Jane Austen: risk manager? The Jane Austen Festival (Photo by Matt Cardy/Getty Images)
Why did Wall Street go astray? For most of the last several centuries, bankers and financiers were the pillars of society, the bastions of morality, the people in society that everyone respected. Of course, there was the odd rotten apple in the barrel, but by and large, bankers were trusted and looked up to. Yet over the last few decades, Wall Street has become almost a synonym of evil. What went wrong? What can be done to restore the financial sector to the level of respect that it once enjoyed?
This week, I talked about these issues with Harvard Business School finance professor Mihir Desai, on the publication of his intriguing new book, The Wisdom of Finance: Discovering Humanity in the World of Risk and Return (Houghton Mifflin Harcourt, May 2017). I’m a big fan of Desai’s work and wrote about his pathbreaking Harvard Business Review article in 2012 (“The Incentive Bubble”) here.
Desai’s new book is unlike almost any business book you’ve ever read, with eight chapters packed with stories from English and American literature explaining the sometimes esoteric concepts of risk management in simple everyday language and showing how they apply to every aspect of our lives. Desai draws from literature in surprising ways. Who would have thought that Jane Austen could teach us risk management?
The book has eight chapters representing a kind of “everyman’s guide to finance:” (1) The wheel of Fortune; (2) Jane Austen’s Pride and Prejudice on risk management; (3) The cruel logic of value creation; (4) How the problem of ‘agency’ got a lot worse; (5) There’s no romance without finance; (6) Using leverage to live the dream; (7) Using bankruptcy to fail forward; and finally, (8) Why everyone hates finance.
I spoke with Desai about his new book.
The Purpose Of Desai’s Book
Steve Denning: I am a big fan of your work, particularly your 2012 HBR article, “The Incentive Bubble,” which I wrote about here. Your new book is very different from that article and from most business books. Why did you write it?
Mihir Desai: Writing this book was a bit of an accident. I had to give a talk to graduating Harvard MBA students two years ago and chose a title, “The Wisdom of Finance,” without knowing what it meant! As I struggled to meet the deadline, I found myself seeing striking parallels between the ideas of finance and how you think about your life. The talk was great fun and I gave it several more times. The talk really resonated with people because they were able to see the real world and their work as the source of wisdom – rather than have wisdom distilled from upon high.
The book has two audiences.
For people outside finance, I wanted to make the ideas accessible. Finance is deeply misunderstood, and we need to make it understandable to people so that they don’t demonize it. The way to do that is not through equations or graphs, but through stories. Finance is central to our lives and ignorance of it is very costly on an individual and societal level.
For people in finance, I wanted to give them an alternative to the demonization of their work that they encounter everywhere. The core ideas of finance are quite life affirming and very noble — we should make people in finance aspire to them rather than expect so little of them. If finance is going to rehabilitate itself, and I do think it’s broken in many ways, the way to rehabilitate is not through regulation, or outrage, but rather returning to its basic underlying ideas, which are actually quite wonderful. In the long run, that’s how we make finance better — by getting back to the core ideas.
What Did Finance Go Astray?
Denning: Let’s start then with the basic question: why did Wall Street go astray? What went wrong?
Desai: There are many reasons but clearly the most important one is that we’ve failed to think through the incentives of our financial actors – and the proliferation of high-powered incentives along with lax regulations have led to significant problems. The last chapter of my book discusses an alternative idea about why everyone hates financiers. Given my outlining of the nobility of the ideas of finance in the book, the question is: why does everyone hate financiers?
One answer is that finance can breed both arrogance and stupidity. This is the only field where you get quantifiable feedback at a high frequency and usually at a scale inflated by leverage. And, we know humans make attribution errors. This leads to the belief that any success is due to the financier’s brilliance while the mistakes are rationalized as part of the context. So, no other field can allow for the frequency and size of these attribution errors — and what we end up with is incredible amounts of arrogance. The people aren’t bad. It’s not that finance per se is bad. It’s that finance can breed this arrogance. The book is aimed at alerting people to that and helping think about ways that they can prevent that from happening.
