Soapbox

June 18, 2012 12:28 am

Academics must address the problems of the financial markets

There must be an understanding of how the financial markets really work

Never before have so many clever people spent so much time painstakingly unpicking the devilishly complex world of finance. Visit any business school and you will find legions of relatively well-paid, dedicated academics scrutinising reams of financial data.

This should be the golden age of academic finance. But a dark cloud hangs over it. The collective failure to predict and sound the alarm bells before the catastrophic financial crisis in 2008 continues to be a source of remorse for many in mainstream academia. Some did see the crash coming and tried to sound the alarm, but you do not need a PhD to realise that collectively academics did not interrogate their subject with the necessary rigour. When mainstream society really needed academic finance, academic finance let mainstream society down. The sad thing is that academics have only themselves to blame.

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For years, finance academics longed for a rational subject that they could study rigorously, measure and hypothesise upon. They longed to copy the rigour of the physical sciences and to treat data objectively. They just needed a means to do it.

The answer came in the 1960s in the guise of the Capital Asset Pricing Model. The CAPM is supposedly used by investors to value shares by modelling the relationship between expected risk and expected return. It assumes rationality underpins the financial markets and has been the unchallenged core of academic finance ever since it was adopted. Mainstream academics take data from the real world of finance then devote their time to reconciling it with these core principles. It results in an endless stream of puzzles that keeps the academic finance industry busy. Unfortunately, this misses the point of the CAPM. The model is a good basis for understanding the markets, but that is all it can ever be – a basis upon which to build.

In the 1950s, finance was a largely descriptive subject covering institutional and legal structures. The growing fascination with CAPM in the 1960s resulted in finance’s gradual transformation into an analytical and quantitative study.

By the 1970s, powerful computers were being used to analyse data from financial markets and test new theories. At the same time, booming western economies were generating vast amounts of money for institutions to invest in the markets. The quantification of financial markets had begun, leading to the mass commoditisation and development of increasingly complex financial products.

To fuel this fast-growing business, large financial institutions needed bright, hard-working individuals and found a plentiful supply of young graduates trained in financial econometrics in the top business schools. In effect, academic finance had begun feeding into the markets, making it ever more complex in the process. Finance academics would study the results of the new market data created by the trading and investment activities of the new generation of finance graduates. It seemed like a virtuous circle.

However, it came at a tremendous cost. Academics spent less time studying the financing of organisations and more on the financial markets. The new “supercomputers” enabled them to analyse ever bigger data sets without getting their hands dirty by understanding the detail of how things really worked at the coalface. These factors combined to make the finance industry an overblown and self-serving industry, far removed from its original purpose of serving the real economy.

Today, the industry is almost impossibly complex and yet the consequences of its actions are often accepted without question. Companies listed on the stock market announce plans to sack thousands of employees and their share prices rocket.

These job losses, however, are not an issue as the efficacy of the markets means that those being made redundant will be employed elsewhere in the economy, yet all the real-world evidence shows unemployment remains persistently high.

There must be an open, critical debate about what has gone wrong in academic finance. At the core of good academic practice must be the notion of scientific progress – the discovery of new facts, models and ideas. If rigorous and robust questioning is not allowed, the subject becomes moribund. It is deeply ironic that by protecting the core belief that the markets can be studied in an objective, rational way, academic finance has become the antithesis of the objective science it strived to become.

Academics must endeavour to understand how the financial markets really work on a minute-by-minute basis, what drives the people that work in it, what their biases are and how they operate.

If the global financial crisis has not made it blindingly obvious that we need a more open and critical debate about financial markets, nothing will. Finance academics must humbly admit that they got it wrong, recognise that finance cannot be studied by churning numbers alone and collectively apply themselves to the problems of real financial markets.

Academics should be leading the debate on where the boundary between the private sector and the public sector starts and stops; how to finance SMEs and foster sustainable growth in the economy and how to regulate business properly. If not, the clever people who spend their time studying finance will become progressively less relevant to mainstream society and as an industry will have no one to blame but themselves.

Prof Kevin Keasey is head of accounting & finance and director of the International Institute of Banking and Financial Services at Leeds University Business School. Dr Iain Clacher is a lecturer in accounting and finance and the deputy director of t he Centre for Advanced Studies in Finance at Leeds University Business School.

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