Crisis and Consequences

As the global financial markets go on a wild ride, politicians and economists scramble to put together rescue plans. Will they work? And what can b-school students learn by dissecting the crisis as it unfolds?
Crisis and Consequences

The subprime mortgage market has a meltdown. Bear Stearns collapses. Lehman Brothers fails. The U.S. government loans billions of dollars to AIG—and then makes that sum look paltry by crafting a $700 billion bailout plan for the banking industry. Many financial neophytes learn for the first time about the London Interbank Offered Rate and how LIBOR affects everything from their mortgages to their business loans. The Dow Jones plummets, soars, and plunges again. Around the world, the Nikkei, the FTSE 100, and the DAX tumble and recover and slump again.

These are perilous times for everyone, from the C-suite banking executive to the teller at the local branch, from major stockholders with millions invested to ordinary citizens with a few thousand dollars in a 401(k), from small-town politicians to presidents and prime ministers. Colleges and universities are not immune from the ill effects of a troubled economy, but business schools can perceive one bright spot in the cloudy forecast. The economic crisis offers a fascinating real-life, real-time case study that teaches students how the market is supposed to work—and what happens when it doesn’t.

In the following pages, three finance professors from the U.S., Europe, and China offer their insights into the current situation and what they think might happen next. They also share their thoughts on how the crisis will affect business school students who are not only learning the industry, but also looking for jobs in an uncertain economy. Their views are complemented by the frank “Your Turn” on page 60, in which a former finance professor addresses all the students who passed through her classes and are now professionals in the banking world.

Their consensus? Today’s financial situation is not unique; the banking world has suffered disasters in the past and undoubtedly will undergo them again in the future. The best hope for tomorrow’s financial leaders is to study the mistakes that were made this time and figure out ways to mitigate the next disaster that surely lies ahead.

Preparing for the Worst

Gabriel Hawawini
H. Grunfeld Chaired Professor of Investment Banking
INSEAD
Fontainebleau, France, and Singapore
Visiting Professor of Finance
The Wharton School
University of Pennsylvania
Philadelphia, Pennsylvania

One of my colleagues recently noted that the Western banking world goes through a crisis every ten to 15 years. While we’re living through an event like the current one, it seems to be disproportionately acute, but these situations have happened before and they’ll happen again. I don’t believe that boom-and-bust cycles can be eliminated—but I do believe they can be attenuated.

We need to think about ways to regulate the banking sys¬tem so we can prevent these sudden and deep shortfalls, even if the crises never disappear entirely. And we need to consider what business schools can do to prepare the next generation of financial officers to handle the emergencies of the future.

Planning Ahead

One measure I favor is called “pro-cyclical provisioning.” Under this plan, financial institutions set aside funds during boom cycles so they have resources on hand when the next bust occurs. Some of the provisioning would take place at the level of individual banks, so they could draw on their own funds during a localized crisis. Some would take place at the industry level with a centralized global insurance fund that would support international institutions that did not have enough money to weather a global catastrophe.

Such a plan would follow the model of the U.S.’s Federal Deposit Insurance Corporation, which insures individuals’ deposits up to $100,000—a limit that has been temporarily raised to $250,000 through December 31, 2009. One of the hallmarks of the current crisis is that depositors have remained calm; they haven’t made a run on the banks. That’s because depositors know there’s a mechanism in place to prevent disaster, and they know the fundamental banking system is still solid. Pro-cyclical provisioning would create an analogous system at the industry level that would protect the owners and shareholders of a bank.

Because we know it’s only a matter of time before the next banking crisis occurs, we must consider what we can do now to ensure that future events are less dramatic. Perhaps banks can work together to establish pro-cyclical provisioning, or perhaps the government should promote the idea through tax incentives or legislation.

One lesson I hope we have learned from recent events is that no country is isolated from a major crisis, particularly one that originates in the U.S. The very nature of banking is that it facilitates trade; as nations become more connected to each other through trade, so do banks. We can’t have the benefit of a global economy without the costs.

Therefore, if any new regulatory systems are created, it will be critical to coordinate them around the globe. If one country legislates that its banks must put money aside, those banks will be at a disadvantage compared to institutions in other countries unless there is coordination among nations to level the playing field. I recognize that this level of collaboration is not easy, yet during times of crisis, people and nations can come together in a way that benefits everyone.

No country is isolated from a major crisis, particularly one that originates in the U.S. We can’t have the benefit of a global economy without the costs.
Gabriel Hawawini, INSEAD

In the Classroom

It’s clear that the current economic situation should be addressed in our business school classrooms, but it poses a challenge to the way we have traditionally taught our students. We lecture about the clever mechanics of valuation, and we explain how specific products solve problems like risk, funding, and liquidity. But we rarely help students understand how these innovative financial products might fail when the market is in trouble. A Ferrari may be a fantastic car, but if you drive it recklessly, you’ll have an accident. We must teach students how to handle the Ferraris we have created for the finance market—and how they have crashed in the past.

