Finance isn’t evil but incentives can be

Remuneration incentive schemes are at the heart of problems in finance, and need to be overhauled to reflect long-term effort, Mihir Desai, professor of finance at Harvard Business School and professor of law at Harvard Law School told delegates at the CFA Institute Annual Conference in Hong Kong.

Corporate governance is the most important problem in modern capitalism, Desai said, pointing to the fact that 150 years ago ownership and control were not separate, so the corporate governance issues that exist today were not present.

“Why do investors trust managers with their money? All of finance is one big daisy chain of principal agent problems,” he said.

At the heart of the issue, he said, is remuneration incentive programs.

“The massive experiment of modern finance is incentives as a way of aligning interest but it hasn’t worked out that well, and now we are in an incentive bubble,” he said.

Desai advised that incentives need to be changed to apply to the “extremely long run”, and suggested that they measure 10-15 years.

“Why have we bought into this logic that you have a liquidity moment in three years?” he asked. “We should be thinking 15 years out – it’s absurd.”

Further, Desai said quarterly reporting in itself was not a big deal, but the incentive structures tied to it could be destructive.

“I’m more interested in changing the incentive programs,” he explained, and suggested that this needed to be a structural shift in finance leadership.

In his book The Wisdom of Finance: Discovering humanity in the world of risk and return, Desai argues that the disciplines of finance and humanities can work together to better explain the value, and values, in finance.

“Finance is special in many ways; if you invest, you get feedback every day. There is “attribution error”, in which people interpret every good outcome as their doing and every bad outcome as the world’s fault.

“In finance, you believe you are really good at what you do, but you need a lot of data to prove that,” Desai said. “You never know if you’re skilled until the end of your life. Better to act as if it is luck than skill.

Desai also argued that finance needed “humanisation”.

“The gulf between finance and humanities is a real loss,” he said. “We need to demystify finance for people and humanities can play a role in that, via storytelling. Finance needs humanisation. If it’s all about screens and graphs, you lose a touch on humanity.

“We need to own up to the problems we created, to acknowledge that there is value extraction going on.”

For its part, he said the humanities area needed to lose its caricature of finance as greedy and evil, and argued instead that finance was “a noble set of ideas, no matter the current state of practice”.

“The most important issues humans face are finance – their homes, their education and their retirement and it needs to be de-demonised,” he said.