The future of finance: Richard Brealey

Richard A. ‘Dick’ Brealey talks to Stuart Crainer to discuss what lessons can be learnt from the financial crisis


You wrote the world’s most popular finance textbook and held important finance positions in the public, private and academic sectors. There may be no one more qualified to answer this question: what must change to prevent another worldwide meltdown in global finance?

Well, we already have some tougher capital limits on banks, though I don't think they are nearly as tough as we need. We need also to recognise that the government gives a subsidy to banks to borrow, then complains when they borrow too much and has to put on capital requirements to stop them borrowing too aggressively. So we need to think much more about removing those incentives for banks to borrow so heavily.

We also need to do a lot more in terms of measuring the risks that banks are taking. At the moment, the regulator measures the risk of individual assets; and we've got that down tolerably well. But what we don't have down is the effect of a bank's overall risk profile on the risk in the financial system — so we need better measures of risk and we need to understand how that risk gets transmitted. There are a lot of people working on this, including some of my colleagues and myself.

How could we have had such a massive financial collapse after decades of incredible increases in the expertise and sophistication of finance professionals and the development of an array of complicated financial models?

I don't think, as is popularly believed, that the recent financial crisis was caused by today's complicated financial instruments. There are instances where they didn't help, but the crisis arose out of simple, basic lending on houses.

Did you anticipate the crisis?

No. I thought houses were overpriced, but then I've thought that for many years. I also thought security markets were too high, but that warrants a correction, not a collapse. So I didn't anticipate the crisis, especially its severity.

Is the criticism of academics, for not anticipating it, unfair?

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 better scrap all of their complex models and come up with something basic that can warn of impending disaster.

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.

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. So there's a lot to learn, but not by going back to the drawing board.

It seems that every decade or so we have a severe financial crisis somewhere in the world. Are we failing to learn?

That question can mean either of two things: one is, why don't we learn why such crises occur? The other is, why don't we do something about them?

We're not doing badly at the first of these: learning. But the second, doing something, is a much tougher nut to crack — because the solution resides in the political and public policy arena. That is where responsibility lies for making banks subject to much tougher capital requirements and removing the perverse incentives that make financial institutions do things that are bad for our financial system.

What's more, it is in this arena of politics and public policy that action, or inaction, are heavily influenced by the media. They pursue the flashy stories about, say, taxing bankers' bonuses — an almost wholly irrelevant issue. So we're often driven by the media and resulting political pressures to focus on exactly the wrong things.

How might business schools contribute to preventing, or at least lessening, the impact of financial crises?

We need to teach more about financial institutions and the way they're organised and the way they operate, rather than simply how to value the particular financial instruments they deal with. We're very good at teaching how to value a swap, option or whatever. I don't believe we say very much about the bank itself or teach very much about bank regulations. Banking as a business is complex, and we need to understand that business better and convey that understanding to tomorrow's bankers and the related professions that work with bankers — in particular, regulators.

Speaking of the public policy and political arena, you spent some eventful times there, in the late 1990s, as special adviser to the governor of the Bank of England. What brought that about — a change in your interests?

Clearly, my interests have changed over the years. I started as an investment management practitioner, moved on to teaching investment management and then moved much more into corporate finance. Then the opportunity arose with the Bank of England, where I served for three years, from 1998 to 2000.

Do you think the general public understands why the bank exists and what it’s doing?

People understand the monetary policy side. They see an interest rate set each month and that's a very tangible thing. I think they understand less about the financial stability side, possibly because there are no particular tools the bank can use to influence that, other than through its expertise and influence.

How did the job come about?

I had recently completed quite a big project here, called the City Research Project, on London's competitiveness and how that was changing. I finished that and wasn't quite sure what I should do next, when I was invited by the bank to become an adviser.

It must have been quite a change from London Business School.

A very big change. The Bank of England is a wonderful institution; it has very bright people, but it is a much more hierarchical than London Business School. So I really found it quite difficult to get my oar in at times.

Perhaps you left too early.

If you're alluding to the financial collapse of 2008, the answer is 'no'. I was there at a marvellous time, which you may think a perverse characterisation, as those years included the Asian financial crisis, the Brazilian crisis, the Russian crisis and the LTCM [Long Term Capital Management] crisis.

For me, it was a wonderful time. Not that I really had an effect on anything, but I learned a lot. I learned in particular how little interested the world at large is in how society's critical institutions, financial institutions in particular, were structured. I learned a great deal about these issues, which served me well as concern about them has emerged in a very big way over the ensuing decade.

You launched your career in the private, profit-seeking sector and have maintained involvement through some consulting and non-executive board memberships.

Yes, this was a long time ago: I was an investment portfolio manager in London. One big problem that we encountered was judging how much risk one of our large holdings was contributing to the portfolio as a whole and whether the prospects for gain in that holding were sufficient to justify its risk. Now it seems a very obvious question, but nobody quite knew how to answer that at the time.

Then somebody introduced me to what was then a fairly recently published book [1959] by Harry Markowitz, called Portfolio Selection: Efficient Diversification of Investments. This was my life‟s 'road to Damascus' moment. I saw for the first time that there was a logical structure to the things I'd been doing or trying to do. And even more, it said that if you could put down some relatively simple numbers about the prospects for the stocks that you‟re holding and you could feed these numbers into a computer, then out would come the ideal portfolio.

To my naïve mind, that sounded absolutely wonderful, so I then went to the States to work on portfolio theory at a mutual fund, for three years.

And at the end of those three years, you came back to the UK and began your academic career here at London Business School. But over those ensuing three decades, haven’t you kept in touch with the bigger practitioners?