Denning: Is rapid feedback really new? If you look over the last couple of centuries, that rapid feedback has always been in place. So why is the excessive arrogance happening now? There have been “bad patches” for finance before, with periods of financial frenzy and greed. Why are we having such a bad patch now?
Desai: If we think about the 2008 financial crisis, we can see that it was the product of both mistaken beliefs and terrible incentives. Over the last 30 years, we have seen the growth of the alternative asset industry and the proliferation of very high powered incentives (“2 & 20” and stock options), which make people very attuned to market outcomes. Those outcomes are the basis for market-based compensation and that, in turn, leads to the magnification of these attribution errors. That is new. Why did the growth of the alternative assets industry and high-powered incentives happen? A savings glut and demographic changes that led people to reach for yield. Declining interest rates that made hedge funds look brilliant and allowed private equity to boom. Those are recent phenomena.
Jane Austen: Risk Manager?
Denning: As a Jane Austen fan, I was particularly interested in chapter 2 and your presentation of Elizabeth Bennett, the central character in Pride and Prejudice, as a risk manager. As an outsider, one can interpret the story in that way. But I was wondering: what would Jane Austen have thought of that interpretation? Would she have applauded? Or would she have said, “That’s not what I’m talking about at all. I’m talking about duty, about manners, and about love, not about calculating how to land the best husband in a marriage market of gains and losses.” Is that a fair question?
Desai: Absolutely. I don’t know about gains and losses, but Jane Austen was certainly thinking about risk. The core of Liz Bennett’s problem when Mr Collins proposed marriage to her was one of managing risk. Mr Collins and her mother tried to play on Liz’s risk aversion, by suggesting that no better suitor would come along. Then Liz tells her father that she wants to go on gambling. She is managing the risk of a young woman in that period, who is in a marriage market. It’s a complex risk-management problem. They were not thinking about gains and losses. That’s not what finance is about. It’s about risk and how we manage it in our lives.
Denning: Looking at Jane Austen’s own life, we can see that she received only one marriage proposal, which she accepted for one day and then turned it down the next. The suitor — Harris Bigg-Wither — was wealthy, Oxford-educated, but personally disagreeable. The match would have solved all of the financial problems of Jane Austen and her family. But Jane Austen turned it down and, so far as we know, she never received another proposal. Does that mean that we should regard Jane Austen’s life as a failure, because she mismanaged her risk in the marriage market?
Desai: Not at all. She was obviously a remarkable person and one of the greatest authors — perhaps the greatest — of the last three centuries. I didn’t mean to equate getting married with success. What I do mean is that risk is ever present, and Austen understood that. The fact that she resisted the pressure to get married demonstrates her character and her willingness to go against societal norms. The fact that Jane Austen and her characters were struggling with issues of risk management helps explain and humanize finance and risk management to a wider audience. I also use Anthony Trollope’s Phineas Finn to show how another young character, Violet Effingham, intuited options and diversification as strategies for managing those risks.
Denning: One might say perhaps that, as an author, Jane Austen managed risk brilliantly. Her life goals were simply not those of the marriage market of her day.
How Efforts To Solve ‘The Agency Problem’ Made It A Lot Worse
Denning: Let’s turn to the “agency problem” that is discussed in chapter 4. You talked about this in your 2012 article, “The Financial Incentives Bubble,” and came down quite harshly on the role of incentives. At the heart of the disaster, you said, is market-based compensation — the idea that the C-Suite and financial managers should be compensated by the issuance of stock. Market-based compensation was intended to align managers’ interests with those of shareholders, but the result has been the opposite. The idea of market-based compensation, you said, is “intellectually flawed” and “a foundational myth.” It seems that the “agency” theory which was meant to solve the supposed problem of agency has aggravated and turned it into a macro-economic problem.
In chapter 4 of your new book, you talk about the various chains of agency that are in place. The C-suite acts as agents for the board. The board acts as agents for the shareholders, and possibly other stakeholders like employees and customers. The institutional investors act as agents for investors, who are often in the end “us,” through our investments in mutual funds. In other words, we are complicit in supporting the whole system. I was hoping to learn what we should be doing about this tangled web of agency relationships, but on page 83, you say that this will have to wait for your next book. So, I was wondering whether you could give us a preview of that next book?
