Soapbox: a remedy is to hand

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Finger-pointing has become a popular sport as we attempt to round up all the culprits responsible for the current economic crisis but, recently, two unlikely suspects have been charged: financial engineering and business school education. While there is plenty of blame to go round, faulting technical expertise and higher education seems like the desperate acts of a prosecutor with no evidence, an impatient judge and an angry mob outside the courthouse.

Financial engineering is no more responsible for the crisis than aerospace engineering was responsible for the Space Shuttle Challenger explosion in 1986: in both cases, incorrect human judgments involving inappropriate uses of technology led to disaster.

Although evidence from the crisis is still being gathered, preliminary indications suggest that senior management at the most troubled financial institutions apparently placed little or no weight on risk assessments that clearly warned of large potential losses in the face of a downturn in the US residential real estate market. This is not a failing of financial engineering but more likely a case of poor judgment, lack of understanding and training or greed blinded by success.

While business schools breed successful entrepreneurs and reflect the spirit of modern capitalism that has made the US the richest country in the world, they also teach future business leaders how to measure and manage risks, how to assess the creditworthiness of various counterparties and how to price and hedge the alphabet soup of financial securities at the heart of the crisis. But the rapid growth in the size and complexity of financial markets has strained business school curricula and matriculants, and the standard two-year MBA programme may no longer be sufficient training to understand all the intricacies of asset-backed securities markets and their derivatives.

This is why business schools offer PhDs in financial engineering – but not enough to go round. In 2007, the Sloan School of Management at MIT produced only four finance PhDs. During the same period, MIT graduated 337 PhDs from its School of Engineering. The numbers are comparable at other top business and engineering schools.

The explanation for this disparity is simple: the vast majority of non-financial engineering PhDs is paid for by grants from government agencies; financial engineering currently receives no government support. Moreover, it is a twist of irony that, in recent years, the salary premiums commanded by financial engineers have attracted legions of other engineering students to Wall Street where they were hired for their technical skills. It was only belatedly discovered that their lack of financial training could be hazardous to our wealth.

This dearth of financial expertise can be remedied easily and without cost to the taxpayer – why not create scholarships for financial engineering programmes funded by levying a very small “systemic risk surcharge” on the notional values of the most complex over-the-counter derivatives transactions? A small tax will have little impact on market liquidity and efficiency but will provide significant educational support to enrich the stock of intellectual capital required to measure and manage the risks of these complex financial instruments. And those most likely to benefit from such talent will be paying for it.

The crisis highlights the growing complexity of the financial system as well as the transformation of business education from the generic to the specific – from the old boys’ network to the global financial network and from boardroom tactics to risk analytics. By training tomorrow’s leaders to manage the risks of the financial system effectively and ethically, we shall have a fighting chance of surviving even the largest crises. This is what business schools do and we need to do more of it, not less.

Andrew W. Lo is the Harris & Harris Group professor at Sloan School of Management, MIT, and director of the MIT Laboratory for Financial Engineering

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