Financial models create a false sense of security

Business schools are perpetuating a fundamentally flawed system of thinking and misleading an entire generation of managers

Financial education has misled a generation of managers, encouraging them to behave badly under the pretext of pseudoscientific principles. Too many business schools are presenting these principles as financial theory to their MBA students, teaching as fact financial models that, to some extent at least, are responsible for the 2008 financial crisis.

Unless business schools make a rapid reassessment of these flawed financial tools they run the risk of fatally damaging their credibility and in turn letting down a generation of MBA students.

Masquerading as financial models, pseudo- scientific principles have created consequences for us all. Theorems and theories present a simplistic view of society, corporations and markets, that drive poor decision-making for many actors: chief executives, market participants such as fund managers and, even worse, regulators.

Most financial models taught today rely on false mathematical assumptions that create a sense of security even as failure approaches. These models rely heavily on the tenets of the so-called science of finance developed in the 1960s and 1970s. Before 1970 most finance teaching was descriptive and referred to the diversity of products and institutions in place. But from 1970 onwards, finance education promoted a theory of finance that resembled a scientific subject such as physics, based on theorems and mathematical proofs.

Indeed, many of the Nobel Prize-winning authors of new financial theory were trained in physics and used what were then advanced mathematical tools.

There is nothing wrong with using advanced mathematics to resolve problems and develop theories. The problem arises when one simplifies the world in order to make it fit a mathematical model. Corporate decisions, as well as market prices, are the result of complex individual choices, involving many stake- holders such as employees, customers and taxpayers, and cannot be moulded to obey a financial theory. Today’s financial theories do not account for such complexity and, worse still, this complexity was ignored by the authors, giving the world a finance philosophy that has misled many.

Take for example the Modigliani Miller (MM) Theorem, a fundamental “theorem” of scientific finance at the core of corporate finance. The basis of the theorem is that financial markets can act as a substitute for corporate, regulatory or government decisions. Anything can be “arbitraged”. This has led to the belief that financial market choices can replace corporate decisions, even though they do not take into account different stakeholders – employees, environment, society, etc.

Much of the growth in financial markets is credited to this theorem. The MM Theorem has influenced the perception of financial actors. It is part of the reason why banks assumed healthy positions in securitising mortgages into complex structures that could adapt to market forces, the so-called collateralised debt and mortgage obligations at the heart of the financial crisis. It was thought that these positions would not hit the real economy. The same thinking has also framed current regulation and financial views and is perpetuated through years of education in business schools and elsewhere.

The list of flawed theories goes on; Black and Scholes option pricing, agency theory etc are all finance models based on simplifying complex choices. This pretence that mathematical models are the solution for human problems is dangerous and is not only at the core of finance theory but is also in the heads of many corporate and financial managers.

Given the tremendous changes in financial systems, these theories must be scrutinised and then abandoned as models for the future. As business schools and institutions continue to preach these principles, they perpetuate a fundamentally flawed system of thinking. Now more than ever, it is as important to teach the flaws as it is to teach the basis that presents them.

Didier Cossin is professor of finance and governance at IMD, director of the IMD Global Board Center and programme director for High Performance Boards

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