The first social cause is the limited liability of fund managers and corporations, which means profits are shared but not losses. This has serious consequence in terms of risk taking. For example, suppose one has a trading strategy that leads to 20 percent gains 99 percent of the time. Then it is not clear at all whether a rational individual should use the strategy, as those 1 percent cases may lead to huge losses. However, it is optimal for fund managers and corporations to pursue such a strategy due to the limited liability protection. Since the limited liability protection is a fundamental principle of firm structure, there is no way to eliminate it.

But one can have still some checks and balances. For example, the fund managers can set up a deposit, such as 10 percent of fund capital, by using the manager's own money, and if there is a loss, the deposit money will be used first to offset the losses; in return the fund manager can ask for higher profit sharing such as 40-60, versus the current hedge fund standard of 20-80. The above compensation scheme has been quite popular in China for privately held funds (which are similar to hedge funds in the U.S.).

The second social cause is the social prestige of the financial profession. To attract outside capital, financial institutions have to earn social trust by creating prestigious self-image, such as impressive buildings, hiring many Ivy League graduates, etc.; no one wants to deposit money in a bank that is operated in a run-down building.

As a result, even if the pay is the same, a university student may prefer to be a trader on Wall Street than an engineer in a factory. For example, among about 800 undergraduate students at the engineering school of Columbia University, perhaps 200 of them major in financial engineering, making it by far the largest major in the school. Not surprisingly, the most popular undergraduate major at Columbia University is economics. This may create an oversupply of human capital to Wall Street.

Supply and Demand


To balance the demand and supply, one can either reduce the compensation or create new job opportunities by introducing more complex financial products, many of which have the feature that can make money most of the time but may incur heavy losses during the unfortunate time periods. A remedy for this is to increase the entry barrier of financial professions.

If prestigious professionals such as medical doctors and lawyers are required to have at least three years of post-graduate studies and a license to practice, the traders of complex derivatives on Wall Street should have more extensive training and even perhaps license requirements. Right now the entry barrier is very low; undergraduate students, students with only one or two years M.S. or M.B.A. training, can make commissions by selling multi-million dollar derivative contracts without much understanding of the risk and return of the products. One can increase the entry barrier by requiring three years of graduate study for financial professionals, along with some license requirements.

The last but not the least social cause of the crisis is the herd behavior of investors. It is well documented in the academic literature that if investors are more likely to follow other people's actions, e.g. buy when other people are buying and sell when other people selling, then the asset prices will inevitably swing from one extreme to another. Of course, governments can use certain regulations to counter-balance such herd behavior. For example the up-tick rule for short-selling is aimed at halting the price declines when the market is in panic mood. Unfortunately the up-tick rule was removed most of the time during the current financial crisis.

Another less noticed but equally important subject is the margin requirement. Currently, when prices go up, investors of both equity and housing markets can use the inflated asset prices to borrow more money, often times resulting in unreasonable leverage ratios right before asset bubbles burst. What can be done? Create certain formula for the margin requirement that takes into consideration a potential market bubble. For example, in calculating the margin requirement, instead of using the inflated asset or housing market prices, one can cap the growth of the prices at no more than that of the inflation-protected treasury bonds. In doing so, investors will not be able to have very high leverage during the market bubble.

In summary, unless the society can deal with the social causes of the current financial crisis, fiscal and monetary policies alone cannot prevent the next severe financial crisis.



Steven Kou (sk75@columbia.edu) is a professor at the department of Industrial Engineering and Operations Research at Columbia University where he teaches financial engineering. A version of this column first appeared in Analytics.

Table of Contents

OR/MS Today Home Page


OR/MS Today copyright © 2009 by the Institute for Operations Research and the Management Sciences. All rights reserved.


Lionheart Publishing, Inc.
506 Roswell Rd., Suite 220, Marietta, GA 30060 USA
Phone: 770-431-0867 | Fax: 770-432-6969
E-mail: lpi@lionhrtpub.com
URL: http://www.lionhrtpub.com


Web Site © Copyright 2009 by Lionheart Publishing, Inc. All rights reserved.