The question is how to introduce the historical perspective in the classroom. It reminds me of the debate business schools have had about the best way to teach ethics. Do we introduce the topic in a separate class, or do we touch on it in every course? Ideally, the same finance professor who teaches about a product should also warn students how it can fail. But most of us don’t have a historical perspective. We might be experts in financial innovation, but we don’t know as much about financial collapses. We’re often not competent to talk about past banking failures, and we’re reluctant to discuss things we don’t fully understand. We’d rather describe how great a Ferrari is than detail the risks that come with driving a fancy car.

If we want finance faculty to add that additional perspective, we’ll have to train them differently than we train them now. But how? Should that historical perspective be part of our training for PhD students? Should senior faculty encourage junior faculty to develop a deeper understanding of financial history? Should we ask for such background information to be included in our textbooks—where it cannot be found at the present time? I’m not sure.

At the same time, I’m not sure if we need to learn an altogether different lesson from the current crisis. Perhaps we need to teach our students more about risk management and our other financial models. There is no doubt that a large number of people in the financial industry, including those in the top management positions, were handling sophisticated products that they did not fully understand. When they promised us that everything was fine, either they were lying or they didn’t realize how deep and serious the problem was.

Perhaps a more thorough business education would have helped them see trouble coming in time to avert it. As management educators, we need to consider how we can deliver that education—before the next banking crisis occurs.

The Outlook from Asia

Xinge Zhao
Associate Professor of Finance
CFO Programme Director
China European International Business School (CEIBS)
Shanghai, China

While the Chinese economy is still relatively strong, it has been affected by the financial crisis in the U.S. and Europe. Export is a major engine for growth in China. If American and European customers buy fewer goods exported by China, that will have a negative impact on the Chinese economy.

The news might not be that bad for the Chinese financial market. Because it’s not as open as markets in more developed nations, its exposure to the subprime crisis has been limited. Some Chinese banks do have investments in mortgage-backed securities, but it doesn’t seem likely that any major Chinese bank is going to get into serious trouble. On the other hand, what’s happening in the world financial market will definitely affect the mood of China’s investors.

China’s Economic State

China already has suffered its own financial downturn. After more than a year of tremendous growth, the Chinese market reached its highest levels in October 2007. Exactly one year later, it was down by 60 percent to 70 percent. But because this downturn was not caused by the subprime mortgage crisis, many believe that China will recover more quickly than other parts of the world will. In fact, if there aren’t any other major problems, the Chinese market is still anticipating a growth rate of about 9 percent for 2009. If the global economy falls into a recession in 2009, the outlook for the global economy will be gloomy, but the future of the Chinese economy may remain relatively bright.

The big question in China right now is how much we should participate in the U.S. bailout plan. The U.S. would fund most of its $700 billion bailout by borrowing money, and Japan and China are among the countries that are considered major potential lenders. While the decision ultimately will be made by the top authority in China, economists are debating both sides.

Some believe that China already has a large enough exposure to U.S. Treasury instruments and should diversify its portfolio instead of taking on more U.S. debt. Although they realize the risk is low because, technically, the U.S. Treasury will never default, they still entertain the possibility of a worst-case scenario. In that instance, the U.S. Treasury would print more money, and that’s definitely not a real solution.

Others point out that the whole world economy is linked together. If the U.S. economy is in serious trouble, that will hurt Chinese companies, investors, and consumers. That’s a strong argument in favor of lending money. I think that Chinese authorities will support the bailout, but they may negotiate issues outside of the financial crisis when they do so.

Teaching in a Time of Turmoil

The turmoil has made this an extremely challenging time to teach an investment course, as I did during the fall 2008 semester. At that time, exchange students accounted for about 30 percent of the students taking my course, and we always have international students enrolled. Many of our foreign students were from Europe and the U.S., and they had a deeply personal interest in the financial crisis.

I never knew on any day what major story was going to develop next. While I taught the class, we learned about Fannie Mae, Freddie Mac, the Lehman Brothers, the bailout, the cuts in interest rates, and other news. My first job was to clarify these events for my students. But then I put the information into a historical context.

For instance, I used a Harvard Business School case about the junk bond crisis of 20 years ago. If I changed the words “junk bond” to “mortgage-backed securities” and swapped the names of 1980s investment banks for those of Lehman Brothers and Bear Stearns, the case still worked to show how quickly things can go wrong.

