Q&A with:William A. SahlmanPublished:October 6, 2008Author:Sean Silverthorne

Sean Silverthorne: "How to Write a Great Business Plan" has been one of the most downloaded articles on Harvard Business Publishing since you wrote it in 1997. Why do you think you hit a nerve?

Bill Sahlman: Writing a business plan is a seminal moment in the life of a new venture. Doing so entails committing to paper a vision of the factors that will affect the success or failure of the enterprise. People take the exercise very seriously and get emotionally invested in what they produce.

In that context, the article was written to give insights into how to think about the role of a business plan and its relation to new venture formation. I tried to explain that a business plan can't be a tightly crafted prediction of the future but rather a depiction of how events might unfold and a road map for change. I emphasized the notion that successful entrepreneurs constantly seek the right mixture of people, opportunity, context, and deal. They anticipate what can go wrong, what can go right, and they try to balance risk and reward.

Over the years, I have received many e-mails from folks trying to craft a business plan. They want feedback. Actually, they really want me to say that they are on the right track. I explain that I would need to get to know them and their opportunity much better than what is possible in an e-mail and that the written document is not as important as the people writing it. It's not science—it's art and craft.

Q: In the decade since the original article came out, business conditions have changed. If you were writing this piece today, would you change it much?

A: I don't think the world has changed materially. Successful ventures still have competent people pursuing sensible opportunities, using resources that help, in a favorable context. Yes, the context is very challenging today. But challenges create opportunities.

If gaining access to capital is hard, sometimes that means there will be fewer competitors. This period is almost the antithesis of the Internet bubble when everyone could raise money and start a company regardless of how lamebrained the idea. Also, we have difficult factor markets like energy, but that simply means that there are great opportunities for people with ideas for alternative energy.

Were I rewriting the article today, I might emphasize the importance of controlling your destiny by being conservative about access to capital. Many great ventures in the Internet era (pre-1999) ended up failing because they assumed they would have continued access to cheap capital. Many of those businesses failed, though the underlying idea was sensible. Similarly, we have seen a period when capital markets got ugly, which has a negative effect on all ventures, sensible and nonsensical.

I would also reinforce the idea that entrepreneurship is critical around the world. We are confronted with many crises from health care to the environment to global poverty. Solutions are likely to come from talented private sector and social entrepreneurs.

Q: You wrote in the original article that most business plans "waste too much ink on numbers and devote too little to the information that really matters to intelligent investors." Still true today? What really matters to investors?

A: When there is great uncertainty in the market, investors become quite risk averse. They will only back proven entrepreneurs with truly compelling ideas. People make the numbers, not conversely. So, I still think the people making the forecasts are more important than the numbers themselves.

Q: More and more entrepreneurial ventures are "born global": They seek to address a global market and attract funding from global investors. Should a business plan be tailored in some way for a global audience?

A: We live in a world of democratized access to ideas, human capital, and money. There are fabulous global ventures being started in every corner of the globe. These ventures can raise money locally or globally. They can disperse talent in many countries.

Take a company like Skype. When I visited Skype several years ago, it had 125 employees from 23 countries. The development team was in Estonia, and its headquarters in Europe. Skype had raised seed capital in Europe and in the United States. That's the new model.

Q: On the technology front, software applications such as Microsoft Word, Excel, and PowerPoint have added many charting, graphing, and visualizing capabilities. Some business plans are even written as Web pages. Should entrepreneurs avail themselves of these tools for business plans, or do they clutter the message too much?

A: On the first floor of the Rock Center at HBS there is a copy of the original business plan that Arthur Rock wrote for Intel some 40 years ago. It's only a few pages long, but it describes an outstanding team pursuing a new technology. I have seen compelling business plans in the form of a few PowerPoint slides, a couple of scribbled pages, and a brief video. What matters is having all the required ingredients (or a road map for getting them), not the exact form of communication.

Q: If you were to update your "Glossary of Business Plan Terms" and what they really mean ("We seek a value-added investor" really means "We are looking for a passive, dumb-as-rocks investor"), what current terms would you include?

A: The glossary holds today. I think entrepreneurs, investors, and employees need to be suitably skeptical about what they read in business plans. I have read perhaps 5,000 plans and have only seen three companies really meet their plan. That sounds like a pattern to me. If anyone makes a bet based on the company doing exactly as written, he or she will be sadly disappointed.

At the same time, every player has to be somewhat optimistic about the possibility of overcoming inevitable setbacks. I think of ventures as roller coasters, not rocket ships.

Q: Any general advice to entrepreneurs seeking funding in the uncertain capital markets of today?

A: The best money comes from customers, not external investors. I think entrepreneurs need ideas that are so compelling they can get early money from customers. I also believe that great teams with great ideas can continue to access capital on quite attractive terms from outstanding investors. If the short term looks unsettled, that often means that focusing on the long term has a big potential payoff.

About the author

Sean Silverthorne is editor of HBS Working Knowledge.

Published:October 2, 2008Author:Jim Heskett

In view of world financial events, which take new turns every day, it's difficult to think about more mundane topics that were candidates for this month's column. Clearly, an inability to identify and evaluate risk has led to an inability to value assets. What follows is the failure of "fair value accounting" and markets themselves. Without markets, it's hard to "mark to market" in establishing balance sheet value, the outcome of which can mean life or death to an institution. And it's a short step to a loss of trust that people can repay what they borrow and the resulting unwillingness to lend cash, regardless of how much you have or the quality of the borrower's credit. These are complicated issues. Do they require complicated solutions?

