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The European Financial Review October - November 2013

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Rethinking the Wisdom of the Crowd ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••

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Motivating Diverse Salespeople via a Common Incentive Plan

The Surprising Power of (a Lack of) Numbers

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The European Financial Review October - November 2013

Contents Risk Management

5 Winning with Risk Management: Focus on Operational Risks Russell Walker 10 Manage Third Parties and Manage Your Risks Adam Turteltaub


14 Banking on Technology: the David and Goliath of Financial Services Philippe Eschenmoser 17 Becoming A More Innovative Culture: From Assessment To Action Jay Rao & Joseph Weintraub 22 The New Emerging Market Multinationals: Four Strategies for Disrupting Markets and Building Brands Amitava Chattopadhyay, Rajeev Batra & Aysegul Ozsomer 27 Rethinking the Wisdom of the Crowd: Why Individuals are More Creative than their Groups Leigh Thompson & Elizabeth Ruth Wilson



Business Development Editors Ian Love Marcus James Mellisa Ford Production Saul Luckman Charlotte Godfrey Illustration Mark Hithersay Nigel Sirett

35 Opportunities for Businesses Caused by the Challenge of Climate Change Matthew E. Kahn

Head of Finance Lynn Moses

39 India Makes CSR Mandatory: A Really Bad Idea Aneel Karnani

Editor in Chief The European Financial Review Publishing Oscar Daniel

42 The Surprising Power of (a Lack of ) Numbers Jingjing Ma & Neal J. Roese


51 Identity and the Economics of Organizations George A. Akerlof & Rachel E. Kranton


Commissioning Editors Rebecca Lord Nisha Khimji Natasha Scott Krithika Natarajan Simon Rosenthal

33 Alphabet International: Capturing the eMobility Zeitgeist with AlphaElectric

47 Motivating Diverse Salespeople Through a Common Incentive Plan Doug J. Chung, Thomas Steenburgh & K. Sudhir

Global Economy

Editors Jane Liu David Lean Elenora Elroy

The views expressed in articles are the authors’ and not necessarily those of The European Financial Review. Authors may have consulting or other business relationships with the companies they discuss.

56 The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy: The Case of Europe Michael Pettis

The European Financial Review 113 Sternhold Avenue London SW2 4PF Tel +44 (0)20 8678 8991 Fax +44 (0)20 7000 1252

61 The Ethical Economy – Rethinking Intangible Value Adam Arvidsson & Nicolai Peitersen

67 Time to Win Investors Over Baruch Lev

Copyright © 2013 EBR Media Ltd. All rights reserved.

70 Putting Mind into Markets David Tuckett

No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without written permission.

Given such a diverse set of abilities and levels of motivation, how can companies design a single plan that motivates everyone to work to the best of their abilities?" Doug J. Chung, Thomas Steenburgh & K. Sudhir Management, p 45

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Risk Management

Winning with Risk Management: Focus on Operational Risks By Russell Walker Operational risk in financial service firms is largely selfinflicted and the losses mainly preventable. Below, Russell Walker suggests that firms should be proactive about operational risk management and in doing so seek to develop competitive advantages in operations.


he current regulatory spotlight on banks’ operations continues to illustrate the importance of processes, especially those that impact customers and markets. Recent fallout for the industry has included new regulation, a downturn in public sentiment towards financial firms, and large and numerous fines imposed on banks for various customer-facing actions, stemming from operations and practices. Such events confirm that firms must place greater emphasis on operational risk even though operational risk remains difficult to detect at times. And while operational risk can initially appear as unexpected credit or market losses, it can impact firm reputation and lead to unwelcome regulation. Preventing this dangerous contagion of operational risk must be a priority. Thus, firms should be proactive about operational risk management and, in doing so, seek to develop competitive advantages in operations.

While operational risk may appear as unexpected credit or market losses, it can impact firm reputation and lead to unwelcome regulation.

Focus on Operational Risk In the banking and financial services industry, the Basel Accords define operational risk as risk coming from ‘inadequate or failed internal processes, people and systems, or from external events’.1 This definition is broad and does not specify the exact causes of operational risk, but primarily highlights that a firm’s operations drive operational risk, not the firm’s investments. However, operational risk can also be embedded in other activities undertaken by the enterprise, even though firms do not take on operational risk explicitly as they would market risk or credit risk. The Basel Accords definition also fails to illustrate that operational risk often gives rise to related or additional risks. The financial crisis of 2008 is a prime example of when bad operational practices create systemic risk, which, after an economic shock, left few parts of the industry unscathed. Such events are troublesome to the business, but

can be remedied by processes that can ensure containment. Additionally, while firms may initially just experience credit and market losses, these can open the door to regulatory risk or new rules that will alter profitability going forward. Following the financial crisis, a new emphasis on consumer advocacy, the increased role of governments in the financial industry, and countless lawsuits and large fines all signal an uncertain climate for financial firms and greater scrutiny on operations. In sum, these new perils do not come from credit or market exposure directly, but rather from how firms conducted business and how it impacted customers.

Preventing reputational risk is best done by preventing operational risk that leads to negative customer impacts.

