Hung-Gay Fung ( 馮鴻璣 ) Dr. Y.S. Tsiang Professor of Chinese Studies

New Paradigms after the Global Financial Crisis Hung-Gay Fung (馮鴻璣) Dr. Y.S. Tsiang Professor of Chinese Studies University of Missouri-St. Louis USA

Outline • Highlight some patterns related to the financial crisis, • Review assumptions of economic and financial models, and • Identify some recent trends of development in finance. • Discuss some possible future directions for research and teaching in finance and in the business schools.

First: Highlight some patterns related to the financial crisis

1.1 Excessive executive pays • A CEO of a Standard & Poor’s (S&P) 500 index paid, on average, $9.25 million in 2009, while millions of workers lost their jobs, their homes and their retirement savings in the worst financial crisis. • Eric Daniels, CEO of Lloyds Banking Group, now 41.3%-owned by the UK government, got bonus of $16 million for bad financial performance in 2009 and $1.6m for departing bonus in March 2011 along with huge auditing fees paid to accounting firms that issued reports of which the accuracy is in question on Lloyds Banking Group.

Executive compensation in the U.S. are commonly based on size of the firm but not on the performance. • The investment banking has returned to huge bonus after the financial crisis, implying that business as usual.

2. Firms are too big to fail • AIG that has close connections with the US government and got bailout; • Many US big banks such as Citicorp, Bank of America got bailout during the financial crisis.

3. Moral hazard • banks and corporations are willing to take excessive risk for banks and financial institutions • Agency problem

4. Financial Frauds • Financial frauds such as the Madoff case are frequent. • In addition, there were many insider trading cases such as hedge funds are common as shown in media. Implications: • Lack of ethical values in financial professionals

5. Excessive use of derivatives • CDS was a US$60 trillion market; now, after the crisis, it is about a $40 trillion market

6. inappropriate government policies • Guarantees on low-income loans and low interest rate, • deregulation, • inappropriate bailout scheme, • the US Government provides false reports on the health of the banking performance

Observation • Pundits and practitioners indicate economic models have not been working leading to the financial crisis. • Prominent economists and finance scholars are particularly silent, implying businesses are as usual. • The crisis has been looked at purely as an aberration, a rare occurrence in the probability sense. • Self-interest of the academic profession to protect the profession

Second: Premises of Economic and Financial Models

These models basically assume that the “invisible hand” will work its magic to resolve all imbalances and bring the economy back to the steady-state equilibrium . • Market efficiency and International financial parity theory across countries work • Parity theory of international financial flows assumes the interest rate with inflation expectation equals to the expected future exchange rate • Carry trade

M&M theory • M&M on capital structure theory assumes a perfect market, homogenous expectations, atomistic investors. Substantial evidence has shown M&M model cannot explain well behavior of firms on capital structure because of information asymmetry, agency cost problems, and market impediments

CAPM • CAPM assumes quadratic utility functions of investors or normal distribution of returns along with a perfect market. The pattern of home-bias investment flies in the face of the CAPM or international CAPM.

Black-Scholes Model • Option pricing of Black-Scholes-type model assumes no information flows in a steady state. • Throughout the financial crisis, the pricing of derivatives become an issue because the pricing model does not provide a price that matches the market price.

Third: Some recent trends of development or challenges in finance

Efficient Market • Notion of efficiency has been called into the question as illustrated by the mounting evidence of displaying momentum patterns shown in equity prices • In 2001, an overreaction of market participants for the IT bubbles in the US and across the world and the recent gyrations of stock prices question efficient market

Firm Goal: Value Maximization • Average CEO tenure, which has dropped from 10 to six years since 1995, as the complexity and scale of firms have grown. • CEOs would likely focus on the shorter-term performance instead of the long-term interest of the company to maximize their bonuses that are tied to performance.

Suppose CEOs miss their quarterly earnings targets, some big investors agitate for their removal and financial analysts issue negative reports, forcing CEOs to manipulate earnings to meeting earning expectations by analysts • Two implications in US: • First, there is a substantial decline in option granting but an increase in cash bonus. Second, a current debate to implementthe “restricted stock grants” to senior executives

In the 1970s the average holding period for U.S. equities was about seven years; now it is more like seven months, a much shorter holding period. • Investors are looking at the short-term performance of the firm as they have no patience for long-term growth. • it seems that investors across the globe are quite unforgiving their firms that are missing earnings targets

Examples • Shares in Kathmandu NZ, a New Zealand company specializing in outdoor supplies and clothing were 12.5 per cent lower in early trade in August after the outdoor clothing company reported lower earnings than forecast for fiscal 2010 last year; • Teck, Canada’s largest base-metals and coal producer, declined 8.3 percent in February 2011 after profit fell 20 percent short of the average estimate;

Shares of hospital software maker MedAssets Inc. in the U.S. tumbled almost 30 percent in February 2011 after reporting a loss for the fourth quarter and missing the Wall Street estimates. • HP stock prices dove nearly 12 percent to $42.45 per share in trading on a trimmed earnings forecast in February 2011.