In the midst of all the knotty discussions, a simple proposal arrived in my email late last week. It's from Peter Solomon (one of the few "good guys" portrayed in the book Barbarians at the Gates, which chronicled the greed of the 1980s) and Anders Maxwell. In it, they advocate focus, immediate funding, and the U.S. government as shareholder. You might think of it as "Buffett Squared." The government would engage "experienced and disinterested professionals—not politicians" to invest in the preferred stocks of "viable financial institutions deemed beneficial to the public interest." Private institutions would be welcomed to join in such deals as well. The mere identification of institutions in which the government invests would have a beneficial effect on the value of the investment, not unlike Warren Buffett's buys.

The model here is the "top down" response of the Reconstruction Finance Corporation of the Depression era rather than the "bottom up" strategy (involving the purchase of individual properties) of the Resolution Trust of the 1980s. The former returned 100 percent of its investment to the American public. The latter is estimated to have cost citizens about $200 billion, a sum that went to those who were more expert at determining value than the government's representatives.

The proposal would have immediate effects, but they might not be as noticeable to "Main Street" as some other proposals. Its immediate benefits would be to investors, but the long-term effect, it is assumed, would be to reverse the "doom loop" described above. For better or worse, it would be much more straightforward than the proposal on which more than one vote will be taken by the U.S. Congress this week, a proposal which is a mixture of "top down" and "bottom up" provisions, the product of a political compromise.

Some would claim that markets that were too free and not sufficiently regulated got us into this mess. That will be a topic of debate (not unlike the one that led to the creation of Sarbanes-Oxley oversight) over the coming months. But to what degree should the U.S. government take advantage of free markets to free them up when they become frozen? Can it employ the "Buffett Effect" to do so? Or is the analogy even appropriate? Should this be called a workout rather than a bailout? So many questions. So many answers. What do you think?

To read more:

Peter J. Solomon and Anders Maxwell, "It's Credit—Stupid!" available on PJ Solomon.com as a PDF.

Published:October 2, 2008Paper Released:August 2008Authors:Francesca Gino, Lisa L. Shu, and Max H. Bazerman Executive Summary:

Most of us regularly make ethical judgments about others' behavior and make decisions regarding whether or not to punish others' unethical behavior. Although many of us know how we would rationally like to behave in these situations, little prior research has explored the systematic errors we commit in the process of evaluating others' unethical behavior and acting upon it. The present research by Gino, Shu, and Bazerman focuses on the effects of both the outcome of unethical acts and the identifiability of the victim of wrongdoing on ethical judgments and decisions to punish unethical behavior. Key concepts include:

• The decision to withhold or disclose information about the victims and outcomes of a behavior can be a powerful determinant of the ethical perception of that behavior.
• Decision-makers should anticipate being judged less for the ethics of their actions than for the consequences of those actions and the identifiability of the victim of their wrongdoing.
• No matter how ethical the decisions of a manager or a company may be, judges (such as customers, citizens, or employees) might punish the manager or company if things go wrong or if the victims are clearly identified.

Abstract

People often make judgments about the ethicality of others' behaviors and then decide how harshly to punish such behaviors. When they make these judgments and decisions, sometimes the victims of the unethical behavior are identifiable, and sometimes they are not. In addition, in our uncertain world, sometimes an unethical action causes harm, and sometimes it does not. We argue that a rational assessment of ethicality should not depend on the identifiability of the victim of wrongdoing or the actual harm caused. Yet in four laboratory studies, we show that these factors have a systematic effect on how people judge the ethicality of the perpetrator of an unethical action. Specifically, we find that identifiability of the victim of wrongdoing and information about the outcome of wrongdoing influence both ethical judgments and decisions to punish wrongdoers. Our studies show that people judge behavior as more unethical when (1) identifiable versus statistical victims are involved and (2) the behavior leads to a negative rather than a positive outcome. We also find that people's willingness to punish wrongdoers is consistent with their judgments, and we offer preliminary evidence on how to reduce these biases.

Paper Information

• Full Working Paper Text
• Working Paper Publication Date: August 2008
• HBS Working Paper Number: 09-020
• Faculty Unit: Negotiation, Organizations & Markets 

Published:October 1, 2008Author:John Quelch

Editor's Note: Harvard Business School professor John Quelch writes a blog on marketing issues, called Marketing KnowHow, for Harvard Business. It is reprinted on HBS Working Knowledge.

Customers are the source of all cash flow. Organic growth depends on developing relationships with new and existing customers. And future growth prospects are baked into stock market valuations of companies.

Yet an increasingly high percentage of Fortune 500 CEOs have not come up the ranks through marketing or sales. At the same time, in many companies, the chief marketing officer position turns over every two years. Facing the current economic downturn, companies need marketing skills more than ever. But while every corporate mission statement pays lip service to respecting customer needs, actual customer expertise is typically a mile wide and an inch deep.

Marketing expertise depends on customer insights. These insights cannot be gleaned from looking at market research data on a computer screen. Just like politics, all marketing is retail. The customer votes every day at the supermarket ballot box. To be customer-oriented, executives must get out and meet customers on their home turf—in their homes, on job sites, in their offices. Here the CEO has to set an example. AG Lafley, CEO of Procter & Gamble, reinstituted consumer home visits and store visits for himself and his senior executives after discovering that Procter's product managers spent on average only three percent of their time in contact with end consumers. Terry Leahy, CEO of Tesco, the UK supermarket chain, spends two days a week in stores interacting with employees and customers.