Reputational risk – a byproduct of operational risk contagion In a communication to banks, the US Federal Reserve defines reputational risk as: ‘the potential that negative publicity regarding an institution’s business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions’.2 Here, the US Federal Reserve links reputational risk to operations via the mention of ‘practices’, indicating management of reputational risk should be implicit in the business operations of the firm. And for many in financial services, reputation and trust are the hallmarks of their relationship with customers. However, while many firms worry about the loss of customer trust, reputational risk is challenging to quantify because it is unclear which constituents will react negatively to the firm and to what degree they will do so. Still, the storied example of Lloyds of London paying in full all claims stemming from the 1906 San Francisco earthquake (and that it is remembered today) is testament to the importance of reputation in the insurance industry.3 On the other hand, the accusations against the audit and accounting firm Arthur Andersen brought about its downfall, and the acts by various insurers in the 1980s and 1990s to deny and reduce asbestos claims harmed insurance-customer relations for many years.4 Investments to reverse reputational harm are generally expensive but as the realities highlight, harm may linger, and indeed be impossible to correct. Preventing reputational risk is best done by preventing operational risk that leads to negative customer impacts.


Risk Management

Regulatory risk – another byproduct of opera- Success in Operational Risk Management5 Look for explanations to ‘unexpected loss’: When credit tional risk contagion Regulatory and reputational risks share an important and unfortunate similarity: they are often perpetuated by an offended or motivated agent (regulator or customer) who is seeking a judgment or penalty against the firm for harm. The recent movement by U.S. and European governments to enact new regulation in financial services and other consumer-facing industries has drawn new attention to the harms associated with regulatory risk. First, regulatory risk can be a game changer in the industry in that it can help some market participants and harm others. Specifically, regulations may not be objectively applied and may even be directed at specific market participants for political or economic reasons. Second, these risks, when manifested, cannot be directly controlled by the firm through internal operations.5 Third, firms may face punitive damages, the extent to which may depend on the firm’s reputation. The potential economic impact means that firms must consider reputation and regulation risk to holistically consider operational risk. It is often operational risk and its impact to customers that provides regulation an open door to the firm.

In a world where operations are complex and scale across millions of accounts, focusing on the small details in operations is critical and will reduce operational risk.

Operational risk is hidden in product performance What results when a bank that issues mortgages fails to confirm borrower income during the loan application? The missing information means that credit information is subject to error and misrepresentation. The error is not due to a credit policy but rather to an operational failure to confirm input data. This operational risk would well result in the bank experiencing higher loan default and higher loan delinquencies than predicted, relative to pre-issuance credit expectations. More dangerously, the impact of this not-so-uncommon operational error may not be seen for years or decades, making detection and containment challenging. Separation of the operational risk from the credit risks of the product becomes more troublesome. Fixing the problem does not come from changing the credit policy but from improving the process to confirm borrowers’ income. Despite these aforementioned challenges, there are important steps a firm can take to overcome operational risk and to develop a competitive advantage.


The European Financial Review October - November 2013

losses materialise and the losses are higher or realised sooner than expected, it is tempting to assign the errors to the product design or to critical underwriting assumptions. Often these are the causes. However, it could be that these errors stem from failed processes or customer selection, the result of marketing, underwriting, or management practices. It is important to determine how an unexpected loss comes to the firm. Is it because of the execution or the policy? If the loss stems from execution, it is operational risk. Measure the losses – bring focus to the errors: Measuring losses is necessary so that improvements can be made. Otherwise, operational risk will remain hidden in product risk unless explicitly examined. Create metrics that focus on how operational data links to the profit function in your firm. Measure the operational loss events in dollars lost, ultimately linking the metrics back to the profit function of the firm. This places firm-wide focus on operational risk and is separate from just examining overall losses or claims. In other industries where operations are critical, there has been new focus on the use of metrics to drive errors down. The manufacturing industry and many aspects of call centers have embraced Six-Sigma analysis and LEAN analysis to bring clarity to metrics. Seek explanation for errors: Besides tracking errors and setting team goals to reduce errors, it is important to seek information on how and why errors occurred in the first place. First, dig deep into the aforementioned metrics so

that the erroneous processes or practices can be stopped. Second, develop a corporate understanding of the holistic operational environment. The time spent understanding processes leads to opportunities for improvements, too. In a world where operations are complex and scale across millions of accounts, focusing on the seemingly small details in operations is critical and will reduce operational risk. Finally, encourage the investigation of the unknown, misunderstood, perplexing, and complex. Insights gained from that inquiry become valuable company information and ultimately lead to competitive advantages. This must be a goal motivated by management. Disregarding errors, even small ones, is counterproductive to developing a culture that can address errors.

With the advent of e-mail and social media, it has never been easier for a customer to spread her displeasure, discontent and experience with other customers and regulators.

Create a culture for seeking improvements and for using a data-driven approach to making improvements When investigating errors and losses, it is important to realise that personnel may feel uncomfortable and become defensive if the investigation looks unfavorably upon them or their team. Overcoming this natural human reaction is only possible if a culture is in place that values continuous feedback and all team members see it as their duty to improve and assist in the discovery of errors. Setting this culture and tone is best done by senior management and reinforced with actions that legitimately support and recognise process improvement, audit investigations, and overall risk management as critical to the existence of the organisation. Elevating these functions by authority, title, recognition, resources, and pay, will go a long way in developing a culture that seeks improvement.

