The future of finance: Francesca Cornelli

Francesca Cornelli talks about being an applied theorist in the finance world and the importance of thinking strategically about regulation


Are you an ‘applied theorist’ and, if so, what does that mean in today’s world of finance?

I still think of myself as an applied theorist, even though that entails something very different in my current field of finance than it did in my former focus on economics. In theoretical economics, concepts are often difficult to test due to lack of data. In finance, relative to economics, we can be inundated with data. 

Does that change the nature of your work?

I do a lot of empirical work now. And people say, “Of course, in finance everybody does empirical work.” And they attribute that to finance being dominated by empirical people. But I believe it's because the data available in finance is abundant and very detailed. For example, you have a great deal of data on companies' financing activities, data on how much people buy stocks, bonds, options and so on at different prices.

What can the applied theorist like me do with all this data? We can test theories in more detail. You can inform the empirical investigation with the subtleties of a theory.

In your teaching, does the data get in the way of instructing at the theoretical level?

Yes, in a literal sense, but not necessarily in a pejorative sense. The dynamic is actually very interesting because, in class, I always start with a case study — lets say, in oil. Well, there's always someone who is, say, a petroleum engineer, who wants to argue from the perspective of data — which usually means from the perspective of detail.

But at this point, seeing the trees of detail blocks one's view of the forest — meaning the ability to see the big picture. And even though I may try to dismiss it, because I want them to see the big picture, the student may alert me to something that I didn't know or had't considered and that may make me think differently. So it's not all bad, although I still want my students to see the big picture.

Didn’t theoretical finance models take it on the chin in the financial meltdown?

I believe the theoretical work that may have indicated trouble ahead had quite substantially been done. The problem with its being accepted was that it did not demonstrate an all-inclusive rosy outcome. In economics, your paradigm is Pareto improvement, in which you have to show that everybody's better off and nobody's worse off. That largely cuts economists out of having anything to say about, for example, regulation, because someone's always going to lose out a bit. I presented a proposal regarding health insurance in the US in a paper that remains unpublished because my model indicated lower profits for health insurance companies. So the economists said, “Yours is not a Pareto improvement. So it's not a good solution.” Well, yes, if you require an improvement that leaves no one unscathed and everyone better off, you'll never fix the problem.

Would I correctly presume, then, that this same sort of thinking would have rejected the notion that markets don’t always work efficiently and justly?

When we teach, we start with the presumption that markets work, we don't equip students to think in terms of what to do if the market doesn't work. I, as an applied theorist, worked very much in areas such as moral hazard and adverse selection. We had the models that dealt with what was wrong with incentives and conflicts of interest and other contributors to the financial collapse. But they weren't widely known or even recognised to the point that, at a minimum, the devastation might have been lessened.

But now, with the facts of the collapse known and experienced by everyone, will you at least have an easier time teaching the theory?

Time will tell. It's always been almost impossible to go to people with a theory. They just don't get it. I work around this, as I mentioned, with case studies. So the well-written case demonstrates to students exactly what the theoretical model suggested. And what had previously looked very abstract, all of a sudden, makes sense.

But don’t you sometimes wish you were teaching solely from the empirical perspective?

I believe that the value proposition I can bring, even to my strictly empirical work, is thinking like a theorist. So what I'm always looking for is something that's not obvious empirically. It's something other researchers have not thought about. In a way, this sort of contribution is what the financial crisis brought to a head. People made the mistake of relying on the empirical evidence that markets work and in these known ways. But below this surface of evidence were the realities of all that was not obvious empirically.

So usually I'm looking for a twist. By that, I mean the thing you can't forecast, that isn't obvious. And sometimes it's not what people — either students or practitioners — would ever think. For me, the intrigue and excitement are not as much in the conclusion I reach as in the mechanism that produced that conclusion. It's the underlying and often unacknowledged incentives that made things turn out a certain way.

In business parlance, would you say that’s your core competency?

Yes, it's an ability to think in terms of a model, a model that explains an outcome and can suggest future outcomes. If you're exclusively empirical and do nothing in terms of theory, as I say, you will just look at the result.

Looking further at the value of models in finance, what do they tend to tell us about regulation?

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 naive. I think you want regulation that accommodates, rather than kills, incentives.

You can’t ‘set it and forget it’?

That's right. You can't just impose regulation and then ignore its effects. And you have to recognise that no regulation provides complete control — as the perfect model in the perfect world might indicate. There’s no such thing as the perfect solution.

Exactly. And, in a way, this is exactly what I like most about finance. I don't believe you ever find the perfect solution to any problem in finance. This is an inherent attribute of finance resulting from the fact that finance is complicated. I see a lot of smart people who try to get around this; but, for me, that's exactly what makes this area so persistently interesting. If I thought that by next year we could solve every problem of finance that we would have the perfect world — it would be boring.

In light of that, what should regulation seek to do?

We need to think strategically about regulation. The attitude of politicians toward regulation presumes the existence of a world of certainty. You see something that's going badly; and you issue a regulation that says “don't do that” or “do this instead of that.” Problem solved. The theory tells you: make this one rule and that will change the behaviour. Politicians ignore that affect.

Are you saying that the absence of a perfect world means you cannot regulate?

Not at all. What I'm saying, I hope, is that everyone needs to make an effort to understand those with different perspectives and opinions. Researchers should be more willing to think of their research as it's actually applied. And, at the same time, politicians and practitioners should try to understand what researchers are doing. Just because a model doesn't reflect exactly how things transpire in the real world doesn't mean you throw out the model.