But how far should the CEO go? What percentage of his or her time should be spent interacting with customers? Perhaps we can all agree on at least 10 percent, but as much as fifty percent? Of course, a company suffering a temporary crisis of confidence requires all hands on deck. But, in normal circumstances, the answer depends on at least two things: the nature of the business and the company's strategy. In a service business like Tesco's, the health of the brand depends heavily on the quality of the millions of daily transactions between shoppers and staff. Motivating the front-line personnel is critical. But in the pharmaceutical business, the key to success is not customer intimacy but product innovation; the CEO will need to spend time with his chief scientists, medical opinion leaders, government regulators, and CEOs of the companies distributing pharmaceuticals, but not so much time with end consumers. And, if cost minimization is the focus of the business strategy, it's not necessary for the CEO to spend time learning how different clients would prefer customized solutions.

Even in companies that see customer intimacy as their point of strategic differentiation, there are two reasons why CEOs should be cautious about overdoing the percentage of time interfacing with customers. First, marketing and selling should be a prime task of the CEO's direct reports, the individual business unit leaders. The CEO should not have to do their work for them, except, in occasional cases, to be brought in to close a major sale. The hero salesman does not usually make a good general manager or CEO. Second, no CEO—especially one with a marketing background—should spend time with customers as a way of avoiding dealing with other important aspects of the business (such as managing the balance sheet) or mentoring and coaching direct reports. A good CEO knows how to balance time spent on the outside versus the inside.

While balancing their own time, CEOs should nevertheless work hard to ensure the continuous attention of their people to customers. They should do the following three things:

First, the CEO should spearhead the identification of three or four customer health metrics that are leading indicators of sales or profit performance. These metrics should not be off-the-shelf standbys such as customer satisfaction (which, in any case, is a lagging indicator): they must be specific to the strategy of the business. Company scores on these metrics may be benchmarked against direct competitors and/or outstanding companies in other industries.

Second, CEOs must ensure an adequate pipeline of new product and market opportunities. This requires the investment in uncovering customer insights discussed above, either through business leaders regularly going into the field and through more formal customer research studies.

Third, the CEO has to develop marketing talent throughout the company. This cannot merely mean appointing a high-profile rainmaker as chief marketing officer. It requires the long-term infusion of customer centricity and marketing strategy capability throughout the organization. Over time, this should mean a higher percentage of general managers coming up through the marketing ranks.

Every CEO should spend at least 10 percent of his or her time taking care of these three challenges. Running around visiting customers is simply not enough.

Join the discussion on Harvard Business Publishing.

Published:October 1, 2008Paper Released:August 2008Authors:Erin M. Reid and Michael W. Toffel Executive Summary:

Social activists are increasingly attempting to directly influence corporation behavior, using tactics such as shareholder resolutions and product boycotts to encourage companies to improve their environmental performance, increase their transparency about operations and governance, and more stringently monitor their suppliers' labor practices. This paper examines how companies are responding to these pressures, in the context of requests for greater transparency about the risks climate change poses to their business—and the strategies these companies have developed to address these risks. This paper reveals that a company is more likely to comply with social activists' requests for greater transparency about climate change when the company itself, or others companies in its industry, has been targeted by formal shareholder resolutions on environmental topics—and when the company is facing potential regulations restricting greenhouse gas emissions. These findings demonstrate that changes in corporate practices may be sparked by both social activists and by the mere threat of government regulations, and that challenges mounted against a specific firm may inspire broader changes within its industry. Key concepts include:

• Firms are more likely to acquiesce to a shareholder request if they or other firms in their industry have already been targeted by a shareholder resolution on a related issue.
• Political context affects the success of private politics, in that firms under threat of regulation are more likely to acquiesce to a shareholder request.

Abstract

The challenges associated with climate change will require governments, citizens, and corporations to work collaboratively to reduce greenhouse gas emissions, a task that requires information on companies' emissions levels, risks, and reduction opportunities. This paper explores the conditions under which firms respond to shareholders' requests for this information. Building on previous theories of how social activists inspire field-level change, we hypothesize that shareholder actions and regulatory threats are likely to prime firms to cooperate with shareholder requests for information disclosure. Using a unique dataset, we find evidence of both direct and spillover effects. In the domain of private politics, shareholder resolutions filed against a firm, and against others in its industry, increase its propensity to acquiesce to these shareholder requests. Similarly, in the realm of public politics, the threat of state regulations that target a firm's industry-as well as those that target other industries-increases the likelihood that the firm will acquiesce to shareholder requests to disclose related information. These findings extend existing theory by showing how organizational change can be sparked by both activist groups and government policymakers, and that challenges mounted against a single firm (and industry) can inspire field-level (and state-level) changes.

Paper Information

• Full Working Paper Text
• Working Paper Publication Date: August 2008
• HBS Working Paper Number: 09-019
• Faculty Unit: Technology and Operations Management 

It may seem costly to increase staffing levels in retail stores, but is it also smarter and more profitable over time? Yes, according to HBS professor Zeynep Ton. Ton found that bumping up labor in a store is associated with higher profitability because employees are better able to carry out their tasks. Service quality also increases, yet findings suggest there is no direct relationship between service quality and profitability. Ton based her results on observations of stores owned and operated by the same company over four years. Her findings have both operational and strategic implications: Operationally, managers may be thinking about labor too much in terms of cost rather than profit. Strategically, the ability of employees to carry out their duties-known as conformance quality—in certain service settings may have more impact on profitability than service quality itself.

