Unearthing the wisdom in finance
The world of banking and finance has earned more than a little opprobrium in recent years. Some of the black marks: The pumped-up subprime loan and layered derivatives mortgage crisis, which led to the Great Recession; the false, “robo” signed affidavits that led to people losing their homes through illegal foreclosures; the LIBOR and foreign exchange trading scandals; the hundreds of billions in fines paid for wrong-doing, while executives rarely, if ever, went to prison despite the typically large sums involved. So just what lessons does the finance industry have to offer? Mihir Desai believes there is wisdom in the industry that can apply to everyone. He is a finance and law professor at Harvard, and he has gathered his ideas into a new book: The Wisdom of Finance: Discovering Humanity in a World of Risk and Return. He recently joined the Knowledge@Wharton Show on Sirius XM channel 111 to discuss the many parallels he sees between challenges in finance and some big questions we all have in life.
An edited version of a transcript of the interview appears below.
Knowledge@Wharton: When you talk to people about this book, given what finance and the banking sector have been through over the last decade, do they do a double take because there is so much negative association with the industry?
Mihir Desai: Yes, I think that’s right. Frankly, just putting the two words ‘wisdom’ and ‘finance’ in the title makes people think it’s an oxymoron of some kind. What I really wanted to do, though, was go up against that image. In particular, I think people are really upset about finance, and some of them have good reason to be. Obviously, finance is not doing everything it should be doing, but there are also a lot of misconceptions. So the book is an effort to demystify finance for those people who don’t know it, but then also humanize it, because I think we desperately need finance to be humanized. That’s part of the problem today: People perceive it as a complex topic that is not accessible. In fact, it’s pretty intuitive, and the book really just tries to lay that out.
Knowledge@Wharton: This started as a commencement speech, correct?
Desai: Yes. I was giving a talk to the graduating MBA students in 2015, and I had no idea what I was going to talk about. In fact, I was going to do some narrow “finance-y” thing, and then I realized — that’s not what you’re supposed to do in these settings. So I came up with a title, The Wisdom of Finance, and then I had to figure out what it meant.
I was just struck by how quickly the parallels emerged between the big ideas of finance and big questions in life. That parallelism really struck a chord when I gave it as a talk, and I think the reason was because people want meaning and wisdom, but they don’t want it dispensed from upon high. They want it from their lives, and they want it from their work. So if you can talk about meaning by talking about leverage or value creation or options, you can communicate it in a way that’s more resonant than talking about it in some abstract way.
Knowledge@Wharton: Give us the backstory on linking the finance industry to the humanities.
Desai: Once I gave the talk, that was just uncovering the parallels. Then I realized that to tell this in a book, I really wanted to tell stories. One of the great things about writing this book was I got reconnected to storytelling. When you’re an economist like I am, you get skeptical about stories, because you think if you can’t show it in the data, it doesn’t mean anything. What I did, in this case, was actually try to write a book where all the big ideas of finance were talked about, but with no equations, no graphs — just stories. To do that, I had the greatest year and a half of my life, during which I just read amazing stuff, and I saw finance everywhere.
“Think about the problem facing young women in the 19th century … “I’ve got all these suitors. … I don’t know how to choose. How do I weigh those risks?’”
For example, when I was trying to think about how to talk about risk management, I found the stories of Jane Austen and Anthony Trollope, who people would never think about in the context of risk management. But if you think about the problem facing young women in the 19th century, it’s this: “I’ve got all these suitors. Some of them are good. Some of them are bad. I don’t know how to choose. How do I weigh those risks?” And they talk about it that way. In fact, in Anthony Trollope’s Phineas Finn, the character Violet Effingham actually gives voice to the logic of diversification and options, which are the two big risk-management tools in finance.
I started to see it everywhere. So I thought it would be much more interesting, much more fun to talk about risk management with that [context], as opposed to the Black-Scholes-Merton pricing formula.
Knowledge@Wharton: You also approach a variety of aspects, linking it to pop culture — different artists, different singers and films.
