David Pitt-Watson is a pioneer in the field of responsible investing. He is a fellow and former Pembroke visiting professor at Cambridge Judge Business School. He is a winner of an FT 2024 Responsible Business Education award.
No one can doubt the profound importance of the finance industry, yet it is held in deep disregard by those it is there to serve. This raises questions about the way we study finance and whether it helps the industry to do its job better.
It is impossible to imagine addressing the most critical issues we face — economic growth, climate, poverty, ageing populations — without the participation of the world of finance. But, when a Bank of England survey asked British people what single word best summed up their view of the finance industry, they chose “corrupt”.
To me, as a finance practitioner, that judgment seems galling. It is simply not the case that those I work with are corrupt. As someone who has spent much time devoted to corporate governance, I am struck by the fact that the structure and accountability of UK company boards have improved greatly over the past 30 years.
This has mainly not been done by law, or incentives, but by good people, from Adrian Cadbury onwards, who have advocated for best practice. If it were not for them, our financial system would not work. As Alfred Marshall stressed in his 19th-century book Principles of Economics, the system depends on a “spirit of honesty and uprightness”.
One shining, but rare, example, is 2006 Nobel Peace Prize winner Muhammad Yunus, a banker who loaned money to the poor to let them invest productively, lifting thousands out of poverty. This he did not by any mathematical insight, but by a new, human approach to underwriting: lending to women in groups for purposeful investment.
More broadly, however, the public’s condemnation of the finance industry is not entirely wrong. The evidence that it serves itself too much and the outside world too little is all too apparent. Consider high-frequency trading: a costly activity which, if undertaken in real time, could look like front running (trading with prior knowledge of imminent similar trades) and hence illegal.
Academic studies also point to a problem. French economist Thomas Philippon estimates the efficiency of the industry over 120 years by calculating the cost of accepting a dollar of savings from the “real world” and reinvesting it back in the “real world”. Technological innovation should suggest significant productivity gains, but there has been almost no reduction in cost passed on to consumers.
There is a set of techniques about how financial decisions should be taken — much of it quite mathematical — that constitutes the core of what we teach in business schools. It includes present values; theories of capital structure, portfolios, options; capital asset pricing; and efficient markets.
But it seems these have not been enough to create a more efficient industry, still less one focused on addressing the pressing problems the world faces, where finance has such a vital role to play.
Why is it these mathematical theories underpin the way we study finance? Some argue that finance and economics suffer “physics envy”, with any conclusion required to be the result of statistical proof. But the finance system is a human system. It is not, as in physics, composed of inanimate objects, which always behave in the same way.
Every City practitioner understands that working with people whose word is their bond is very different from a world where people only work to contract. Maths does not explain fiduciary duty. Classical economics imagines us all as self-interested homo economicus. Yet anthropologists find no societies characterised by such amorality.
This is not to say that these theories don’t have their place, or that markets and competition are unimportant. But neither are institutions, information, laws, professionalism, fiduciary duty and ethics. They are dynamic, not static. That suggests that our academic curriculum must stress that these characteristics are as central to the effective working of capital markets as the elements that have come to dominate what is taught.
The implications of the Philippon study should surely be debated in every finance degree. The nature and limits of fiduciary duty, which demands we set aside personal interest, need to be fully understood. The design of institutions and the incentives that encourage purposeful behaviour need to be constantly in our minds.
Beyond academia, if we turn a blind eye to how well our financial institutions are fulfilling their function, we will end up with less purposeful financial systems. High-frequency trading, for example, may fill the coffers of the stock exchange but, if the number of companies raising money has fallen, that is surely a sign that a core purpose of the stock exchange is not being fulfilled.
There is a deeper danger if all we teach is a narrow curriculum. The evidence suggests that, if students learn models built on homo economicus, they will respond by becoming more self-interested and behave as though the rest of the world is similarly selfish. That would be a step backwards. Bad theory will replace good practice.
We need a radical reappraisal of the way we think about and study financial markets. Not because today’s approaches are entirely wrong, but because they are partial, and thus blinkered. We need to incorporate all the elements that contribute to the creation of a purposeful industry.
We need a system that encourages markets in which institutions are well designed to meet their purpose. It should encourage us to recognise the better angels of our nature, and reward those who focus on fiduciary responsibilities. When people look at our finance industry, they should be proud that it is playing its part in addressing the problems the world so desperately needs to address.
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