A working paper about the research, "The Effect of Labor on Profitability: The Role of Quality," may be downloaded here.

Other faculty research of note this week includes a case study of global talent management at Novartis: Can the same system take hold in China? And an article on how firms make cross-border decisions for operations, financing, and investments.

— Martha Lagace

Working Papers Parallel Search, Incentives and Problem Type: Revisiting the Competition and Innovation Link Authors:Kevin J. Boudreau, Nicola Lacetera, and Karim R. Lakhani Abstract

This paper presents econometric evidence of two independent effects of adding more competitors on innovation: 1) a competition effect whereby increasing rivalry shapes, and often decreases, incentives to expend effort and invest in innovation; and 2) a parallel search effect whereby adding greater numbers of "searchers" benefits innovation by broadening the search for solutions. We further show the importance of these effects depends on the nature of the innovation problem being solved. The analysis uses data from TopCoder's software contest platform, on which elite software developers were assigned different problems to solve within assigned groups of direct competitors. Econometric relationships are identified by exploiting random assignment and a separate instrumental variables procedure.

Download the paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1264038

Welfare Payments and Crime Author:C. Fritz Foley Abstract

This paper tests the hypothesis that the timing of welfare payments affects criminal activity. Analysis of daily reported incidents of major crimes in twelve U.S. cities reveals an increase in crime over the course of monthly welfare payment cycles. This increase reflects an increase in crimes that are likely to have a direct financial motivation like burglary, larceny-theft, motor vehicle theft, and robbery, as opposed to other kinds of crime like arson, assault, homicide, and rape. Temporal patterns in crime are observed in jurisdictions in which disbursements are focused at the beginning of monthly welfare payment cycles and not in jurisdictions in which disbursements are relatively more staggered.

Download the paper from SSRN ($5): http://www.nber.org/papers/w14074

Attitude-Dependent Altruism, Turnout and Voting Author:Julio J. Rotemberg Abstract

This paper presents a goal-oriented model of political participation based on two psychological assumptions. The first is that people are more altruistic towards individuals that agree with them and the second is that people's well-being rises when other people share their personal opinions. The act of voting is then a source of vicarious utility because it raises the well-being of individuals that agree with the voter. Substantial equilibrium turnout emerges with nontrivial voting costs and modest altruism. The model can explain higher turnout in close elections as well as votes for third-party candidates with no prospect of victory. For certain parameters, these third-party candidates lose votes to more popular candidates, a phenomenon often called strategic voting. For other parameters, the model predicts "vote-stealing" where the addition of a third candidate robs a viable major candidate of electoral support.

Download the paper from SSRN ($5): http://papers.nber.org/papers/w14302

The Effect of Labor on Profitability: The Role of Quality Author:Zeynep Ton Abstract

Determining staffing levels is an important decision in retail operations. While the costs of increasing labor are obvious and easy to measure, the benefits are often indirect and not immediately felt. One benefit of increased labor is improved quality. The objective of this paper is to examine the effect of labor on profitability through its impact on quality. Since employees at retail stores perform both production-related activities and customer-service activities, I examine both conformance quality and service quality. Using longitudinal data from stores of a large retailer, I find that increasing the amount of labor at a store is associated with an increase in profitability through its impact on conformance quality but not its impact on service quality. While increasing labor is associated with an increase in service quality, in this setting there is no significant relationship between service quality and profitability. My findings highlight the importance of attending to process discipline in certain service settings. They also show that too much corporate emphasis on payroll management may motivate managers to operate with insufficient labor levels, which, in turn, degrades profitability.

Download the paper: http://www.hbs.edu/research/pdf/09-040.pdf

Cases & Course Materials Global Talent Management at Novartis

Harvard Business School Case 708-486

This case tackles the topic of global talent management. It can be used to analyze the performance measurement, incentive, and talent development system used at a major multinational company. This case can also be used to analyze the extent to which this system should or should not be adapted for China and other emerging economies.

Purchase this case:
http://harvardbusinessonline.hbsp.harvard.edu/ b01/en/common/item_detail.jhtml?id=708486

Power Across Latin America: Endesa de Chile

Harvard Business School Case 799-015

Endesa, a privatized Chilean electricity generator, has made significant investments in the privatization of Argentina's electricity sector and is now contemplating an even larger privatization opportunity in Peru. In deciding how much to bid in Peru, Endesa must account for the political context in which privatization is being undertaken, as well as a host of other uncertainties.

Purchase this case:
http://harvardbusinessonline.hbsp.harvard.edu /b01/en/common/item_detail.jhtml?id=799015

Publications Optimal Reserve Management and Sovereign Debt Authors:Laura Alfaro and Fabio Kanczuk Publication:Journal of International Economics (forthcoming) Abstract

Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign's willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why don't sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the reserve accumulation does not play a quantitatively important role in this model. In fact, we find the optimal policy is not to hold reserves at all. This finding is robust too considering interest rate shocks, sudden stops, contingent reserves, and reserve dependent output costs.

