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6 Report of the Panel on the Financial Services Industry The Panel on the Financial Services Industry comprised six members, in- cluding one NAB member from industry, two other members from industry, and three members from academia. Three of the panel members were also members of the parent committee. The panel reviewed the literature and sent a question- naire to experts in academia, the financial services industry, and government. The questionnaire was followed by a workshop attended by 21 senior individuals in the financial services sector (see Addendum). Financial services are the foundation of a modern economy. They provide mechanisms for assigning value, exchanging payment, and determining and dis- tributing risk, and they provide the essential underpinnings of global economic activity. The financial services industry encompasses banking, insurance, equity markets and brokerage houses, leasing, venture capital, and personal and com- mercial credit. The industry provides the wherewithal for the capital investment that drives innovation and productivity growth throughout the economy. As the economy has become larger, more global, and more complex, the industry has become increasingly innovative in delivering products and services. The scope of the financial services industry is enormous: U.S. financial institutions process more than $9 trillion per day, approxi- mately equivalent to the U.S. gross domestic product (GDP) in 2001. Daily average trading volume on the New York Stock Exchange was more than one billion shares in 2000. · Commercial banks in the United States hold more than $6 trillion in assets (Federal Reserve, 2002~. 173
174 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE · The annual global life insurance market is more than $1.2 trillion in written annual premiums; the United States accounts for 24 percent of this total. Other kinds of insurance total more than $900 billion in annual policies; the United States accounts for 40 percent. · The U.S. savings and loan industry holds more than $1 trillion in assets. · The industry employed nearly 6 million people in 2000 (U.S. Bureau of the Census, 2002~. Financial services has long been perceived as a staid, conservative industry. However, the growth of information technology and global competition has driven the industry to embrace rapid technological advances and innovation. Informa- tion technologies, the Internet, risk modeling, and the creation of new markets in derivatives and other financial instruments have accelerated the pace and volume and increased the efficiency of financial transactions, at the same time driving the industry to make significant investments in new technologies. For instance, fi- nancial services firms account for more than 60 percent of investments in infor- mation technology in the United States. Hence, highly technically trained experts have become increasingly important to the industry. These trends have also led to an increase in competition and a blurring of the definition of financial institutions. Financial services firms are involved in leasing (GE Capital Corporation is perhaps the leading example), personal credit (e.g., AT&T's entry into and subsequent exit from the credit card business)) and other activities that were once the preserve of commercial banks. With the virtual elimination of interstate banking restrictions and mergers of firms from disparate parts of the industry, consoli- dations have proliferated in the banking industry. The end of the Glass-Steagall Act of 1933, which prohibited banks from accepting deposits and underwriting securities and established the Federal Deposit Insurance Corporation, and the constant entry of new domestic and global competitors, have created an industry subject to continuous redefi- nition and restructuring. Technologies and services for institutions and individual inves- tors on a national and global scale are now widely available. The consequences of rapid innovation, continuous restructuring, and on- going regulatory changes have been largely beneficial to the U.S. economy and society. However, these trends have also had some negative consequences. Some innovations have been credited with having a destabilizing effect on financial markets leading to "failures" that have been very costly to the industry in both dollars and public trust. For example, the application of derivative pricing for- mulas (developed by academics) in the large global hedge fund, Long Term Capital Management, was implicated in the fund's near collapse in 1998. DEFINITION OF THE INDUSTRY Because new players have entered the field from areas not traditionally associated with the industry, and firms already in the industry are expanding
FINANCIAL SERVICES INDUSTRY 175 their services to encompass different parts of the business, a narrow definition would not be useful. The adoption of new technologies to provide new services and existing services in innovative, more convenient ways further complicates efforts to define the boundaries of the industry. Defining the industry using specific companies or current participants as examples may also be some- what misleading. Therefore, the panel decided to approach a definition from two directions. The first is based on a functional view of financial services, which is perhaps the most useful way to examine how and why the industry is changing. In the functional view, most financial services or processes can be divided into two broad categories: (1) the packaging and description of securities; and (2) the facilitation of trade. Each function poses very different questions for aca- demic researchers. The second approach is to examine changes in the industry over time since about 1980, when it still resembled the traditional industry, which was dominated by commercial and investment banks, insurance companies, and brokerage houses. Transitions in the industry can then be assessed by comparing the indus- try in 2002 with the 1980 version. The characteristics of the industry in the near future can be suggested based on current trends. This approach provides a sense of the changes taking place in the industry over time. Functional View The first function of the financial services industry is the packaging and description of securities for consumers and businesses. This function spans a wide range of core services, from the mundane, such as providing savings accounts, certificates of deposit, and insurance for consumers, to the esoteric repackaging of risk for large corporations, such as security bundling, (e.g., mutual funds and mortgages). Recently, repackaging services have been mar- keted like real goods that are manufactured by a factory and brought to the attention of consumers by a marketer. In the complex world of finance, the industry must also play an advisory role. In fact, many firms focus more on advising investors than on selling securities, although the recent weakness in the stock markets and the wave of auditing scandals have made this function more difficult. The second major function of financial services is facilitating trades, or helping implement transactions. Financial service firms have always played a key role in moving trades involving actual goods and services or financial products through the economy. A simple example of this type of activity is the interest-free checking account: the bank provides standard check-clearing functions to help consumers and businesses make trades but does modify the securities that are traded. Other examples of transactional services are automated teller machines (ATMs), foreign exchange, and debit cards.
