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The future of finance

Over the last 40 years the world of finance has been revolutionised. In no other discipline are theory and practice so intimately related.

By Julian Franks Francesca Cornelli Stephen M. Schaefer and Richard A. ‘Dick’ Brealey . 17 June 2011


Read the full interviews or an abridged article below:

Richard (Dick) Brealey recently sat down with Stuart Crainer to discuss what lessons can be learnt from the financial crisis. Download pdf

Francesca Cornelli talks about being an applied theorist in the finance world. Download pdf

Julian Franks on how to prepare for the next financial crisis. Download pdf

Stephen M. Schaefer on the evolution of finance over the last 40 years. Download pdf


The expertise of finance professionals has increased dramatically over recent decades. But has the development of sophisticated financial models by researchers in this area encouraged the sorts of complicated financial instruments that led to the worldwide crisis?

Brealey: I don’t think the recent financial crisis was caused by complicated financial instruments. There are instances where they didn’t help, but the crisis arose out of simple, basic lending on houses.

Cornelli: I agree. Instruments, such as collateralised debt obligations and credit default swaps, are inanimate. They are products of the human mind. They can’t ‘cause’ anything. If we want to ban such instruments, we can do so prospectively only if we ban the innovation of financial instruments. Yes, we should be more vigilant and track all these things and try to predict where they might lead us. But we shouldn’t tell bankers that all they can do is borrow and lend. If you accept, as I do, that financial innovation can ultimately create wealth and improve well-being, that it can improve the distribution of resources among firms, then you also have to accept the risk of unintended consequences. That’s where models can reveal danger ahead, allowing you to mitigate risk.

Is the criticism of academics, for not anticipating the crisis, fair?

Brealey: The fact is, it wasn’t anticipated by any sector, not just academics. If you look at the Bank of England Financial Stability Report just before the crisis, it was quite correctly listing the possible dangers, but concluded that these were so slight that there was no great worry. I’m not blaming the bank, but illustrating that very few people appreciated the risky state of the financial world at the time.

Some people say that academics should scrap their complex models and come up with something basic that can warn of impending disaster.

Brealey: I couldn’t disagree more. People are saying, for example, that financial economists need to go back to the drawing board, because everything they’ve said for the last 50 years was obviously wrong. That’s absolute nonsense. I think that everything we’ve said, and still say, about the importance of risk management, the importance of agency theory, about how to motivate people to do what you want them to do, is largely still valid — and valuable. That doesn’t mean we don’t have a lot to learn; we clearly do.

In which areas do we need to learn most?

Brealey: We need to learn a lot more about how to regulate banks; we need to learn a lot more about the liquidity that we’d assumed was adequate, but wasn’t. We need to understand more about why markets suddenly dry up.

Have we done enough to avoid another financial crisis?

Franks: There will be another financial crisis. History tells us that. The only question is: have we put in place the financial architecture to minimise its costs? My answer is no not at the moment. I think there’s a great danger that we’ll revert to carrying on as normal. We do have some voices out there yet to be heard, such as the governor of the Bank of England.

You mention the Bank of England. But is more regulation really the answer? Isn’t it a busted flush?

Cornelli: In the real world, regulation is often heavy-handed; it brings on strategic behaviour that can be counterproductive. To think that you can just impose regulations and make them work exactly as envisioned, with no unintended consequences, is simplistic. I think you want regulation that accommodates, rather than kills, incentives.

Now the hullaballoo has died down, what are the lasting lessons to be learned from this crisis?

Schaefer: I think there are many lessons to be drawn from it. For example, one of my particular areas of interest is fixed income markets; and one of the things that we learned from the crisis is that there are risk exposures in some of these markets, that have some of the characteristics of earthquake insurance: most of the time nothing happens and then, very occasionally, something awful happens. The interesting thing is that it seems that you could actually detect some of those exposures before the crisis.

What does it mean for people entering finance now – whether as a researcher or as a practitioner?

Franks: Research in finance has become far more international. You look at Europe, and finance research is flourishing. You look at banking innovations, and this side of the pond is contributing just as much as the US. You look at stock markets; and you see that those in South America, China, Hong Kong and so forth are increasingly important. You look at capital markets; and see not only Wall Street, but rising markets in India, China, Hong Kong, Russia and, of course, Europe.

I tell my students that what they need to know to make an impact today is far more than it was even a mere 10 years ago. The technical knowledge possessed today by practitioners in regulatory agencies, corporate finance and treasury departments, and commercial and investment banks is far greater than in the last years of the 20th century. So, the bar has been raised considerably for academics like me in trying to influence practitioners. You have to say things that are far more insightful; and that means that students have to learn more, have to be far better trained and have to be more thoughtful than was required years ago.

Are you optimistic about the future of finance?

Cornelli: I’m optimistic so long as we don’t cripple financial innovation. I’m concerned that fear of broadly negative impacts may lead politicians or regulators to stifle innovation in finance. That can be regarded as the safest thing to do: nothing. But, then, we will no longer see progress. That is a very pessimistic point of view.

What we must do as a society, I think, is to take a step back and see that innovations in finance and the globalisation of finance are lifting hundreds of millions of people from unending poverty and subsistence living for the first time in human history. The massive scale of this transformation is what created the massive scale of the financial crisis. The proper response is not to halt the innovations that make the transformation possible but to precisely target actions that can stop or at least limit abuses, while the benefits of wealth continue to enrich lives everywhere.

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