Bad teaching leads to world financial crisis

In a nutshell Cossin is of the opinion that many business schools are teaching students financial models that, to some extent, are responsible for the 2008 financial crisis. And his prognosis in the “Financial Times” is even more sinister: “Unless business schools make a rapid reassessment of these flawed financial tools they run the risk of fatally damaging their credibility and in turn letting down a generation of MBA students.”

These are Cossin’s arguments:
- From 1970 onwards, finance education promoted a theory of finance that resembled a scientific subject such as physics, based on theorems and mathematical proofs. Most financial models taught today rely on these – false – mathematical assumptions that create a sense of security even as failure approaches.
- There is nothing wrong with using advanced mathematics to resolve problems and develop theories. The problem arises when one simplifies the world in order to make it fit a mathematical model.
- Corporate decisions, as well as market prices, are the result of complex individual choices, involving many stakeholders such as employees, customers and taxpayers, and cannot be moulded to obey a financial theory. Today’s financial theories do not account for such complexity.

Cossin then discusses the Modigliani Miller (MM) Theorem, a fundamental theory at the core of corporate finance. Its basis is that financial markets can act as a substitute for corporate, regulatory or government decisions. Anything can be “arbitraged”. This in his view has “led to the belief that financial market choices can replace corporate decisions, even though they do not take into account different stakeholders – employees, environment, society, etc.”

MM is part of the reason why banks assumed healthy positions in securitising mortgages into complex structures that could adapt to market forces, the so-called collateralised debt and mortgage obligations at the heart of the financial crisis, writes Cossin in the British daily. “It was thought that these positions would not hit the real economy. The same thinking has also framed current regulation and financial views and is perpetuated through years of education in business schools and elsewhere.” Cossin is also very critical in regards to Black and Scholes, a theory to price share options, agency theory and other finance models based on simplifying complex choices.

He concludes: “These theories must be scrutinised and then abandoned as models for the future. As business schools and institutions continue to preach these principles, they perpetuate a fundamentally flawed system of thinking.”

Sources:
IMD
Financial Times