John Coffee Explains Why Regulation Is Good for You

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.

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  1. Mencius Moldbug

    The problem is that there are two kinds of regulation.

    There is (a) regulation which protects the rights of the shareholder. And there is (b) regulation which purports to protect the rights of the shareholder, but actually serves the interests of an entirely different party.

    Such as: the accounting industry, the law industry, the union industry, or simply the regulators themselves.

    People complain about regulation because they see that a very large percent of it is (b) regulation. They also see that in a world with freedom of contract and jurisdictional arbitrage, principals and agents would arrive at (a) regulation on their own.

    Unfortunately, no such world exists. And there are two kinds of complainers: (a) people who don’t like (b) regulation, and (b) people who don’t like (a) regulation…

  2. doc holiday

    A bit OT, but this relates to non-regulation:

    Show Me the Money

    For example, go to the Fed’s H4.1 site, and check the numbers for January 4, 2007, and the latest. This shows that FCBs bought only $78.6 billion in Treasuries, and $235.4 billion in “Federal agencies”. Going back to January 5, 2006, FCB custodial holdings of “federal agencies” has increased $409 billion. In total FCB hold $836.9 billion of these so called “federal agencies”. What is the collateral and condition today of all this paper bought at the peak of the housing market? None too good I would imagine? I have come to conclusion that there is no transparency at all in this general “federal agency” account label.

  3. doc holiday

    Very OT, but again, regulation and or the lack of it (guess they want to cover this up for some reason):

    The following is excerpt of Project Wing – the executive summary of a plan, put together by
    Merrill Lynch, Citi and The Blackstone Group, to sell stricken mortgage lender Northern Rock,
    code-named Blackbird. This “Briefing Memorandum” has been sent to all potential acquirers.

    Any assets and liabilities not transferred to the purchaser will be retained within an entity called
    FinCo is expected to remain listed and to be placed into a solvent run-off with the objectives of (i)
    orderly run down of the balance sheet; (ii) repayment of creditors; and, if appropriate, (iii) the return
    of residual value to Blackbird shareholders.
    Blackbird invites recipients of this Memorandum to participate in a process for the acquisition of all
    or parts of the business. This Memorandum is intended to assist recipients in assessing, in particular,
    the WholeCo, PrimeCO and PlatformsCO structures, the ongoing new business potential, the nature
    of obligations with FinCo, and the corresponding value of the proposed new standalone entities.

    Blackbird is currently pursuing a sale of its business as a whole (”WholeCo” or the “Whole
    Company”). This is Blackbird’s preferred outcome. As an alternative to the sale of WholeCo and to
    assist interested parties, Blackbird has defined two discrete preferred asset sale structures, namely
    the acquisition of either (i) the Company’s existing infrastructure/operational platform and/or
    Blackbird’s retail deposits and matching assets (”PlatformsCo” of the “Platforms Company”) or (ii)
    PlatformsCo plus further selected assets and liabilities, including the securitisation and covered
    bond funding programmes (”PrimeCo” or “Prime Mortgage Company”). Blackbird and its advisers
    encourage offers for assets and liabilities of the business which are different from those
    contemplated under the preferred structures. For example, this Memorandum also gives separate
    financial information on the retail deposits platform.

  4. doc holiday

    Perfect Storm Stuff & More OT:

    Northern Rock: Labour’s fig-leaf for failure
    By Philip Stephens
    Published: January 21 2008 18:09 | Last updated: January 21 2008 18:09
    I cannot help thinking that there is something more than a touch ironic about the British government putting its reputation in the hands of an investment bank as it struggles to salvage something from the wreckage of Northern Rock. The financial chicanery that brought the roof down on global markets last summer is now to be set to the purpose of rescuing one of its casualties.

    Anything but nationalisation, one of Prime Minister Gordon Brown’s cabinet colleagues told me the other day as he mulled the government’s narrowing options.

  5. Charles Butler

    Moldbug –

    Is your point merely that ‘..people see that in a world with freedom of contract and jurisdictional arbitrage, principals and agents would arrive at (a) regulation on their own..’ or, ‘(a) regulation’ would be the natural outcome of said freedom?

    Please advise.

