| Robyn Fadden – host: | What regulations are at play when a country invests in stocks and businesses in another country – and who are those regulations ultimately benefitting? The 2008 global financial crisis changed how we think about the interconnection of different countries’ finances and investments, and that interconnection’s effects on each country both domestically and internationally. We continue to live in a world of nations intent on protecting themselves while also opening their doors to lucrative global trade and a certain amount of foreign investment. The 2008 financial crisis shone a spotlight on the winners and losers in that respect, resulting in greater regulation of foreign investment and how much could be borrowed or leveraged for those investments. Today’s increasing inflation and interest rates reveal similar tensions in the relationship between nations’ domestic economies and their international financial markets. |
| Robyn Fadden – host: | Welcome to the Delve podcast – I’m your host for this episode, Robyn Fadden. On this episode, Desautels Faculty of Management Professor Francesca Carrieri discusses her research on the dynamics of global market integration, in particular the details of foreign investment and current barriers to it. Studying alternative financial integration measures, international capital flows, and institutional portfolio holdings, Carrieri and her co-researchers have shown how regulatory constraints on foreign investors’ use of leverage can act as an international investment barrier. What level of risk will foreign investors take today in the name of diversification of their portfolios, and what barriers are holding them back not only for their own sake, but for the integrity of any foreign country’s domestic market? |
| Robyn Fadden – host: | Welcome to the Delve podcast Professor Carrieri. I’d like to start with a question of curiosity: What main research question or gap in this research area of global financial integration and investment inspired your paper? |
| Francesca Carrieri: | We can say that a lot has changed for finance research after the financial crisis. And a lot of research got redirected directly toward looking at the role of intermediaries in financial markets, right, because it was clear also that intermediaries had a large role in what happened then. So it made sense, right to add to our knowledge. And so in all areas, both domestic research and international research, we started looking at problems that were related to financial intermediaries. |
| Francesca Carrieri: | I’ve been working on international problem of international finance for a long time. And so you can say that a part of my research agenda has always been for a long time looking at what we say is international financial integration. So how international financial markets move together, if you can broadly speak. Or why do they move together? When is it that they move together? What kind of risks make them move together? So this is like the broad question I’ve always been interested with. And for some time, I would say my research was really focused on figuring out the role of what we say were investment barriers. So we can think of it also what happens, especially what used to happen a lot in the past in Canada, of investors, domestic investors, who were not allowed to own foreign securities in large amounts – there was just a small amount allowed right in their portfolio, whether these were institutional investors, also, retail investors. But now we are in a different world, where we all, also thanks to academics, we understand the benefit of being internationally diversified. |
| Robyn Fadden – host: | And before that, why was international investment limited for Canadian and other international investors? |
| Francesca Carrieri: | A lot of it had to do with a sense of protecting the investors, I would say. So, this was on one side. So it was more on the domestic side that there was this right in terms of regulations. At the same time, it is also fair to say that for a long time, market countries around the world were also closed to foreign investments, right. So, it was two ways. On one side domestically, regulators wanted to protect investors and wanted to say maintain capital within its own countries without regard for the fact that may be allowing people, allowing investors to go abroad had some advantages – global diversification is the primary source of this advantage. |
| Francesca Carrieri: | On the other side, also, we said countries were imposing restrictions on foreign capital coming in or going out. Some of it was maybe due to the desire to protect capital markets internally because very often foreign capitals is said is kind of fickle, right. So in some cases are the first note of stress around the world, it may it might leave the country. And so that creates a bigger crisis than what it then that how it starts. So there were all these different reasons – for that we didn’t see a lot of international investment. But then slowly, slowly countries, regulators realized the importance of it. So countries opened – we hear about liberalisation, liberalisation of financial markets. What is that? It was exactly the fact that many countries removed these restrictions primarily on ownership of some assets of some industries, allowing foreign investors recognizing that capital from foreign investment is important. And therefore, there was in the 90s among developed markets, and in 2000 also definitely expanded to emerging markets, we saw there was this broad trend across investors too. Also, of course, look abroad, look at foreign investments, and that was facilitated by the fact that all these, which we called barriers to international investment, were falling. And so, that was I would say what my research had been for a long time – focusing on international financial integration, focusing on the existence of these barriers, focusing on the capital market liberalization, therefore, the reduction of these barriers, and as a result, focusing on how markets change in their correlations. |
