December 18, 2009

Quantitative Ethics

Bruce Kogut considers who should bear the burden of examining — and addressing — the consequences of financial innovation.


Financial innovation is often admired because it belongs, by appellation, to the category of innovation. Recently, it has attracted a lot of negative attention. We don’t have major public debates on whether Intel’s latest chip reduces the demand for labor and is responsible for unemployment. Nor do we argue about whether industrial innovations are systemic — which they are — in their implications and should be curbed. Why then is there such debate over financial innovation? After all, innovation is a driver of economic growth and wealth, so why all the fuss?

First, consider the disparity between social and private value. Many people remain unconvinced that financial innovations add social value commensurate with the private value they have provided to a relatively privileged few. The finance industry grew from a few percentage points of U.S. GDP over a decade ago, to 8 percent of U.S. GDP and a sizeable share of corporate profits prior to the crisis. The profits are net of wages, which are highly skewed toward rewarding a small fraction of all wage earners.

These numbers do not point only to questions of disparities in income and the associated power implied by these disparities — though these are important considerations for any democracy. They also prompt the question as to whether financial innovations have created excess profits for reasons that have not been adequately explained and justified. It is very reasonable to think that financial markets are not highly competitive and thus firms capture more value than they would under competition. The division of social and private value can also result from the provision of social insurance, such as federal deposit insurance and too-big-to-fail moral hazards, whose costs are borne by society at large rather than by the financial sector itself. In innovative industries such as pharmaceuticals, the government grants legal but inefficient protection, such as patents, because of a belief that the social costs are compensated by social benefits. This compensation is, at first glance, less compelling in the case of many financial innovations.

Second, consider the commonly-held belief that financial innovation leads to the proliferation of systemic risk. There is frustration that practitioners of finance, proud of the field’s scientific foundations, do not have the open debates found in other scientific fields concerning its relationship to society at large. It is reasonable to ask in what ways financial innovation is different than nuclear power plants or new technologies that have negative consequences for the environment. If financial transactions were often simply a game among poker players — the analogy made in Michael Lewis’s book Liar’s Poker — then there would be less debate. However, the unintended and negative consequences of many financial innovations are apparent and massive. A great frustration stems from the refusal of firms and universities to acknowledge that financial innovations pose great implications for society and impact innocent bystanders.

Third, financial innovations move at rapid speeds. I have shared with the sociologist Donald MacKenzie, who was a recent guest of the School at a conference that examined many of these questions, a fascination with tacit knowledge, the idea that innovations are slowed down in their diffusion because they are not well understood. Today, as opposed to 30 years ago, quantitative financial innovations are quickly identified and understood. In his book A Demon of Our Own Design, MIT-trained risk management expert Richard Bookstaber has described how his Japanese clients bought the minimal amount of his derivative products in order to backward engineer them — much like we used to hear how Japanese firms would backward engineer new microchip innovations. Many countries produce well-trained physicists, mathematicians and engineers in greater relative abundance than the U.S. and quickly adopt and further diffuse financial innovations with profound effects on communities and countries across the world. In other words, financial models diffuse so fast and so globally that their systemic risks are often hard to test except in real time.

These are a few reasons why we might be concerned about such models, and they might give concern to those who believe, often rightfully so, that few understand the positive contributions of financial innovations. However, if we are to benefit from such innovations, we need to consider the validity of the criticisms and the mechanisms by which the gap between social and private value might be closed. In my view, this starts off by building better fail-proof systems that begins with the moment of invention. Here we can learn more broadly from the field of science and technology.

In the popular imagination, technology often provokes a Frankenstein reaction, whereby our innovations end up killing the master. In the case of financial innovations, there might be some truth to this. But there are larger issues. Many of us who like science fiction might be familiar with Asimov’s three ethical laws of robotics, of which the first is that no robot should harm a human being. A robot is software that propels hardware and a financial innovation is ultimately software that propels computers, humans and organizations to take financial actions. I would like to make the simple claim that financial engineering has violated Asimov’s first principle in the recent crisis: models behind the software are not neutral.

Who then bears the ethical responsibility to restore this principle? The social implications of financial innovations might be addressed by better risk management, self-regulatory bodies (for example, derivative exchanges), government regulation or professional principles of software design. It would be odd to blame the software and better to look to the financial practitioners who use the software or to those who design it. I am persuaded that they must not be permitted to shirk responsibility. In other words, the ethical implications of financial innovations should be built into the education of financial engineers and finance practitioners. And if we cannot trust the latter to think in reference to ethical and reasoned principles for the design and management of financial innovations, then the search for solutions will turn to regulation or to law or to prohibition. Financial innovations are the amazing product of considerable science — and it is time to drop the illusion that this science is without social consequences any more than other sciences, be it physics or chemistry or biology.

Bruce Kogut is the Sanford C. Bernstein & Co. Professor of Leadership and Ethics in the Management Division and the director of the Sanford C. Bernstein & Co. Center for Leadership and Ethics at Columbia Business School.

This piece is adapted from remarks given at the research symposium, “The Quantitative Revolution and the Crisis: How Have Quantitative Financial Models Been Used and Misused” at Columbia Business School on December 4, 2009.

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