Embrace and practice customer centricity With the advent of e-mail and social media, it has never been easier for a customer to spread his or her displeasure, discontent, and experience, with other customers and regulators. Additionally, the speed at which this can happen has never been greater. Customer centricity should proactively be holistic in the treatment of the experience, considering the communication and flow of information, as well as setting expectations for customers’ inquiries. It is important to develop both proactive and reactive processes that focus on the customer experience and use metrics to determine if complaints are resolved or remedied. The benefits of a holistic approach towards customers can also ameliorate the

Understanding and reducing operational risk requires examination of complexity, as well as a data-driven culture that designs internal processes around important metrics. language and accusations that may be used in a legal challenge. Firms that show a history of callousness or customer misdeeds are often subject to greater scrutiny and fines by regulators.

Conclusion Operational risk is increasing in importance, owing to its potential to impact the prudential of the firm and a firm’s relationship with its many constituents (shareholders, customers, and regulators). Furthermore, operational risk losses are increasing in frequency and magnitude, confirming that more operational risk is being realised.6 Understanding and reducing operational risk requires examination of complexity and errors, as well as a datadriven culture that designs internal processes around important metrics. However, it is not about esoteric mathematical models; rather it is about developing an engineering-like understanding for operations and controlling and eliminating errors. This all signals that the management of operational risk ultimately is tied to preventing reputational and regulatory harm. Leading with risk management and developing an approach for winning, despite inherent risks, is winning in business.

About the Author Dr. Russell Walker is Associate Director of the Zell Center for Risk Research and Clinical Associate Professor at the Kellogg School of Management, Northwestern University. He authored Winning with Risk Management, which examines risk management through case studies, with emphasis on operational risk and corporate governance. He is at


1. BCBS (2001), ‘Working Paper on the Regulatory Treatment of Operational Risk’, Basel Committee on Banking Supervision. 2. ‘Commercial bank examination manual’, (2004), Board of Governors of the Federal Reserve System. 3. Lloyds of London, ‘San Francisco earthquake’, Available at http:// 4. White, M., 2004, ‘Asbestos and the future of mass torts’, Working Paper 10308, National Bureau of Economic Research, February. 5. Walker, R., (2013), Winning with Risk Management, World Scientific Publishing Company. 6. Rosengren, E. Risk Management Lessons from Recent Financial Turmoil, President & Chief Executive Officer of the Federal Reserve Bank of Boston. Conference on New Challenges for Operational Risk Measurement and Management, Boston, Massachusetts, May 14, 2008.


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Time to Win Investors Over By Baruch Lev

Managers need to be able to respond to investors’ concerns and regain their trust, but their response is seriously hindered by the numerous myths and misconceptions they hold about investors and capital markets. This article explains why.


bet you believe that most investors are short-term oriented, obsessed with quarterly earnings; that the wide criticism of executives’ pay is unwarranted, motivated by misinformation and envy; that activist shareholders are politically motivated and intruding hedge funds just look to make a quick buck; that guiding investors about the company’s future performance is misguided; that overvalued shares are good; and that independent boards enhance business performance. If you do hold to such beliefs, you are in good company; most executives and board members do. Have I a surprise for you! In my book - Winning Investors Over (Harvard Business Review Press, 2012) - I show that these and other deeplyrooted managerial beliefs about investors and capital markets, which shape their strategies and actions, and false, rejected by rigorous economic and finance research. But slaying myths and misconceptions is only the fun part of my book. It’s the charting of an operational, systematic capital markets strategy to regain investors’ trust

and support that constitutes the main mission of the book. And there has never been a time when regaining investors’ trust was more urgent. Investors in stocks and bonds just came off the worst decade of losses in recent history. If that wasn’t bad enough, they endured a world-wide parade of corporate accounting scandals, led by Enron, WorldCom, Parmalat (Italy) Satyam, (India), Olympus (Japan), Healthcare Locums (U.K.), Nortel (Canada), and SinoTech Energy (China) - a very partial list - as well as a long series of managerial pay excesses and stock options manipulations. No wonder that investors and the public all over the world developed deep resentment and suspicion toward corporations and their managers. And investors vote with their feet, deserting equities in droves and pushing hard for legislation constraining managers’ power and decision space: “say on pay” regulation in the U.K. and U.S. mandating shareholder vote on executives’ pay, and the very costly Sarbanes–Oxley Act (2002) and the recent Dodd– Frank (2010) legislation in the U.S. Investor resentment comes at a stiff price. For the sake of their companies’ success and their own careers, managers obviously need to respond to investors’ concerns, and regain their trust. But managers’ response is seriously hindered by the numerous myths and misconceptions they hold about investors and capital markets, which are a recipe for strategic failure and stagnation. What’s needed is debunking the misconceptions and charting a coherent, practical managerial strategy for dealing with investors and the public at large. Let me briefly present some of the major building blocks of such trust–building strategy.