176 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE Changing Nature of Financial Services Until 1980, the financial services industry could be divided into four distinct categories: commercial banking, investment banking, insurance, and investment management. Applying the functional definitions to these categories is relatively easy. Commercial banking served both functions, but the other three primarily packaged securities and advised customers. Full-service brokerage houses per- formed advisory and transactional roles. The financial services industry in 2002 is in a state of continuous change, and pinning down exactly what is happening is very difficult. Many outside forces are at work, including macroeconomic changes and globalization, technological in- novation, competitive pressures, evolving regulatory climates, and specific events in the market. Given that financial services are really almost entirely information, the most powerful force for change is in information technology, especially the emergence of networks, such as proprietary information networks that deliver up- to-the-minute financial information, greatly facilitating financial transactions. The astounding impact of advances in information technology is immediately apparent when the amount of money moved, the number of shares traded, or the speed of transactions are compared with the same figures for the early 1980s. Technological changes are intertwined with other forces, especially changes in domestic and international regulation, which are transforming many parts of the industry. The number of traditional companies is decreasing because of con- solidations, which are also bringing firms together from disparate parts of the industry to form new entities. The increase in global linkages means that few financial service firms are immune to macroeconomic events that spill over na- tional borders. Both of these trends consolidation and globalization have raised questions about the stability and safety of traditional financial services firms and the ability of regulators to oversee them. Because of changes in industry structure, regulatory environments, the scope of services, and technological capabilities, the boundaries of the current financial services industry are very difficult to define, and may be even more difficult to define in the future. New firms that are not in the conventional circle of financial services are providing traditional functions. Examples can be found in e-commerce, where new entrants include firms that heretofore were associated with computer software and hardware and entirely new web-based start-up com- panies. Both of these transaction and information service providers are outside the traditional realm of commercial banking but provide many of the same ser- vices. Note, however, that by regulation, commercial banks are the ultimate providers of money in all forms. A similar situation has arisen with new and potential providers of electronic money. Electronic commerce is not the only area pushing the boundaries of financial services. The bundling and repackaging of securities is more extensive than ever before in areas that are not obviously related to financial products. For instance,
FINANCIAL SERVICES INDUSTRY 177 new musical recordings are "securitized" to spread the risk if sales of a recording are poor and the rewards if the recording is a hit. Other kinds of securities also blur the boundaries. An investment bank might issue options on physical events, such as earthquakes, which have been the province of insurance companies. The growing areas of equipment leasing and risk management are also difficult to classify; they include many services provided by actuaries, accountants, and other consultants whose activities are difficult to classify along traditional lines. The industry today includes many nontraditional functions, such as retailer sales, software development, network management, and key functions in the consumer industry. In general, these innovations have radically changed the key financial players. Many firms whose primary line of business is unrelated to financial services are integrating financial capabilities into their traditional busi- ness offerings to provide innovative business approaches. This trend is especially prevalent in the world of e-commerce and Internet business. Also, core parts of the industry, such as consumer banking, are now facing competition from compa- nies that historically had nothing to do with financial services. As consumers are increasingly able to make investment decisions them- selves, the industry is being forced to adapt. The government and others have been encouraging people to take more control of their long-term financial needs, and consumers are now more active in their long-range investment planning. The Internet has enabled firms to deliver detailed financial information and advice directly to consumers' homes. Indeed, unlike the old "transaction-based" rela- tionships, financial advice has become a key factor in the establishment of endur- ing relationships with clients. This combination has opened new areas of invest- ment advising, and new players have entered the field, ranging from simple web sites that provide stock quotes to complete data and software services provided by firms like Quicken and Microsoft.2 The shape of the industry in 5 to 10 years is difficult to predict. Change is likely to continue, and the industry is likely to become increasingly commodity oriented with an emphasis on the development of relationship-based interactions with customers. Future participants are likely to have more direct contact with consumers, who, in turn, will have more choices to make. To meet the needs of consumers, the industry is likely to be under great pressure to use more sophisti- cated marketing approaches. Financial services are likely to be provided in chunks corresponding to certain functions, and overlaps with other services are likely to decrease. Crucial people in the industry are likely to have technological back- grounds rather than traditional commercial or investment banking backgrounds. Future industry extensions will be difficult to classify along conventional busi- ness lines. Some will fit into the category of bundling of securities, while others will be more transaction oriented. However, in a few areas, even functional definitions will not apply. Nevertheless, the function-based definitions should be retained for three important reasons. First, the traditional breakdown of the industry (commercial
178 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE and investment banking, insurance, mutual funds) is no longer satisfactory. Sec- ond, the functional breakdown may be important for future academic research, because some areas, such as encryption for electronic transactions, clearly have very large engineering components. Other areas, such as the pricing and packag- ing of new types of securities, have more of a finance/economics/financial engi- neering component. Third, government regulation will be promulgated according to where the boundaries are drawn. INNOVATION SYSTEM Changes in the past 20 years have fundamentally changed the markets, the way customers interact with service providers, and the range of products in the financial services industry. These changes have taken place in a relatively short period of time and with no organized innovation process or formal organizational units devoted to research like the ones in most science- and engineering-based industries. Historically, however, many science- and engineering-based indus- tries did not have structured innovation systems in the early stages of their devel- opment. If the history of these industries is any guide, developments of the last several decades in financial services, in which technology has become critical to success in the industry, could represent the beginning of a shift to an organized research base. In the meantime, the absence of an organized research base has not hindered rapid innovation. Industry Drivers There are three primary drivers of innovation in financial services: market forces; tax and regulatory policy; and technology, particularly data processing, communications, and software. Often, these drivers interact. For example, the spread of the Bloomberg and other reporting services were made possible by technology, but were driven by market demand, which was reinforced because the availability of this information made the markets work better. A second pathway for innovation is regulatory reform, usually triggered by a large loss or failure. Pension plans, for example, are highly regulated to avoid repetition of earlier mismanagement of pension assets. The Employee Retirement Income Security Act (ERISA) requires that actuaries conduct independent evalua- tions of all defined pension plans each year and estimate the plan's surplus or deficit, based on a careful analysis of assets and liabilities over a long time horizon. Meeting this requirement provides employment for tens of thousands of actuaries. Insurance companies must perform similar studies. The insurance industry is even more complicated because all 50 states have insurance commissions with separate requirements. Insurance companies must report their statutory surplus/ deficits (STATs), their surplus/deficit according to generally accepted account- ing principles (GAAPs), and sometimes their economic surplus/deficits. Tens of
FINANCIAL SERVICES INDUSTRY 179 thousands of accountants, tax advisors, and related professionals are employed in these studies. Periodically, new regulatory requirements are added. According to the Finan- cial Accounting Standards Board (FASB) and its standards, such as FASB 87, pension plans in the United States must use a close-to-market discount factor when computing the market value of liabilities, rather than a fixed or arbitrary discount rate. This change is consistent with market-driven reporting but can cause large swings in surplus/deficits because of changes in long-term interest rates. As a consequence, pension plans must be more careful in allocating their assets and may purchase new financial products, such as complex options, to help them achieve their goals. As a rule, when regulators impose new burdens on investors, the finan- cial services industry responds by offering new products and services. Another example of regulation-driven innovation is the ever-changing tax code. Tax-advantaged investing is possible through a myriad of options tradi- tional individual retirement accounts (IRAs), Roth IRAs, Keogh plans, state col- lege tuition plans, variable annuities, other insurance-related investment vehicles, and many others. University researchers sometimes play a key role in these innovations. The U.S. Treasury Department's Office of Tax Analysis (OTA) routinely hires university faculty members for one- to three-year assignments. During a major study on tax reform, for example, David Bradford (of Princeton's Woodrow Wilson School) was head of OTA. Faculty advisors are also shaping the current debate on social security reform. New financial products will cer- tainly emerge as the government provides new avenues for deferring taxes or shifting ordinary income into capital gains. Although regulatory constraints can accelerate innovation by creating incen- tives to meet them (or work around them), regulations per se are not the principal drivers of innovation. Competitive pressures and innovations enabled by ad- vances in computing and communications technology and the modeling and simu- lation of financial markets are much stronger drivers. Institutional Drivers Academic research has played an important role in innovation in the finan- cial services industry, but a number of other players and factors have also contrib- uted significantly. The players are (in no particular order) financial services companies, universities/academic institutions, government agencies (oversight regulations and taxation), software developers, hardware manufacturers, spin-off companies, and consulting companies. Financial Institutions Innovation in investment banking has generally been initiated at major com- panies and has then been diffused to smaller companies and individuals. Large