Multinational Firms, FDI Flows and Imperfect Capital Markets Authors:Pol Antras, Mihir Desai, and C. Fritz Foley Publication:Quarterly Journal of Economics (forthcoming) Abstract

This paper examines how costly financial contracting and weak investor protection influence the cross-border operational, financing, and investment decisions of firms. We develop a model in which product developers can play a useful role in monitoring the deployment of their technology abroad. The analysis demonstrates that when firms want to exploit technologies abroad, multinational firm (MNC) activity and foreign direct investment (FDI) flows arise endogenously when monitoring is nonverifiable and financial frictions exist. The mechanism generating MNC activity is not the risk of technological expropriation by local partners but the demands of external funders who require MNC participation to ensure value maximization by local entrepreneurs. The model demonstrates that weak investor protections limit the scale of multinational firm activity, increase the reliance on FDI flows, and alter the decision to deploy technology through FDI as opposed to arm's length technology transfers. Several distinctive predictions for the impact of weak investor protection on MNC activity and FDI flows are tested and confirmed using firm-level data.

The Influence of Ownership on Accounting Information Expenditures Authors:Leslie Eldenburg and Ranjani Krishnan Publication:Contemporary Accounting Research (forthcoming) Abstract

This paper analyzes the association between ownership, top management incentives, and expenditures on accounting information. We argue that organizations with privately appointed boards of directors such as for-profit and non-governmental nonprofit organizations use incentive pay practices which encourage managers to use accounting information to improve performance. In contrast, government organizations are publicly governed and are constrained in their compensation practices because hospital CEOs are administrators of government-provided services. However, these hospitals must prove their efficiency to continue to receive adequate budgetary funding. Therefore government hospitals are more likely to use accounting information to gain legitimacy with stakeholders and regulators. Accordingly, we predict a positive relationship between expenditures on accounting information and contracting intensity in privately governed organizations, whereas we expect no such association for publicly governed organizations. We analyze data from California hospitals to determine differences in these roles across ownership types. We find a positive association between contracting intensity and expenditures on accounting information in privately governed hospitals but no relation in publicly governed hospitals. Finally, we find differences in the use of accounting information within the privately governed hospitals, based on ownership. While for-profit hospitals expend resources on accounting information that helps improve their revenue positions, nonprofit hospitals expend resources on accounting information that facilitates decision-making related to operating efficiency and cost containment.

Can Nanotechnology Improve the Sustainability of Biobased Products? The Case of Layered Silicate Biopolymer Nanocomposites Author:Satish V. Joshi Publication:Journal of Industrial Ecology (forthcoming) Abstract

Recent developments in nanotechnology, especially in the area of nanoclay composites, are improving the technical performance of biobased polymers and moving them toward technical and economic competitiveness with petroleum-based polymers and conventional composites. We assess whether these developments also improve the environmental sustainability of biopolymers, by using a life cycle approach. We estimate energy use and emissions from the nanoclay production process and compare these with prior life cycle data for biopolymers as well as other fibers, and we find that nanoclay production results in lower energy use and greenhouse gas emissions than production of many common biopolymers and glass fibers. Nanoclay composites hence can improve the life cycle environmental performance of several common biopolymers. However, for some biopolymers the relative performance depends on the functional unit.

Management Accounting in India Authors:Sanjay Kallapur and Ranjani Krishnan Publication:In Handbook of Management Accounting Research. Vol. 3, edited by Christopher Chapman, Anthony Hopwood and Michael Shields. Elsevier, 2008 Abstract

This chapter surveys the history, evolution, and current status of accounting systems and practices in India. Tracing the roots of Indian accounting systems to the ancient civilization of the Indus Valley, we discuss the accounting contributions of historical writings such as the Smritis and the Arthashatra. We also discuss the accounting system used by the East India Company. Next we provide an overview of contemporary Indian accounting systems institutions as well as accounting education and curricula. We discuss the prevalence of modern management accounting practices in Indian companies. We conclude with a discussion of future research opportunities provided by India's current status as an emergent economic power.

Rewriting History Authors:Alexander Ljungqvist, Christopher J. Malloy, and Felicia Marston Publication:Journal of Finance (forthcoming) Abstract

We document widespread ex-post changes to the historical contents of the I/B/E/S analyst stock recommendations database. Across a sequence of seven downloads of the entire I/B/E/S recommendations database, obtained between 2000 and 2007, we find that between 6,594 (1.6%) and 97,579 (21.7%) matched observations are different from one download to the next. The changes, which include alterations of recommendation levels, additions and deletions of records, and removal of analyst names, are non-random in nature: They cluster by analyst reputation, brokerage firm size and status, and recommendation boldness. The changes have a large and significant impact on the classification of trading signals and back-tests of three stylized facts: The profitability of trading signals, the profitability of changes in consensus recommendations, and persistence in individual analyst stock-picking ability.

Q&A with:Jay Light, Robert C. Merton, David Moss, Nicolas Retsinas, Clayton RosePublished:September 29, 2008Author:Martha Lagace

Harvard Business School faculty members, looking at the U.S. financial crisis from a variety of disciplines, urged caution and prudent analysis in a recent panel discussion.

The discussion titled "Turmoil on the Street: Fathoming the Financial Crisis" was held September 23.

Jay O. Light, professor and Dean of the Faculty, provided a brief outline of the landscape as well as thoughts on how to view the proposed bailout. Lecturer Nicolas P. Retsinas, Director of Harvard University's Joint Center for Housing Studies, then gave a brief history of housing in the United States and shared his insights to set the stage. Senior Lecturer Clayton S. Rose, who for 20 years worked at JP Morgan & Company and headed global investment banking and global equity there, discussed the implications of change in commercial and investment banking. Professor and historian David A. Moss stressed the importance of risk management and oversight. Robert C. Merton, the John and Natty McArthur University Professor, similarly expressed concern about the unintended consequences of change on Wall Street, closing with the assertion that innovation should and must continue.

