Risk, Innovation, and Social Value
The Bernstein Center has been an important public forum to discuss key issues as the financial crisis unfolded. In your latest effort, Sandra Navalli and you created a video program in conjunction with the Fred Friendly Seminars at Columbia Journalism School. What did you hope to achieve by producing this program?
I have felt that the leaders in finance have articulated a defense but not an argument for what they will do better and why they deserve that chance to do it that a large public understands, and student representatives to the Bernstein Leadership and Ethics Center Board proposed independently the idea of a doing a film on this subject. We decided to bring great people together to have an honest debate in which we could nudge panelists to address the big underlying questions that emerged from the financial crisis and to say where they stood on those questions. What is good or bad about regulations, where are possible conflicts of interest in trading, is finance itself providing social value, is finance taking up too many of our national resources and our best talent?
We ended up with wonderful discussions with the legislators and regulators, including Congressman Barney Frank and Gary Gensler of the CFTC, with Blythe Masters of JPMorgan, Wilson Ervin of Credit Suisse, and David Abrams of Abrams Capital, who said plainly: this is where we went wrong, and this is where we can do better.
There’s been so much focus on what the financial sector has done wrong — and that discussion should by no means be over — but finance has always also provided real social and economic value to society. As Peter Stringham, CEO of Young & Rubicam, made so clear, the public sees a disaster that hurt them and they don’t understand why financial institutions will behave better and are to be trusted. We wanted a venue accessible to the public to debate if the same markets that brought us misery can also achieve goals that help society. The program includes, for example, a terrific exchange between Alicia Glen of Goldman Sachs [also an adjunct at the School] and Linda Gibbs, Deputy Mayor for Health and Human Services of New York City, about a new social impact bond, which has low risk and offers performance-based returns that provide high savings and some revenue potential for school districts.
How does this social impact bond work?
The terms are tied to the performance of the educational program being financed. The investors advance funds to a school district to a specified program to create improvements in educational performance that would result in more efficient use of resources and in so doing would save the district money. The district would agree to share the savings with the investors; if there are no savings, the investors lose out and so does the school district. The district is thereby incentivized to perform well. It’s a win-win for all parties. [Watch Bruce Kogut and Lew Kaden, vice chairman of Citigroup, discuss financial innovation for social change.]
Some in the financial industry believe that too much regulation can stifle this type of innovation. How can we regulate without over-regulating?
The social impact bond is a structured investment vehicle that uses many of the same principles of finance that also got us in to trouble. How do you get the good stuff without getting the bad? Regulations will help solve that.
But there is a risk management side as well that is under the control of financial institutions. As Blythe Masters noted, innovation has to scale. If it is viable, it will spread rapidly — but the danger is that, like a virus, almost before you know it you can find you’ve created a trillion-dollar market like credit default swaps. So banks themselves need better risk management structures to evaluate their innovations — how to evaluate their risk; how to create internal systems that say this innovation is a go, this is not a go; and an understanding of the risk they are putting out into the market. Firms in the United States, France, and elsewhere are creating these internal systems.
However wonderful such innovations might be, information asymmetry, where one party to a financial transaction is privy to more relevant knowledge about the deal than the other, remains a concern. Given the increasing complexity of financial innovations and the challenge of communicating clearly about complex issues, how can Wall Street alleviate the extremes in information asymmetry?
It’s not going to be easy. People invest time and money to acquire information, and they of course want to use it in a way that benefits them. The exchange between Ed Conard of Bain Capital and Robert Solow, the MIT Nobel Prize winner in economics, was a golden and amusing exchange of views on the relative responsibility of seller and buyers of financial instruments. And that it happened under the bemused eyes of Gary Gensler and Barney Frank just showed the value of the program in capturing the critical debates in this video.
The debate went something like this. Who is responsible on the other side of the transaction to make sure the buyer knows what is going on? We can debate whether the answer should be "the buyer, stupid", but there are some activities that most people agree are a conflict of interest: when you the financial intermediary has an implicit fiduciary responsibility for long-term customers to whom you sell and you knowingly create instruments that hurt them and help other clients and worse you bet against your client’s investment that you just facilitated.
Today, most banks and financial intermediaries would recognize this as a conflict of interest. This was not true before the financial crisis.
There will always be some information asymmetry because the market depends on it for liquidity. But there are certain kinds of rules and regulations that have to be followed, and there is a normative understanding of what is fair play, because ultimately the market has to operate on norms as well as on the law.
In the program, the School’s own Bruce Greenwald, in speaking about a risky bond proposal presented to a strapped city, said he would gladly turn away a client who couldn’t stomach or didn’t understand the risk involved in that investment. He implied not only that it would waste his firm’s time and talent but also the responsibility to not take advantage of a less sophisticated investor. How can we incentivize financial institutions to embrace that way of thinking?
Here again it is as much a question of norms that influence market behavior. Bruce’s comment was so important because here is this well-known figure, beloved by our students and alumni, whose reputation was built on his presentation of value investing over the long term, who is very serious about finance, who knows the world of hedge funds, and yet who draws a line on activities that would take advantage of less sophisticated investors.
Markets don’t really work by nickel and diming every last sucker on the street. When Bruce makes that statement, it reinforces that normative understanding of how markets should work so that they in fact will be able to work.
As your research has shown, boards can be an important source of norm enforcement. What role can and should boards have going forward?
It’s interesting. In the United States we don’t allow directors to sit on multiple boards in finance. In the MIT Press book we just put out, The Small Worlds of Corporate Governance, it’s quite obvious that most countries do allow complex financial and industrial governance structures.
I would like to see a discussion about whether we really need the multiple board prohibition. Financial markets require a degree of social capital. Many kinds of financial institutions that do not compete directly with one another could do well from sharing industry knowledge. They could benefit from best practices, from better risk assessment, from understanding exposures.
Coming at the governance question from a different angle: Andrew Ross Sorkin said that while, to mitigate systemic risk, he thought [American] banks should probably not be allowed to become too big to fail, he also noted the reality that they need to be large to compete globally with the likes of growing banks in Asia and the rest of the world. That suggests the need for a global financial regulator with teeth. Do you see that happening?
The reality is no one really knows how big is too big to fail. It’s worth asking what is behind people’s fear of big banks. People worry that banks just want to get big because they get free or cheap insurance when the government bails them out when they’ve taken on too much risk. There are ways to make bailouts less attractive to banks, like having shareholders wiped out entirely, so we discourage some mistakes that were made in the financial crisis. And the Dodd-Frank bill will now allow for a much more orderly resolution when banks fail. While we all know it’s not going to work perfectly, the bill is a positive contribution post-crisis that will make a big difference.
Internationally, the current frontier is the lack of global governance in finance but also in other spheres where there are important externalities that go across national borders — climate change, for instance, may dwarf financial regulation these days.
People talk about global regulation, but right now there is no entity that inspires enough confidence to play that kind of role. I think we’re far away from a global regulator.
So what do we have? One positive effect of our international crisis is there is more of a global infrastructure that can facilitate coordination: regulators, elected officials, and financial leaders can pick up the phone a little bit easier than they did before to discuss common policy reactions. And we know just how crucial transparency about the flow of debt and capital around the globe is now, and with that has come an increased understanding about the interconnected nature of banking among governments and their citizens. The world watches the financial sector in a way it did not before.
Bruce Kogut is the Sanford C. Bernstein & Co. Professor of Leadership and Ethics in the Management Division and Director of the Sanford C. Bernstein & Co. Center for Leadership and Ethics at Columbia Business School.