Some readers go ballistic when I suggest that tougher credit markets regulation is an important and not sufficiently considered part of the remedy to our current economic woes. In their eyes, regulation is always and ever a bad thing.
John Coffee, Columbia Law professor and long standing expert in the securities industry, tells us that tougher (by international standards) US regulation of equity markets produces benefits for both the issuers (the companies who sell stock) and society as a whole, in tangible economic terms.
Consider: if anonymous parties (ie, they don’t know each other, and they lack a personal relationship with the producer of the goods they are exchanging) are to trade with each other, they will either engage in costly due diligence (on each other and on the goods they are buying) or offer a low price to reflect the very high risk. Would you buy a supposed Picasso from someone who wasn’t either an auction house or a very well-regarded art dealer? The same principles apply in other markets.
From the Financial Times:
Conventional wisdom holds that the London Stock Exchange is winning the international battle for listings and offerings, in large measure because of the “regulation-lite” policies of the UK’s Financial Services Agency. The reality is, however, more complex. A significant enforcement gap exists between the US and the UK, and its impact creates a regulatory dilemma for both countries.
London’s Alternative Investment Market has been spectacularly successful but does that success prove the value of a “light touch” on enforcement? The answer probably depends on what a country most wants its capital markets to do: either attract foreign listings, transactions and trading volume, or reduce the cost of capital to issuers.
A growing body of economic research shows the cost of equity capital varies with the regulatory and disclosure environment. In particular, these studies show that when a foreign company cross-lists on a big US exchange it incurs a significant reduction in its cost of capital and also displays a valuation premium (often 30 per cent or more) over non cross-listed companies from its home country. This pattern has continued for nearly 20 years, varying only in degree. Conversely, when a foreign company cross-lists on the London Stock Exchange, no valuation premium results and there is no reduction in its cost of capital. This pattern has also persisted since at least 1990.
What can explain this puzzle? The most plausible explanation is that stricter enforcement in the US causes investors to view the cross-listed company’s financial results and projections with greater trust and confidence and assign a higher valuation. Put simply, deterrence works.
Ultimately, stricter enforcement yields a trade-off: it deters many companies from cross-listing, but it also implies a lower cost of capital for both domestic and cross-listed companies. Companies with controlling shareholders may spurn this benefit and avoid the US in order to continue to enjoy the private benefits of control, which is worth more to them. Still, the important point to remember is that a lower cost of capital carries potential benefits for the broader society: namely, a higher gross domestic product and lower unemployment.
A public/private conflict easily arises over the desirability of strong enforcement. From the private perspective of market professionals, low enforcement means increased business. But from a public perspective, low enforcement implies greater insider trading and market manipulation, which in turn raises the cost of equity capital.
How great then is the current enforcement gap? First, viewed in terms of “enforcement inputs” (that is, regulatory budgets and staff size), common law countries invest much more in enforcement than do civil law countries, such as France, and the principal common law jurisdictions – the US, the UK, Canada and Australia – are all roughly comparable.
Second, viewed in terms of “enforcement outputs” (enforcement actions brought and penalties levied), however, the US and Australia are at the high end of the continuum and the UK at the opposite end. Even after adjustment for differences in market capitalisation, the financial penalties levied for securities violations in the US exceed those imposed by the FSA by at least 10 to one.
Third, over recent years, the FSA has allocated between 8 and 12 per cent of its budget to enforcement, while the US allocates about 40 per cent and Australia around 45 per cent.
Finally, the US actively uses criminal penalties for insider trading and “cooking the books” by publicly held companies. Criminal enforcement of securities offences is virtually unknown in the UK and even civil insider trading cases remain rare.
Why are these differences so dramatic given otherwise close similarities in the disclosure systems of the two countries? Three reasons stand out: First, the UK probably does have stronger substantive corporate governance rules than the US and to a degree that mitigates the need for enforcement. Second, the City of London and the FSA both tend to view the capital markets as a polite club in which gentle guidance and a regulatory frown are sufficient. Third, the US market is much more retail oriented. Because the American middle class holds its retirement savings in the stock market, there is a stronger political demand for enforcement.
These differences seem likely to persist. But, in a globalising world, the view of the capital market as a gentlemen’s club seems anachronistic. Strangers are increasingly dealing with strangers and gentle guidance does not deter the predatory. Given the hidden costs of insider trading, perhaps the time has come for the UK to take enforcement more seriously.