Leverage, Transparency, Liquidity

Dean Jay Light began his introductory remarks by characterizing the crisis and collapse of housing prices as a test that has exposed how fragile the recently evolved U.S. financial system is. "Leverage, transparency, and liquidity lie at the heart of much of what's going on. The system has proven to be unexpectedly fragile in a way that I think nobody I know really understood," Light said.

To illustrate his point about the interlocking nature of housing and the U.S. financial system, Light said that for decades beginning in the 1930s, the ratio of median home prices to median income remained relatively stable, about 3 to 1. Over the last 20 years, however, the financial markets that financed the housing system in the United States changed remarkably. Local markets once dominated by tightly regulated savings and loans—a simple system of buy and hold—evolved into something much more complicated due in part to the development of mortgage brokers. The new system fueled a bevy of mortgage backed securities and derivatives that were terribly difficult for experts to comprehend, he said.

Too much leverage combined with too little transparency meant that the markets froze. Liquidity vanished. Similar to mortgage-backed securities, highly leveraged loans and other transactions were characterized by a lack of transparency. "When one looked at an institution, it was very hard to understand who had what risk. In a world like that, liquidity disappears. So too does the liquidity of institutions. … That in fact is where we are today," Light said.

Just as a hospital treats patients by focusing on three tasks, so too should we remedy financial turmoil, he said. First, stabilize the patient, in this case the markets. Second, fix the problem through either surgery or other medical care. Finally, prepare long-term rehabilitation. Those three tasks must be accomplished in order.

As for the $700 billion proposal described as a bailout by Treasury Secretary Henry Paulson, it is deliberately void of many details that would be hard to pre-specify, Light said. "It isn't clear it's a bailout at all. … It may in fact be a very profitable investment. And at what price are the assets to be purchased? You see, it's actually needn't be a bailout proposal at all. It's in fact a proposal to try to re-liquefy markets by reducing leverage, by increasing transparency, and by increasing liquidity by establishing a set of pricing processes that involve the private market as well as whatever this public entity is.

"How is this exactly going to work? Nobody knows," Light continued. "The details have yet to be described."

Light recommended designing various auction processes that treat differently the questions of what is bought, from whom, and at what price. "In order to try to re-liquefy the markets, get some price discovery and begin to understand what these assets are worth. It is a big job in the intermediate run. And in the long run we've got to have a system that substantially readdresses leverage, transparency, and liquidity.

"It will be in fact a whole new ballgame that takes many years to play out. It will be years before we figure out where the crucial financial functions lie, in what new institutions, governed how, and regulated how," Light concluded.

Home ownership: "back to the future"

Housing was Topic A for panelist Nicolas Retsinas, who before arriving at Harvard served as assistant secretary for housing in the U.S. Department of Housing and Urban Development. Offering a brief historical background, Retsinas said that prior to the Depression, people who wanted to buy a home were typically required to make a 50 percent down payment. They were issued a 5-year interest-only note, and effectively crossed their fingers that they could refinance at the end of five years. Not many people owned homes or could borrow under such conditions. As a response, the modern housing finance system undergirded by the federal government arose during the New Deal to make credit and liquidity available to people wanting to buy a home.

"In the 1980s a traditional loan was made by a regulated bank, a deposit-taking institution that most often kept the loan on its books, retaining the credit risk. But over time the banks would sell more and more loans to the secondary market, particularly since the Fannie Maes and Freddie Macs that had evolved since then, in order to relieve the banks of some of the interest rate risk. In the 1990s a couple of things happened that set the stage for where we are today: There emerged automated underwriting and credit scoring. All of a sudden the world of the deposit-taking institution, your neighborhood bank, transformed into large national mortgage banks—a mortgage delivery system that was populated by brokers, mortgage banks, and investors.

"This opened the door to new sources of capital from around the world. Holding that door wide open were Fannie Mae and Freddie Mac. By that time those government corporations had become private corporations, but were still overseen by the government," said Retsinas.

If we look back to that period, one of the arguments for such wide-scale change was to both create more liquidity and minimize risk, he observed. It was believed less risky if banks did not keep all the risk but rather sliced, diced, and parceled out the risk to investors to better set, price, and absorb it. "An ironic argument, as we have learned," he quipped.

The housing boom in the 1990s was led by "strong demographics—people coming to this country needing a place to live," low interest rates, liquidity, and a bustling economy. Early this decade home price appreciation in many markets far exceeded the growth of income, he continued. By 2005 such a high rate of home price appreciation drew ever more investors to the market. Between 25 percent and 30 percent of all home sales were purchased by investors. People who owned their homes took advantage of this equity buildup, some becoming what he termed "serial refinancers."

"What used to be a goal of people like my parents to someday have no mortgage, all of a sudden was forgotten. And the new goal was, how do I capture this equity?" said Retsinas.

On the issue of affordability, home prices rose so high that it became virtually impossible for people to take out regular or prime loans. "It's hard to overstate the dramatic buildup in subprime lending over this period. Subprime lending represented a minimal share of home mortgages in the 1990s. As recently as 2001, it represented only 2 percent of home purchase originations. In 2005, it represented 20 percent."

By now the system promoted and rewarded the selling of mortgages. Mortgage brokers originated over two-thirds of the mortgages as opposed to the one-third they did 10 years earlier, he said. Mortgage brokers were paid on commission and on the basis of originating a loan; they were unconcerned with whether the mortgage was repaid. In the pursuit of scale, mortgage banks bundled mortgages and worked with investment banks to put them into complex securities.