| Francesca Carrieri: | This was the story before the financial crisis. Then I was telling you how things overall broadly in finance research, the focus of finance research, changed somewhat with the financial crisis. So, then, the question me and with my co-authors, we started thinking okay, so clearly, there’s a lot of barriers to international investments that have been reduced, maybe even eliminated, so we might think that, look now there’s absolutely no problem. If I can just boil it down in a very simple way: there’s absolutely no problem into investing abroad, whether we’re talking about institution investors, retail investors, no problem. Well, the question, however, is not so simple, right? |
| Francesca Carrieri: | So we started digging into the rules that are behind this foreign investment. And we focused more on certain aspects that were highlighted during the financial crisis. So we might have heard a lot that issues with leverage, the fact that financial institutions were highly leveraged, had heavily borrowed for investments had become one of the reasons that triggered the financial crisis. So our question was, okay, can we say something about that, but now not focusing on simply what happened within a domestic market? Of course, the US maybe, or Canada, but actually see how that can impact cross-border investment, whether or not these are relevant barriers, whether first of all they exist, and if they’re relevant. |
| Robyn Fadden – host: | How did you figure out how to measure cross-border funding barriers? And how do Cross Border Funding Barriers (CFBs) affect investment choices and asset prices? |
| Francesca Carrieri: | It wasn’t easy to come up with a measure. In this paper, we actually come up with a more sophisticated way of modeling this, but to boil it down simply was really to figure out whether they are restrictions on using leverage for foreign position to invest in foreign securities. And so while it is very clear and straightforward when we think about an ownership restriction on a foreign security is very simple. It’s either the government that says in foreigners cannot involve and cannot buy stocks of airlines, for example, or banks, because these are some sectors that are protected, or, you know, companies in their charter that say no, we don’t want foreign capital more than, you know, 20%, again for that, for some reason, they want to protect their domestic investment. So it’s very clear and straightforward. When it comes to cross border funding barriers, in a way, we can say that, I don’t want to say we came up with this language, but indeed, the idea of funding barriers already existed right at the domestic level. So you can think of what could be the reason why some institution cannot borrow or leverage their position borrow to invest. So this idea of some kind of frictions, in borrowing for investments existed already. But there was not, I will say, any understanding of whether this matters, and to what extent this friction might matter when it comes to investing abroad. |
| Robyn Fadden – host: | The data for your research involved studying financial regulations and data around securities as well as observing stock market prices and their dynamics. That’s quite a lot of data – what did you focus on within that information? |
| Francesca Carrieri: | One of the problems, when we look at international financial market is data – data availability and data comparability. So if we want to do something that is meaningful, we need to have similar data across many countries. Otherwise, you know, it’s not very significant as a study, but there is, there are there are problems into achieving that. The first thing was like, okay, so which market do we want to start studying, and, of course, we focus a lot on the regulations of the US market, because, as you might imagine, represents the largest market for investors, both within the country, and as investors investing abroad bring in their money, institutional investors bring in their money in other countries. So we started looking at that. And then we, you know, we also try to understand whether similar regulation exists, for example, in Canada, or in other country, we don’t have a fully comprehensive, fully comprehensive data on this. And that was the reason why we needed to come up with our own measure. And then we were if we and we verified whether this measure fits with the limited data that we can collect. |
| Francesca Carrieri: | And so this measure is actually a measure that we extract from financial, from asset prices, from prices of stocks. And we extract this measure, not only for the US, where we have some sense of what the rules are when it comes to leverage, but we also extract this measure from all other countries around the world. And so this is our own extracted, yes, extracted measure of cross-border funding barriers that then we validate that measure with the limited data that we have extracted from the US regulations. |
| Robyn Fadden – host: | In your assessment, what has changed since the global financial crisis 14 years ago? Has anything shifted backwards? |
| Francesca Carrieri: | The thing that was interesting for us to look at this is because on one side, when it comes to, as I said, some form of barriers, they have been reduced or completely eliminated – foreign investment barriers. What has happened instead on the leverage, and all those types of rules, they are still there. And in some cases, they’ve actually been strengthened, because if it is the case that we observed some of the problems during the financial crisis being driven by either a lack of regulations or lack of oversights and so on, that clearly justified looking at this again and strengthening – these rules strengthening the resilience of the financial markets and so on. |
| Francesca Carrieri: | With respect to rules when it comes to leverage itself, these are still in place. When it comes to some rules with respect to mutual funds and the opportunity for these other institutional investors to actually look abroad, those have been even strengthened, because now there’s an I’m talking about the US primarily there is there are rules with respect to some liquidity provisions with respect to liquidity risk management. So, if mutual funds have certain foreign stocks, they have to maintain a certain level of liquidity that depends on how the regulator’s looks at these stocks, how risky they are, what is the sovereign countries are, what is the currency of denomination? What is the jurisdiction, all these things have become really been scrutinized more closely, and in some new regulations have been added or strengthened. |
