Monday, March 30, 2009

Blaming BSchools

As a graduate of a business school myself, I've taken great interest in reading about the current crisis will shape how these educational institutions operate. However, I've had some problems with how I've seen the story approached.

First, I'm pretty sure I remember seeing a few of stories that imply that focusing on shareholder value encourages managers to make immoral decisions that harm society. To most people, I'm sure, that vague concept of shareholder value does conjure images of a company fattening its profit margins by destroying rainforests and exploiting foreign workers. But the situation is really much more complex.

Let's take, for instance, the case of a company that wants to tear down an historic building for a new factory. Management expects the plant will be wildly profitable, but locals have been protesting the demolition of the existing structure. Manager A might indeed forge ahead, salivating at the double-digit profit margins he expects the factory will produce. But Manager B might not, realizing that the bad press, boycotts and lawsuit that will no doubt ensue will cut into those profits and lead to a loss. Contrary to the typical characterization of the term, the company would actually maximize shareholder value by NOT building the factory.

I argue that part of the crisis is actually attributable to the fact that management didn't focus enough on maximizing long-term shareholder value. Instead, as has been well documented, bankers and traders at Wall Street banks enriched themselves at the expense of shareholders thanks to a bonus system that encouraged short-terms gains. They reaped rewards creating and investing in products that have led to billions in shareholders losses in the long-term. A quick look at the stock charts tells you that, if anything, these people have minimized shareholder value.

And I'm not sure there is an easy fix to that selfish behavior. Business schools are obviously going to attract people that want to make money. Not all these people are bad people, but for the ones that are, taking an ethics class or two, as some have suggested, isn't going to stop them from making self-serving decisions in the future.

That said, there are parts of the business school curriculum that must be reassessed. Schools continue to teach the financial theories responsible for the Crash of 1987, the downfall of Long-Term Capital Management and the current crisis. As Nassim Taleb -- one of the most vocal critics of business schools* -- points out, for some reason, people still take the word of people like Nobel Prize winner Myron Scholes as gospel despite his role developing the theories that have gotten us into the mess we're in:

First, [Taleb] says, we have to unmask the charlatans of risk like Myron Scholes. To Taleb, Scholes is the Great Oz in this Emerald City because his work on options and derivatives allowed the whole of the financial system to adopt poorly understood products-like the ones that brought AIG down-that hide risk. To Taleb, Scholes' academic work, which enabled the widespread use of complex derivatives, was like "giving children dynamite."
"This guy should be in a retirement home doing Sudoku," Taleb says. "His funds have blown up twice. He shouldn't be allowed in Washington to lecture anyone on risk."

To me, schools continuing to teach these theories seem like a much bigger issue.

* Here's a sample from Fortune:
I worked on Wall Street for close to two decades in trading and risk management of derivatives. I noticed that while portfolio models got worse and worse in tracking reality, their use kept increasing as if nothing was happening. Why? Because in the past 15 years business schools accelerated their teaching of portfolio theory as a replacement for our experiences. It looks like science, and they have been brainwashing more than 100,000 students a year. There is no way my experiences can be transmitted to the next generation because of these schools. We've had fiascoes in finance that they need to neglect because they contradict their models. The problem may also be the Nobel in economics that gave a stamp to these junky theories. Someone needs to make the Nobel committee account for this, for the damage to society - and I hope to do so.

Also see this interview from Bloomberg.

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