Desai: Yes, exactly. Actually my favorite chapter, frankly, in the whole book is about the corporate governance problem, which is a really central part of capitalism. It’s the issue of managers misbehaving, basically, and not doing what shareholders want. So rather than approach it in a typical way, I do it with Mel Brooks and ‘The Producers.’ It’s an old movie, but it was made into a Broadway musical a while ago.
You might recall, the underlying story is a governance story.
That’s an interesting way into the problem. Then to develop the idea further, I talk about Apple, and I talk about Tootsie Roll, two interesting companies. Then, I try to use ‘The Producers’ and Mel Brooks again, to come back to how the principal-agent problem — which is that corporate governance problem — actually is a pretty useful frame on life. It’s a way of saying, “we’re all principals or agents at one time or another, and trying to figure out whether we’re behaving well as a principal or an agent is a lot of what life is about.”
Knowledge@Wharton: You mentioned risk management a minute ago. How do you link bankruptcy back to this?
Desai: Bankruptcy is fantastic, because it’s such a dramatic thing. The first part of what I try to do is just tell a story so people understand it. And it’s a fantastic story. It’s the story of Robert Morris, who is the wealthiest man in the Colonies, who is first asked to be the treasury secretary before Alexander Hamilton, because he had done so much to finance the Revolution.
Obviously, nobody knows his name anymore, and the reason why is, he turned down that job. He went on to become, again, the wealthiest man in the new country. He owned half of New Jersey, half of New York — and then he went bankrupt. And his bankruptcy was the triggering event for us to stop thinking about bankruptcy as a moral failing. The Bankruptcy Act of 1800 changed a lot of things about bankruptcy because of Robert Morris. We started to view failure not as something that you should look down on and demonize, but as something where you should actually protect the people who fail, and you should understand it as a consequence of risk-taking, not moral failure.
That is one example of recognizing that, actually, bankruptcy is a way to think about failure and how we should react to failure. And I think it’s pretty instructive in that way. I also discuss the American Airlines bankruptcy, which is fantastic as a way to talk about how bankruptcy is also about managing all these conflicting obligations. That’s what we do in a bankruptcy. There are all these people. There’s a limited pie. How do we carve it up?
Knowledge@Wharton: Here in 2017, we’re seeing an incredible number of bankruptcies being filed by companies in the retail sector. Can you see the correlation there as well?
Desai: Obviously, what people have been talking about for years is coming to fruition — which is that we have a real problem in the retail sector. What’s interesting about what’s happening is, once these companies teeter on the edge, then it becomes a question of how do you know when to declare bankruptcy?
“People like to think of [finance] as this skill-based, meritocratic thing. … In fact, there’s no industry where it’s easier to dress up failure as success.”
Some people, like the American Airlines CEO, say, “I’ll never declare bankruptcy. It’s wrong, and you have to live by your commitments.” That’s nice to say, but it’s not realistic. The next CEO comes in at American Airlines and basically restructures the airline, he guts the pensions, he does some things that are terrible and some things that are wonderful, but in the longer run, he actually gets the company through. And the company emerges in a much stronger way.
The person who’s usually valorized — the guy who says, “I stand by my commitments, no matter what” — is not really the hero. It’s the guy who’s willing to go through the muck of a bankruptcy to salvage the assets who is actually the hero of that story.
Knowledge@Wharton: Is it your hope to give people a little bit better of an understanding of the financial industry in general? … If people have a better understanding of finance in general, then maybe they will be more hands-on with a lot of elements that end up being very important to them, especially later in life.
Desai: That’s exactly right. What I observe in my classroom and with people generally is that finance is really intimidating. As a consequence, people do passive things — they don’t really want to engage because they’re intimidated by the ideas, and that is really unfortunate and really costly to us individually and to us as a society — because finance is just so important. It’s so important to your life when you think about retirement. It’s so important to your life when you think about student loans. If you block it all out, that’s a terrible way to live. So in a way, the book has these two audiences. So for people outside of finance, it’s a way of saying, “Come on in. It’s easier than you think, and you can learn a bunch of stuff just with stories.” And that’s a big chunk of the book.