Desai: Sure. The next book would be an expansion on the 2012 HBR article. First, it would acknowledge that the principal agent problem is the fundamental frame on modern capitalism. Second, the rise and dominance of investors and the investor mentality have changed capitalism. It’s manifested in the way CEOs think about the world, the way investors make CEOs do things, and it’s highly problematic. There are many good things about it, but I am also concerned about the bad things. The book will go through those things and try to come up with guard rails. In the current book, I try to outline that problem so people become attuned to it (by reading about Mel Brooks!) but also describe why it’s a subtle, difficult problem not amenable to simple solutions. Recent shareholder activism at Apple and Tootsie Roll help explain how difficult a problem it is.
As one example, the share buyback craze is something I have been concerned about. There are a variety of guardrails that one could put up. We need to keep in mind that returning cash to shareholders is sometimes good, although the current craze is problematic. We should craft a solution that would recognize what that solution is trying to accomplish and then guard against the excesses. I don’t have an extreme view of the world. I don’t think that one class of people are good and another class are bad or that we need to stop doing x and start doing y. The system is prone to excesses and we need to think about guardrails.
Denning: Would you agree with Bill Lazonick when he wrote in HBR that almost $7 trillion in share buybacks in the U.S., Canada and Europe over 10 years is in effect stock price manipulation?
Desai: I think that what managers have done is excessive, and it’s problematic. But characterizations like that are not constructive. It makes people think that capitalism is all bad and that we should shut it down. I don’t think that’s right. We have to understand what people are trying to accomplish. Capital allocation is a hard problem. Figuring out how to distribute cash to shareholders is a hard problem. Distributions serve a purpose and they can be done very effectively. But the practice has come to the point where we do it without sufficient transparency.
Some of the proposals I would make are (a) to stop open market operations and only allow year-end tender offers, (b) to stop accelerated share re-purchase programs, and (c) to change the accounting of repurchases so the performance of managers when buying back shares is manifest in financial statements. I am not saying that something bad isn’t happening. Something bad is happening. But we should be careful how we characterize and guard against it.
Denning: You would agree that stock price manipulation is a bad thing?
Desai: Of course. It’s true that there have been a lot of ill-timed and poorly-executed share buybacks, that have been the source of value destruction. Some of those activities may have been stock price manipulation, but it is more likely to have been incentive-driven. They were not saying that they wanted the stock to be a certain price. They were saying: “I get compensated in a certain way and I need to feed investors in that way.”
Why Does Everyone Hate Finance?
Denning: Let’s turn to chapter 8, which is entitled, “Why Everyone Hates Finance.” Here you get to the question of whether “more” is ever enough and the fact that in the finance sector, it seems that there is no such thing as “enough.” It is always a quest for “more.”
The chapter cites as a positive example the story of Alexandra from Willa Cather’s novel, O Pioneers! She has a sense of herself and who she loves and is a steward of her involvement in the financial system and uses that in very astute ways. That’s an example of a financier who is acting as a steward.
My question is whether the problem isn’t deeper in the sense that the stewardship that we may need may be stewardship of the system, not just stewardship of personal finance and needs. Looking back on finance 40 years ago, it did seem like the partners at Goldman Sachs at that time were husbanding their own personal capital and were acting to some extent as stewards of the system overall. Now they are playing with other people’s money, where if they win, they win big, but if they lose, it’s not really their problem. In Singapore for instance there is more of a long-term perspective in the structure of financial markets. Do we need an equivalent of that kind of stewardship in the U.S. system — perhaps from institutional investors?
Desai: That’s a great and deep question. I tend to be skeptical about the possibility of stewards of the system. Part of the reason is that I don’t know who these stewards would be. I would be deeply skeptical of any financial institution that claimed to be acting as a steward of the system. The government might also act as a steward: they could be helpful but they can also be quite problematic.
I am interested in a more decentralized outcome. That means people understanding their responsibilities to their capital providers in a more serious way. It would also mean that we need more effective government agencies that are better at policing them. So, I just don’t buy the idea of stewards of the system as a simple solution to the problem.
