UC Davis Professor Robert Marquez On The Behavior Of Financial Institutions

Through a lifetime as a leading researcher and teacher of banking and corporate finance, Professor Robert Marquez has come to an important realization.

“I’ve learned to recognize that the world is imperfect and that there’s a lot of questions out there completely unanswered,” he says. “This realization has informed my research. A lot of answers are just not out there. And we kind of have to still progress with limited answers, limited information, not knowing who we’re competing against always. We’re just going to try to learn as we go along.”

And he has learned quite a lot. In his research, Marquez attempts to uncover the mechanisms that underlie the behavior of financial institutions. One important focus of his work is the effect low interest rates have on banks and whether they encourage banks to take on more leverage.

Marquez joined UC-Davis’ Graduate School of Management in July 2012. Before graduate school, he worked for several years for the Federal Reserve in San Francisco. Marquez also spent eight years on the faculty of the University of Maryland before accepting a faculty post at Arizona State University’s W.P. Carey School of Business. After three years, he crossed the country again to Boston University, where he was a professor of finance.

His study “Lending Booms and Lending Standards,” published in the Journal of Finance, offered an explanation for the sequence of financial liberalization, lending booms and banking crises observed in many emerging markets. It proved to be a telling recipe for financial disaster that could, and did, spread globally, with devastating impacts.

Marquez earned his Ph.D. in economics from Massachusetts Institute of Technology and his B.A. in economics from the University of California, Berkeley.

In this wide-ranging interview with Poets&Quants Founder John A. Byrne, Marquez opens up about the academic life, his research and teaching responsibilities. His favorite part of an academic life? “I like the thinking part of it,” says Marquez. “I think this is probably a common answer that researchers will give you, but the job is to create and disseminate knowledge. And the knowledge creation part, to me, is what has been fascinating because it’s very open-ended. A lot of the process is sitting down and thinking through ideas.”

John A. Byrne: So let’s start at the beginning. what inspired you to become an academic in the first place?

Robert Marquez: It was somewhat serendipitous. I think this is true for a lot of people. After I finished college, I went to work for the Federal Reserve Bank in San Francisco, so I was kind of a Bay Area person. And I worked there with a lot of people who were doing long-term research in economics, in finance and international trade issues. And until that point, I really hadn’t thought about the world of academia, the world of research, the world of doing a PhD, which I barely even knew what that was.

But it was actually my boss who immediately said, ‘Okay, you should be thinking about our graduate program in economics. A few years later, I wound up applying and began my academic journey.

Byrne: What was your dissertation on?

Marquez: I began thinking about issues related to competition and banking. Information in financial institutions is a very important component of what they do. They profit essentially by what information they have that somebody else doesn’t have. And I was interested in thinking about the structure, the industrial organization specifically, of credit markets.

So I was thinking about banks that have customer information and how that can make it difficult for other banks to poach those customers away. That creates a certain market structure which then has implications for the pricing of loans, for who has access to credit, and those kinds of things.

Byrne: That’s fascinating because in a way social media companies are operating on the same premise, aren’t they?

Marquez: Yeah, so there’s a lot of talk these days about who really owns the data these social media companies have and control and how important that data is to their long -term success. That’s a big topic these days.

Byrne: Robert, what was it about banking that intrigued you?

Marquez: That’s another one of these serendipitous things. I wasn’t initially interested in banking. I was doing economics, but the time I was doing my degree, banking itself was not so much of a topic in economics.
It had moved over into business schools where I am now, and it became an area of finance, much more so than an area of economics. I came at it from the perspective of an industrial organization.
I thought of myself as a micro-economist interested in topics related to competition, competition policy, barriers to competition, and, how competition is impacted by information flows. It was really through discussions with classmates and professors and seeing other people’s presentations that I realized that banking credit markets in particular were a very good way of applying the tools of economics, of industrial organization and information economics.

Byrne: So in all the years of research that you have done in the field, what would you consider to be your most significant discovery?