But the other chunk of the book is, “Hey, you folks in finance! Think hard about these ideas, because finance has got a bad rap, and you need to be able to explain finance, and we need to make finance more aspirational. And in fact, the underlying ideas are worth aspiring to.”
Knowledge@Wharton: You also talk about the diversity issue in the sector.
Desai: Part of what happens in finance is that people — as you know, it’s a very un-diverse sector. There’s underrepresentation of women and of minorities. I think part of the way people rationalize that is they think, “Well, gosh, finance is so meritocratic.” The market is a hard master, and I go demonstrate my worth every day because I’m investing, and I’m trying, and the market is telling me I’m doing well or I’m not doing well, and so if people aren’t represented, it’s just a function of that meritocratic nature.
That’s really problematic. In fact, the underlying ideas of finance would suggest exactly the opposite, which is there is a ton of luck in the world. Finance is, in a way, about how you can never separate out luck from skill. You should be really humble about any accomplishments in finance because the whole idea behind, for example, efficient markets is that it’s really, really hard to beat the market. Yet people in finance routinely say they do. This is one of the puzzles about finance: People like to think of it as this skill-based, meritocratic thing, and that justifies all kinds of exclusions. In fact, there’s no industry where it’s easier to dress up failure as success. Every fund is “in the top quartile.”
Knowledge@Wharton: You also talk about the fact that as a whole the finance industry is fairly ethical.
Desai: Well, yes. It certainly can be. What I try to separate out in the book is the practice of finance, which is broken in some ways — meaning there’s a little bit more value extraction going on than value creation, relative to the actual function of finance which is so central and can be like this really life-affirming thing. In the book, I try to walk a line. People who say “Finance is God’s work, it’s all great” — I think that’s really problematic. It’s not. It’s an industry, it’s a good industry, and it does something incredible, which is it transfers capital from people who have it to people who need it, which is the biggest thing to do in capitalism.
So it’s a great industry, and it has great ideas. It’s just that we’ve lost track of those ideas. The book is a way of saying, “If we’re going to fix finance” — and I think it does need to be fixed — “regulation is possible, but it’s got a lot of side effects that are complicated.” You can just be outraged, but that doesn’t do anything. I think the real thing is, let’s get back to these underlying ideas as a way to move the industry forward.
“We know mergers that are a setting where synergies are always overestimated. I think that’s true in the marriage setting as well.”
Knowledge@Wharton: I asked you that because in the recent past, we’ve seen things going on with Deutsche Bank and Wells Fargo. When you think about it, the number of issues that pop up in the finance industry — especially in the last couple of years – have been small, but when something happens, it is a massive problem. It’s hard for a lot of people to really want to delve into the finance industry when you see these huge issues popping up.
Desai: That’s exactly right. You put your finger on two things. One is, there are these problematic things that happen, which signal that there is a real underlying problem. And then they get blown out of proportion, which creates a societal taint on finance. That taint — and that view of “finance is kind of evil”– is doubly bad, because then there’s nothing to aspire to. What I see in people in finance is that they’re a little bit ashamed of going into it, or they try to think of their professional life as separate from their personal life because finance is “dirty.”
That’s really problematic. The book tries to bring your personal and professional life together. You work in a field that’s actually fantastic. It’s got these great ideas — live up to that. I want to make finance aspirational, as opposed to defining it downward, as an evil field.
Knowledge@Wharton: What do you think could be the effect on the finance industry of tax reform, if we see something significant in the next year or two?
Desai: Tax policy is my major area of scholarship, so I think it’s really interesting what’s happening today. I think first, markets are being moved by the prospect of tax reform. That’s been a huge piece of why people have been getting excited in markets. I think that’s pretty misplaced because the kinds of things that are being talked about are not going to happen. And you know, the Trump sheet of paper that came out, his “tax plan,” is barely a plan. It’s got some interesting ideas embedded in it, but it’s not really a plan.
