Answering the Big Money Questions

Traditional economic theory would argue that a bank should be willing to set its interest rates so that the demand for loans exactly matches the available supply. This point of equilibrium between supply and demand can be shown mathematically to maximize bank earnings. In practice, however, bank managers sometimes ration credit, choosing a lower rate than they might and refusing to meet some of the demand for loans that this rate encourages. Puzzled economists then are tempted to ask: How can such a strategy be justified? Surely it is irrational to choke off supply and reduce earnings from their theoretical maximum?

This kind of seemingly irrational behavior is only puzzling when you confine yourself to a limited set of assumptions, says Anjan V. Thakor, NBD Professor of Finance and current chairman of the Finance Department at the Indiana University School of Business. "A lot of my own research has been aimed at explaining these so-called puzzles. I can account for a great many things that on the face of it look irrational but that are, in fact, natural and rational outcomes." The explanations are based, it is true, on certain standard assumptions about the way people behave in the aggregate, but they add to those assumptions new insights and move beyond existing economic paradigms.

Thakor's research in the field of finance has primarily focused on corporate finance and financial intermediation. His work on the financial policies of corporations deals with such questions as how companies determine whether to issue dividends or repurchase stock, how capital structure decisions on the ratio of debt to equity are made, and how capital budgets are determined. In the area of financial intermediation and banking, Thakor inquires into the structure of financial contracts and institutions and asks whether, for example, banking should still continue to be restricted--with commercial banking separated from investment banking--two generations after the Great Depression.

Of the two approaches to research in finance, the empirical and the theoretical, nearly all of Thakor's published writings are on financial theory. Empirical work looks at existing data and tries to find regularities. An empiricist might ask, for example, what determines the ratio of debt to total assets in a corporation and turn for the answer to the vast reservoir of computerized data on this subject. A theorist, on the other hand, builds mathematical models, seeking either to explain existing stylized facts or to make predictions. A theory thus can either follow empirical research, in an effort to interpret established regularities, or it can lead such research, in which case the empiricist must then seek data that will either validate or refute it.

"If I have a bias in my own research, it's rather to explain unexplained phenomena than to generate new relations," says Thakor, "although I've done both." It was observed, for example, that when firms repurchased their stock from shareholders, the stock price rose more than could be justified by existing models. When firms issued new stock, the price tended to go down. Thakor coauthored a paper in the late 1980s examining precisely these phenomena. There was no theory at the time that could clarify the mechanism of such market reactions. Thakor described the reactions in mathematical terms and concluded, in essence, that managers signal the true value of their firm to the public by using a dividend or a stock repurchase or both. The public then responds to those signals,bidding up the price when the signals indicate the stock has been undervalued.

To build effective theories about financial relationships, Thakor and other researchers, such as Arnoud Boot, a former student of Thakor's who is now a distinguished professor at the University of Amsterdam in the Netherlands, accept certain basic assumptions about human behavior. That people act rationally is one of them. In economic terms, says Thakor, we are rational because we will use all the information available to us in order to make decisions that are in our own best interests. It is also a given that we have a utility function (a level of satisfaction) that is always increasing with consumption, which is to say that we will choose more of something rather than less. And, it is recognized, the marginal utility of our consumption always decreases, meaning that the more wealth we have, the less we enjoy the final increment: a hundred dollars earned means less to a millionaire than to someone with more modest resources.

But what of the common perception that people do not act rationally in regard to financial matters, that the stock market, for instance, is driven primarily by greed and fear? Among economists, these emotions can be considered natural signs of rational behavior, counters Thakor. Greed is another word, albeit a loaded one, for utility. Fear is a description of the observed fact that people tend to avoid financial risk: they are "risk averse," which in economic terms means that an individual prefers an investment return that is certain to a gamble with the same expected return.

"I don't deny the existence of irrational people," says Thakor, "but they are not very important for what I want to study." Economists assume rationality, he says, because to do so leads to theories that have structure and predictive power. The great disadvantage with building a theory based on the irrational "is that it can explain anything and predict absolutely nothing. That's not terribly helpful if you want to understand the world around you."

That the majority of people are risk averse is another of the standard assumptions made by researchers in finance. Thakor defines a number of these concepts in the first chapter of his recently published textbook, Contemporary Financial Intermediation, which he coauthored with his former dissertation adviser, Stuart Greenbaum. One of the most important concepts is related to precontract asymmetric information, an assumption first introduced to financial theory in 1970. To admit formally that information is asymmetrically available is to recognize that when entering into a contract, one party usually has more information relevant to the transaction than the other and is likely to use that information to seek a strategic advantage. Thakor has incorporated this assumption into the mathematical models in a great number of his research papers. "When you recognize that people act strategically (that there is gaming behavior) and that information is asymmetric, there are a lot of economic puzzles you can solve while still retaining the assumption that people are rational."

(The existence of asymmetric information, say Thakor and Greenbaum, explains why the bank manager mentioned above may choose to ration credit. With information about its borrowers necessarily limited, the bank cannot always judge how much risk they represent, now or in the future. In addition, a higher interest rate might discourage the safest borrowers, reducing the likelihood that all loans would be repaid. The bank concludes, therefore, that a lower interest rate and fewer loans would give it the highest probability--weighted profit.)

Thakor embarked on the textbook project because he felt that existing texts had not kept pace with what had been a decade of solid research. "Banking has been a very dynamic area," he says, "yet it became boring to teach because the textbooks were institutional and descriptive rather than analytical. There is nothing intellectually challenging or interesting in a text which just gives you facts. The whole purpose of our book is to ask, 'Why?'"