Marquez: That’s that’s always a difficult question. But but one topic that had the biggest impact is one that I worked on around the time of the financial crisis. I’d like to think about it as having helped explain the crisis. But unfortunately, it was published a little bit too early for that. And by crisis, we’re referring to the 2008 subprime crisis.

Byrne: A lot of people lay the blame for that crisis on derivatives.

Marquez: Yes, but a lot of that also was fueled by a tremendous increase in lending that took place both in the real estate sector as well as in small business lending. And I had been working on a topic related to how credit booms arise. So what leads banks to all of a sudden switch from being very conservative in their lending, keeping tight controls of their portfolio, and keeping track of their customers to deciding, ‘Hey, let’s open up the floodgates, lend to everybody we can, get as much market share as we can.’

Essentially, you wind up with this problem that banks become overextended, maybe they have limited resources, maybe simply their underwriting standards have gone down upfront. They wind up making worse loans, they have bigger portfolios, they have higher leverage at the same time.

And this can lead to a substantially higher probability of having a crisis event, meaning bank customers start to default, the bank finds itself in trouble with low capital and winds up potentially being in receivership as well.
So we had thought about it from the perspective of international crises. One of my co-authors on this paper does a lot of work on international finance. We had thought about it from the perspective of a balance of payments type crisis. That’s what originally inspired us.

And they tend to go hand in hand with banking crises. This paper was published when the subprime crisis really got going in in 2006 through 2008. I think that there’s lessons from our work, even though we hadn’t written it at the time thinking about the subprime crisis specifically.

Byrne: So what causes banks or bankers to loosen up the restrictions on lending? Is it competition? Is it greed? Is it a combination of the two?

Marquez: I’m sure that everything you said is true. I am sure that there’s a component of greed. Competition is a primary force in economics, and so we always think about competition as a driving force and an important component. My work falls into what. As economists, we think about rational frameworks, and all I mean by that is that the idea of greed is a human trait that economics doesn’t do a great job of capturing unless I can demonstrate that it’s fully rational, self-interested behavior that drives this kind of greed. There’s an element of competition that leads me to feel the need to, if I have some set of customers, maybe I need to steal some customers from you, because the market is only so big.
And if I can’t steal customers from you, then I have to find other people that I might lend to. In some contexts, this has been referred to as a search for yield, this idea that there’s poor investment opportunities out there, and I just have to hunt to find more of them. But of course, doing that means a lot of times making more mistakes and assuming greater risks. People believe that if they want to get a bigger return, they have to be willing to put up with higher risk.

Byrne: That what fueled a lot of the lending to people who probably couldn’t pay those loans.

Marquez: My impression is that there are two components to this. One was industry changes changes in which long-time institutions had gotten bigger and more highly levered. That created a greater need for them to go out and search for yield. More deregulation fuels the growth. You look at the financial services industry and you look at banks specifically, and then you look at commercial banks. The commercial banks went from something like 15,000 or 16,000 banks in existence just in the U.S. in the early 80s, and you fast forward to around 2000 and you have half that number, and probably less, 6,000 to 7 ,000 banks. And so you’ve had this big consolidation, and you would think these institutions are not only getting bigger, they are getting better and smarter, but that’s not necessarily true.
What it means is now they have more resources, more capital to deploy, and more need to earn a return as well for their investors. And so you wind up with institutions that had been smaller, regional if not local, getting bought by a bigger bank and suddenly they have the resources to compete with the next big bank. That actually can lead to an enhancement of competition.

Byrne: And competition is also a function of power, influence, and desire among humans. The reason why you want to be bigger and you want to earn more is you want to be able to tell the world, I’m better than you.

Marquez: What I’ve been saying has made it seem as if competition is a bad thing. No, it’s a good thing. Competition is what gives us growth. It’s what gives companies access to credit. It’s what reduces interest rates for corporate customers when they’re trying to borrow. All of these things are great aspects of competition. That doesn’t mean that everything about it is good, especially when it’s driven by greed. Or the chest-stumping desire, the feeling to want to have a big complex institution that I’m controlling. Then you can have some negative aspects associated with competition. And my research has kind of focused on those more negative aspects, but definitely there’s a strong positive side, of course, to competition.