180 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE banks with large budgets for new or improved technology are able to support both internal and external research. The results then trickle down to the overall market and smaller competitors. Much of the research is performed at various levels within the banks. Some of the work is undertaken in response to a central corpo- rate directive, but most of it is done in the operating units with no particular coordination. In general, the most productive R&D in the industry has taken place in a few pockets in larger firms and has been loosely organized. The disciplined ethos of R&D that can be found in high-technology manufacturing industries is totally lacking in financial services. Consultants and Consulting Firms Consultants and consulting firms have contributed significantly to innova- tion in financial services, sometimes based on academic research. More and more of these firms are developing internal quantitative-research capabilities. Manage- ment consulting firms, for instance, have developed the following innovative frameworks for measuring a company's economic performance: activity-based costing (a refinement of standard accounting practice that allocates costs to specific business activities) economic value added (EVA(~) (an approach used by Stern Stewart & Co. to measure the economic profit of an enterprise by calculating net- operating profit minus an appropriate charge for the opportunity cost of all capital invested in the enterprise) cash-flow return on investment (CFROI) (an approach used by Boston Consulting Group to compare a firm's cash flows with the inflation- adjusted capital used to produce them) · balanced scorecards (developed by David Norton, a consultant, and Robert Kaplan, a professor at Harvard Business School) to combine fi- nancial scores with measures of less tangible assets, such as customer satisfaction and loyalty, and a firm's ability to nurture the skills of its employees) Government Government has played a limited role in funding and using research in finan- cial services. Government has, however, funded the development of some crucial infrastructure technologies, such as check imaging. In addition, government re- sponsibility for the safety and soundness of the financial system has been a driver of economic and mathematical research in risk measurement and risk manage- ment. The resulting improvements in risk measurement and modeling technolo- gies played a significant role in the decision to repeal the Glass-Steagall Act of 1933. In the 1970s, government-funded research developed models for analyzing
FINANCIAL SERVICES INDUSTRY 181 tax policy, which provided systems for analyzing the impact of changes in the tax code on different groups in the United States. Today, these models are used by every government agency. Although government funds only a small amount of academic research relevant to financial services, it does support research in economics and math- ematics ($89 million and $229 million respectively in federal funding in 2000~. Total funding for academic research from federal and nonfederal sources was $255 million in economics and $341 million in mathematics (NSF, 2003~. Software Developers and Hardware Manufacturers The financial services industry relies heavily on technology developed in other industries, especially information technology, computers, communications equipment, and software. In a compilation of R&D spending on information technology in 500 end-user organizations, banking and financial services had the largest budget (9 percent) as a share of projected revenues and were estimated to have spent the largest percentage (0.45 percent) of projected sales revenues on information technologies R&D (NRC, 2000~. Investment in information technology has resulted in software development that has enabled much of the innovation in financial services. For example, Algorithmics is a growing software firm specializing in risk measurement and management software. Dr. Ron Dembo, the founder and CEO of Algorithmics, was formerly on the faculties of several universities including Yale, MIT, and the University of Toronto. Industry Consortia and Cooperation Financial services have traditionally worked together in moving funds, set- ting standards, facilitating cooperation, and sharing risk. However, sharing infor- mation in financial services is not easy. Because of competitive secrecy and the lack of protections for intellectual property, cooperation has not been focused on innovation. Because of competitive secrecy, it is difficult to get a sense of how much interesting and valuable research is being performed within the industry. The threat of competition from companies that have access to new innova- tive technologies has encouraged some attempts at cooperation in precompetitive research. The Financial Services Technology Consortia (FSTC) was established in 1993 to undertake precompetitive, collaborative R&D in electronic commerce, cryptography, education, and other areas. This initiative marked a first attempt at collaboration in R&D by the industry and mirrored the same trend in technology industries. The American Bankers Association followed with its own technology initiative, the Banking Industry Technology Secretariat (BITS), a division of the Bankers Roundtable. Another example is the Smart Card Alliance, in which more than 185 companies participate. The Smart Card Alliance was formed by the
182 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE 2001 merger of the Smart Card Forum, comprising primarily financial services firms, and the Smart Card Industry Association, whose members include a vari- ety of industries and government agencies. In 1999, a risk management initiative was launched by 12 of the world's leading banks, 11 of which had been part of the consortium that provided Long- Term Capital Management with $3.5 billion following its near collapse in the fall of 1998. The risk-management group, called the Counterparty Risk Management Policy Group, included Barclays Bank PLC, Bear Stearns & Company, Chase Manhattan Corporation, Citigroup, Inc., Credit Suisse First Boston, Deutsche Bank, Lehman Brothers, Inc., Merrill Lynch and Company, Inc., Morgan Stanley Dean Witter, and Warburg Dillon Read, a unit of UBS AG. The stated purpose of the group is to enhance existing risk-management practices and to compile infor- mation that could be reported to "regulators and supervisors, all with a view to enhancing the discipline, efficiency and liquidity of financial markets." (Bloomberg Information, 1999~. The group issued a report in June 1999 that included more than 20 recommendations to improve risk management (Counterparty Risk Management Policy Group, 1999~.3 Intellectual Property Historically, protecting intellectual property was not an issue in financial services because there was little opportunity to create it and, therefore, little need to protect it. When new financial instruments were created, they often had very short half-lives, so the emphasis was on being first to market with innovations and capturing market share before competing products were introduced. Trading systems and databases are considered highly proprietary and are regarded as trade secrets. This industry posture vis-a-vis intellectual property (e.g., the need for secrecy, tight controls) has probably been an impediment to collaborations with academic researchers. The potential to create competitive advantage through patenting was suc- cessfully demonstrated when, in 1980, Merrill Lynch filed for and was issued U.S. Patent No.4,376,978. The patent relates to the Merrill Lynch Cash Manage- ment Account program (CMA) and, specifically, the data processing methodol- ogy and programs for effecting the CMA. The CMA consolidated checking, savings, investments, and borrowing into an all-in-one account, which is invested in a money market fund. The patent allowed Merrill Lynch to exclusively offer the CMA; later the company gained substantial revenues by licensing the same technology to other securities firms. Recently, banks and other traditional and aspiring financial institutions have become interested in patenting in the area of financial services, due in part to the 1998 "State Street" decision by the Patent Court, which broadened patent protec- tion to include "business methods," including financial services. Although much of the patent activity is by technology companies outside financial services, the
FINANCIAL SERVICES INDUSTRY 183 top two assignees for patents are Merrill Lynch and Citicorp (Lerner, 2000~. Today, many new patents are being issued, some involving systems and techno- logically based financial innovations, but only one of the top five companies with patents in the area of electronic commerce is a financial services company. It remains to be seen if these patents are enforceable. Human Capital Traditionally, bankers were regarded as predominantly "relationship people" who were not mathematically oriented or analytical. Bankers today, however, use financial applications based on the Black/Scholes model for pricing financial options (Black and Scholes, 1973~. Because of regulatory changes, technological innovations, globalization, and other factors, bankers must now understand and react to events in financial markets. This has resulted in a significant increase in the demand for scientists and engineers. For example, in 1997 when the Federal Reserve imposed new capital/reserve requirements based on a value-at-risk sys- tem, it created a demand for people who could calculate these requirements on an integrated basis. At the same time, science and engineering graduates with new knowledge and new skills enabled the Federal Reserve to develop these new reserve-requirement formulas. Scientists and engineers are generally not hired to perform research in finan- cial services companies. They are usually scattered throughout the organization, including the small business units, where they are often indistinguishable from traders and other personnel. CONTRIBUTIONS OF ACADEMIC RESEARCH The links between academic research and the financial services industry are not nearly as well established as they are in many other industries. Nevertheless, academic research has made very important contributions to the industry. There is a tendency to overstate the importance of breakthrough innovations in financial services and to understate the importance of a long list of small but significant incremental innovations. The aggregate consequences of academic research for the financial services sector cannot be quantified, but examples can be cited to illustrate their impact. Academic research on financial engineering4 has been especially useful to the industry. Because underlying theory and actual practices are well aligned in this area, a steady stream of academic contributions has flowed to the industry (Heath et al., 1992~. Related academic research has also contributed to other kinds of modeling (e.g., volatility skew), binomial methods and their extension, and partial differential equation methods. Monte Carlo methods, originally devel- oped in the national laboratory system for weapon design, have been advanced through excellent cross-fertilization between industrial and academic research.