What will actually end of happening, either this year or next, is a pretty narrow corporate tax reform, I think, where the corporate tax rate comes down to something more like 25% or 22%, and most importantly, we get out of this worldwide regime. Both of those things are going to help financial players and markets a lot, and that’s great, because it’s going to help the economy more importantly a lot. It’s going to free up a lot of capital that can come back to this country. It’s going to make the U.S. a better place to invest. Those are the really important things.
But I do think the market has gotten ahead of itself, because there’s talk about this border adjustment tax, which would have a lot more significant effects. I think that’s probably a very risky move, and I think it’s probably not going to happen.
When people readjust their expectations to something more modest — which is going to be better, frankly — it’s going to take them a little while to digest that.
Knowledge@Wharton: What do you see as being the future of the finance industry?
Desai: I’ve been struck by how little has changed over the last 10 years. If you look back to 2008 and you come to today, how much has really changed? The answer is, well, look at the banking sector — very little. Some of the banks have grown bigger. The biggest have grown bigger. There’s been very little to no entry [of newcomers], and there have been no real bust-ups. That’s true across the sector. Only now do we see some compression in alternative assets and in hedge fund fees. So it’s been really slow moving, which says something about the political power of finance and maybe just the unwillingness to tackle it.
What happens in the longer run is, I think these large banks have a business model problem, and they’ve got to figure out how to make money, and they’ve got to figure out what their business model is. Unless they do that, it’s going to be tough to sustain them. I think some of them are doing really great jobs, but that’s a big problem.
What I hope happens in finance is that we re-orient ourselves to these core functions, which are value-creating, like managing people’s risks, like simple credit, simple brokering, and get away from the things that are more extractive, like chunks of the money-management industry, which are a little more questionable. That’s what I hope happens — we move back to simpler, core finance, like what banks in a way used to be in some sense, and get away from these much more complex institutions that are both hard to regulate and hard to manage.
“Finance is, in a way, about how you can never separate out luck from skill.”
Knowledge@Wharton: This is the first finance book I have discussed on this show that has references to Ray Charles and Kanye West.
Desai: In part, I wanted to make the book broad, so anybody can come in: People who like Jane Austen, people who like Kanye — anybody. What I did with those two is, there’s a chapter on mergers and marriages, which is titled, somewhat cheekily, “There’s No Romance without Finance.” I wanted to show that these concepts of love and finance, which people think of as being totally separate — one is lovely and beautiful, and one is crass and dirty — in fact have been linked throughout history. Romance and finance have been linked. Part of the way I introduce that is with the movie ‘Working Girl,’ which is the greatest Wall Street movie ever, I think.
Then I show how Ray Charles and Kanye West take on this same idea. Ray Charles’ original idea is this beautiful idea of how romance has nothing to do with finance, and how this woman who loves Ray Charles is fantastic. Then Kanye flips it in “Gold Digger,” completely flips it in sentiment, and he literally uses the lyrics that Ray Charles used to really question that. The reason I like that is it makes you just see these things are connected. In the ‘Mergers’ chapter, for example, I really try to show how — and this is really cheeky, but I think it works — a lot of the folklore about how mergers applies to marriages.
For example, we know that mergers are a setting where synergies are always overestimated. I think that’s true in the marriage setting as well. Integration planning is always underdone.
Knowledge@Wharton: Sigourney Weaver’s character referred to marriage as a merger, which was truly Wall Street.
Desai: Exactly. It’s one of those great proposals. There are these two great proposals in the book. One is Sigourney Weaver proposing to Harrison Ford and basically saying, “You and me, let’s merge,” as if that was the ultimate. Then the other great proposal was from Pride and Prejudice, where Mr. Collins tries to play off of Lizzy Bennet’s risk aversion and basically says, “You’re never going to get anything better, so you’d better take me.” These are probably the two worst proposals in the world, but they both serve a purpose of showing risk management in Jane Austen, but also this parallel between marriages and mergers in that chapter.