Denning: That leaves us with the question: how do we get to a situation where the regulators are more alert to what is occurring, and where we have more “Alexandra’s” acting in a more prudent fashion with enlightened self-interest?
Desai: There are three paths forward. One is outrage. That can stir things up but it offers no real solution. A second is regulation. Clearly some things are under-regulated. But regulations are blunt instruments and regulators are susceptible to being “captured.” They have been captured in the past and they appear to be captured now in some ways. So, the real answer — the third path — is returning to the underlying ideas of finance.
The Shift From Value-Extraction to Value-Creation
Desai: Finance has lost its way because it got divorced from the underlying ideas. Finance is broken because it is no longer thinking about value-creation. It is thinking about value-extraction. That is the way forward. Maybe it will take decades? Maybe it will take more than our lifetimes? But that’s the way we get better.
Denning: Could you envisage a world in which academics and analysts were more systematically evaluating what is value-creation, and what is value-extraction.
Desai: Absolutely. That would be a huge step forward. And also having citizens and pension funds thinking about these issues in a clearer, more thoughtful way. That is exactly the right way to go.
The reason I tell the story of Alexandra is to contrast her with the more problematic characters in finance like Gordon Gekko in the movie, Wall Street. You need to pick the right story to live your life by. If you pick the wrong story, which is frankly what most people are doing today, and Gordon Gekko is the model of what they do, then not surprisingly they are going to behave badly. We need to pick our stories more carefully. I end with Alexandra Bergson and the quote from that book: “There are only two or three human stories in the world and they go on repeating themselves as fiercely as if they had never happened before.” We all pick stories to live our lives by and you should choose your stories carefully.
Denning: Is it more of a system problem than a problem of individuals acting badly? Individuals find themselves in systems that have certain incentives, and values, and corporate cultures. Is it surprising that they “fit in” to the system? They are almost trapped in the existing system. It’s difficult for people to do otherwise, unless they “get out of the system.” Do we need to change “the system”?
Desai: If you take that approach, I see two possible outcomes. One is revolution. That’s neither likely nor helpful. The second option is intervention by the state, which is a revolution of a different kind. The state and its politicians have demonstrated very limited capacity for resolving these problems. Often, they will make it worse. I don’t disagree that we have a system problem. I think that decentralized or individual action is likely to be the best way forward.
A Story-Based Outcome
Denning: I wonder whether there isn’t a third option, building on your idea of decentralized and individual action. Let’s use a metaphor. Let’s take the case of pesticides and DDT in 1962. The chemical industry was politically and financially dominant in the U.S. It was insistent that the pervasive use of poisonous DDT wasn’t a problem and that it was in any event necessary to assure America’s food supply. Otherwise the country would starve. The big firms had control of the media. Politicians and the general population also went along with the continuing the status quo. Objectively, the prospects of change in the use of poisonous pesticides in 1962 were hopeless. It was a massive system problem.
But then along came Rachel Carson and her book, The Silent Spring. She had no political power or financial resources. All she had were stories about the disaster that was unfolding and also stories about how the problems could be resolved. Lo and behold, people listened to her stories. A national, and eventually a global, movement emerged and so, the system changed, despite the overwhelming political, financial and media power of the chemical companies who were arrayed against change. Is something like that conceivable in the finance sector?
Desai: I think that’s a brilliant analogy and it’s basically right. I would love my work to contribute to that, both this book and the next book. People start believing in the underlying ideas. And the state starts to believe in the ideas and things snowball to the right outcome. It’s not a state-sponsored outcome. It would be a movement born of stories. I think that’s exactly right. If you think about the Progressive Era and Jacob Riis and Upton Sinclair, that’s the way that revolution happened. Their stories led to better behavior by both people and the state. I believe that’s what we need now in finance.
Some of the material in this article will appear in a different form in my forthcoming book, The Age of Agile (Amacom: February, 2018).
And read also:
The Pernicious Nonsense of Maximizing Shareholder Value
Mihir Desai: HBR Blows The Lid Off C-Suite Over-Compensation
How Modern Economics is Built on the World’s Dumbest Idea
How Big Firms Increasingly Resort To Corporate Cocaine
How Corporate America Is Cannibalizing Itself[“Source-ndtv”]