Byrne: If market competition works, why is the interest on credit cards for consumers as high as it is? Credit cards interest today is what the Mafia used to charge on a loan. How can that be?

Marquez: I don’t have a strong view on this. Some of my colleagues here at Davis, as well as people I’ve worked with in the past elsewhere, believe competition is not really working in the retail sector for credit cards. People don’t make very good decisions around their own finances. They don’t spend the time shopping around that they probably would need to figure out how competitive that landscape is in the first place.They latch on to one thing, and once they have that, they don’t really want to switch away from it.

Byrne: So these interest rates are rooted in low information consumers?

Marquez: It’s a kind of behavioral problem or search friction that arises from whatever it happens to be. Maybe you have a family that is too worried about feeding their kids. People don’t search for a better interest rate perhaps because they have other things that they’re doing. That the part that’s a little bit less clear, but there’s all these behavioral aspects to why. And it doesn’t seem like competition does a great job.

Byrne: It’s a puzzle to me that there is no company with a 10% interest rate on a credit car. Because at 10%, you can make a good amount of money as long as you make sure the credit risk is right.

Marquez: If you talk to the credit card companies, they say that credit cards for a lot of the larger banks at least are not tremendously profitable for them either. The claim is that the good customers tend to pay off their bills all at once, and so they’re really earning almost nothing from them other than the transaction fees they get from the merchants.
And it’s the customers who are much more likely to default who wind up rolling their debt over and paying those high fees. So their argument is they’re not actually making any kind of a usury rate or any kind of extraordinary markup on those customers, and they’re basically covering their expenses.
I don’t know that I necessarily think that’s true, but I think that there is some kind of segmentation in the market in terms of who tends to roll over. And it’s exactly those customers that would probably benefit the most from the introduction of this company that you have in mind that would have the cost of financing for these households, and they’re the ones that are probably the most locked in and the least willing to search out best opportunities for themselves.

Byrne: Robert, you’ve also done a lot of work on M&A transactions. What have you discovered there?

Marquez: So, my work on M&A has focused a little bit on acquisition prices, thinking about at what price will a transaction take place. I mentioned earlier I’m a microeconomist by training, and so the lens through which I’ve looked at M &A has been primarily through the lens of, okay, what does microeconomics have to tell us, and specifically when people look at M &A on the finance side and on the economic side, a good way of thinking about this has been, okay, if we come back to competition, there’s competition to buy some assets, to buy a company, which is a collection of assets, and how should we think about that competition?

We want to understand what are the forces what might lead to higher acquisition prices, higher premiums, lower premiums. A good way of doing that is to use this idea of competition. The way economists tend to view competition is through the use of auction models. We assume that a firm is being auctioned off, and there are people interested in buying it. They make bids, and we use auction theory that gives us some guidance on the bidding process and whether it will ultimately lead to a higher or lower price. My work has focused on that auction part of how acquisitions are done.

Byrne: Generally, companies are acquired based on a multiple of earnings or revenue. You get into the premium area if it’s a strategic acquisition or if there’s competition with other firms to acquire, which is the ideal situation if you’re selling. What have you actually discovered about this whole process of buying and selling companies?

Marquez: This kind of question comes up a lot in my classes. So I teach in a segment on M&A and students always come to me with examples from their lives. And they always look at it from the standpoint that a buyer never pay more than three times the company’s annual earnings. Or somebody else will say, ‘No, my aunt owned dental offices and a buyer would pay six times quarterly revenue or something like that.
There’s all these rules of thumb. And I always want them to sit back and ask, ‘Well, where are these rules of thumb coming from?’ And it’s not surprising that there are different rules of thumb for every. The multiple for a dental office will be very different from a toy store or a tire shop. So I get them to try to focus on the valuation side of it, starting with the value of a company’s assets.

What we’d like to do is value those assets. But the value of the assets that we might get isn’t necessarily what we’re going to have to pay. So now we start thinking about who else wants to buy those assets? If there’s a big fish out there trying to buy these assets, then I’m going to have to either pay a higher price, or that might lead me to back out entirely and let somebody else win.

