Business schools may not have been focused enough on teaching future leaders how to keep an eye on the downside in an interconnected world.

Question: Did HBS play any role in causing the financial crisis?

Jay Light: Now to be sure it was largely the government’s legislatures, the Fannie Mae, Freddie Mac in this country, the federal agencies and the financial institutions that were most directly involved, but also many of them showed a failure to really think broadly about risk and about how bad things could get and I think that reflects you know for the prior 25 years we hadn’t seen a lot of downside and frankly, all of us got out of the habit of thinking about the downside and at business schools we got out of the habit of teaching about the downside, so in fact, in the 1970s I used to teach a course called "Capital Markets: The Financial System" here, which was in fact, all about these ideas; all about the kinds of risks that could arise from changing financial markets and the mortgage markets and the consumer credit markets and the commercial loan markets.  Those kinds of courses both here and at other business schools had largely atrophied.  There was relatively little student demand for them.  The faculty was more interested in teaching about other things too, so the curriculums got focused on the upside if you will, the how does one increase market share, how do you increase earnings per share, how do you think about how to grow a bigger and better institution.

And that’s great.  That is what you should be thinking about except at the same time you have to keep an eye on "How could things go wrong? What kinds of data should I really be putting into my risk management model?" In a world where housing prices were in a bubble and where consumer lending organizations were in fact incenting consumers to borrow at very, very high loan to apparent value ratios the old data that one put into risk models was completely, completely out of touch with the changing reality as became so quickly apparent when the whole down leg started.  So I think it was a failure of leadership in the sense that it was a failure to think in a broad and creative and responsive way about risk.  There were also some ethical failures I think as there are when any bubble collapses, but the single most important lesson coming out of this crisis in my judgment was more about values and judgment and how you think about analyzing and keeping your eye on the downside in a complex interconnected world.

Question: Is the solution to minimize risk?

Jay Light:  Well so I think there is the need for some structural change.  A good example is we can’t ever again let true leverage in a financial system get up to the same levels it had gotten to, so we need to insist upon more robust measures of capital, financial capital in a financial institution.  We need to insist upon lower leverage ratios.  We need to insist upon more stringent liquidity criteria, so there is a regulatory response that I think is much needed and is in the process of being developed.  There are also a set of related question about just how interconnected one wants the scope of financial institutions and whether large institutions ought to be forced to divest certain of the activities they’re in and if so just which activities. And that is a more complex question and but I think some real regulatory reform would be appropriate and is quite likely there also.  

There is on the other hand, a real danger here because I think what our economy needs more than anything else as a nation is innovation and innovation means we need people to provide funds to different kinds of new companies doing different kinds of new and innovative things and one can go overboard with the vilification of financial institutions.  One can go overboard with strenuous and hard to understand regulation that causes firms to become much more risk averse across the board even if the possible things that they could be… might be funding could turn out to be the very innovative kinds of things we need to do as a country, so I think one has to always have a balance here.  The pendulum for sure has swung back now towards managing risk, towards thinking about the downside both from a regulatory point of view and from the point of view of those people who manage financial institutions, but there is a danger that the latter could go too far.  Indeed there is lots of evidence I think right now that it is going too far, so keeping a balance there between thinking about upon an entrepreneurial perspective on the evolving economy and the evolving financial system while at the same time worrying about risk is where we want to come out and it’s a complex every changing thing that requires enormous amounts of judgment and leadership. 

Recorded May 19, 2010
Interviewed by Jessica Liebman