This time has been challenging for students as well. Because the Chinese market was so strong a year ago, making money appeared to be easy, and many students had decided they wanted to go into the financial industry. Now those students are wondering if they’ll actually be able to get jobs in investment banking. The answer most likely is no, at least for the coming year.

Instead of considering this an entirely negative experience, I hope my students treat this as a once-in-a-lifetime opportunity. This is probably the worst situation they will see in their personal and professional lives, and it will demonstrate clearly the potential risks that exist in the financial business. If nothing else, they’ll learn how important risk management is. I think it’s good for students to see a very different kind of economy before they jump into the real world.

The Ultimate ‘Teachable Moment’

Thomas F. Cooley
Dean and Professor of Economics
Stern School of Business
New York University
New York, New York

What has happened on Wall Street is the ultimate teachable moment for a business school. We are seeing not just an economic crisis of global proportions, but the very rapid evolution of the whole international financial architecture. Our students are eager to deconstruct the failures involved and study the way regulation will impact the banking and finance industries. Moreover, they want to understand what the larger implications are for society when the pursuit of profits leads to a systemic breakdown that destroys the wealth of so many.

Since the crisis began, the Stern School has held several panel discussions and town hall meetings where our students could hear from our economics, finance, and financial history faculty, as well as alumni involved in the financial sector. Students were both excited by the opportunity to learn about such a historic episode and concerned about what it would mean for them and their careers. We have tried to give them a realistic message. We told them there will be challenges in the short run, but even financial crises and recessions end. Business will continue to be a powerful force for social change; there will still be careers for students with a passion for finance.

It is essential, however, that we teach students to do more than learn what’s happening right now. We can’t prepare students for careers in business just by talking about the way business is done today or was done in the past, or by adhering narrowly to case studies. If we don’t talk about the future, we impoverish the whole notion of education for careers in business.

This Disaster Won’t Be the Last

Gaining a perspective on Wall Street beyond the present is easier said than done: After all, the systemic effects of this financial breakdown have made this crisis extraordinary. The housing meltdown has magnified the loss of wealth on the balance sheet, making this event bigger than the dot.com bubble of the 1990s. Our students and faculty must understand what happened, what incentive systems broke down, and why our system of checks and balances failed.

Business is still the most powerful social institution in the world. Business will go on and go forward.
Thomas F. Cooley, New York University

But students also must realize that this isn’t the first speculative bubble, and it won’t be the last. The history of banking and finance provides many examples of financial crises, but the lessons of history are easily forgotten. Therefore, we must help students develop the analytical tools that will help them understand this crisis and prevent—or, at least, manage—the next one. It’s very clear that they have a lot of work to do.

Research-driven business schools can help students in this way, because research helps us understand underlying fundamentals. Students must learn to think analytically and critically, not just reference current or past business practice. Through their research, faculty not only can decipher and explain current issues, but they also can lead the business and policy dialogue that aims to solve similar problems that might arise in the future. The structure of markets, the regulatory system, the credit rating agencies, financial derivatives, mortgage finance, incentives, and compensation—all these issues will fuel business school research for years to come.

Respect for Interconnection

These issues also reinforce our understanding of our interconnected global economy. In recent years, there has been some discussion of how economic growth has allowed other countries to decouple from the U.S. economy. It has been tempting to think that we live in a “brave new world,” where one country’s economy could prosper even if another’s failed. Clearly, that’s not the case. We now can show students just how interconnected the financial system is.

But the sudden and disastrous nature of this crisis has shown us another revealing truth: If we don’t tend to each part of this system with care and respect, we imperil the whole structure. Our students must know why those connections matter and how they work, if they are to be its stewards in the future.

After Enron’s collapse, I remember being asked how business schools could be training people with so little respect for the truth—how the company’s executives could engage in such deception. I say now what I said then: We must acknowledge our failures. We live in a complex world, and this set of events is a huge disgrace for Wall Street and much of the financial industry. We must be honest about the causes and be part of the solution.

But at the same time, we must recognize that the world financial system is the circulatory system for the world economy. We may need to adjust our regulation of our old capitalist model to make it run smoothly, but we don’t throw that model away. Business is still the most powerful social institution in the world. Business will go on and go forward. That’s why I think it’s so important for business schools to use this crisis as a springboard for discussing the social impact of business.

An even bigger lesson: The most stunning thing about recent events is that they didn’t happen because people wanted them to happen. They happened because people acted on assumptions that they thought were right. Then, they watched as the crisis unfolded at warp speed. That’s what makes this the ultimate teaching moment.

The reality is, students will work in a fast-changing, globally interconnected, often unpredictable world of business where the decisions they make can have real consequences. If students learn nothing else from this economic meltdown, they must learn just how interconnected banking and finance are within the larger economy and how globally interconnected our economies are to each other. They cannot escape these realities anymore.