184 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE At the same time, research in the traditional disciplines of finance and economics has also made substantial contributions to financial services. Ex- amples include conceptual breakthroughs such as portfolio diversification and "two-fund separation" theory, which helped lay the foundation for modern index funds; the development of optimal capital-structure theory; contributions from behavioral finance on decision making under uncertainty; as well as such widely used tools in econometric and economic modeling as the generalized method of moments estimation. The financial services industry can be widely defined to include just about all business applications dealing with financial information. Our focus on the narrow area of financial engineering illustrates the relationship of academic research and subsequent applications in industry. Additional linkages could be cited, depending on the definition of financial · 1 r. · ~ economics and Ilnanclal englneenng. The nature of academic contributions to the financial services sector is likely to change in the future. As the industry evolves, new areas of academic research are likely to become useful. For example, academic research in con- sumer behavior that sheds light on how individuals make decisions regarding financial products and services has become extremely important. As large amounts of data derived from networks, databases, and transaction systems become available, the industry is likely to use more advanced, nonlinear math- ematical analyses and other methods to predict consumer behavior. Areas and Types of Contributions Major contributions of academic research to financial services can be traced back to five areas: conceptual breakthroughs; financial products and tools; con- sumer research; research on legal, regulatory, and institutional issues; and re- search on industry infrastructure. Conceptual Breakthroughs Fundamental research in portfolio theory, linear programming, derivative pricing theory, and prospect theory laid the foundation for entirely new families of financial products and services. At least nine Nobel prizes in economics have been awarded to researchers associated with universities for major conceptual breakthroughs important to financial services: . . Daniel Kahneman (Princeton) in 2002 for integrating insights from psy- chological research into economic science, especially concerning human judgment and decision making under uncertainty. Along with Amos Tversky (Stanford), this work created the field of behavioral finance. Myron Scholes (Stanford) and Robert Merton (Harvard) (with Fisher Black of Goldman Sachs) in 1997 for a new method of determining the
FINANCIAL SERVICES INDUSTRY . . . . 185 value of derivative securities. The breakthrough idea was that derivatives can be priced without estimating the future direction of the underlying security. This concept spawned a new industry the development, pric- ing, and trading of derivative securities. John Harsanyi (University of California, Berkeley), John Nash (Princeton), and Richard Selten (Rheinische Friedrich-Wilhelms- Universitat Bonn) in 1994 for pioneering analysis of equilibria in the theory of non-cooperative games. Non-cooperative game theory excludes binding agreements while making predictions about the outcome of stra- tegic interactions. It has become a standard tool in the analysis of oli- gopoly and the study of competition between firms in the theory of indus- trial organization. But the concept has also been used in macroeconomic theory (e.g., for economic policy, environmental and resource economics, foreign trade theory, the economics of information) to make complex strategic interactions more understandable. · Harry Markowitz, Merton Miller (University of Chicago), and William Sharpe (Stanford) in 1990 for their work on portfolio theory using qua- dratic programs to explore diversification strategies to reduce risks. Con- cepts based on efficient frontiers and mean-variance are used to find a mix of assets that simultaneously maximizes the investor's return and minimizes risks. This theory provides the basis for a large number of financial planning packages. Merton Miller (University of Chicago) in 1990 and Franco Modigliani (MIT) in 1985 for their seminal contributions to the development of optimal capital-structure theory, specifically for positing the theory for the capital- market relationship between the capital-asset structure and dividend policy of production firms, and firms' market value and costs of capital. This work provides a basis for structuring corporations in highly competitive markets. · James Tobin (Yale) in 1981 for his work on portfolio diversification and "two-fund separation theory," which along with the Capital Asset Pricing Model, developed by William Sharpe, provided the conceptual founda- tions for index funds. Tjalling Koopmans (Yale) and Leonid Kantorovich (Moscow Academy of Sciences) in 1975 for optimum resource allocation theory, which pro- vides a practical approach for managing large, complex organizations and is used by many financial companies for managing assets and liabilities.5 Kenneth Arrow (Harvard/Stanford) in 1972 for foundational work on economic equilibrium and state-spaces models of uncertainty. · Paul Samuelson (MIT) in 1970 for his role in bringing quantitative rea- soning to economics and for his work on the implications of optimization for understanding the qualitative behavior of models.
186 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE Financial Products and Tools Academics have been involved in applied research to develop specific prod- ucts in financial engineering and optimization, such as pricing models and port- folio methods. Although relatively few financial services firms have specialized personnel capable of incorporating the results of academic research, a growing number of firms are convinced of their value for real-world business. Some of the most important products and tools are listed below: foundations of option pricing (Black and Scholes, 1973; Merton, 1973) numerical methods of pricing and hedging, including discrete approxima- tions of diffusion processes, partial differential equation methods, and Monte Carlo survey methods arbitrage restrictions on the term structure of interest rates, especially the standard interest rate model developed by David Heath, Robert Jarrow, and Andrew Morton (1992) at Cornell University, and earlier work by Oldrich Vasicek (1977), Thomas Ho and Sang-Bin Lee (1986), and others formulation and solution to problems of portfolio optimization begun by Harry Markowitz when he was a doctoral student at University of Chi- cago and continued by many others, such as Michael Dempster at Cam- bridge, John Mulvey at Princeton, Stavros Zenios at the University of Cyprus, and William Ziemba at the University of British Columbia methods of analyzing financial time series, especially models that incor- porate autocorrelation and varying volatility (e.g., autoregressive condi- tional heteroskedasticity [ARCH] models, introduced by Robert Engle, New York University, in 1982, and their variants) generalized method of moments estimation tools that are widely applied to a large number of econometric and economic models (although the method of moments has been known for more than 100 years, L.P. Hansen [University of Chicago] extended the concepts in what became known as the generalized method of moments) (Hansen, 2001) use of mechanism design theory, which studies the design of institutions or mechanisms implementing collective decisions under different circum- stances, for contractual design · incorporation of credit risk into pricing models (e.g., Jarrow and Turnbull, 1995; Duffie and Singleton, 1997) Consumer Research Consumer research began about 25 years ago and is now very common. Academic research has contributed to an understanding of large data sets, con- sumer behavior, and so on. The closest academic counterpart to industry research on consumer financial behavior is in the social sciences, which tend to focus on
