by: anjan v. thakor ecgi and john e. simon professor of finance at washington university in st....

The Real World and the World of Research:

A Battle of ParadigmsBy: Anjan V. Thakor

ECGI and John E. Simon Professor of Finance at Washington University in St. Louis

Keynote Address for the 2011 International Finance and Banking Society (IFABS) Conference, Rome, July 2011

July 1, 2011

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“Of all the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself…

For in the end, economists are social scientists, trying to understand the real world. And the financial crisis has changed that world.”-The Economist

“The recent financial crisis has damaged the reputation of macroeconomics largely for its inability to predict the impending financial and economic crisis…

Modern Cassandras will always claim to have seen the crisis coming. What they will not say is how many times they saw things coming that never materialized, or how the specific mechanisms behind the crisis are different from those on which their predictions were based…

What does concern me about my discipline, however, is that its current core – by which I mainly mean the so-called dynamic stochastic general equilibrium approach - has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision it has achieved about the real one.”-Caballero (JEP , 2010)

“Most of mainstream macroeconomics is dead. It’s a zombie”. -L. Randall Wray, Businessweek; January 17-23, 2011

The recent financial crisis has caused us as academics to fundamentally re-examine our own paradigms in various subfields of Economics and Finance...

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I would extend Caballero’s remarks to Finance as well… We have “become so mesmerized with” the “internal logic” of our own models that we have begun to confuse the precision we have achieved about the world of our models “with the precision it [our field] has achieved about the real one”.

WHAT IS THE CONSEQUENCE OF THIS? A plethora of “anomalies” that are hard to explain!

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Greenwood and Hanson, “Issuer Quality and Corporate Bond Returns”, HBS WP, December 2010.

** Paper finds that when times are good in terms of how investors assess corporate bond risks, there is a surge in bond issuance by relatively low-quality (high risk) borrowers.

Subsequent excess returns (corporate bond yield – riskless rate = credit spread = expected credit losses + expected excess return) on high yield and investment-grade bonds are low and often significantly negative.

“The results are difficult to reconcile with integrated-markets models in which the rationally determined price of risk fluctuates in a countercyclical fashion.”

EXAMPLES OF ANOMALIES

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Chiang, Hirshleifer and Sherman, “Do Investors Learn from Experience? Evidence from Frequent IPO Investors”, RFS, May 2011.

** Paper documents that personal experiences with IPO auctions affect the decisions of individual investors and institutions to bid in future IPO auctions.

** Investors who enjoyed good early returns bid more aggressively subsequently and experience deteriorating subsequent returns.

EXAMPLES OF ANOMALIES (con’t)

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Malmendier and Nagel, “Depression Babies: Do Macroeconomic Experiences Alter Risk-Taking”, forthcoming, QJE.

** Paper finds empirically that those who were born during or lived through the Great Depression exhibit very different risk-taking behavior from that exhibited by those who learned about it only through the history books.


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Billett and Qian, “Are Overconfident CEOs Born or Made? Evidence of Self-Attribution Bias from Frequent Acquirers”, Management Science, June 2008.

** CEOs who initially enjoy better performance with acquisitions are more likely to undertake future acquisitions, even when this superior initial performance turned out to be followed by negative performance on subsequent acquisitions.


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Fahlenbrach and Stulz, “Bank CEO Incentives and Credit Crisis”, JFE, 2011.

** Establish two stylized facts:- Executive compensation was only a small portion of

the wealth of bank CEOs, with stock holdings in their own banks being major portion;

- Prior to the crisis, bank CEOs did not reduce their stock holdings in their own banks.

** How could this be if bank CEOs were greedy rascals deliberating taking “tail risks” to exploit government guarantees and therefore saw the Titanic sinking before others did? That is, how do we square this with…


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Greedy Bankers taking excessive risk to exploit government safety net (old insight revived)

“But this is not a crisis caused by the failure of complex financial instruments. This is a crisis caused by the failure of leaders on Wall Street.

The Heads of firms like Bear Stearns, Lehman Brothers, AIG, Countrywide Financial and Washington Mutual all too often sacrificed their firms’ futures in order to maximize short-term gains. This meant under-pricing of risk in exchange for immediate fees and taking on inordinate levels of debt to invest in complex, highly uncertain instruments.”

-Bill George in “Wall Street’s Crisis of Leadership,” Bloomberg BusinessWeek, October 3, 2008

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None of these phenomena can be explained well within a framework of Rational Expectations...

AND...

A modeling view of the world that everything we observe can be put inside TWO (and only TWO) buckets: Agency AND Asymmetric Information/Signaling.

SIMPLE TRUTH

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a) Rational Expectations often do not describe beliefs and revisions of beliefs;

AND

b) There’s more to the world than asymmetric information and moral hazard

MY MAIN POINT IS THAT…

CLASHOUR PARADIGMS

REAL WORLD

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On average, expectations are “rational” (correct) about the future

RE paradigmBelief revision is Bayesian

But…evidence says both assumptions violated in practice◦ Agents do not consistently make rational, unbiased

forecasts of the future◦ Belief revision often deviates from Bayes rule

RATIONAL EXPECTIONS (RE)

ILLUSTRATION OF FAILUREOF RATIONAL

EXPECTATIONS

RATIONAL EXPECTATIONS?