I. Pay for no–performance. The evidence shows that the wide criticism of managerial compensation is largely warranted. Figure 1, pertaining to the U.S. S&P 500 companies - the largest American enterprises - says it all. The Figure pits the mean 2003–2007 total CEO compensation (horizontal axis) for each S&P 500 company against the company’s same–period mean performance, measured by the return–on–assets (ROA) on the vertical axis. If executive compensation really incentivizes and rewards performance, as advertised, then the dots in the figure should be located closely around a steep, upward– sloping line: the higher the company’s ROA, the larger the compensation. But that’s clearly not the case. In fact, figure 1 is a mess, with no discernable trend. The multiple dots on the lower right side of the graph represent highly paid CEOs who generated meager, if any, return on assets, whereas on the upper left side of the graph are many low–paid CEOs



Figure 1

II. Directors’ independence is not a panacea.

S&P 500 Company-Specific Total CEO Compensation (in $ Million; Horizontal Axis) vs. ROA (in %; Vertical Axis); Averaged over 2003-2008

0.25 0.2 0.15 0.1 0.05 0 0






Sources: Execucomp and Compustat databases.

who delivered handsome asset returns. In between are the expected high-pay-for-high-performance and low-pay-forlow-performance managers, but they are swamped by the outliers, as indicated by the overall statistical correlation of executive compensation and ROA, which is an unbelievable zero! The inescapable conclusion: for too many companies, there is only a tenuous relation between managerial reward and performance; in essence - pay for no performance. Investors and the public cannot be faulted for being irked by that. I didn’t conduct this analysis for other countries, but I doubt the results are very different, because managers’ incentives and corporate governance systems are similar in developed economies. What should be done to restructure managers’ pay systems? Here are the essentials: • Renumerate performance only. Except for the fixed salary - a safety net - all other compensation components (bonuses, stock grants, etc.) should be strictly linked to the company’s performance, measured relative to peers. No automatic bonuses or stock grants.1 • Measure performance by hard-to-manipulate indicators. Net income is easy to manipulate to enhance compensation; “organic” revenue growth (excluding acquisitions), gross margin, and fundamental value – drivers (customer growth, order backlog, cash flows), are “harder” performance indicators. • Grant stock options smartly. Options are useful for attracting talent by high growth, cash–strapped, or early–stage companies. Options also contain managers’ risk, motivating them to invest in growth (R&D, brands, talent). But directors should beware and avoid the widespread options abuses (backdating, repricing). • Heed say on pay vote. This mandatory vote in the U.K. and U.S. is non–binding, yet studies have shown that substantial negative votes tend to occur in firms having excessive, detached from performance managers’ pay. So, a considerable negative say on pay vote should trigger a compensation soul–searching by the board.


The European Financial Review October - November 2013

Jeffrey Gordon, a Columbia University law professor and a leading expert on corporate boards summarized the empirical evidence on the relationship between board independence and company performance as practically non–existent. How can this be? Directors’ independence was the mantra, cure–all– ills solution for corporate governance failures in recent years. However, Enron and WorldCom had boards with a majority of independent directors, as had practically all the financial institutions that collapsed in the financial crisis (Lehman Brothers, Merrill Lynch, Countrywide Financial and AIG). Independence doesn’t assure expertise, vigilance, or courage to face a powerful CEO. That’s why independent directors without specific expertise in the firm’s business (former government officials, civic leaders, certain academics) don’t enhance company performance. “Busy directors,” serving on multiple boards - a common phenomenon worldwide2 - even if independent, are too distracted to contribute to company performance. And directors with fat consulting arrangements with the company, or close friends of the CEO are too subservient to act as effective monitors of executives. Needed are directors who will augment and complement the top executives’ skills. Proven experts in the company’s business and technology and persons who can facilitate the opening of new markets. Precious board seats should not be wasted on friends of the CEO and over–the–hill big names. And yes, research does show that directors with considerable investment in the firm’s equity do contribute to performance.

Needed are directors who will augment and complement the top executives’ skills. Proven experts in the company’s business and technology and persons who can facilitate the opening of new markets. III. Guiding the misguided. Earnings guidance, managers’ published forecasts of the company’s future earnings and sales, got a bad rap in recent years. Influential organizations, such as the U.S. Business Roundtable and the Chamber of Commerce implore their members to stop guiding investors because guidance is an “unproductive and wasted effort” of managers, it “neglects long–term business growth in order to meet short–term expectations,” and the pressure to satisfy myopic investors drives public companies to the arms of private equity firms or to foreign listing. Warren Buffett too doesn’t like guidance and Google announced during its IPO (2004) that it won’t provide earnings guidance. And yet, a full third of U.S. public companies and many in other countries release regularly quarterly and/or annual earnings guidance, many predict sales too. Why? Because, as research shows, guidance confers lots of benefits on investors,

firms and managers. Managerial Guidance keeps investors’ expectations, and particularly analysts’ forecasts, within a realistic range, thereby decreasing share price volatility and avoiding unpleasant surprises to investors. Warnings prior to an earnings disappointment is considered by judges a mitigating factor in shareholder lawsuits that often follow such disappointments. And, successful guidance, the ability to predict future performance, increases managers’ credibility in capital markets and draws more analysts to cover the firm. All good things.

Ignoring legitimate concerns of activists shareholders is poor strategy. Better engage the activists, understand fully their concerns and implement the warranted changes.