| Robyn Fadden – host: | So this matters to many different types of investors. From banks to brokerage firms to everyday people who have investments in mutual funds. |
| Francesca Carrieri: | Absolutely. So the in the paper, we really go through all the investors and we really sure how at every level, this restriction matters. And we start with banks, financial institutions in general in their capital requirements, then we go down and we look at financial intermediaries that are regulated like a brokerage and prime brokers, then we look at hedge funds, that heavily use leverage, then we will look at mutual funds that cannot use leverage to protect the investors. And we also look at retail. So we show how constraint on leverage exists at every level. But we also say these constraints are not, they are there, this is the level of constraints, but they’re not always binding. They only become binding urgence under certain conditions when financial markets are under stress. So credit becomes less available. And therefore, you know, prime brokerage requires changing in their margin requirements, or in the rules on how you can borrow funds to invest. |
| Francesca Carrieri: | It’s clear in stressful periods, it makes sense to think that it becomes harder to borrow, and when credit is easy, of course, there’s no problem. But the moment markets become more nervous, a lot of these margins account. So, how certain financial institutions provide borrowing credit to invest in another financial instruments becomes more difficult. And so that is basically what we were able to observe during the financial crisis. And that goes back to the integration stories that you had asked me earlier. So what has happened during the financial crisis is the moment credit becomes more scarce, banks have to call in some of their loans, in terms of margins and so on, what you observe is that these constraints that exist all the time become binding. And therefore, this integration that exists between financial markets around the world decreases. If before, every country was equally risky, maybe this is a good way to put it: if every country was equally risky in periods of stress. which in this research, we’re really motivated by this funding, liquidity, lack of funding liquidity – in periods of stress, countries take their own path. So risk is not equally shared around the countries. And we start seeing periods of stress in some countries more than other countries – some countries are viewed as more risky than others. During periods of calm, all markets kind of go together, and risk is kind of equally shared and priced around the world, then it starts diverging during periods of stress – broadly, you know, taking a broad explanation of these events. |
| Robyn Fadden – host: | What types of international investors are most affected by leverage constraints? |
| Francesca Carrieri: | It is broad in terms of when it comes to regulation, but of course, because there are some investors like hedge funds or mutual funds that really make the large represent the large portion of foreign right of cross border investments, then we can say these things become really binding for these type of investors in terms of stress. Now, when it comes to retail investors, they’re there and actually pretty binding. It’s just that in general, from the very beginning retails investor find it very hard to invest abroad, right. So, that’s maybe it would be even harder to really documented empirically for retail investor. So that’s why we do it. And we focus more in our empirical analysis on what we can learn from the rules to institutional investors into mutual funds. |
| Robyn Fadden – host: | We know that the financial crisis was obviously a source of stress, which caused leverage constraints on some investors – how did those constraints drive up the cost or premiums of asset-related risk? |
| Francesca Carrieri: | I think I mentioned earlier that there’s this level, there are rules that always exist, these rules imply that if institutional investors want to invest abroad, so borrow, let’s say, an institution, a hedge fund wants to borrow on margin from a prime broker, wants to borrow some money to buy foreign stocks. So there is a rule there that tells that these margins are more expensive than borrowing on margins for domestic stocks. So you can see how the moment credit becomes more scarce, necessarily hedge funds the first thing they would do is they would retreat from investing in what is more costly. And so that explains, why we observe risk between assets to increase during this period of stress, and we say this risk, this increasing risk, is really driven by the fact that there exists a level of investment barriers that then become binding during periods of stress. And that explains why then risk is repriced during this period. |
| Robyn Fadden – host: | One of your major research findings is that in periods of stress, certain investors will back off from foreign investments in particular. What do you see as the policy implications or other effects of your findings? |
| Francesca Carrieri: | Yes, it’s that in periods of stress, when credit becomes more scarce, one of the first thing that becomes a reason to worry for institutional investors or mutual funds is the fact that they have foreign stocks in their in their portfolio, and the fact that they might pull back from investment in these foreign stocks, because of certain rules, or another important aspect, especially for mutual funds that cannot use leverage, is that to amplify their excess closer to risk they pull toward what are called high beta stocks. High beta stocks are stocks that we say have embedded leverage; they help investors to amplify their exposure to markets without borrowing. This is basically what we have observed. |
| Francesca Carrieri: | Do we provide some kind of policy or prescription? Well, the fact that we say that during these periods of stress, markets become more segmented, are not integrated, that really tells us that it becomes harder for countries around the world to share risks. And so what we can do is just trying to strengthen the financial system overall. But I think in a way, as I said, certain things have been happening. The fact that there are all these liquidity risk provisions that have been introduced, again, is to make sure that, under certain conditions, institutional investors have the liquidity necessary to strengthen their underlying positions, basically. |
