Financial education in crisis time and beyond

The function of the financial system is to channel money from parties with a surplus (investors) to parties with a shortage (firms) in order to keep investments and development going. To finance itself, a firm needs debt (less risky) and equity (risk capital). A well-functioning financial system provides both. So in addition to their traditional credit business, banks should carry on engaging in investment banking, which involves placing shares and bonds on the market.

Virtually everyone agrees that banks have taken on too much risk. But where were the supervisory bodies? Unfortunately, after each disaster the danger of over-regulation also arises. The challenge is to introduce new supervisory rules in moderation, without stifling the financial system.

Where did things go wrong? Through concerted lobbying by the financial sector, financial institutions gained permission to remove high-risk activities from the balance sheet via securitisation and thus place them outside the supervisory domain. The famous example of securitisation is the American sub-prime mortgages that are sold on by banks. Banks were able to operate with lower capital buffers, although the risk had not been reduced. Furthermore, investors in these securities relied blindly on credit ratings, which turned out to be unreliable. The lack of information about asset values caused investors to desert in droves, and a systemic crisis was triggered.

The systemic crisis has seriously damaged confidence in the financial system. In order to overcome the current crisis, mutual confidence needs to be restored. A way forward is to shorten the virtually endless chain of the onward selling of assets. In this way, financial institutions – as the bearers of the credit risk – would once again have to assess for themselves just how creditworthy the customer (the business or family to whom money is being lent) is, rather than relying on external credit scores. The same applies for investors. They too have blindly trusted in ratings without conducting sufficient analyses themselves of the value and risks associated with their investments.

Finally, every financial crisis triggers two kinds of reaction. Firstly, we want to assign blame: who caused the misery? By now, to many different people have blamed everyone else for the crisis. The second reaction involves looking at the system itself: the system clearly is not up to the job and needs to be adapted. Both reactions make it possible for us to avoid considering our own role and actions in contributing to the problems. Yet our behaviour is the core factor. Crises are not caused by systems, but by human behaviour within systems. Systems, rules and enforcement affect behaviour, but often in ways that are unexpected.

Economists have long believed that people’s behaviour can be steered to a significant extent with economic incentives. The problem lies not so much in the theory, however, but in the fully informed, all-understanding and always rationally acting man, homo economicus, who is presupposed by the theory. Such a creature does not exist. The research field of ‘behavioural finance’ has now shown what human behaviour is really like: from the exaggeration of herd behaviour on markets, both upwards and downwards, to the tendency to be more eager to avoid losses than to achieve gains. This kind of research is not based on assumptions about what supposedly rational people do in particular situations, but takes a factual, empirical and experimental look at how people really behave and what explanations can be found for their behaviour.

How can these lessons and insights be incorporated into financial education? At the Duisenberg school of finance we have created four themes which run across our different MSc Programmes in Finance. These themes are 1) risks in the financial sector; 2) behavioural finance; 3) redesigning financial regulation; 4) corporate governance and ethics.

Taking the first, students need to get a strong grounding in risk management. What are the statistical properties of the risk management models that banks and insurers use? Do these models only incorporate average price declines or can they also cope with extreme events, as we have witnessed in 2008? Extreme value theory can, for example, deal with such extreme events. That is the academic training. Next to that, students want to know how the risk management models fared during the financial crisis. Here at the Duisenberg school of finance, our founding partners from the financial sector give practitioners seminars to tell about the strong points of their models, as well as the shortcomings. In that way, students combine theory and practice. Moreover, a mandatory internship helps students to prepare for a job in the financial industry.

This approach reflects my own experience in London. I did my PhD research on financial regulation at the Financial Markets Group, which was established jointly by the London School of Economics and the City. Analytical rigour was combined with practical insights from the City. I have learned to appreciate both sides of the same coin. Universities are fertile grounds to train people in analytical concepts and to think in different scenarios. Most importantly, academic training brought me a critical attitude asking questions rather than taking things for granted. The City provided me with a unique opportunity to learn about the real world of finance.

For students who are considering to do a MSc Programme in Finance, here are some experiences from current students at the Duisenberg school of finance.

• "It is nice to have an international mix of • students. Students tell about the reaction of business and politics on the financial crisis. The reaction in India, England and the Netherlands is very different and students can explain about their own country. I find it very interesting to discuss these different views in the lectures."

• "I thought about going to one of the bigger • business schools, but that seemed to be mass teaching. You often attend lectures with over 50 or 60 students. At the Duisenberg school, we have small classes of a maximum of 25. I now get a lot of attention from professors."

• "I would like to work for one of the founding • partners of the Duisenberg school. These founding partners are leading financial firms. From the guestlectures by practitioners we learn how these financial firms operate. The internship at one of the founding partners is a unique opportunity to get to know these firms better and to have a good starting position on the job market."

The unique combination of training by international top-academics and seminars by practitioners provides a fertile ground to educate the future leaders of finance at the Duisenberg school of finance. As the financial crisis indicates, we need a new generation of leaders in finance. Not the financial system itself, but the human capital within the system needs an investment boost. Those with ambition will invest in their future.