Triple-bottom line • Stockholders in public companies including American Airlines, Citigroup, Electronic Data Systems, and JP Morgan have approved proposals enabling them to be actively involved in the board decision on executive pay and others • Some groups of stockholders have become more aware of corporate social responsibility.

Implications • First, stocks prices appear to overshoot or undershoot fundamental values as investors are skeptical of the announcements. • Second, Unilever, Coca-Cola, Ford, Microsoft, and many others have stopped issuing earnings guidance altogether; • many firms today do not look at the short-term measure of sale performances to inform their investors and customers • Third, corporate social responsibility as real option

Finally: Some implications for Research and Teaching in finance

Silo effect of financial research • Given the break down of the separation theorems in finance (with stockholders and consumer) • Interactions of disciplines (marketing and management) • Ethics research in finance • Financial strategies

Implications on Teaching • Warning of the model assumptions writ large • Decision making • Focus on both analysis and decision making • Avoid non-linear thinking • Ethical values vs rationality • Example of rationality trap • Study yin-yang theory (I-Ching and Lao Tze)

Two themes of I-Ching • Relativity • Cycles

Relativity • I-Ching stresses relative positioning. That is where you stand and its context. • We often ignore this aspect of position in the way we act. • Environment and the role we play (business environment and firm itself) • Constraints we confront/assessing one’s strength/weakness • Mindset/attitudes: Best of time, Worst of Time, and a time of uncertainty

Confucius says: “If a person who is crude and yet sincere asks anything of me, I will raise different questions from one perspective to the other, so it could be understood thoroughly” (Analect: 9:8--子曰：「… 有鄙(bǐ)夫問於我，空空如也，我叩其兩端而竭 (jié)焉 (yān )。」)

Relative positioning- illustration • Justice Minister Wang, Ching-feng (王清峰: 法务部长) in Taiwan openly expressed opposition for capital punishment and was reluctant to sign execution orders for the 44 convicts on death row in early 2010; • Being underestimated the reactions to her public voice, she was asked to step down from her post; • For the new justice minister (Tseng, Yung-fu/曾勇夫), the willingness to carry out the death penalty has become the leading consideration for appointment of the Taiwan president (3/11/2010)

Barbie in China • Barbie, the slender symbol of American consumerism, has shut up shop in Shanghai in March 2011 just two years after opening her biggest flagship store in China’s most populous city. • The owner chose the wrong location [for the flagship store] and they offered sexy clothes designed by Patricia Field of Sex and the City fame when young Chinese women tend to prefer cute designs like Hello Kitty.

Home Depot Case • Home Depot, the largest US home improvement retailer by sales, hasclosed its last store in Beijing in January 2011. • Why? • Do-it-yourself culture is absent in China, where low wages, an abundance of migrant workers and other cultural, social and economic factors suppress demand for the kind of home improvement retailing common in the US or Europe

SWOT analysis • Environmental factors internal to the firm usually can be classified as strengths (S) or weaknesses (W), and those external to the firm can be classified as opportunities (O) or threats (T). • Good framework, it is static in nature, ignoring dynamics – historical effect; cycle

Resource-based theory • Developed in 1970s in the West • It is clearly part of the relative positioning implications by Lao Tze and I-Ching (3,000-4000 years ago)

Cycles • Environment changes: regulation and de-regulation • Moving up the corporate ladder • Each stage requires different skilled set • Product life cycles • When to innovate • M&A • Consumer and stockholder attitude changes – such as corporate social responsibility

In September, 2008, Paul Parker, Lehman Brothers' co-head of mergers and acquisitions negotiated the sale of the bank's North American operations to Barclays. Park explained to his family at that time that Lehman's collapse was his low point personally. • In March 2011, two and a half years later, that deal has helped put Barclays Capital, the investment banking division of Barclays, in a second position to challenge Goldman Sachs (#1 in 2010 total mergers and acquisitions in the U.S.) • Parker, 47, now global head of M&A at Barclays Capital believe the forced sale is the most successful financial-services combination

Concluding Remarks • We need to challenge the traditional financial theories and their applicability in research and teaching • We need to integrate the approaches from the West (using model analysis) and East (philosophical perspective) in decision makings. • I sincerely wish you well in your profession by integrating life and research together. • Thank you!

Hung-Gay Fung ( 馮鴻璣 ) Dr. Y.S. Tsiang Professor of Chinese Studies