FINANCIAL SERVICES INDUSTRY 187 aggregate human behavior, but rarely cover financial behavior. Although market- ing is taught as an academic subject, there are few, if any, programs on consumer (credit) finance. The University of Michigan Panel Study of Income Dynamics covers some financial behavior, and the Credit Research Institute also does some work in this area.6 But little academic research focuses directly on how financial institutions can influence customer behavior (business strategies), how technical tools can be used, or the best strategies for affecting consumer portfolio behavior. Academic research has contributed to the development of data and technical tools for personal financial management but has had little influence on teaching people how to analyze data or use the tools effectively. Unlike investment bank- ing, there seems to be little underlying social theory in this area. The trend in consumer financial institutions is to hire scientists (e.g., physicists and mathema- ticians) and other highly trained technical people who often have little experience in dealing with consumer behavior and the fuzziness of action/reaction patterns. Research in this area could be very helpful to policy makers, who know very little about this area of social behavior or have ideas based on outdated studies. Re- search could improve their understanding of which segments of the population are able to manage their own financial portfolios to maintain adequate income through retirement, which segments require public management through Social Security and Medicare, how public programs can be made more efficient, and how changes in public programs can be made. In 1996, the Employee Benefit Research Institute (EBRI) arranged a review of public-sector and private-sector dialogues to call attention to the lack of good research on retirement issues. EBRI and the Investment Counselors Institute managed to create a shared database on 401(k) participants to inform more effective policies. Legal, Regulatory, and Institutional Issues Academic researchers have been instrumental in analyzing legal and regula- tory constraints on the industry and in reforming the regulatory environment. Academia-developed models of asset and arbitrage pricing and risk management have been extremely influential. Rules for trading activity are based on value-at- risk models. Because of the complexity of many global markets, such as energy, securities, and foreign exchange, regulators and economic policy makers now depend on models as a basis for decisions, which provide an objective basis for making decisions in real-world markets that are too diverse or take too long to provide feedback. In these cases, the models do not simply represent reality; they become reality. Infrastructure of the Industry Academic research has contributed to the infrastructure of the modern fi- nancial services sector, particularly in the area of encryption technology and
188 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE networking. The technological infrastructure of the financial services industry is probably the most extensive and complex of any service sector in the U.S. economy. Academic contributions to networking technology have had a funda- mental impact, enabling electronic payment systems, automated teller machines, and the growth of credit and debit cards in the 1970s and the emergence of electronic commerce via the Internet in the 1990s. (For more about networking technology, see discussion in Chapter 2.) TRANSFER MECHANISMS A pattern has developed for transferring the results of academic research to the financial services industry. First, academic researchers publish a series of papers on a topic in the field of financial economics. The papers set the stage for a few innovative firms to test products based on the idea; faculty members are often involved as consultants to these firms. In some cases, junior and senior faculty resign from academia to work on these projects full time. If the product proves to be effective, the financial industry invests in further development. At this point, many firms attempt to duplicate the product or service. Controversies about the protection of intellectual property via trademarks, copywriting, trade secrets, and patents are addressed in the courts as they arise. An excellent example of this pattern involves index funds. During the 1970s and 1980s, there was considerable debate among academics about the efficiency of financial markets and the ability of portfolio managers to succeed over long periods of time. Some argued that a market fund could outperform the majority of active portfolio managers. Wells Fargo and several other innovative banks set up mutual funds with the sole aim of mimicking the return of the S&P 500 stock index. (Often the banks would purchase the stock in all 500 companies). At the urging of Professor Burt Malkiel at Princeton University, the Vanguard Company established the first index fund for individual investors. Since then, index funds have become enormously popular because of their low cost structure, their avail- ability, and their historical performance. For example, Vanguard's Total Stock Market Index Fund had a net asset value of $15.8 billion on January 31, 2002. Fidelity's S&P 500 index fund had a net asset value of $8.6 billion at the end of January 2002. These funds are directly attributable to the early research of academics. A significant portion of current activities in the financial services sector would not be possible without fundamental mathematical tools that were devel- oped or adapted to financial problems by academics. Beginning with the Black- Scholes option-pricing formula now applied in a myriad of ways, these math- ematical techniques enable the industry to price an almost unlimited variety of financial instruments. Markets as diverse as options, futures, other derivatives, securitization, and reinsurance could not exist in their current forms without these tools. Today, these techniques are widely known and understood, and new
FINANCIAL SERVICES INDUSTRY TABLE 6-1 Innovations in Financial Services Resulting from Academic Research 189 New financial instruments/securities/products · index funds · financial derivatives · securitization (risk neutral valuations) · credit derivatives (emerging)/credit management (modification of models developed for science and engineering) Analytical and Modeling Tools · option pricing (black-scholes and successors) · portfolio theory · market microstructures Financial Information and Research Tools · online information services (mixed academic-industry heritage) · online investment services · off-the-shelf risk-management software · risk metrics/credit metrics Transactions · cryptography · electronic commerce/world wide web (mixed academic-industry heritage) Consumer Research · scoring models · panel studies products and applications are being developed without further interaction with the academic sector (although the work is done by individuals trained in academia). Table 6-1 shows innovations in financial services that were generated at least partly by academic research. Flow of Ideas Advice and ideas from academia to the private sector continue to flow. Commercial and investment banks rely heavily on academic economists, who have a substantial influence on risk management because they are instrumental in the development of techniques and modeling tools and have insights into the macroeconomic developments that are inputs to the models. A mutually reinforc- ing dynamic is at work among the diffusion of human capital into the financial services firms, the development of increasingly powerful computer hardware, and the insights of academics into financial theory. For example, the combined capabilities of technology and academic research were involved in the develop- ment of the structure of large-scale auctions, such as the auctioning of the radio- frequency spectrum.