And if such an effort had been made several years ago, we may not have had to endure the global financial crisis?

I'm not going so far as to say that. The human species seems predisposed to creating ruinous financial bubbles every so often. What I'm saying about the financial crisis is that the models warning of underlying problems were very much there, but that these models were abstract; so nobody paid attention to them in the real world.

So the fault, in part, lays with us researchers who were not finding ways to make our work accessible to non-researchers. And, in part, the fault lays with practitioners, who said, “Here comes another researcher who doesn't know how real life works.” So the fault is on both sides.

That seems to be a very different view from the conventional wisdom that attributes the crisis in large measure to the development of new instruments such as collateralised debt obligations and credit default swaps.

These instruments 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.

You’ve shown an interest recently in private equity. Why?

It's not so much to understand private equity as a way to get at incentives, to learn more about how our market economies, mostly through organisations, employ incentives to enhance investor returns.

How do you provide the right incentives? How do you design the optimal organisation? Those are questions private equity has tried to address. Private equity companies are trying to set incentives in the best possible ways. For me, this is another opportunity to use the tools of an applied theorist. So, I'm not so interested in private equity per se, but to study the field more as an example — as a way to study whether incentives work and how to set up the optimal organisation. For me, the essential, underlying questions about market economies are: what works — and what doesn't? Private equity is a perfect laboratory in which to explore these questions.

What do you mean by the ‘optimal organisation’?

Very often, people take for granted how we're organised, like whether a bank should both lend to a company and be an investor in it. But, does a bank that acts as both an investment bank and a commercial bank serve us best? Or should you separate these activities? On further thought, it's not something that people should take for granted.

And that opens the floodgates to other questions. Should you have a central bank? Should you have bankruptcy regulation or just leave parties to write contracts between themselves and agree on their own terms in the event of bankruptcy? So, in a way, there are a lot of things in the economy that are organised in a certain way that people take for granted. But, in fact, it's very useful to constantly challenge these things.

How do private equity companies allow you to do this?

A recent example is my examination of the turnover of GPs [general partners] in private equity companies. It's extremely interesting because all the LPs [limited partners], when they try to decide in which fund to be based, they want the same old familiar, reliable GP. That for them is a mantra. At the same time, a lot of GPs say, “This is absurd; we should be able to fire our own if there's bad performance.” Also, the world changes and the people who were good in the old world, when you were leveraging up like crazy, aren't necessarily the best when you move on to the next phase of company growth. So why do we have to keep the same people?

That's the very practical question for them. For me, it's an interesting question because it's about whom you want to follow. Do you want to follow the organisation or the people? The reason LPs want the same old GP is because they say, “I know these people; they perform well. I just want to stick with them.” But maybe there?s something about an organisation, about its own ability to self-renew, that goes beyond the individuals. The world of private equity exacerbates these considerations, which exist in all organisations. I find it's an ideal laboratory for studying these things.

Why shouldn’t you be in Silicon Valley in the US, the centre of the private equity world, to study this?

First, because PE firms are an object of convenience. Second, and more importantly, the intriguing action in the PE world has been shifting, first to Europe and subsequently to the emerging markets. And what is interesting about that for me, as a theorist, is that the shift from country to country entails a few changes in the regulation of the way PE firms operate. That's interesting, because I want to use the differences to see whether the results produced by the companies are different. It's a unique opportunity to say, “Look, I change this on the input. What ends up being changed on the output?” You can add or subtract a seemingly insignificant clause and have a huge difference because of that.

So are you ultimately trying to discern the effects of incentives — often in the form of regulation — on how people perform?

Absolutely. The world of finance is hugely complicated and, therefore, never perfect. It is also very human and, where people are involved, how can you predict with total accuracy what they will or won't do? As I say, that's what makes it all so interesting: the unpredictable nature of the markets. What is fascinating is that events are not happening as part of a grand finance experiment, that we're not reproducing causes and effects under ideally controlled conditions.

So is it a science — but a messy science?

Yes, which is what I especially like about finance. It attracts a lot of very intelligent people, which means they'll be very quick in figuring out ways to get around any regulation or rule or provision — legally — that they see impeding their success in our market economy. The effects of incentives are exacerbated in finance. It's very human, but human in terms of the worst-behaved children in your class, the ones who quickly figure out how to do what they want without disobeying the rules.

How do you think the world of finance is going to change over the next decade?

I think we'll see an extension of the recently burgeoning area of the implications of behavioural psychology for finance. We'll see increasing recognition that those of us in finance have to account for what we regard as irrational behaviour. That's an especially difficult chore for those of us who regard ourselves as so rational and, in part, were attracted to finance by its seeming rationality. Our models are much easier to construct and our outcomes are much easier to predict when we can take rational behaviour as a given. But when we can't — when we must cope with irrationality — an almost infinite number of dimensions can be introduced.

Doesn’t this point to one of the problems you alluded to earlier, that there’s economics, there’s finance, there’s psychology — the silos still exist?

Yes, but that's decreasing. That's one of the things I most love about being at a business school, relative to when I was in a department of economics outside of a business school. In a business school, there's naturally much more interaction among people from different disciplines. The world is smaller and you'll have the chance to see the psychologists in the Organisational Behaviour department. There are chances to talk.

Are you optimistic about the world of finance?

I'm optimistic so long as we don't cripple financial innovation. As I said earlier, 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 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.

This article was taken from Business Strategy Review, for the latest business thinking from all London Business School faculty

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