Long Term Driven Market Value (%)

Figure 2 Petroleum & Natural Gas


Measuring & Control Equipment


Medical Equipment








Business Services






Electronic Equipment


Insurance Retail Chemicals

48.24% 44.58% 40.32%

Pharmaceutical Products




Financial Trading


And what about the argument that earnings guidance plays into the hands of myopic investors? Well, as I show in my book, while some investors are indeed short–term oriented— and there is nothing wrong or illegal about that—capital markets are clearly dominated by patient, long–term investors. How else can one explain investors’ support of about a trillion dollars annual investment by public companies in long–term growth (R&D, IT, brands, human resources), while such investments are decreasing current earnings? My computation, exhibited in Figure 2, shows that in practically all industries, the long–term component of stock price—reflecting investors growth expectations—exceeds 50%, and in some industries even 70%. So much for myopic investors. But guidance shouldn’t be provided by everyone. Make sure that you are a better prognosticator of future earnings than analysts. Furthermore, guide where investors’ uncertainty about the firm is high: innovative, high growth companies, intensive in intangible, hard–to–value asset, and companies undergoing restructuring. And be sure to warn investors ahead of a disappointing quarter/year.

hedge funds, research documented large stock price increases upon the announcement of hedge fund investment in target companies, reflecting investors’ strong expectations of an improvement in companies’ performance brought about by the “intruders.” This is consistent with the findings that hedge funds target undervalued companies and those having governance deficiencies. So, ignoring legitimate concerns of activists shareholders is poor strategy. Better engage the activists, understand fully their concerns and implement the warranted changes: replacing ineffective directors, restructuring managers’ pay, or distributing excess cash. Summarizing, these cases of managers’ misconceptions about investors and capital markets, and more, hinder their efforts to regain and maintain investors’ trust in companies and their leaders. A significant change in managers’ attitude and actions is urgently called for.

IV. Activist investors and hedge funds are a nuisance.

About the Author

Investor’s deep resentment of public companies and their managers, mentioned above, leads to increasing shareholder activism. Shareholder resolutions in general meetings, proxy contests, and most ominously for managers—hedge funds’ attempts to intervene in directors selection, corporate strategy, or shareholder distributions (special dividend, share buyback), are on the rise. Increasingly activists target manager’s compensation, lax boards and underperforming firms. Managers often treat shareholder activism as a nuisance, arguing that it is motivated by politics (labor unions’ activism), greed (hedge funds), or misinformation. Researchers beg to differ. Studies show, for example, that shareholder resolutions aimed at managers’ compensation tend to target companies with excessive pay considering managers’ performance, and that after the vote managers’ pay is reduced. As to

Baruch Lev is the director of the Vincent C. Ross Institute of Accounting Research and the Philip Bardes Professor of Accounting and Finance at Stern School of Business, New York University. Professor Lev is the author of several books and numerous articles. This article is adapted from his latest book Winning Investors Over: Surprising Truths About Honesty, Earnings Guidance, and Other Ways to Boost Your Stock Price (Harvard Business Review Press, 2012).

Source: Compustat and I/B/E/S.

References 1. Fortune magazine (December 12, 2011, p. 144) recounts Bank of New York Mellon’s directors being “extremely critical” of the CEO, yet awarding him a $5.6 million bonus for 2010. 2. It was reported, for example, that Gerhard Cromme, former chairman of giant Thyssenkrupp, also served on the boards of seven German companies and three French ones.



Putting Mind into Markets By David Tuckett The 2008 financial crisis showed that human emotion has a critical impact on financial markets. The newly established discipline of 'emotional finance', pioneered by David Tuckett, draws on principles of psychoanalysis to enable financial markets to be understood in a completely new way. Based on some of the ideas from his groundbreaking new book “Minding the Markets: An Emotional Finance View of Financial Instability” (Palgrave Macmillan), Professor Tuckett provides fresh insights into what happens in the emotionally-charged real world of financial trading.


onventional thinking about financial markets begins with the idea that security prices always accurately reflect all available information; it ends with the belief that price changes come about only when there is new information. Markets are supposed to reflect new information quickly and efficiently, albeit with a few anomalies. In 2007, I interviewed over 50 investment managers mainly in New York, Boston, London, and Edinburgh. Talking to them I came to the conclusion that conventional theories of finance miss the essence of market dynamics. Information is usually ambiguous and its value uncertain. When information is ambiguous and outcomes are fundamentally uncertain, decisions are not clear cut. They necessarily rely on human imagination and judgment, not simply calculation. Human imagination and judgment are impossible without

human emotion. Conventional theories of finance, which ignore emotion, are therefore a very poor basis for understanding and policy. Uncertainty and ambiguity are what make financial markets interesting and possible. They generate feelings that manifest in exciting stories, problematic mental states and strange group processes. As long as we neglect emotion’s role in financial markets, and fail to understand and adapt to dimensions of human social and mental life that influence judgement, financial markets will be inherently unstable. They will also be likely to create poor outcomes for ordinary savers and significant distortions in capital allocation – exactly what we have been witnessing in the market today.

As long as we neglect emotion’s role in financial markets, and fail to understand and adapt to dimensions of human social and mental life that influence judgement, financial markets will be inherently unstable.


The European Financial Review October - November 2013

Uncertainty and the nature of financial assets The uncertainty to which I refer can be termed radical, fundamental, Knightian or Keynesian uncertainty. I use these descriptions to stress the fact that, although we can imagine the future, we cannot know it in advance. My interviewees collectively risked over $500 billion every day. Every one of the positions they took depended on interpreting ambiguous information and each would be vulnerable to unforeseen events. Consider the present possibilities that the Euro crisis will lead to a return to national currencies, and that disputes in the US congress will lead to problems meeting US debt obligations. What the existence of such possibilities will do to the prices of commodities, currencies and securities over the next thirty-six months, and what different financial decision-makers will think about it, is not knowable – and there will be many more unexpected developments with significant ramifications.