The transition, in finance, from research that rarely exceeded mundane description to research founded on rigorous mathematical analysis began in the late 1950s with the first of three important breakthroughs. The work of Franco Modigliani and Merton Miller on the financial policies of corporations, which was awarded the Nobel Prize in economics, introduced economic logic to the field of finance, says Thakor: "Now we could make predictions about how firms should behave." The second breakthrough occurred in the early 1960s with the development of the capital-asset pricing model. The model provides a benchmark rate of return for investments, so that investors know the minimum return they are justified in demanding given the risk they take. The Black and Scholes option pricing model of 1972 was the final breakthrough. It was so mathematical, says Thakor, that when it was published very few of the professors of finance could even read it, yet within five years the formula was on the pocket calculator of every trader on the Chicago Board of Options Exchange. "This was the explosion point," says Thakor. "Afterwards nothing was too mathematical for finance."

Thakor entered the field in the wake of these analytical breakthroughs, after receiving an undergraduate degree in engineering and then an M.B.A., both in his native India. He worked in industrial marketing for a couple of years, noticed he was beginning to get bored, and realized that any such job, if it is efficiently organized, is bound to become routine. "I really needed a profession where I could learn all the time and where the fact that I was learning would not be an impediment to the job." Academia was one of the obvious choices, so Thakor entered the doctoral program in finance at Northwestern University in 1976. "I picked finance because it was the one field that I couldn't find any flaws in. Everything was extremely logical and yet not rule-driven: finance always explained why you did what you did. It was also more human than engineering. These were not machines you were trying to understand--these were human beings."

Since coming to IU in 1979, Thakor has published more than fifty articles and monographs, many of them in collaboration with former students whose dissertations he has directed and with colleagues at other universities. "It's a personal thing," he says. "I just enjoy interacting with these people. A research project is a very creative process, and so there are moments of depression and joy. It's much more fun if you have someone to share it with. Oftentimes, too, research ends up being a way to socialize intellectually."

Given its highly theoretical nature, Thakor's research finds publication in academic journals that would seem esoteric to the nonspecialist. "I wouldn't expect, for example, a corporation manager to read my articles," he says. A second tier of journals, also scholarly, deals with the applications of such research, sometimes trying to extract predictions not present in the original work, sometimes performing a critical analysis of it. A third tier of journals, which deals at the level of the practitioner, focuses on articles written with the express purpose of applying theory to the business world.

"If the research is good," says Thakor, "eventually it finds its way into everyday practice." How fast this happens depends on the area involved. Typically, in investments the time lag between research and its application is the shortest, perhaps because what business investors do translates immediately into a great deal of money. (Hence the speed with which the option pricing model, mentioned earlier, was adopted by professional traders.) In banking and corporate finance the impact of theory is much more long term, says Thakor, and may take a decade or longer to be felt.

The implications of theoretical research can even reach the level of national government. A paper Thakor wrote in 1984 dealt with some very basic issues in the area of financial intermediation, asking, "Why do we have banks and financial intermediaries? What theoretical purpose do they serve?" The paper was a breakthrough in understanding why financial intermediaries exist, says Thakor, and generated more research by other scholars. As a result of all these studies, the way people think about the role of banks in the economy, from a policy standpoint, has been greatly affected. Since the paper was published, Thakor has twice been invited to be a visiting distinguished scholar by the board of governors of the Federal Reserve System.

There has been a progression, says Thakor, in the focus of his research over the past fifteen years. Much of his earlier work was "positive," which in economic terms means that it explained something observed or made a prediction that could be tested. His writings on credit rationing and stock repurchasing, mentioned previously, are examples of positive research, as are papers on why capital budgeting in corporations tends to be centralized, why purchasers of municipal bonds also buy insurance for their bonds, and why companies sometimes form separate subsidiaries to finance new projects.

In its progression, Thakor's research has become more normative in purpose, more prescriptive, studying not specific phenomena but rather a general class of problems. Normative research asks: What is the optimal arrangement of that portion of the world that interests us? How should it be organized? This focus in his work, which represents a new theme, seeks answers to such questions as: How should investment securities be designed? Is fairly-priced deposit insurance possible?

The normative trend in Thakor's research has also led, most recently, to work that could have repercussions at the international level. In consequence of the collapse of the Soviet economy, the question has been asked: How do you design an entire financial system? What, for example, should be the scope of banking? of the financial markets? The optimal design of such a system is clearly of vital concern to the Eastern European nations that must rebuild their economies from the ground up. They ask themselves: Should we build a bank-dominated system, as in Germany, or a market-dominated one, as in the United States?

Financial design appears less interesting in the United States, to the extent that the system we have is judged to be working. Yet it is a relevant issue, even here, because of its implications for the field of banking. It is reasonable to hypothesize, says Thakor, although it is not yet proven, that the broader the scope of banking, the narrower will be the scope of the financial markets. Does that mean, he asks, that if our long-standing restrictions on banking were lifted, the influence of banks would grow and that of the financial markets would diminish? The correlation between banks and the development of markets is one of the areas Thakor is addressing in his current research.

"We don't have good theories about financial system design," says Thakor, "and I can't rely on any of the existing research." The question is, given the standard assumptions about how people behave collectively, can we learn how such a system should be designed? Said another way, do we at least understand, without making value judgments, what the implications are of the different possible designs? Thakor is determined to investigate the larger issues of this new theme in his work. He entered academia, after all, because he wanted a career in which he could learn constantly. It is hardly a disappointment to have to say, "Research on this topic is just beginning."

--Tom Tierney