We start thinking about these kind of competitive forces that shape the prices that we might observe. Once we get there, we ask how can we now use what we have to back up and say, ‘Let’s go back to those rules of thumb and ask where it comes from.
Often, it comes from thinking about a historic average profit margin for this industry and how that translates into a valuation. That’s where we wind up with the rule of thumb that they might have.

Byrne: Right, interesting. So, what do you like most about what you do?

Marquez: I like the thinking part of it. I think this is probably a common answer that researchers will give you, but the job is to create and disseminate knowledge. And the knowledge creation part, to me, is what has been fascinating because it’s very open-ended. When it comes to disseminating, I know what I’m supposed to be teaching, and I try to pepper into classes new findings in the field whether they’re my own or somebody else’s. I know what I want to teach. When I’m trying to figure out what I’m going to research, I don’t really know. So one idea will sometimes, if I’m lucky, lead to another, which will then lead to another. A lot of the process is sitting down and thinking through ideas. My wife sometimes jokes about this, that a full day of work might be me staring at the computer, typing like three lines, and that’s about it.
And then it’s like, oh, that was a long day. And she wants to pull her hair out because she feels that I’ve done nothing. But it’s true. For me, making progress on my research is sometimes simply coming up with a new question. Not even necessarily how I’m going to address that question, but just having it in mind. And that might take me a day, might take me a week, might take me a month. Co-authors are particularly good for bouncing ideas off of them. You want to work with other people who will give you some perspective as to whether what you’re doing makes sense or not.

Byrne: Do you find teaching what you learn is sometimes more difficult than research itself?

Marquez: It used to be when I was younger and I first started, coming particularly from economics. The distinction between economics as a field of study and finance are not very big, but the distinction between teaching economics, which I did a little bit when I was a graduate student to undergraduates, is quite different from teaching students that are doing a master’s in business administration who have a very different perspective.
They want things to be much more applied. They want things to matter to them. They want to be told why something is relevant. They say, ‘I don’t care about learning some formula if I’m not gonna be applying it.’
So the first few years when I started at the University of Maryland, I found the teaching part pretty challenging. I had to do a mindset change moving from my Ivory Tower of research to how do I make this relevant and interesting to students.
Now I guess I’ve become a bit of an old hand in this and I quite enjoy the teaching part of it. I feel like it’s an opportunity for me to not just tell them some of the things related to M&A and banking, but also to try to take some new ideas that are out there that people are researching and think about why is this relevant to an MBA student.
And not every idea is, I think, not right away. We hope that every idea will eventually become relevant, but in the first iteration, a finding may not be. But there is stuff out there that people should care about because it’s interesting and it informs the world and what they might do in the future.

Byrne: It’s also true that PhD programs do not teach would-be professors how to teach. You are taught how to research and explore a topic in an innovative way,.

Marquez: I won’t mention the person’s name, but the worst class that I had as a graduate student was from a professor who wound up going on to win the Nobel Prize in economics. And it was just terrible. He couldn’t really explain, even to a set of graduate students who were interested in his research. part of it, He was a brilliant individual, of course, and did obviously very influential work, but he was not necessarily the best at conveying that. You really don’t getany training. To the extent that you do, you get a little bit where you’re a teaching assistant for somebody, which probably means grading some papers for the most part. It becomes a little bit of trial by fire. That’s why I struggled a little bit the first couple of years.

Byrne: Robert, how has your work informed your life?

Marquez: I’ve learned to recognize that the world is imperfect and that there’s a lot of questions out there completely unanswered. This realization has informed my research. A lot of answers are just not out there. And we kind of have to still progress with limited answers, limited information, not knowing who we’re competing against always. We’re just going to try to learn as we go along.

Byrne: So true. Well Robert, I hope the next time you’re in front of your computer and you’re staring in your thinking, your wife doesn’t pull out too much of her hair.

Marquez: Hopefully not. I don’t know if I can convince her that way, but we’ll try.

Byrne: It’s been a true pleasure. Thank you.


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