190 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE Flow of Human Capital The flow of human capital into financial services firms has been crucial to the evolution of the industry, which draws on people from a wide variety of disciplines who have mathematical and modeling skills. It is not clear whether this diversity is a plus or a minus for innovation. On the one hand, considerable "on-thejob training" is necessary before a physicist or nuclear engineer can apply his or her modeling skills to the analysis of financial problems. On the other hand, people with diverse backgrounds who have been encouraged to think creatively by graduate research may be a source of creativity and may come up with new approaches to problems. It is probably inevitable that training for employment in the financial ser- vices industry will gradually become more traditional. As finance and financial engineering programs become more widespread and more firmly established, they will probably provide a steady flow of people with postgraduate degrees targeted specifically to the financial sector. In general, although academic research is stimulating to some, it can seem esoteric and confusing to others. Although much of the academic literature is all but incomprehensible to nonacademics, the dissemination of research results is essential for continued innovation. So-called "quants" (scientific quantitative people) working in the derivatives industry are most likely to try to keep abreast of academic research by reading preprints and attending conferences. To bridge the academia-industry gap and to meet the need for more avenues of transfer, some have argued that applied research should be done in individual companies (loosely linked to a university) or through university think tanks. Impact of Academic Research Links between academia and the financial services industry are less formal, less structured, and more amorphous than the links in science-based industries. This may be because innovation in financial services is inherently less amenable to structured, scientific investigation. It could also be that this is a natural stage in the evolution of the industry and that, as academic disciplines such as finan- cial engineering evolve, the structure of the innovation system will evolve with them. If so, the current transitional relationships between academia and the financial services sector will be replaced by a more structured innovation system in the future. The financial services industry can be divided into two fundamental areas: (1) securitization, or the packaging and bundling of financial products or services for consumers or businesses (security bundling); and (2) the facilitation of trades, or helping to implement transactions (transactional). Academic research has had a more direct impact on securitization (i.e., with development of novel financial products and services). Clearly, financial instruments, investment management,
FINANCIAL SERVICES INDUSTRY 191 and decision support tools created in academia or through public-private-sector partnerships have been critical to the success of the financial services industry. Quantitative measures of the impact of academic research are difficult to determine. The entire industry is characterized by phenomenal increases in the amount of quantitative data concerning transaction volumes, flow rates, asset bases, customer activity, product ranges, and other activities, but assigning spe- cific increases to academic research is difficult. Certainly the number of new securities introduced each year based on academic research is large and growing, and the number of institutions and people who use these products for managing their financial affairs can be estimated. For example, the dramatic increase in option trading in the past decade is largely attributable to the efforts of academic researchers. Another measure is the increase in the number of people who are working on the development of financial products and in related areas. Finally, it may be possible to measure improvements in economic efficiency. Although the task is complicated by the heterogeneous nature of the industry, an informed, intuitive review suggests that much of the recent growth in the industry can be traced to academic research. Some have argued that academic research can also be considered to have had a negative impact on the industry. Some have argued that a number of recent financial disasters, such as the near demise in 1998 of Long Term Capital Man- agement, a very large, global hedge fund that was heavily influenced by aca- demic research, can be attributed to the results of research in financial engineer- ing. This experience demonstrated that the pricing formulas used in many financial models do not account for periods of economic turmoil and alerted the financial community to these pitfalls and limitations. OPPORTUNITIES FOR FUTURE ACADEMIC RESEARCH A broad range of academic research in engineering, natural sciences, eco- nomics, mathematics, social sciences, and public policy will continue to contrib- ute to the success of the financial services industry: · identification of rogue traders · allocations of capital to various activities · the dynamics of markets (stochastic models) and market microstructures · evaluation of mergers of financial services providers · issues of globalization, such as diverse regulation, capital flight driving countries to near bankruptcy, tax havens, and money laundering · investigations of legal, sociological, and technological issues related to privacy, trust, security, contract law, etc. · assessments of the impact of technology · risk audits · ethical dimensions of finance
192 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE FINDINGS AND RECOMMENDATIONS The results of academic research in economics, information systems, and other areas have had a substantial, direct impact on the structure and performance of the financial services industry in the past 20 years, especially in the areas of risk management and new financial instruments, such as derivatives. The panel has attempted to distinguish between the direct contributions of research (e.g., modeling and risk management) and indirect contributions (e.g., contributions of people educated and trained at universities and research results embodied in software and hardware used by the industry). Indirect contributions, such as research on cryptographic algorithms that now play a critical role in financial services, have been significant. Both fundamental and applied research have affected the industry. In some areas, such as the pricing of securities, academic research has played a major role. In other domains, such as the identification of arbitrage opportunities, economic incentives are more than adequate to keep researchers busy. These are important distinctions, because funding for academic research should be focused on the exploration of basic concepts that will not be undertaken under the current incentive system. A natural tendency has been to look for specific engineering or applied research influences in financial services. However, a considerable body of academic research, including fundamental re- search in economics and finance, has been applicable to financial services. Con- necting the academic research base with the financial services industry remains an ongoing challenge as well as an important opportunity. Although it is difficult to predict the future significance of academic re- search, the increasing innovation and complexity of financial services will prob- ably prove to be a rich and fertile area for future academic research. For example, the emergence of global consumer markets for financial services could create research opportunities in consumer research and behavioral sciences. Overall, it is difficult to compare the importance of academic research to the importance of other sources of new knowledge and innovation. It is evident, however, that the contributions of academic research have been fundamental and consequential. Finding 6-1. Technology derived from academic research in economics, infor- mation systems, engineering, and other areas has been fundamental to innovation in financial services in the last 20 years. Technology can be defined broadly to include pricing securities and risk- management systems. In the past, academic research relevant to financial ser- vices was concentrated on fundamental concepts in finance, economics, and tech- nology. Now, academic research on applications from engineering disciplines and the physical sciences has become more important, and the number of joint university-industry activities in these areas has increased significantly. Opportunities for the application of engineering methods and processes in the financial services industry are expanding rapidly. With the advent of mass-
FINANCIAL SERVICES INDUSTRY 193 scale consumer marketing involving tens of millions of transactions, financial services are becoming similar in some ways to manufacturing and process indus- tries. The advent of the Internet and its potential transformation of financial services has underscored the role of engineers and technology to the future of financial services. At the same time, engineers can also learn from engaging with the financial services industry, particularly in the areas of stochastic and model- based approaches to problem definition and solution. Recommendation 6-1. The National Academy of Engineering together with other agencies or private foundations should examine how engineering methods and processes practiced in advanced manufacturing industries can be applied in r. . Ilnancla. . services. Finding 6-2. Because financial services firms traditionally have had no formal research function or culture (in contrast to science-based industries), no formal organizational structure has been established for technical personnel to keep track of academic research or to communicate industry research needs to academia. At the same time, academia has also failed to establish an organized way of mapping the needs of the industry and relating them to academic research. Recommendation 6-2. The management of financial services companies should become more familiar with the ways academic research affects their businesses. Managers should review the processes they have (or need) to ensure that they can take advantage of the results of academic research. The creation of an engineer- ing research center for financial services, similar to the research centers sup- ported by the National Science Foundation for engineering, could provide a nexus for industry-academic activities. Finding 6-3. A convergence of events, including deregulation, globalization, increasing competition, and the information revolution, has made financial ser- vices more technically intense and accelerated innovation in the industry. The panel expects innovation to remain very rapid, driven mainly by developments in engineering and technology. Recommendation 6-3. Professional societies, policy research organizations, and federal agencies associated with science, engineering, and technology, including the National Academy of Engineering and the National Science Foundation, must recognize the importance of research and technology to financial services and include financial services in their mainstream activities. Accordingly, federal funding for long-term, potentially high-impact research relevant to financial ser- vices, which is currently very limited, should be expanded. Finding 6-4. Regulation has been a major factor shaping the financial services industry, both as a boundary condition and as a stimulus to innovation. The impact of academic research on regulation has been relatively small historically (and usually in response to a crisis); however, the impact of academic research on