| Robyn Fadden – host: | When we look at what is going on today in global financial matters, where there’s been talk since the beginning of the Covid pandemic about a possible recession and credit crisis, and more recently we’ve seen inflation and interest rate hikes. How does your research relate to broader problems like these, not necessarily in the economy in general, but in global financial markets? |
| Francesca Carrieri: | This research in itself is not directly linked to a recession in the real economy, but is more directly linked to problem in financial markets. If you want, definitely, we can say that today we see those two kinds of going together, although it’s very hard, we know to say, Oh, we are in a recession, it’s usually easier to see financial markets collapsing, or, you know, losing value, and only later we might learn about a recession, and so on. So the research itself is not, once again, about the real side of the economy, the recession part these days, but is about investment. |
| Francesca Carrieri: | And so what is the problem, for example, these days? What we observe is that we see interest rates increasing across the board, we know, we central banks are fighting inflation everywhere around the world. And that’s part of their mandate – ensure price stability means that they have to increase interest rates. So increasing interest rates necessarily make things more costly. So borrowing at every level, becomes more costly. And at the same times, higher interest rates means that maybe some at least maybe the retails investors would be less willing to invest in in stocks, and even less maybe in foreign markets. So indeed, we really haven’t seen this type of crisis that we observed in 2007-2008. Some people say, because the financial structure has been strengthened through all this additional regulation. So we’re we haven’t seen that. So the type of market drops that we’ve seen lead lately, I mean, like just last night yesterday, and markets now today are a little bit more calm if you want, or not really driven by the high exposure to leverage that, you know, caused instead, instead, the financial crisis of 2007 2008 is definitely more driven by the underlying economic situations. But there is no doubt that higher interest rates always create stress for markets, create stress for credit availability, and so can also create problems for foreign investments. |
| Robyn Fadden – host: | This research also shows how completely integrated the world is right now – yes, we can separate financial markets from national economies and recessions and inflation, but we can also see how linked they really are today. |
| Francesca Carrieri: | Absolutely. Yes, that exactly. Again, as I said, this is part of my general type of research – to think how integrated the world is, or is becoming. So I started looking in the 70s that happened through first developed markets becoming more integrated, than also emerging markets eliminated some barriers and some restrictions, and then looking again at what happened in 2007-2008 when we all think, oh my god, there’s no more restriction, we can do whatever we want, invest abroad and so on. |
| Francesca Carrieri: | Basically, this paper said there still some things that are out there that differentiates between a domestic type of investment and an international type of investment. And how we can fund this different type of investment clearly is different because the foreign investment is viewed by regulators as riskier, and therefore they’re more guardrails if you want. And so it’s more difficult to borrow if you wanted to invest abroad, there’s certain liquidity provisions that have to be maintained and so on. So yes, it’s true, the world is more integrated, more correlated, but there are still things there, and maybe it’s because regulators in each country want to protect the integrity of its own financial markets and its own investors. And therefore, as long as we can, we’ll continue to see domestic assets different from foreign assets, there will always be these tensions and possibility for this dislocation in financial integration driven by these types of problems. |
| Robyn Fadden – host: | So no country is going to stop watching what’s going on in investments both within their borders and by foreign investors. |
| Francesca Carrieri: | If anything, yes, that’s what we learned with the financial crisis of 2008. Also, at an international level, there are all this push to allow connection between financial markets in different countries, but also keep the integrity of the domestic market. |
| Robyn Fadden – host: | So that the domestic remains safe. While so much is linked globally, we still live in a world of separate nations, of course. |
| Francesca Carrieri: | Yes, exactly. We still live in a world of nations. Yes, and their own people to protect and their own markets to protect, their own companies to protect. |
| Robyn Fadden – host: | And that’s something that can be lost sight of when you’re looking at the details of stock markets up and downs, where the financial world is perhaps more easily abstracted away from its tangible effects on people. |
| Francesca Carrieri: | Yes, but behind that there are people – there are people working in companies, and therefore that makes sense why regulations think about what’s behind just stock prices. |
| Robyn Fadden – host: | Behind stock prices are investors of all kinds, of course, as well as companies and the people that run them and work for them, the people that buy their goods and services, who hold workplace and government pension investments, who in some way or another are touched by the financial sphere. |
| Robyn Fadden – host: | Our guest today on the Delve podcast was Desautels Faculty of Management Professor Francesca Carrieri, whose research provides an overview of both the importance of studying international investment through unbiased academic means, and how safeguarding the domestic market through regulations affects foreign investment and greater global markets. You can find out more about this research in an article at delve.mcgill.ca. Thank you for listening to the Delve podcast, produced by Delve, the thought leadership platform of the Desautels Faculty of Management at McGill University. You can follow DelveMcGill on Facebook, LinkedIn, Twitter and Instagram. And subscribe to the DelveMcGill podcast on your favourite podcasting app. |