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So…If it’s not rational expectations, what kind of beliefs do agents have?

Experience-Based Beliefs.

“Experience keeps a dear school, but fools will learn in no other, and scarce in that; for it is true we may give advice, but we cannot give conduct.” —Benjamin Franklin

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Agents revise beliefs based only on their own personal experiences, not those of others. More generally… agents attach more weight to what they learn from personal experience.

Agents view all events based upon which they revise their beliefs as being linked to their own personal talent or skill. That is, when it comes to outcomes they are personally associated with, agents revise beliefs based on the premise that these outcomes are influenced by their talent/skill levels.

EXPERIENCE-BASED BELIEFS (EBB)

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A. FIRST PAYOFF OF EBB : A NEW THEORY OF FINANCIAL CRISES

In my new working paper: Success-Driven “Pretense of Skill” and Financial Crises…

I develop a theory of financial crises that explains why crises should be expected to follow periods of success as defined by sustained banking profitability.

Idea:- Agents revise beliefs based on their own experiences and believe that outcomes are influenced by the talent/skill of the agents managing the assets that are associated with these outcomes.

- Initially, banks cannot invest in risky new securities because nobody thinks they have the skills to manage the risks.

- So they invest in prudent and safe assets.

EBB: THE PAYOFFS FROM A DIFFERENT APRROACH

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These prudent/safe assets pay off and banks enjoy sustained profitability

Beliefs about banker’s skills go up

Now banks invest in risky new securities and investors are willing to fund them, and regulators are willing to let them

Then…

investors sometimes get signals about the true success probabilities

Liquidity vanishes and crisis ensues.

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Why banks tend to keep capital levels prior to crises that seem too low ex post after the crisis has occurred and why risk managers are often ignored prior to crises;

Why bank CEOs are paid relatively high levels of compensation prior to crises and they appear to make risky bets that contribute to those crises; and

Why bank regulators seem to be lax in monitoring banks prior to crises. Not moral hazard, as in…

THEORY EXPLAINS

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“So where were the risk managers? And why weren’t they pointing out the dangers of these practices?...At other banks, risk management was simply pushed aside. At Lehman, in the years immediately preceding its failure, according to Ross Sorkin’s account, the risk manager was actually asked to leave the room when risks were under discussion in executive committee meetings, and she was dropped from the committee in 2007.

…Why do the Guardians of Finance so frequently fail to work for the public at large? The short, perhaps tautological, answer is that the public does not have an effective mechanism for compelling regulatory authorities to act in society’s best interest.”- Barth, Caprio and Levine (forthcoming).

But…EBB!

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With EBB, none of the five anomalies listed earlier are anomalies:

1. Greenwood-Hanson: Good Times excessively bullish (low) assessment of risk

bond price sky rocket and lots of bond issues

very low (negative) subsequent returns

2. Chiang-Hirshleifer-Sherman: Positive personal experiences with bidding in IPOs

excessively bullish assessment of personal talent

low subsequent returns

3. Malmendier-Nagel Personal experience with Great Depression

cautious behavior

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4. Billett-Qian:Good personal experience with initial acquisitions performance

excessively bullish assessment of talent in acquiring firms

poor subsequent performance

5. Fahlenbrach-Stulz:None of the CEOs saw crisis coming.Good personal performance in bull market

excessively bullish assessment of risk-management ability did not sell own stock in time

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B. SECOND PAYOFF OF EBB : FUNDAMENTAL DISAGREEMENT (GOING BEYOND AGENCY & ASYMMETRIC INFORMATION/SIGNALING)

• EBB explains why people may have heterogeneous but rational beliefs. These beliefs are “rational” in the sense of Kurz (they cannot be invalidated based on past data), but they do NOT necessarily satisfy Rational Expectations.

• If different agents all observe the same data and have different prior beliefs (all consistent with historical data but heterogeneous because each agent assigns more weights to his own personal experiences than experiences of others), then various phenomena can be readily explained:

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1. Dittmar and Thakor: “Why Do Firms Issue Equity?”, JF, 2007.

2. Boot and Thakor: “Managerial Autonomy, Allocation of Control Rights and Optimal Capital Structure”, forthcoming, RFS.

3. Boot, Gopalan and Thakor: “Market Liquidity, Investor Participation and Managerial Autonomy: Why Do Firms Go Private?”, JF, 2008.

4. Van den Steen: “Interpersonal Authority in a Theory of the Firm”, AER, 2010.

5. Van den Steen: “Rational Overoptimism (and other Biases)”, AER, 2004.

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Crisis made us poorer financially but richer in research ideas. Greater receptivity to new ideas that reinvigorate the profession

May be time to look beyond RE, agency and asymmetric information/signaling models to different ways of looking at the world. Upheaval is needed in all areas.

Banking: crises, capital requirements, optimal regulation? View that leverage is good and equity is costly may be misguided (at least for the reasons in existing models).

Asset Pricing: Successor to CAPM?: Problem is too many “successor claimants”.

Corporate Finance: Corporate governance, internal governance, capital structure and interaction with firm boundaries.

CLOSING REMARKS

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EBB may be useful alternative to RE

Disagreement may be useful addition to agency and asymmetric information/ signaling tool kit.

THANK YOU!

CLOSING REMARKS

by: anjan v. thakor ecgi and john e. simon professor of finance at washington university in st....

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