194 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE regulation, particularly on risk management, is growing. In general, the regula- tory community lags behind the industry proper in the application of new knowl- edge and tools in the area of risk management. Recommendation 6-4. Regulators should be encouraged to support more aca- demic research in their areas of concern and to become more knowledgeable in modern risk-management methods. Finding 6-5. The responsibility for financial decisions is being shifted to indi- vidual consumers of financial products, and individual responsibility for financ- ing retirement is becoming increasingly likely. The current administration' s pro- posal for partially privatizing Social Security is a move in this direction. The knowledge and tool base available to help individuals make good financial deci- sions is in its infancy. Most marketing research is descriptive and is performed for the benefit of financial service providers; very little normative research is aimed at helping individual consumers make better financial decisions. Recommendation 6-5. The National Science Foundation and other federal agen- cies should fund normative research to help consumers make better financial decisions to complement anticipated legislative action that would shift financial responsibilities to individuals. Finding 6-6. Individuals play an important role in transferring the results of research from academia to the financial services industry. As the field of finance becomes more quantitative and analytical, the training of engineers and financial analysts is becoming increasingly similar. The migration of academically trained people to the industry has apparently had a significant impact on successful innovation. Unlike more science-based industries, financial services companies have only recently begun to hire technically trained people who can interact profitably with academic researchers and translate industry needs to academia and academic research results to industry. Today, academia provides much of the human capital for the financial ser- vices industry. Business schools, for instance, train large numbers of practitioners for the industry, including many who advance to senior management levels. Engineering departments train many of the analysts, but there is very little sup- port or guidance for this training from the financial industry. Although the indus- try benefits greatly for very little investment, the benefits could be even greater if the industry provided more support and was more closely involved. Recommendation 6-6. The financial services industry should encourage re- search exchanges, sabbaticals in industry, industry practitioners teaching in uni- versities, and other industry-academic interactions. The industry would benefit greatly from the establishment of mechanisms to facilitate the flow of people between academic research and the financial services industry. Mechanisms could include more targeted curricula and programs in computational finance,
FINANCIAL SERVICES INDUSTRY 195 financial engineering, and other areas; revised incentive and reward systems; and protections of intellectual property. finding 6-7. Historically, intellectual property in financial services has not en- joyed the same level of protection as intellectual property in science-based indus- tries. Instead, the industry has focused on keeping trade secrets and speed to market. Although patenting has increased greatly, it is too soon to tell if this will have a positive or negative effect on innovation and growth. Because technology is essential to many innovations, more patents are sure to be granted. Recommendation 6-7. The panel calls upon the U.S. Patent Office, Federal Reserve, U.S. Department of the Treasury, National Science Foundation, and other affected federal agencies to support research on the impact of changes in the treatment of intellectual property in the financial services industry, specifically the impact of the recent flurry of patent activity. ~ inding 6-X. rl~he relationship between innovation and economic performance is poorly understood. This problem is not specific to the financial services industry. Recommendation 6-8. Given the sheer size and importance of the financial services sector to the nation's economy, measures of innovation and of the rela- tionship between innovation and economic performance should be developed for the financial services industry. Although defining the end product of financial services will be difficult, focused research on this problem could reveal suit- able measurements. Finding 6-9. The deregulation of markets has created many opportunities for businesses and individuals but has also increased risks. For a variety of reasons, including technological advances, esoteric financial instruments and structures, globalization, the speed and magnitude of money/asset movement, and mass communications, risk management is more important for financial services now than it was in the past. Risks, ranging from operational risks to credit and cur- rency risks, are more numerous and less understood than ever before. Each risk has the potential of endangering not only financial institutions but also sovereign nations and, ultimately, the global economic system. Recommendation 6-9. Management in financial services should review how leading engineering-intensive industries have integrated risk management and quality improvement into all aspects of the design, production, and delivery of their products and should apply the principles to financial services. The National Academy of Engineering should convene a meeting to develop a suitable re- search agenda. Finding 6-10. A research gap has become apparent between basic research and applied research, particularly in the areas of financial models and market reality, and the financial infrastructure and its behavior under various conditions. To
196 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE bridge the gap between theory and practice in experimental economics, economic theories should be tested in real markets and the structures analyzed before new (potentially destabilizing) products are introduced. Although regulators have tried to anticipate problems by using models and other tests, their efforts have been hampered by inadequate data and a lack of established processes. In general, the industry does not have a solid theoretical foundation to mount an institutional response to problems. The lack of data is largely the result of companies being unwilling to share data on credit risk, operational risk, corporate defaults, and other aspects of their businesses. Recommendation 6-lOa. To make data more widely available to academia, data from competing financial institutions should be collected by third parties and "sanitized." One simple idea would be for the industry to fund a web service that would help individual researchers find the sources of data in financial services. Users of this data could include off-Wall Street firms and, of course, individuals, who are increasingly being urged to manage their own financial futures. Recommendation 6-lOb. Financial services companies should establish consortia/ cooperative research to define and build a technological infrastructure and knowl- edge base for various sectors of the financial services industry. Cooperative activities could be based on insights from Bankers Roundtable Information Tech- nology Secretariat (BITS), Financial Services Technology Consortium (FSTC), Smart Card Forum, and Counterparty Risk Management Policy Group. NOTES 1AT&T sold its Universal Card business to Citicorp in December 1997. 2It is not at all clear that available financial advice, tools, and data are sufficient for individuals to take control of their financial future. Should investment management by professionals, always controversial in terms of performance, be replaced by investment management by individual con- sumers? Can an individual consumer exposed to information from many sources understand "real- time risk" as financial and economic events unfold almost in real time on television or the Internet? In the wake of stock market declines in 2000 and 2001 and the Enron debacle in 2002, the answers to these questions have assumed real policy implications. 3In June 1999, representatives of the Counterparty Risk Management Policy Group presented policy recommendations to the Subcommittee on Capital Markets, Securities and Government Spon- sored Enterprises of the House Committee on Banking and Financial Services. 4Financial engineering, the quantitative analysis of financial markets, complex securities, and risk management, using mathematical, statistical, and computational models, is now included in the curriculum at many universities. 5George Dantzig's development of the simplex method should also be noted. 6The Panel Study of Income Dynamics (PSID) at the University of Michigan is a longitudinal survey of a representative sample of individuals and their families. The study has been ongoing since 1968. The data were collected annually through 1997, and biennially since 1999. The data files contain the full span of information collected over the course of the study. PSID data can be used for cross-sectional, longitudinal, and intergenerational analysis and for studies of individuals and families.
FINANCIAL SERVICES INDUSTRY 197 REFERENCES Black, F., and M. Scholes. 1973. The pricing of options and corporate liabilities. Journal of Political Economy 81(3): 637-654. Bloomberg Information. 1999. Securities Firms and Banks Form Risk Management Group. Jan- uary 7. Available online at: http://www.bloomberg.com/. Counterparty Risk Management Policy Group. 1999. Improving Counterparty Risk Management Practices. New York: Counterparty Risk Management Policy Group. Duffie, D., and K. Singleton. 1997. An economic model of the term structure of interest rate swap yields. Journal of Finance 52(4): 1287-1321. Federal Reserve. 2002. Assets and Liabilities of Commercial Banks in the United States. Federal Reserve Statistical Release. Washington, D.C.: The Federal Reserve Board. Hansen, L.P. 2001. Method of Moments. In International Encyclopedia of the Social and Behavior Sciences, N.J. Smelser and P.B. Bates, eds. Amsterdam and New York.: Elsevier. Heath, D., R. Jarrow, and A. Morton. 1992. Bond pricing and term structure of interest rates: a new methodology for contingent claims valuation. Econometrica 60: 77-105. Ho, T.S.Y., and S-B. Lee. 1986. Term structure movements and pricing interest rate contingent claims. Journal of Finance 41: 1011-1029. Jarrow, R., and S. Turnbull. 1995. Derivative Securities. Cincinnati, Ohio: South-Western College Publishing. Lerner, J. 2000. Where Does State Street Lead? A First Look at Finance Patents, 1971-2000. Work- ing Paper No. w7918. Cambridge, Mass.: National Bureau of Economic Research. Merton, R. 1973. Theory of rational option pricing. Bell Journal of Economics and Management Science 41: 141-183. NRC (National Research Council). 2000. Making IT Better: Expanding Information Technology Research to Meet Society's Need. Washington, D.C.: National Academies Press. NSF (National Science Foundation). 2003. Academic Research and Development Expenditures: Fis- cal Year 2001. NSF 03-316. Arlington, Va.: National Science Foundation. U.S. Bureau of the Census. 2002. Statistical Abstract of the United States-2002. Washington, D.C.: U.S. Government Printing Office. Available online at: http://www.census.gov/prod/www/ statistical-abstract-02.html. [June 24, 2003] Vasicek, O. 1977. An equilibrium characterization of the term structure. Journal of Financial Eco- nomics 5: 177-188.
