Column: The Hollow Science

In the aftermath of the financial meltdown, it’s become clear that the executives of many major financial institutions operated with inadequate and distorted information about the value and risks of their firms’ assets. As a result, they failed to anticipate the crisis and reacted slowly and ineffectively when it hit. Perverse incentives, insufficient governance, and weak regulation clearly contributed. But after decades of management research and education, it’s fair to say that business scholars bear some responsibility as well. We have largely failed to produce a body of knowledge that would have helped companies value and manage risky financial assets. How did this happen? The problem was neatly described 15 years ago by the economist Paul Krugman in a provocative essay that compared research trends in development economics to the evolution of the mapping of Africa: The coastline…was first explored, then plotted with growing accuracy, and by the eighteenth century that coastline was shown in a manner essentially indistinguishable from that of modern maps….On the other hand, the interior [had] emptied out. The weird mythical creatures were gone, but so were the real cities and rivers. In a way, Europeans had become more ignorant about Africa than they had been before….improvement in the art of mapmaking raised the standard for what was considered valid data….Only features of the landscape that had been visited by reliable informants equipped with sextants and compasses now qualified. Business scholars bear some responsibility for the financial meltdown. Krugman could have been writing about my own discipline. For the past 40 years, most research in accounting and finance has focused on the coastline of business—the capital markets where companies and investors meet. Academics have applied ever more sophisticated analysis to the associations between the prices of traded equities, debt, and financial instruments and the information in company disclosures, corporate governance practices, and financial analysts’ reports. But like the 19th century African cartographers, we actually know less about what happens inside companies than we did 40 years ago. Most of us are neither studying nor teaching the emerging best practices in asset valuation and risk management in well-managed financial institutions. (A few of these do exist and are worth learning from.) I know of one major bank that does not hire U.S. business school graduates because they don’t have the requisite skills to value and assess the risks of complex, infrequently traded assets. To remedy this knowledge gap, more business school scholars, particularly in accounting, need to shift away from coastline studies, conducted on computer terminals in their offices, and begin to explore the interior of leading-edge company practices. A detailed, qualitative case study that documented and analyzed how innovative managers value and manage risky assets would be far more informative than yet another study of the correlation between public accounting data and average stock market returns. Careful clinical and descriptive research gets done by scholars in other professions, such as medicine and engineering, where practice innovation and small-sample research coexist comfortably and collaboratively with the randomized experimental trials and epidemiological research that test emerging practices in large samples. Some opportunities arise just from breaking down silos around academic disciplines. Accounting scholars, standard setters, and regulators have been slow to apply the options pricing models created by financial economists in the 1970s as tools for measuring and disclosing the risks of many company assets, including pension plans. That’s surely misguided. What if physics professors in 1945 had taught and done research using only Newtonian mechanics, ignoring the breakthroughs from the discovery, 40 years earlier, of quantum theory?

Column: The Hollow Science

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