Rethinking international finance: introduction and overview

Citation

Mittoo, U.R. (2011), "Rethinking international finance: introduction and overview", International Journal of Managerial Finance, Vol. 7 No. 2. https://doi.org/10.1108/ijmf.2011.29107baa.001

Rethinking international finance: introduction and overview

Article Type: Guest editorial From: International Journal of Managerial Finance, Volume 7, Issue 2

Guest Editor

Usha R. MittooBank of Montreal Professor of Finance at I.H. Asper School of Business, University of Manitoba, Canada

The 2008 global financial crisis has highlighted the limitations of our current financial theory and models. It was the most severe crisis since the Great Depression of the 1930s, yet few financial economists saw it coming. What started as a meltdown of the US subprime mortgages in 2007 quickly spread to the US financial sector and grew into a full-blown global banking crisis following the collapse of Lehman Brothers and Washington Mutual in 2008. The asset liquidity vanished, asset prices fell drastically, and financial market volatility jumped to unprecedented levels. The impact of the crisis varied widely across geographical regions and even across countries within regions. The conventional monetary tools appeared to be of little help as the recession continued to deepen and policy makers experimented with different approaches including rescue and stimulus packages to pull the economies out of the recession.

The financial crisis has generated an intense debate about its causes and the consequences for the global financial system and markets. Most financial and economic theories are being sharply questioned in the wake of the financial crisis. A large body of scholarly literature is emerging that re-examines the models of markets, institutions and their interactions in the light of the crisis to draw some lessons going forward. The papers in this special issue are part of this growing literature, and provide an in depth analysis of some specific issues related to the crisis.

The first paper, by Peixin (Payton) Liu, Kuan Xu, and Yonggan Zhao, deals with modeling uncertainty in asset pricing theories and tests. The crisis has highlighted that several dimensions of uncertainty, such as liquidity risk and market volatility, that are at the core of the crisis yet are missing in most models. The authors address this issue by augmenting the Fama and Frenchs (FF, 1992) model with three additional risk factors:

1. 1.

   yield spread;

2. 2.

   credit spread; and

3. 3.

   market volatility.

They take this augmented FF model for testing to the daily stock market data from January 2005 to September 2009 period, which includes the pre-crisis (bull), deep crisis (bear) and transition (recovery) periods. They use a Markov regime-switching model and analyze a sample of the S&Ps sector select ETFs within a regime-switching framework. They confirm the importance of Fama and French factors but also show that credit and yield spread have explanatory power in regime-switching models, and that market volatility is negatively related to most sector ETF returns. They find that the risk premiums of the sector select ETFs and their sensitivities to risk factors are also highly regime dependent. Their findings should be useful in future empirical tests of asset pricing models.

Another major issue in the aftermath of the crisis is the regulation about the capital adequacy of the banks. Banks generally face two types of risks: market risk that is charged to the trading book and credit risk related to the loans that is charged to the banking book. Prior to the crisis banks were able to assign assets like mortgage backed securities to the trading book under the assumption that market liquidity will allow banks to deal with this risk. The assumption of market liquidity, however, broke down following the demise of Lehman Brothers, resulting in substantial mark-to-market losses due to illiquidity and credit deterioration. As the crisis deepened, most financial institutions experienced significant losses in their trading books that arose from credit migrations, widening credit spreads, and evaporating liquidity. To deal with this issue, the Basel Committee on Banking Supervision increased the capital requirements for banks trading books by introducing an Incremental Risk Charge (IRC). An important question is whether the IRC charge will be sufficient in a deep financial crisis similar to the current one.

Simone Varotto addresses this question by comparing IRC estimates with stressed market risk measures derived from a sample of corporate bond indices during the 2007-2009 crisis period. He finds that the capital required to absorb the market risk related to stressed scenarios, could be many times more than the IRC charge depending on bank portfolio characteristics. The findings of this study will be relevant to the policy makers who are grappling with designing the new global banking regulation to ensure the resiliency of the banking system in a severe crisis.

The global financial crisis also triggered dramatic changes in exchange rates and increases in exchange rate volatility. This issue is particularly important for the European Economic and Monetary Union (EMU) members who share a common currency, which can generate asymmetric effects across countries. This poses additional challenges for policy makers as the impact of monetary policy on the value of the Euro and on the business cycle could have asymmetric effects on countries and sectors. Niclas Andrén and Lars Oxelheim examine this issue by analyzing the extent to which the introduction of the Euro changed the price dispersion among participating countries. Prior studies have looked at this issue by focusing on consumer prices. Since consumer prices could be sticky, Andrén and Oxelheim look at the producer prices. They examine producer prices for 12 manufacturing sectors in the first 11 countries that adopted Euro and find significant price convergence before the introduction of the Euro (1993-1998). This pattern is similar to what prior studies have found for consumer prices, and is consistent with a monetary union anchoring inflation rates. However, they find non-linear convergence after the introduction of the Euro, which is only partly consistent with the prior findings. Their evidence suggests that focusing on consumer prices may not be sufficient or efficient for monetary policy making and additional information can be obtained from producer prices.

Finally, an important issue is to understand how credit supply and liquidity shocks affected the real economy and corporate investment decisions. Franck Bancel and Usha R. Mittoo survey and interview Chief Financial Officers (CFOs) of French firms in 2009, about the impact of the global financial crisis and their firms’ financial flexibility levels, before and during the crisis. They find that firms with high financial flexibility had less impact of the crisis. They also provide some insights into how managers perceive and measure financial flexibility. They find that firms with greater internal financing have a significantly lower crisis impact whereas the relation between the firms’ level of access to external financing (self-reported by CFOs) and the crisis impact is much weaker. These findings are consistent with financial theory, which suggests that the real effects of the crisis should be particularly severe for firms that are financially constrained, or dependent on external financing. The paper also shows that firms use several sources to enhance financial flexibility and suggests that an index based on the firms leverage, liquidity, and operating ratios, similar to the Altman Z-score, might be a better financial flexibility measure than the long-term debt ratio that has been used in several studies. These findings will help in a better understanding of the concept of financial flexibility and its role in dealing with crises.

In conclusion, the recent financial crisis of historical proportion has provided a natural laboratory to stress test our theories about how global financial markets and institutions work. The papers in this volume provide results of some of these experiments, related to different issues that arose from the crisis. The findings of these papers should be relevant to policy makers, practitioners, and academic scholars.

In closing, I would like to thank the International Journal of Managerial Finance in sponsoring this special issue on Rethinking international finance, in conjunction with the 2010 Northern Finance Association Meetings held in Winnipeg, September 25-27, 2010. I am grateful to several reviewers who helped in the selection and review process. They include Sarath Abeysekera, Marie-Claude Beaulieu, Wolfgang Bessler, Laurence Booth, Francesca Carrieri, Sean Cleary, Jean-Claude Cosset, Arnie Cowan, Louise Gagnon, Ron Giammarino, Alexander Gordon, Robert Kieschnik, Peter Klein, Lynette Purda,Wendy Rotenberg, Jason Wei, as well as a number of anonymous referees through the IJMF. My special thanks to David Michayluk and Ralf Zurbrugg (Editors) who provided excellent support for this issue at every stage of the process.

Usha R. MittooGuest Editor