198 ADDENDUM Questionnaire The following questionnaire was sent to selected individuals from various parts of the financial services industry, some of whom attended the October 1998 workshop. Included among the questionnaire respondents were senior executives at Falcon Asset Management, the Center for Adaptive Systems Applications, and State Street Bank; professors with expertise in finance, operations research, ap- plied mathematics, and financial engineering from Columbia University, Cornell University, Princeton University, and University of Pennsylvania; and a repre- sentative of the U.S. Department of the Treasury. IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE We invite your responses to these questions, either in the form of general comments or as responses to the more specific questions below. Your responses will be used by our Panel as background information for our report but will not be quoted verbatim without seeking your explicit permission. 1. Briefly describe fundamental or significant academic research contribu- tions to the financial services industry as defined by the panel? (If possible, please supply references to published information that outlines the contribu- tions.) Use additional sheets, as necessary. 2. Overall, would you describe the impact of academic research on indus- trial performance in the financial services industry over the past 20 years as (Please put an X in one box): 1. very large 2. large 3. medium 4. small ~ 5. very small/nonexistent If your response is "very large," could you please identify the specific areas of research you consider has had such a big impact.
FINANCIAL SERVICES INDUSTRY 199 3. What is the role of academic research in educating people who work in your industry? (Please focus on university research activities, rather than univer- sity education generally.) Use additional sheets, as necessary. 4. What structural forms of university-industry collaboration lead to good results in your industry? An example of such a structure might be a discipline- or industry-oriented "center" that solicits industry sponsors for a collection of projects that span a varied research program. What seem to be the essential determinants of success of such structures? Use additional sheets, as necessary. 5. What are significant emerging trends or problems that the financial ser- vices industry will face in the future that could benefit from academic research? Use additional sheets, as necessary. 6. What changes are required, if any, in academic research if it is to be responsive to these industrial trends and problems? Use additional sheets, as necessary. 7. What single step could be taken by universities to enhance the impact of academic research on the industry? Use additional sheets, as necessary. 8. What single step could be taken by companies to enhance the impact of academic research on industry? Use additional sheets, as necessary. 9. What single step could be taken by government to enhance the impact of academic research on industry? Use additional sheets, as necessary. 10. Do you see any downside to enhanced university-industry research col- laboration? Things to be avoided? Use additional sheets, as necessary. 11. Other comments? Any comments, pointers to other studies, or sugges- tions would be appreciated. Use additional sheets, as necessary.
200 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE Worshop Agenda ENHANCING ACADEMIC RESEARCH CONTRIBUTIONS TO THE FINANCIAL SERVICES INDUSTRY October 15, 1998 National Academies Building 2101 Constitution Avenue, N.W. Washington, D.C. 9:00 a.m. Chairman's Opening Remarks and Self-Introductions Colin Crook, Former Chief Information Officer, Citicorp 9:15 a.m. Introduction to the Task of the Financial Services Panel and Description of the Wider NAE Effort Colin Crook 10:00 a.m. Break 10:15 a.m. Panel Discussion of the Financial Services Innovation System: Understanding the Process, Players, and Trends Chester Spatt, Mellon Bank Professor of Finance, and Director, Center for Financial Markets, Carnegie Mellon University William W. Lang, Deputy Director for Special Studies, Office of the Comptroller of the Currency Joe Dauber, Vice President, Customer Management, Novus Services, Inc. 12:00 p.m. Lunch in Meeting Room 12:30 p.m. Panel Discussion of the Contributions of Academic Research to Financial Services: Past, Present, and Future Martin Holmer, The Policy Simulation Group Paul Glasserman, Professor, Graduate School of Business, Columbia University Sholom Rosen, Vice President, Citicorp 2:00 p.m. Break
FINANCIAL SERVICES INDUSTRY 2:15 p.m. Panel Discussion on Assessing the Impact of Academic Research Jack Triple tt, Brookings Institution Patrick T. Harker, Department of Operations and Information Management, The Wharton School, University of Pennsylvania Colin Carlton, Chief Investment Officer, Canada Trust Investment Management Group 3:45 p.m. Academic Research and Financial Services: Where Are We Going? Colin Crook, Chairman 5:00 p.m. Adjourn 201
202 THE IMPACT OF ACADEMIC RESEARCH ON INDUSTRIAL PERFORMANCE Workshop Attendees Colin Crook, Chairs Chief Information Officer (retired) Citicorp John Alic Lecturer in Energy, Environment, Science, and Technology Washington, D.C. Colin G. Carlton Chief Investment Officer Canada Trust Investment Management Group Joe Dauber Vice President, Customer Management Novus Services, Inc. John R. Davies Chairman Center for Adaptive Systems Applications Judith M. Farvolden Director, Research Communications Algorithmics, Inc. Paul Glasserman Professor Columbia University *Panel member Patrick T. Harker UPS Professor and Chairman, Opera- tions and Information Management Department The Wharton School University of Pennsylvania Martin Holmer President Policy Simulation Group William W. Lang Deputy Director for Special Studies Office of the Comptroller of the Currency Blake D. LeBaron~ Center for Biological and Computa- tional Learning Massachusetts Institute of Technology Deborah Malins Senior Vice President Product Development and Informa- tion Research State Street Corporation Alex Meeraus President GAMS Development
FINANCIAL SERVICES INDUSTRY John M. Mulvey~ Department of Civil Engineering and Operations Research Princeton University Mitchell Rachlis Senior Economist General Accounting Office Sholom Rosen Vice President Citibank Chester S. Spatt Mellon Bank Professor of Finance and Director, Center for Financial Markets Carnegie Mellon University Morris Tanenbaum~ Retired Vice Chairman and CFO AT&T Eric Thorlacius Vice President Falcon Asset Management Jack E. Triplett Brookings Institution Andrew B. Whinston Professor and Director of the CREC College of Business Administration University of Texas at Austin National Research Council Staff Stephen A. Merrill, Director, Board on Science, Technology, and Economi Policy Thomas S. Arrison, Senior Staff Officer, Government-University-Industry Research Roundtable NAE Program Office Staff Tom Weimer, Director Proctor Reid, Associate Director Robert Morgan, NAE Fellow and Senior Analyst Penelope Gibbs, Administrative Assistant *Panel member 203 c
