How can we re-establish trust in the financial sector?

Robert C. Merton Nobel Laureate in Economic Sciences, 1997

Robert Merton was eight years old when he began his entrepreneurial activities. (He created the RCM Savings of Dollars and Cents Company, and collected money from family and friends.) Two years later, he bought his first share of stocks. He was a special kid. So it’s no surprise, he later became one of the most influential researchers in financial economics, generalizing the Black-Scholes formula, which contributed to the rapid development of new financial products and more efficient risk management. Today, he emphasizes how financial markets have made our society better off, and argues that we need to reestablish trust in the financial services industry.

Getting lucky

As a PhD student in applied mathematics at Caltech, Robert Merton would get to the local brokerage house every morning at 6.30am for the opening of the New York stock exchange. Before he’d even written his thesis, he realized that things needed to change, and applied to MIT. How did he get into graduate school without ever having taken an economics course? Merton smiles. "You know, I have a favorite phrase. It’s always better to be lucky than smart."

At a glance

Born: 1944, New York, New York, USA

Field: Financial economics

Prize-winning work: Established a new method to determine the value of derivatives; generalization of the Black-Scholes formula

Early practice: Bought his first share of stocks at the age of ten

Interests as a young man: "Math and money and girls and cars"

Motto: “There’s no free lunch”

Managing risk efficiently

In the early 1970s, he’d leave his mark in the field by contributing to a pioneering formula for the valuation of stock options. In general, options give the right, but not the obligation, to buy or sell a financial asset in the future at an agreed-upon price. "They give you flexibility, and flexibility is the greatest value when you have uncertainty," Merton explains. But to allow for an appropriate level of risk in market transactions, options have to be correctly valued - which was exactly the problem Merton was working on, as were his colleagues Myron Scholes and Fischer Black.

"At some point, Myron told me the basic idea they had. My first reaction was: That can’t be right." Merton took home his colleagues’ notes. "I came back from the weekend and said: I think you’re right, but it’s much more general than you know." Merton had realized how far-reaching the formula really was and that it could be applied to other financial instruments, such as mortgages and student loans.

"It was a production theory. How we produce all the financial products out there, how we price them, how we figure out their risks." The methodology became widely used by traders and investors. It also laid the foundation for a much broader and more rapid development of derivatives markets. "You could take something you’d never seen before, and you now had a way to attack it," Merton explains.

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Do derivatives threaten the stability of financial markets?

Merton knows that some people think the high number of derivative products today might be superfluous, if not dangerous.

Have derivatives made us safer? That’s not the right question to ask. The question is: have they made us better off? Yes they have

Merton argues, across the globe.

"People say all you need is a simple system. They’ve never been out in the world ‘cause that isn’t true. You need these tools. Because of them we can run systems much more efficiently and effectively." There may be financial instruments suitable for sophisticated investors only. But to Merton, that’s not a good argument against innovation. "If I have someone who says this is too complicated for me to understand, I’d say: If doing this is useful to society, you have two choices: either you try to understand it, or you find someone who can."

Merton emphasizes how the financial crisis of 2008/09 didn’t take place in any "exotic" part of the market, but the most regulated one. "The mortgage market was thirty-odd years old, it was the only way you could do it and still is the only way. What doesn’t hold up to any data is the idea that innovation was the cause of it all." Nevertheless, there were people, Merton agrees, that were not acting in their clients’ best interest.

What the financial sector needs: trust and competence

Merton emphasizes how both trust and competence are indispensable in financial markets, where you’re likely to face risky situations and where some services, active investing for example, can only be made transparent to a certain degree. "What to put your money in, how much to invest, how often to trade, those decisions are inherently judgmental, therefore inherently opaque."

Merton uses the example of knee surgery. "I want to find a good surgeon. But I want it to be transparent. So my surgeon says, ‘Ok, Mr. Merton, here are all the scientific studies, here’s a list of every tool in the operating room.’ Complete transparency. Except it’s not transparent to me. I can’t tell how risky this is, whether this person’s gonna do a good job. My choice is: I find a doctor I trust."

That’s why Merton feels creating trust should be a strategic consideration. "If you can create trust, you can create a huge amount of value." A possible strategy in the financial sector is fee-only advisors. "Whatever you pay me, that’s the only money I get. No commissions, no gifts or vacations, not a toothpick. That’s a business model.” He knows that there are ways to institutionalize trust, both in the government and in the private sector. "And I think to get out of the crisis, that’s something we need to do because until we reestablish trust, we’ll never have a solution."

Fintech - a threat to traditional institutions?

The huge technological developments of our time have had an impact on the financial services industry too. As a result of new financial technology companies (also known as FinTech), processes and products are changing, but Merton seriously doubts that these are going to be huge changes. "Processing is something that Silicon Valley is very good at. But financial services? They talk about computers that will do it for you. Would you do this with your medicine? You wouldn’t take your meds from someone you didn’t know, even if it was delivered to you on your cellphone, very efficiently, 24/7, with the push of a button, here are my symptoms, here it is, boom."

He explains how there’s an important difference between medical and financial advice and, for example, using great processing to stream a movie. "I know after ten minutes it’s a lousy movie. I’ve just wasted ten minutes. I don’t know someone has given me bad financial advice until it’s too late. That’s why FinTech will not displace financial advisors on its own."

Providing for your own retirement

The father of three knows times are changing fast. As a professor of finance at MIT, he not only keeps a close eye on financial developments, but on his students too. That’s why he also has advice to share when it comes to retirement savings: "If you’ve got the benefit of living longer than your parents, and you want the same standard of living, you’ve got to work longer." But that doesn’t mean young people should worry too much. "They need to understand that there are limits like that. And that there are a lot of good ways that we can do better at saving for retirement."

Rather than young people being hostile to financial innovation, Merton wants them to welcome and encourage it - and use it for their benefit. That’s why it’s so important to him that people working in financial services are competent and trustworthy. "You shouldn’t have to get an education to try to figure out how to manage your portfolio. You should be educated to find someone to trust to do that." He would never give any detailed investment advice, of course, but adds:

There’s no free lunch. If it looks too good to be true, it probably isn’t true. If you learn that, you may miss out on occasional opportunities, but you stay out of an awful lot of trouble.

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