ISB Updates

Perspectives: Richard Roll in conversation with Ramana Sonti

Finance Research - Where Next ?

During the ongoing Certificate in Financial Engineering programme, jointly conducted by ISB and UCLA Anderson, Professor of Finance Richard Roll, who also holds the Japan Alumni Chair at UCLA, was at the ISB to teach a module on Financial Asset Management. Ramana Sonti, Director of Research Training Initiatives and Assistant Professor of Finance at the ISB, is also a part of the faculty teaching this programme. Both of them got together to share ideas about India, the ISB and the state of finance research.

Ramana Sonti: You have been to India quite a few times now, and to the ISB at least twice that I know of, in the last few years. Concurrently India and China are all the rage in the press. From your visits and interactions, what impressions do you have about India in general, and the ISB in particular?

Richard Roll: When I came to India for the first time, fifteen years ago, I thought there was a lot of potential in this country, and fifteen years ago India was not what it is today. I am happy to say that as soon as I went home, the first thing that I did was I put about 30 percent of my pension fund money in the India Fund at the New York Stock Exchange. I have kept that there ever since, and so I am fond of India for more reasons than one.

I have also known so many scholars from this country – my colleagues Bhagwan Chowdhry and Avanidhar Subrahmanyam, and of course I had many Indian students like Rajesh Chakrabarti, who is now a faculty here at the ISB.

I have been at the ISB twice, and I have enjoyed both times. It has a beautiful facility, and the conferences attract a lot of people from a lot of places, and so it is intellectually quite stimulating.

Sonti: Your paper with John Talbot, 'Why some developing countries just aren't,' talks about factors that governments could actually change - things like property rights, black market activity, and regulation and so on. Now clearly these are all points well taken, but there is a question that you could not address in the paper. How do we begin to address the issue of who will bell the cat, who will start these reforms, because typically in emerging economies the problem is not that people don’t know that things have to be done, so much as nobody has an interest in kick starting the process, and sometimes these are actually unpopular to the vested interests in those markets and countries. What are your thoughts?

Roll: I think that there are two aspects to this. One is that today people have an intuitive idea about institutional factors being important for prosperity. Development economists have thought of everything under the sun that might be responsible for this - from latitude to religion to culture. Culture is always the thing that explains everything that cannot be explained by something else. So the issue is whether we as scientists can identify things that can be changed, and that have the possibility of making big differences. Before I worked on the paper with John, I knew that empirically property rights are important, but I had no idea whether they caused wealth levels to go up by a dollar, or a thousand dollars per person. So, it was nice to get an empirical handle on which factors are important, and how much we can get out of ideally changing everything. get out of ideally changing everything.

There are lots of countries in the world that you can go to, as an advisor and convince them that they should change this or that, and they still won’t do it. They won’t do it because people in charge of decision making in those countries have a vested interest in not doing the right thing for the average person in that country. There are also countries where the people in charge are enlightened rulers who do want to do the right thing if they just knew what to do. You need to have a ruler who decides to act in the interest of the welfare of the people and also a revolution that puts somebody like that in charge. Regime shifts are tough to accomplish. India, for example, has got good institutions, and that’s why you are doing really well over the last couple of decades or so.

Sonti: You were instrumental in setting up the mortgage securities group at Goldman Sachs, and hence this question. Today we have seen the boom and burst of the real estate “bubble” in the US, including the sub prime mortgage mess. What is your take on where the system failed? Did it fail, according to you?

Roll: I don’t think it failed. What has happened in the global economy is that there has been a change of investor confidence, and I don’t believe that the sub prime mortgage situation in the US is alone the cause for it, as it is such a small fraction of the mortgage market, such a small dollar amount as a proportion. It couldn’t possibly be responsible for Citigroup to fall to a third of its value. I think a bigger factor is that real estate prices have in general come down in the US. It is not just that a few people defaulted on their loans. If we think back of the crash in 1987, twenty years later, we are still trying to figure out what caused that. Maybe the present scenario is another situation like that, although in the US case, I think the election that is coming up is worrisome for many people.

Sonti: Why? In what way?
Roll: They don’t like either candidate. Candidate, Barrack Obama who is probably going to get elected, has promised to raise taxes, impose additional restriction on free markets etc. The markets don’t like that. And since polls indicate that he is more likely to get elected, the markets are going down. I think that is a factor, but not the only factor. But then that doesn’t explain what happens in other markets, except for the fact that whenever the US hiccups, everybody else sneezes. It is a big economy, and so it has got a ripple effect.

Sonti: Finance, it is really a young field. There has been an explosion of research –Harry Markowitz and the Miller-Modigliani Theorem (M&M) in the fifties, Capital Asset Pricing Model (CAPM) in the sixties, Arbitrage Pricing Theory (APT) and Option Pricing in the seventies etc. Since I entered the profession, barely a decade ago, I sense a stagnation, and I hasten to qualify, in the sense of no big bang ideas like, say the Black and Scholes model. There has not been this revolutionary rupture of the present knowledge. Do you share this view?

Roll: In a certain sense I do, because during the fifties, Markowitz was the only person working on portfolio optimisation, so there were plenty of things to discover. I don’t think you’re going to find any discovery like Black and Scholes every decade. That’s too much to ask. But even in the last decade, we did have some major advances in research in areas of corporate finance, liquidity, and probably have better research now in international issues than we had before.

Sonti: You have had a long, fruitful and illustrious career in this field. Where do you see financial economics heading to in the near and mid term? What are the most promising avenues for future research?

Roll: I am always continuously surprised, ever since I started in finance, about all the new things which have happened, some of which I have contributed to and most of them I didn’t. So it’s always interesting to see what people are working on.

I do think there have been a few developments that aren’t good though. I think that journal publication has gotten so competitive nowadays, to the point where the idea of a referee these days is to find any excuse they can to reject a paper, rather than trying to be constructive and saying that there is a germ of an idea and to help develop that into something useful. Publishing research now is very difficult because first, the rejection rate is high to begin with. And second, the process of refereeing is not a very constructive process.

Sonti: So, here we are sitting in India trying to produce top-notch research, and you have just described the difficulty with the publication process. What advice would you have for the young faculty at the ISB?

Roll: It would be good if you did have some senior faculty here to work with, have some experience in the process. Think about ideas, maybe get ideas from business, chat with your young colleagues about which ideas are feasible projects. Today there are a lot more people doing similar research in this field than ever. When I got out of Chicago in 1968, there probably were three or four places in the world doing first class research and now you have got hundreds of places all over the world and people competing and doing good quality research. And that’s the challenge.