreesen that “software is eating the world” and explained that “code is replacing what is done manually.”  Change in financial services has come slowly because of heavy regulation.  But the financial crisis of 2008 has opened the door to financial innovation.  Over the next 15 years this industry will reinvent itself, he says.  Because of innovations, he anticipates a big decline in employment in the financial services sector.  He noted that the charge on intermediating assets has been stable at 2% for more than a century and that the wave of innovation will drive this charge downward.  Incumbents seem to have a hard time innovating because of their corporate cultures that focus on “risk management” rather than “risk-taking.”  Venture capitalists invested several billions of dollars in fintech startups in 2015—Bouvier mentioned the payment systems segment as especially attractive.  It certainly seems as if the fintech field has momentum, but that may also be its problem (see point #2).

In the next few classes we turn from “who innovates” to “what motivates financial innovation”?  The discussions this week suggest that entrants/outsiders/players-on-the-periphery are better at seeing opportunities to innovate.  But what is it that they see?

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Liveblogging “Financial Innovation” Week 1

This begins a running commentary that parallels a new course that I’ve started at Darden, “Financial Innovation: Opportunities and Problems.”  On August 22nd, we kicked off the course, and developed themes.

1.      The huge range and breadth of “financial innovation.”  I took students through a number of fictional “elevator pitches” (short appeals for funding by entrepreneurs to investors) that illustrated the immensity of financial innovation today and in history.  The term, “financial innovation,” covers “financial engineering,” (a somewhat disfavored term these days) and “fintech,” uses digital technology, artificial intelligence, machine learning, blockchain technology and others to provide new financial products and services. Though we can try to “bucket” innovations in terms of new markets, new institutions, new instruments and new services, we confronted the fact that most innovations are idiosyncratic—they color outside the lines in ways that defy simple categorization.  The idiosyncrasy of financial innovation is both a curse and a blessing.  It brings forward interesting new products and services and makes the lives of individual and corporate consumers, financial institutions, regulators, entrants, and incumbents less certain and more interesting.

2.      Motivation to study financial innovation.  Students are showing increased interest in financial innovation as related to their studies and career interests.  “Fintech” is attracting entrepreneurs and venture capital in growing volumes.  Pundits assert that Bitcoin (and other cryptocurrencies) and the underlying blockchain technology will revolutionize finance.  The subject is relevant to the economy and society as an influence on the stability of the financial system.  And financial innovation retains a prominent place in current political and policy debates—a government report in 2011 accused financial innovation as a prominent cause of the Panic of 2008.  In 2009, former Fed Chairman, Paul Volcker, said, “The most important financial innovation that I have seen the past 20 years is the automatic teller machine…I have found very little evidence that vast amounts of innovation in financial markets in recent years has had a visible effect on the productivity of the economy  ((Paul Volcker, quoted in New York Post, December 13, 2009, accessed at ))  All of this warrants careful examination. 

3.      Current stuff and history.  This course turns to a blend of current topics and examples in history to illuminate financial innovation.  There are plenty of financial innovations in the current environment to fill a course.  But looking only at current events forsakes a grasp of consequences.  It is the longer-range outcomes of financial innovations that help you build a critical point of view about them.  Also, history grants the kind of perspective that can help you understand the future.  For instance, history shows that innovation tends to come from the periphery of finance, not the center; it seems to increase in times of social and political change rather than in quiescent periods; and it tends to be led by entrepreneurial visionaries rather than pushed by the general market.  Studying important financial innovations of the past can help you assess the present to anticipate opportunities and problems in financial innovations to come.

4.      What stimulates financial innovation?  This is a question with which we will deal throughout the semester.  Our discussion this week suggested that the business and economic context creates challenges and opportunities for financial innovators.  The innovators respond with proposals for new markets, institutions, products/services, instruments, technologies—and even government policies (both private- and public-sector financial entrepreneurs design these).  These innovations ultimately create outcomes for consumers, taxpayers, investors, issuers of securities, employment, the voting public, and the stability of the financial system.   Government policies interact significantly with financial innovation, either ex post, in the form of regulations of markets, institutions, and instruments, or ex ante, in the form of incentives or constraints to which innovators respond.  The course will aim to illuminate the interaction between financial innovations and government policies.




5.      Is the blockchain a genuine revolution-in-the-making, or just a lot of hype?  We explored blockchain technology and its potential application in financial innovations—our resource here was the book, Blockchain Revolution, by Tapscott and Tapscott.   And we read the foundational document by the mysterious Satoshi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System.”  The blockchain technology offers many appealing features: lower cost, faster speed, encryption, open source, greater privacy, and potentially increased systemic resilience.  And blockchain’s advocates argue that it will disrupt the financial sector profoundly, as well as other sectors such as transportation, energy, resource extraction, health care, retailing, record-keeping, and the “factory of things.”  But sober assessments (such as a critical piece by David Evans of University of Chicago) suggest that the blockchain won’t eliminate intermediaries, that Bitcoin is not a medium of exchange (it is an investment asset) and will have a volatile value with uncertain expectations, and that the evolution of blockchain technology depends on the adaptation of new systems of governance.  And finally, students (and I) admitted that the actual functioning of blockchain technology remains inaccessible to the businessperson—you need a grounding in computer science to really understand what is going on.  But do we need to master the technical functioning of the Internet in order to start an online business?