Decisions made in a radically uncertain context are totally different in their implications from decisions made in conditions of risk modelled as a Gaussian probability distribution. A Gaussian model constrains future probabilities, thereby creating known unknowns. The outcome of decisions becomes predictable and what is rational becomes clear. Under radical uncertainty this is not the case. What will happen tomorrow involves far more complexity and interaction than can be captured by analogies to games of chance. Taking radical uncertainty seriously, therefore, changes everything. The professional investors to whom I talked were all intelligent, thoughtful, experienced, well-educated and resourceful. Their problem fulfilling their task was not to be rational but how to be so; they used all rational means as far as they could. Rather, their task was to find a way to convince themselves and others their judgments were appropriate and so to gain the support to act. They were paid to act and to stick to their decisions - to buy, hold or sell financial assets – and, in so doing, to outperform their peers and various benchmarks. As my respondents told me about the decisions they had taken in the months before I spoke with them, three rather well known, but nonetheless crucial characteristics of their situations emerged. Each of the three is a consequence of radical uncertainty. First, because asset prices are volatile, trading financial assets was always about managing the feelings created by volatility. The prices of the financial assets they wanted to trade went up and down all the time. The possibility they would go up was what made financial assets interesting. So they offered opportunity and danger. Crucially, when prices went up they created excitement about imagined reward1. And when they went down they created anxiety about loss and other consequences. In other words, financial assets engage powerful human emotions and go on doing so over time. Owning a financial asset is an emotional experience lived through time.

The 24-hour, 7-days-a-week deluge of information in global financial markets produces inherent ambiguity and can constantly generate excitement or doubt. Second, all financial assets are abstract. They are not concrete items like televisions that can be used, but are symbols that have no use in and for themselves. They are worth only what other people think they are worth and (like shares in some banks, energy companies, and financial institutions or like some government bonds or collaterised debt obligations) this could quite easily be nothing. This is where uncertainty, information ambiguity and perceived trustworthiness are all crucial. The present value of a financial asset is entirely

dependent on the future we can imagine and its expected influence on the underlying prospects. What price we will actually see in the future is inherently uncertain. It is dependent not only on the income uncertainly generated by the underlying “fundamental”, but also on the expected demand for the securities from other traders. Third, success trading financial assets is difficult to evaluate. As a result, feedback on investment performance is fuzzy. Uncertainty and ambiguity mean that what looked like good decisions can turn out to be bad ones and what looked bad can be revealed in time to be great. To evaluate performance, it is easy enough to see if one has gained or lost in any period. But did that reflect skill and what does it “tell”? A buy initiated today can take weeks, months or years to play out. In the meantime, all kinds of other things have changed and the manager is involved in creating new positions and managing others in the portfolio. Traditional measures used in the industry such as return, relative return, attribution and even "hit-rates" provide weak insight into skill or decision quality. They can offer the illusion of understanding while facilitating the neglect of uncertainty. The 24-hour, 7-days-a-week deluge of information in global financial markets produces inherent ambiguity and can constantly generate excitement or doubt. Even if information is trustworthy, its usefulness for calculating future prices in an uncertain world is dubious. The problem using it is not to behave rationally, but to know how to gain conviction about particular conclusions and then to make a decision to manage the anxiety that one may be wrong.

Narrative The way people in a financial market succeed in making decisions in the situation I have just been outlining is obvious – at least once it is stated. To create and support their conviction that their judgements are right, they use the human evolved capacity of telling stories – to themselves and to others. My respondents told me over 200 stories about their decisions to buy, hold or sell assets. What the “buy" stories did was to organize and make coherent the always ambiguous and incomplete information they had to hand. These stories created scenarios that made sense of what the traders knew and the judgements they were deploying. These stories combined exciting grounds for taking action with secure grounds for trust. Narrative is one of the important devices humans use to give meaning to life’s activities, to sense truth and to create the commitment to act. Although its procedural logic is different to that in logico-deductive reasoning, reflection will demonstrate that it is not necessarily inferior. This is particularly true in contexts in which data are incomplete and out comes are uncertain. Stories draw on humans’ powerful capacities for pattern recognition, which allow authors to weave facts, reasons and feelings together to create conviction and a sense of truth. Stories dominate the way we make



To create and support their conviction that their judgements are right, they use the human evolved capacity of telling stories – to themselves and to others. everyday sense of the world, ordering the relation between things in space and time. Mostly, they succeed in ordering things in a convincing way. But because they function to paper over the doubts created by radical uncertainty they are always a potentially unreliable basis for financial models. A story does not need to be lengthy or complex. “Greece has a history of fiscal mis-management. It is in the process of defaulting and will take the European financial system with it. Therefore, what I need to do is...” Here the past and future are combined with ideas to produce coherence and support for action. Such narratives, which are widely reported in the financial community, allow investment managers to organise a mass of information about the present and about potential futures. The process of narrative formation blends human emotions and is unconsciously constructed. Moreover, it is so natural and so aligned with efficient social, psychological and neurobiological functioning that people are often hardly aware this is what they are doing. Narratives are seamlessly developed, socially constructed, and shared as acceptable in financial networks and institutional groups.