  6. Anonymous

    Mencius, this is all well and good in theory, but I don’t see evidence that a) regulation arises on its own. How many hundreds of years had the New York Stock Exchange been in operation, and we still had the frauds (the trusts and trading manipulations) that contributed in a significant way to the ’29 Crash? The Securites Act of 1933 and the Securities and Exchange Act of 1934 have served us pretty well, and there is no way they would have come about through a voluntary contracting regime.

    Similarly, we’d probably still have adulterated meat were it not for the FDA. And development experts say that one of the keys for development in third world countries is to have a proper system of property rights, particularly as regards land. This also relatively seldom comes about spontaneously.

  7. newcombat

    I drafted CDOs and other structured finance instruments, along with bond insurance policies, credit card bond master trust docs and primary asset-backed securities for a major wall street law firm most of this decade.

    In August I posted a note here (and an article on my website: suggesting that the nascent disaster in structured finance might perhaps only be cured by price controls on the wounded bond classes. Perhaps for two years or so.

    Friends laughed; some politely up their sleeves.

    The time has now come, with the bond insurers on the brink. If something is not done almost immediately, we will have to stop tallying s-f bond writedowns with billions.

    As the monolines blew up last week, Jumpin’ Jersey Jim Cramer began shouting that the gov’t should simply buy the insurers and guarantee 50 cents on the dollar for the wounded bonds.

    Price controls might be better and simpler. Writedowns would come under control quickly. The world could catch its breath. Monetary and fiscal policy could begin to heal the underlying economic problems. And the bonds could continue to spew out a good deal of the interest they were intended to produce. Issuers could wind up early (almost all s-f deals are expected to wind up much sooner than their stated term in any case).

    Trades would still be hard to come by, since the Price Controlled price would have the stink of artifice about it. But I assure you that 95% of the trillions in complex derivatives out there were never designed or expected (by their buyer & sellers) to be traded in the secondary market. They were “bonds” in name only. Everyone on the inside thinks of and calls them “trades” or “deals”.

    Red faces on the masters of the universe at Davos this week, eh what? Maybe they’ll persuade Ben to lighten up for chrissakes.

  8. Independent Accountant

    We agree! Amazing. What you call (b) is what I call “regulatory capture”. C. Walton Hamilton, a Yale Law School professor, wrote “The Politics of Industry”, 1957, about just this issue.

  9. Clayton

    Let’s start with the “due dilligence” on our sources (since there are no regulations to prevent people from posting articles on things that they don’t necessarily understand):

    B.A., Amherst, 1966; LL.B., Yale, 1969; LL.M. (in taxation), New York University, 1976.

    … not an econommist. Now that doesn’t necessarily mean that his arguments are wrong, but questioning the source of his arguments and motives is a responsible thing todo.


    So next we’ll focus on his arguments.

    #1 The argument that risk is reduced is valid, but this justifies regulation ONLY if the savings in risk exceeds the cost and dead weight losses produced by regulation.

    He explicitly states that the cost of regulation in the US is 40 percent of the relevent budget, compared to 8-12% in other countries, though he does not use the total budget size to calculate a total cost or cost per business.

    He does, however, imply that the direct federal budget for this activity is large. When you add the costs of litigation and prevention (obviously not “on the books”), the total cost is certainly substantial.

    #2 While I trust that the 30% premium is accurate data, suggestion *a single* possible explanation does not necessarily make it true. Further, even if it’s explains some of the difference, it is unlikely to explain all of the difference.

    An equally sensible explanation is that participation in US markets opens them to a much larger pool of investors. Without specific data, it’s reasonable to aruge that major European investors have to consider playing in US markets. Conversely, sophisticated US investors can stay primarily in the US. This is a far more compelling supply-demand argument that justifies a price on simple economic grounds and does not rely on presumptions on the value of litigation… oh I mean regulation.


    John offers a perfectly *possible* explanation, but nothing in the provided data necessarily implies that his explanation is any better than a hundred others.

    Further, he has rational motivations to support regulation (and the associated litigation) and does not appear to have applicable economic experience on which to build this theory.

    I’m not saying that he’s totally wrong, but this hardly meets logical and critical standards (shocking particularly when you consider that the sources is the Financial Times).

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