"In 2004 and 2005 as these subprime loans started to emerge, it really wasn't a particular problem because of the lag effect, because people who couldn't pay off these mortgages with toxic terms and exploding payment schedules did worry.'If I cannot pay off my mortgage, I'll put a 'For Sale' sign on the lawn, I'll sell it, I'll walk away.' As the housing bubble burst, those exit doors were closed," he said.

"All of a sudden, we started to see record numbers of delinquencies, defaults, and foreclosures. The question was, who bore that risk? What had happened with these subprime loans is they were brokered apart, taken apart, put in little subsets, and put in a whole variety of different securities. And no one knew what they had. At that point government had stepped aside, had genuflected at the altar of the market as it relates to our housing financing system, and the de facto regulator became the credit rating agencies," said Retsinas, arguing that regulation became essentially outsourced and privatized. The credit rating agencies weren't able to perform their function whether due to the attendant complexity or their own eagerness to participate in this system.

"We're in a bad place" today, he said. Builders have overbuilt: Retsinas estimated there are now a million more homes than needed. And just when people need credit, credit is constrained. Subprime lending has vanished.

"In some eerie way, it looks like we are going back to the future," he concluded. "If you want to buy a home today, you better have great credit. You better have a down payment. That all sounds fine and secure, but it certainly leaves behind millions of families who are at the lower end of the wage scale and who have some impairment in credit.

And the future? "We know what happened, we know how we got there. Our short-term strategy is to nationalize the housing market. Is that a good strategy over time? If you nationalize that market, how do you balance between extending credit and making sure you have safety and soundness without burdening the taxpayer? That's the question."

Investment banking faces a crisis of confidence

Senior lecturer Clayton Rose shared insights on the turmoil gained in part from his experience at JP Morgan & Company for 20 years, where he headed global investment banking and global equity, and was a member of the firm's executive committee.

The regulatory structure did not keep pace with two decades of deregulation on Wall Street, Rose explained. Deregulation led to intense competitive pressures to which firms responded by deploying more capital and seeking higher returns. Add to this a lack of transparency and a lack of understanding about the values of many of the assets that were acquired using said capital.

Rose also provided a brief history of the investment landscape as it has evolved over the last few decades. Commercial banks and investment banks were separated by law in Depression-era legislation, and remained distinct for many years. Commercial banks made loans, kept the loans on their books, and took in deposits "through the door." For their part, investment banks mediated between companies that wanted to borrow or issue equity, and between investors such as mutual funds and pensions that wanted to invest in those securities. Investment banks also provided advice on mergers and acquisitions.

In the early 1980s the derivative markets were quite small and relatively unsophisticated, and the market for mortgage-related securities was also in its relative infancy, he explained. "By the end of the 1990s, that had all changed. By the early 1990s the legislation that separated commercial and investment banking had been torn down, and banks and investment banks and insurance companies were in each others' businesses," said Rose.

"As a result of deregulation, the derivatives market and the market for mortgage-related securities had exploded in both size and complexity. By the end of the decade, there were as an intentional result of deregulation, intense competitive pressures in the financial services business. And one of the responses that was universal across all firms was to deploy more of their own capital to seek higher returns. Derivative, mortgage, and private equity markets, to name three, were places were firms went to seek out these kinds of higher returns. Until just a couple of years ago, in fact about 18 months ago, this strategy worked quite well.

"But at the same time that we were seeing substantial growth in the financial services business and a remarkable change in the landscape, the regulatory structure had not kept pace at all. It was stuck in a 1980s mode. The checks and balances and oversight that were required in the system were missing. There was a fragmented, highly complex, deeply inconsistent regulatory structure."

As part of firms' efforts to deploy capital and seek higher returns, the mortgage market was ''in the center of the bull's-eye along with a couple of other instruments," said Rose. "Most of the firms on Wall Street followed each other around to the same parts of the market and ended up mimicking each other, which is a classic strategic failure. So when the subprime crisis hit they were all in the same boat together," he said.

Investors and lenders could not understand some of the assets on the balance sheets of these firms. The assets were complicated, and were not traded, so there was no open market, and the models were difficult to understand.

Commercial banks, however, were in a different position from investment banks, he continued. Commercial banks had more capital as a function of complying with the regulatory requirements. They could access deposits as a stable source of funding, as well as the Federal Reserve discount window, which, if they lost access to all the market sources of funding allowed them a way to go to the government and get funding for daily operations.

"Investment banks, on the other hand, had no access to deposits and no access to the discount window. They were reliant on a market that takes place between financial firms and between firms and corporate clients for short-term funding. There's a taken-for-granted notion in that market that there will always be funding. But to the extent that that market disappears, and it hadn't happened until recently, investment banks had maybe a day, maybe two days before they wouldn't have sufficient funding to continue their operations."

In conclusion, the two investment banks that just announced they will become bank holding companies did not do so by choice, Rose said. "This is a requirement that the Fed imposed on them and that the Treasury imposed on them as one of the costs to keep them viable; they will have greater regulatory scrutiny going forward. The regulatory regime that the Fed is going to impose on them is going to be markedly broader and stronger and deeper than anything they have experienced before. Their capital requirements are going to go up significantly.

"It doesn't take a Harvard MBA to figure out that their return profile is going to go down, and the cultures at these firms are going to change dramatically over the next couple of years."

The risk of moral hazard

David Moss, professor and historian, identified three interrelated problems driving the ongoing financial turmoil: the collapse of the housing bubble, significant weaknesses in our financial architecture, and a deep crisis of confidence, particularly in the financial sector. He suggested that the first problem was at the heart of things and that we wouldn’t ultimately see improvement until housing prices stopped falling. "Keep a close eye on housing prices," he advised.