Markets in stories To readers not familiar with orthodox financial theory and to those with experience of real financial markets, all this might sound blindingly obvious. However, orthodox financial theory (including Modern Portfolio Theory, the Capital Asset Pricing Model and the Efficient Market Hypothesis) is a long distance from the reality I just described. This is not trivial. Financial policies and the operation of risk management in financial firms, ratings agencies and regulators have been heavily influenced by these orthodox approaches to finance. The result is that our financial institutional arrangements are built on deeply unreliable models. Applied to financial markets, the narrative perspective allows us to see things hitherto obscured by more conventional approaches. For instance, it highlights the fact that financial markets are in large part about a portfolio of competing narratives concerning the present and the future.2 Thus, it is important to understand how narrative works and can be influenced. Dominant narratives can create bubbles – like the Dotcom Bubble or the South Sea Bubble. They also create conventional wisdoms (such as those about shareholder value, securitisation, leverage and debt) that have recently had such powerful effects. Above all, understanding narrative gives us tools with which to understand market dynamics. The dominant


The European Financial Review October - November 2013

narratives in the market – these are similar to what is often meant by “market sentiment” – change through time. New narratives emerge and old ones disappear. To visualise this process of emergence, we can think of a large inflatable ball released in to a crowd at a concert.3 The ball will move around unpredictably: over time, everybody will influence the direction of the ball but no one individual or group will have full control over its movement. The direction the ball is travelling is emergent and inherently impossible to predict. By contrast, the building blocks of orthodox economics and finance are deterministic, which means that with enough information, the direction of the ball ought to be fully determinable. That, however, is not true in reality: like the suppressed equation of risk with uncertainty, determinism is a fundamental flaw in conventional thinking in both finance and economics.

Financial markets are in large part about a portfolio of competing narratives concerning the present and the future. Thus, it is important to understand how narrative works and can be influenced. Exciting stories The account of markets as narratives that I have offered does at least make sense to money managers themselves.4 It is also the starting point of the approach to understanding markets which Richard Taffler and I call Emotional Finance. By drawing on some core concepts derived from modern psychoanalysis, this approach focuses on the forces that influence how narratives are developed and spread within financial networks. It explains how money managers and the financial market more generally can collectively tell themselves stories that are ultimately implausible and so create highly consequential, unstable situations. Emotional Finance proposes that when investors buy, sell or hold all classes of financial assets, they necessarily establish on-going and unconscious mental relationships with them. These relationships are of precisely the same kind as we all form throughout our lives with people and activities. We know that such relationships are based on bodily experience and feeling – emotion – mapped within our complex brains onto narrative representations from memory. In their simplest form, such mental relationships – unconscious phantasies giving meaning to everyday experience – are stories told in the mind. They are representations of the imagined emotional relationship between subject and object which produce good and bad feelings – for example, those associated with the thoughts “I love him”, “he likes me”, “I hate her”, “they make me anxious”. In discussion with Taffler, I coined the term phantastic

object to highlight the object being sought in most financial narratives. The term conjoins phantasy (as in unconscious phantasy) and object (as in the object of a mental representation). It seeks to specify that what is depicted as so attractive and sought after in various financial-market narratives is much more than just the chance to get rich. Stories about phantastic objects detail participation in an imagined mental relationship in which the possessor of the desired object imagines having permanent and exclusive access to it and all good things. This is a phantasy normally if only partially and painfully given up with weaning and later maturation. Tom Wolfe describes it in Bonfire of the Vanities and Michael Lewis in Liar’s Poker. My respondents were looking for high yield and low risk, which other investors had not spotted. They had to perform exceptionally and to do so had to seek such opportunities - phantastic objects. In effect, they had to live up to the images they projected to the clients who employed them. The narratives supporting the securities they sought out gave them grounds for thinking decisions were exceptionally rewarding and especially safe. This is in fact often the underlying message in asset management advertising. When the Board of Directors at RBS believed it desirable to stuff their balance sheet with mortgage backed securities – magical if incomprehensible products apparently offering security as good as treasuries, but with much higher return – they must have been accepting just such a message. Phantastic objects are strange attractors with the power to disturb thought.

Problematic mental states Most mental relations and especially those featuring any kind of dependence (on a person or situation or object) are what psychoanalysts call ambivalent: they stimulate contradictory feelings and so contradictory mental representations of the objects. They create potential emotional conflict. “I want

to be with him and I want him to go away”; “it will create gain; no, it will cause loss”; “I want to be part of that group and to be away from it” – these are all expressions of such ambivalence. This is easy to apply to securities and indeed to the choice of money manager or pension plan. The crucial point is that we can work to be aware of the contradictions in our relations to objects; we do not have to neglect them. Sometimes emotional conflicts are so powerful that they are unpleasant. We therefore push them from our mind. As a result, they become unconscious, meaning we don’t know we have them. Good as well as bad human decisions are made in states of mind governed by feelings. In the state of mind I call a divided state, conflicting representations of relationships to an object of the kind just discussed are present in the mind but not consciously known and experienced. They are therefore not available to conscious evaluation. In