All of these themes warrant deeper consideration, which the balance of the course will explore.

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The Intern’s Expectations

Sidebar: Those interns who are in the home stretch and really hope to gain an offer might find some of my past advice helpful. Here are some suggestions I’ve given over years past to improve the odds of getting an offer:

  1. Actually ask for the job. Too many summer interns simply don’t “close the sale” (see this.)
  2. Become known. “Lean in,” in Sheryl Sandberg’s parlance. Too many summer interns lean back and fade out (see this.)
  3. Finish at a sprint; don’t coast to the end. Research suggests that the most recent perceptions are very influential to decision-makers. Even if you’re finished with your summer project, walk around and volunteer to help anyone else (see this.)
  4. Quell any sense of entitlement; you must earn the offer. In most settings, arrogance damages, rather than strengthens, career prospects (see this.)
  5. Even if the outcome doesn’t look good, exit gracefully. (see this.)
  6. Focus on finding a calling, not just a job. (see this.)

“It wasn’t what I expected,” said a second-year MBA student who had just returned from a summer internship. He was sitting in my office some years ago, and said, “I aspired to make a difference; to really show what I could do. Instead, what we got was warmed-over projects, company propaganda, and lots of social events. I mean, the company is okay, but if last summer is the kind of work they want me to do, should I accept their job offer?” This student clearly had one leg out the company’s door (if not more of his anatomy). His explanation seemed to beg for my confirmation. Thus, he was a bit surprised when I didn’t leap to his conclusion. I asked him four questions:

  1. Were your expectations reasonable?
    Students tend to set expectations based on hearsay from other students, or on the big decisions embedded in case studies. But frankly, a lot of the high-impact work in business is based on tedious foundation-building. Thomas Edison argued that genius is 1% inspiration and 99% perspiration. Anyway, I said to the student, “if you were CEO of that company, how would you have used a bunch of summer interns, all of whom knew little about the company to start with and some of whom might not return?”
  2. Why might the company have structured the internship as it did?
    Most companies use the summer internship as part of a sophisticated recruitment and selection process. The recruitment piece is that they want to inform the interns in an effort to create ambassadors for the company on school campuses in the coming year. And some companies try to give the interns a jolly time so that they will bring some enthusiasm to their peers. But more importantly, companies use the internship to vet the candidates on the company’s own turf. Does the intern work hard, bring something to the enterprise, and play well in the sandbox? If you thought no one was paying attention to you, think again. It doesn’t take a high-impact project to bring out the best (or worst) in people. No doubt, the Director of Campus Recruiting spent months scrambling to find useful work for all the interns—so I said, “have some empathy for him/her. Someday, you might find yourself in a similar position.”
  3. What’s the outlook for you, the company, and the economy?
    One can start with the assumption that one’s work last summer isn’t a perfect indication of the work that the company might have in store. Therefore, it is worth having a few long conversations with the folks there about what you’d be doing in the future. And any assessment of your own outlook should entail the question, “What’s the alternative?” At the start of the campus recruiting season the substitute to that company is anyone’s guess. And there is always uncertainty about the company and the economy. Take an investment point of view (you’ll be investing your time and effort in building the company): does this company have a good outlook? Would you buy stock in the company (if you had the money)? And whether the economy booms or busts, will this company be a good place to work?
  4. What did you learn about the people and the culture there?
    Just as the company was vetting you last summer, you’ve had an opportunity to vet the company, to get the kind of insights that are rarely possible in campus interviews. There’s a saying that “A-players hire A-players; B-players hire C-players.” Generally, one can trust A-players to use your talents well—did you see any A-players? And the word, “trust,” directs one to think about values and ethics: did the people you met resonate with your best values? Even if your summer work was rather drab, the opportunity to work with great people, with whose values you resonate, will probably turn out well.

My dominant advice to the student in my office was that late summer was probably too soon to decide. Big decisions require time to reflect. I didn’t confirm the student’s leanings—but my questions stimulated a check on his expectations.

There are other lessons here, worthy of longer treatment than I’ll give, regarding how to set expectations for yourself and others. As managers and leaders, we must set reasonable expectations and hold people (and ourselves) accountable. The operative word here is “reasonable.” The student’s expectations for summer work were a tad high. Two filters for the reasonableness of expectations are humility and gratitude—an exemplar in this regard is the cosmologist, Stephen Hawking, who was diagnosed with a degenerative disease when he was a young man. Hawking is a high performer in his field. And he confessed, “My expectations were reduced to zero when I was 21. Everything since then has been a bonus.” [1] I hope that my questions helped the student gain some humility and see a bonus in his summer internship.

  1. “The Science of Second-Guessing” New York Times Magazine interview, December 12, 2004. []
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