The second broad problem facing the United States is weakness in its financial architecture, with excessive leverage across much of the industry, distorted incentives embedded in executive compensation packages, and credit rating agencies that miss the mark. The third problem is a crisis of confidence, which began to look almost like a bank run last week. Historically, such crises have proved very dangerous, he said.

While the $700 billion proposal may be "reasonable," Moss suggested, "I'm concerned that if we don't structure this bailout correctly, we could create an even riskier financial system in the years ahead."

Moss's work as a historian has focused on how and why governments manage risk. Throughout its history, the United States has adopted a broad array of public policies for managing risk, from limited liability law to federal deposit insurance. "If you look across these policies, one thing that becomes quite clear is that anytime you shift a risk around, you have to be concerned about the potential for moral hazard," said Moss. "Anytime you write an insurance policy, whether through the private sector or the public sector, you have to worry that people might get the wrong incentives. Those who are relieved of risk may decide to take more risk. If you've ever had a rental car where you were fully covered against damage or loss, perhaps you drove a little less carefully or parked in a more dangerous place. That’s moral hazard"

When the government manages risk, it also must worry about the potential for moral hazard, he said. A good example is federal deposit insurance. By guaranteeing bank deposits, the federal government could inadvertently invite banks to take excessive risk. The reason this doesn’t happen most of the time, he suggested, is because we not only insure the banks (through FDIC), but also carefully regulate them (through FDIC, the Federal Reserve, and the Comptroller of the Currency). In fact, the original legislation that created FDIC in 1933 had two important parts, providing for both bank insurance and bank regulation. The two have to be paired, he suggested.

"My concern right now is that although there's an enormous amount of discussion about the $700 billion, the discussion may not be sufficiently sensitive to the need for reasonable oversight of the financial system. To be sure, there's been a lot of discussion about oversight of Secretary Paulson, and that's a compelling objective. But we haven't seen nearly as much discussion about what this bailout means in terms of the oversight of financial institutions that will be required. We have to be serious and smart about this. If we don’t structure it correctly, the bailout could very well calm the current crisis, but also provoke even greater – and even more dangerous – risk-taking in the future,” said Moss.

One public policy that should serve as a warning is our system of Federal Disaster Relief, designed to help the victims of natural disasters, he continued. The policy provides relief but does not include land use regulation or risk-based premiums. "We see more and more building in hazard prone areas. The losses keep spiraling up disaster after disaster, because there has been more and more construction in hazard prone areas. And it’s possible that the existence of federal disaster relief actually helped stimulate some of that building. The point is that if we’re going to provide the relief, which I support, we also need to try to control the moral hazard.

"The same holds true for the bailout that Secretary Paulson and Chairman Bernanke have proposed. I just want to make sure that if we’re going to manage this extraordinary risk in the financial sector, we also remain attentive to the sort of oversight that is then necessary to make sure we don't create a bigger problem going forward. Anytime the government manages a risk, it must also manage the moral hazard, and the current crisis is no exception," Moss concluded.

Innovation will continue

University Professor Robert Merton, who received the Nobel Prize winner in economics in 1997, began his remarks by noting that in the current turmoil a large amount of wealth—between $3 and $4 trillion—has been lost without any offset in gains. Loss in wealth will be borne by house owners, those who finance them, and the general population to the extent that the government becomes engaged. "This is not simply a liquidity crisis or simply a problem of a messed-up financial system," said Merton.

Standard financial models remove some of the mystery about what has happened and make the financial crisis comprehensible, he continued. But his larger message to students in the audience was to highlight the relation between financial innovation and crisis.

"Is there a structural relation between innovation and crisis? I think there has to be," Merton said. "Successful innovation will always outstrip the infrastructure to support it, at least for some considerable time. That's true because most innovations fail, so it's not practical to build a new infrastructure to support every innovation until you find out they succeed. So it's inevitable they will be mismatched for some time. We have to have oversight. But if it is too strict we'll never get innovation. There really is a tradeoff, and we have to be prepared for that."

Merton expressed concern about potential unintended consequences of efforts to confront the crisis. He reminded the audience that banks and insurance companies, the sources of some of these problems, are among the most regulated entities other than hospitals in the United States. While regulation is important and needed, "it's not magic," he said. Poorly done regulation could have a long-term negative effect.

"I hope we'll have careful analysis and pathology before we start to set the regulations," Merton continued, suggesting the creation of the equivalent of the National Transportation Safety Board for examining financial crises in a technical, determined way.

Finance as a profession does not look bright, he acknowledged. It will be tough to get jobs on Wall Street. But the good news is that innovation will continue.

"The financial functions of the system, whether providing for retirement or transactions, still have to be performed. This is a global and growing business, and it's one that can have very significant impact on economic development and growth.

"Some commenters say, 'We have to get financially sophisticated people out of the system.' The worst is to say 'financial engineer.' I suggest it's just the opposite. The problem, in part, is that senior managers, regulatory overseers, and members of boards of these financial institutions don't have a good understanding of all of this. And it would be perverse if the solution was to dumb down or limit what the institutions can do in terms of what they develop, to fit the existing managers. I think the longer-run solution is that general managers have to become far savvier."

The finance job market is global, and there remains a strong need for talent. People skilled in general management combined with highly technical training to develop a functional perspective are best equipped to navigate the changes ahead, Merton concluded.

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