One of the great advantages offered by London Business School is its presence close to the City, so it was fairly easy for me to maintain my former contacts with investment practitioners, such as stockbrokers, portfolio managers and so on. If I had a difficulty, it was more with the corporate finance world, which is more geographically dispersed. Our textbook helped a bit with private-sector contact, since it is widely used by corporate finance executives.

What about your role on boards?

I think it's very helpful for me. I wouldn't want to spend my life doing it, because it can be difficult to get inside companies and actually make changes.

Is there any other private-sector role that you believe academics could benefit from pursuing?

I think they should do more consulting, by which I mean on contract rather than on a board. I still do a little consulting. Another area is expert testimony. It's quite stressful, so I no longer do much of it; but it's a significant learning opportunity for younger academics.

You’ve described your entry into academia as accidental and coincidental. How so?

Well, after I returned from the States and my years with the mutual fund, it was almost by accident that I found myself back in London and at London Business School. Like most things in life, it was a series of coincidences.

I say this because I'd been drifting towards academia while I was in the States, because I got to know the finance faculty in various universities as part of my job; in particular, Jim Lorie, who was professor of finance at the University of Chicago, was incredibly encouraging to me, in terms of writing and presenting academic papers. But even so, I wasn't planning to become an academic. I was moving back to London and somebody said, “Why don't you come to London Business School for a few months while you‟re finding a job in the city?” The "few months" became what is currently 43 years.

As an academic, how would you measure success?

For me, with hindsight, any success to which I've contributed has been in three principal ways. One is helping to build a finance group here; I've been terribly lucky to have had a wonderful group of colleagues. Secondly, we've attracted some very good PhD students, many of whom have gone on to join our faculty. Thirdly, I quickly realised that most of the teaching at London Business School was in corporate finance rather than investment management, so I‟d better learn about corporate finance. The best way to learn about something is to go and teach it, so I went to the University of California at Berkeley and taught corporate finance for nearly a year.

Do you think the collegial atmosphere you found at London Business School when you joined the faculty still exists?

Yes, but less so than in the past; and that‟s almost inevitable. Back then, we were a much smaller group. The finance faculty is now four times larger than when I joined. And today's pressures to publish are huge, which result from a far more competitive world of top global business schools. That's life. And that's not going to change. We're competing with other business schools; we're under pressure to publish; it's very important. Understandably.

Regarding pressure to publish, you’re co-author of the world’s most popular corporate finance textbook. How did that happen?

While I was at Berkeley, McGraw-Hill asked me to write it. The other way to best learn about a subject, apart from teaching it, is to write about it, so I managed to persuade Stewart Myers to join me in writing Principles of Corporate Finance. It's now in its 10th edition, and it's really been quite influential in the way that finance professionals have managed their businesses.

How unusual is it, given your career path, to lack a PhD degree?

Very. It is very rare indeed for faculty not to have a PhD. One could say, truthfully, I'm very badly educated. I've compensated by encouraging people who were better qualified than me to work both with me and beside me.

Do you suppose the lack of a PhD made it harder to teach?

Finance is an easy subject to teach. I'm not very good at doing it; but the subject is easy because, first, people believe it's important and, second, because the subject deals with concrete concepts. You can say: “here's how you value an option”, “this is how you value a swap”, “here's how you measure risk.” As I said earlier, the field does have its uncertainties and complexities, but there are also some very obvious messages that one can impart.

I have to wonder if you aren’t actually saying that finance may be a relatively easy subject to teach today. Not many of the principal concepts had been established back in the 1960s and 1970s.

True. Which is why I regard those years as the golden age. I was lucky to get started in finance just at that time. Entirely new concepts seemed to be emerging everywhere and all the time: portfolio theory, asset pricing models, market efficiency, capital structure, options pricing — all came to the fore in a very short period, so it was an extremely exciting time. And many of those ideas were slow in being introduced in the UK, so I moved back here at the right time, too.

But the US was the place to be at the beginning of this golden age?

I believe so. But that, too, has changed, because of the passage of time and also because so many of today's PhD students in America are non-American. Many stay in America, but a lot move either to Europe or, increasingly, to the Far East.

How has finance changed the most, in terms of its impact on how people live, since the golden age?

One way is that those certainties that we had in the 1960s and 1970s have become less certain. It‟s not that the ideas aren't still important; but now we know they aren't God‟s truth, and it's much more complicated than it seemed to be in those days.

Another thing is that we used to think of managers as being almost incidental. Their job was to maximise shareholders' wealth; we taught them how to do it and they performed. Now we've become much more conscious that managers have their own axes to grind, as do employees, debt holders and others.

So the idea of agency theory has become far more important. How do we motivate people to behave the way we believe is best? We need to impart understanding to managers; we need to demonstrate how it makes sense to do things one way and not another. The subject has become much more positive and less normative than it used to be.

And more broadly, would you also say that the average person on the street wants to understand at least the key precepts of finance?

Yes, and that's one of the great advantages of the financial crisis. If anybody had any doubts beforehand that finance is important, they don't have any doubts now. They can at least see that the world of finance isn't irrelevant and boring.

How do you see the financial world changing over the next decade?

In terms of what‟s coming out of academia, I‟m not sure there's going to be any sudden revolution as there was in the 1960s and 1970s. I think we will see rather more interest in some of the behavioural issues — the strange and logically inexplicable behaviours of people in the world of finance, the things that rational economists don't like to think about very much. Also, just as we have learned to introduce managers into our thinking, we need to think much more about the role of financial institutions.

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

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