such states, the relationship to an object may at one moment be consciously felt as only loving and the next as only hating. One moment it means only loss, the next only gain. The theoretical potential of the concept of a divided state (particularly when pursued in groups subject to what I call groupfeel) is that it helps to explain how people can pursue phantastic objects without setting off alarm bells. In ordinary markets, such objects are pursued in small ways. Sometimes, however, these objects capture the market. Participants then believe that the impossible is really possible. In a divided state, a relationship to a phantastic object (such as the dotcom stocks or once highly desired Greek bonds) moves unpredictably from all loving – i.e. wanting – to all hating, and vice versa. Such movements are observed in personal and work relations and in the relations professional investors have with assets in financial markets. Divided states contrast with integrated states. The latter involve more nuanced and subtle relationships to objects. In these relationships, the contradictory or conflicting feelings that are stimulated can be simultaneously known. They can therefore be explored and reflected on. Integrated state relationships are more realistic, but they are also more emotionally challenging. Divided states are adopted, of course, precisely because awareness of emotional conflicts can be intolerably frightening or frustrating – as when awareness of conflict would create guilt or shame or the anxiety which might prevent someone like Fred Goodwin doing what he wants.

Conclusion It is hard to exaggerate the significance of an emotional finance way of thinking for how we understand the

The term "Phantastic Object" seeks to specify that what is depicted as so attractive and sought after in various financialmarket narratives is much more than just the chance to get rich.



financial system. Markets managing uncertainty through exchanging narratives are very different from the markets envisaged by conventional theories. If, for example, the price of securities is in fact governed by narratives shared in groups, the pricing of derivatives based on them cannot possibly make sense using the Black Scholes formulae or similar. Liquidity will dry up very easily, as it has several times recently, precisely due to narratives about banks. Risk modelling too would have to change. Concepts like VaR are inappropriate in a world ruled by narrative and radical uncertainty. Stress-testing needs to look at narratives. The ideas and conventions that have been influencing risk-assessment in financial institutions rest on traditional financial analysis. From my perspective they are misleading and provide false comfort.

Markets have been nervous and particularly volatile for some years. There is a sense that many losses remain unacknowledged. It seems possible that participants also sense that the problems created by the catastrophic reforms of the 1980’s (based in part on what I consider misleading theories) led markets to become progressively captured by the belief phantastic objects and (and so fantastic performance) were attainable. A divided state became normal. The Euro, for one, has some characteristics of a phantastic object. If this is the case, markets still need to work much harder towards the painful acceptance of reality – an integrated realistic state. For this to be possible requires absolute clarity about where losses lie and a much more serious effort than we have seen to face up to how all this happened and to its implications.

ideas from his new book “Minding the Markets: An Emotional Finance View of Financial Instability” (Palgrave Macmillan) which describes an interview study with money managers and a new way of looking at financial markets. He has received critical acclaim from Nobel prize-winner George Akerlof and Bank of England Governor Mervyn King as well as Gerd Gigerenzer, Andrew Sheng and Dennis Snower, among many others. He is a Fellow of the British Institute of Psychoanalysis and won the 2007 Sigourney Award for Psychoanalysis. First trained in Economics and Medical Sociology, he also introduced behavioural sciences to medical education at the Middlesex Hospital Medical School and was Principal of the Health Education Studies Unit at the University of Cambridge.


My argument is that financial crises are not due to malignant outside influence but are caused by the power of financial assets in the form of phantastic objects to distort the human mind. A great deal more needs to be done to understand how financial narratives get created and diffused, and what can be done to create counter-narratives to reduce divided states. The framework offered above is intended as a building-block for developing understanding. With it we can see more clearly why the financial system is a great deal more volatile than orthodox financial theory would have us believe – and that it is inherently volatile. This should concern us and spur much more research. By contrast, a lot of the analysis about the financial crisis has looked for causal factors of the financial crisis that are external to the financial system. For about five years now we have been in the midst of a chronic financial crisis. More acute phases threaten. Some of the solutions to the crisis may reproduce some of the conditions that helped to cause it.


My argument is that financial crises are not due to malignant outside inf luence but are caused by the power of financial assets in the form of phantastic objects to distort the human mind. It is in the interests of nearly everyone to contain this situation. We must begin by understanding this distortion and its inf luence throughout the financial network. Neither conventional economics nor even modern behavioural economics focusing on bias are at all helpful for such a task.

About the Author

The European Financial Review October - November 2013

David Tuckett is Professor of Psychoanalysis and Director of the Emotional Finance Project at UCL (University College London). In this article he sets out some of the

1.For some investors it will be more complicated than this. In my interviews a number of fund managers will profit when the market is going down. So in this instance the remarks just made really apply to prices moving in the direction investors wish, or not, rather than to actual rises and falls. 2.Although my research focused on investment managers, the framework appears generalizable to the whole financial system. Certainly in any consideration of the financial intermediation role of the financial system – i.e. the channeling of savings to investment projects – it is investment managers who clearly have the most important role. 3.I am grateful to Greg Fisher for this example. 4.I have recently had opportunities to present the picture I have just drawn of financial markets to groups of money managers at two meetings of the CFA Institute. I also presented it to those I interviewed - in a follow-up series of interviews from February to April 2011. Although it is far from the traditional description in economics and finance textbooks, there was a rather universal agreement that the picture makes sense.






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