The future of securities regulation

Luigi Zingales, 28 January 2009

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In the 75 years since the enactment of the US Securities Act, securities markets could not have changed more. Concerns that afflicted investors then – lack of transparency and market manipulation – are not at the forefront today, partly thanks to the success of 1930s legislation.

Two fundamental trends that alter the regulatory landscape

Also important are two trends that have dramatically altered securities markets.

Institutional investors – mutual and pension funds, and other forms of asset management – have displaced direct ownership by households; today, they own more than 60% of US equity.

Yet, paradoxically, average American investors are today far more exposed to stock market fluctuations, and are asked to make more financial decisions that could significantly impact their future.

Thanks to successive SEC rulings (i.e., SEC rules 501(a), 506, and 144A), private securities markets have emerged as a viable alternative to public markets and are now responsible for more than 65% of total debt issued in the US (see Zingales 2008 for detailed discussion).

The expansion of private markets at the expense of public markets suggests an increase in the cost of public ownership vis-à-vis its benefits. To be sure, it is hard to say if this change is due to increasing disclosure and compliance costs or decreasing costs of private ownership. Both aspects are likely to be true and both point in the direction of an excess gap in the cost between public and private ownership. But the fact that the biggest competitor of the NYSE is the private market in the US under SEC rule 144A rather than, say, London or Hong Kong suggests that the higher disclosure and compliance costs hypothesis has some validity.

Overregulation of the public market is not the whole story

The size of this gap, however, cannot be entirely attributed to the overregulation of securities market. There are several examples that some private markets are too lightly regulated.

The complete lack of regulation of the Credit Default Swap (CDS) market raises the possibility of a systemic failure with consequences not dissimilar from what one would expect under unregulated insurance markets. With large commercial banks massively exposed to CDS, a default by a major player would leave all other ones un-hedged and would trigger a run to buy insurance. Without precautionary regulation, the CDS market would not withstand such shock and satisfy all demands at affordable prices, which would aggravate the shock.

Collateralized debt obligations (CDO) and collateralized mortgage obligations (CMO) are characterised by asymmetric information that makes it difficult for customers to price these assets correctly. If the benefits of information about the product accrue mainly in the form of liquidity at aggregate level (market), isolated buyers may not have the right incentives to demand full information as they may take liquidity for granted.

Lack of transparency not only engenders the suspicion that some hedge funds play strategies that are illegal or borderline illegal, for example insider trading and front running, but it also makes it extremely difficult to evaluate systemic costs of hedge funds.  

The lack of transparency and public scrutiny in the private equity market can also be the cause of abuses and inefficient contracting. Conflicts of interests between venture capitalists and invested companies create serious moral hazard problems. These have only received incomplete regulatory responses. Lack of transparency also raises doubts about the efficiency of private equity markets relative to public ones.

Three areas of Intervention

Restoring confidence in securities markets will involve reforms aimed at: (1) Empowering institutional investors in corporate boards, (2) protecting unsophisticated individuals with regards to their investments, and (3) reducing the regulatory gap between public and private markets. (These proposals are explained more fully in Zingales 2008).

Corporate Governance: Voting and a “new Glass-Steagall Act”

The real issue affecting corporate governance is not managerial compensation, but rather making corporate managers more accountable to shareholders. Reforms should start by up-rooting "Soviet-like" election systems which allow boards to become self-perpetuating entities. Real elections – where directors can be voted up or down and institutional investors have a saying in who is up for election – will naturally make board members more accountable to shareholders. In so doing, this will make corporate executives more accountable to shareholders.

To be sure, many have criticised such moves on ground that there are risks associated with this remedy such as Balkanisation of decision-making processes and excessive short-termism. These concerns are not validated by empirical support. On the contrary, studies show that the current corporate structure is more likely to lead to short-term bias. The introduction of institutional investors’ representatives will also reduce the risk of "group-think" by boards. The only real risk is that institutional investors’ representatives might pursue their own agenda rather than the interest of all shareholders. This risk, however, can be minimized with appropriate rules on which institutional investors can nominate directors for election. 

To improve corporate governance we also need to tackle the conflict of interest of money managers with respect to investment and commercial banks. These managers depend on corporate managers for business so they are unlikely to take a critical position in the corporate governance arena. One important step in this direction is removing the control of decision of 401(k) and contribution plans from the hands of corporate managers. But full reform would also need to establish a formal separation between investment banking activity and money management activity. Hence, I propose a new Glass-Steagall Act separating mutual fund management from investment and commercial banking.

Protection of unsophisticated investors: The trilemma and enhanced disclosure

Regulatory effort should also be diverted towards protecting unsophisticated investors in their access to financial markets. Some progress can be achieved through regulation that dissuades (rather than prevents) unsophisticated households from investing directly in securities markets (e.g., mandates of precautionary warnings).

These efforts should be complemented with action tackling the "trilateral dilemma" (Jackson 2008) in the mutual fund industry. That is, just as a doctor who gets side payments from a drug company for prescribing particular medicines may not choose the most cost-effective treatment, mutual funds who get paid to divert their trades toward some brokers may not necessarily choose the cheapest ones. Likewise, pension consultants, who advise employer-sponsors on the selection of investment options, get paid by financial service firms offering 401(k) programs.

Minimum protection entails enhanced disclosure. At the time of purchase, investors should be provided with a dollar estimate of all expenses that will be charged to their investment, itemised as commissions paid for trading and those paid for services. Also, brokers should disclose fees and "soft dollars" received in trading costs. These standards should apply to both brokerage and money management accounts.

Mere disclosure is not sufficient when investors are easily gullible. Regulation should target practices that divert competition from veiling for the protection of consumer interest. For example, restricting the ability to offer teaser rates in flexible mortgages would reduce the number of borrowers that are duped and would direct competition forces to address the real cost of a mortgage.

Reducing the public-private cost gap: optional rules with empowered institutional investors in the public market, standardisation in disclosure rules in the private market. 

The existence of disclosure costs suggests that not all companies should be forced to have equal levels of disclosure. The existing two-tier regulatory system has the big advantage of providing some flexibility without an excessive segmentation of regulatory regimes.

The recent wave of migration from public to private markets, however, suggests that the current regulatory differential is excessive. Striking a better regulatory balance between these two markets should be achieved via a partial deregulation of the public market and the introduction of some disclosure standards in the private one.

In the public market, the empowerment of institutional investors will make it possible to transform some of the mandatory regulation into optional rules, following the British comply-or-explain system. Additionally, the progressive institutionalization of the retail market would allow to lighten the burden of disclosure requirements by presuming sophisticated investors and caveat emptor (let the buyer beware) exceptions. For example, at the IPO firms should be allowed to opt out of current litigation systems in favour of an arbitration system.

On the private market front, there are benefits to be reaped from some standardisation in disclosure rules. Under current regulation, trillions of dollars in securities are issued without proper amount of transparency. This calls for empowering a regulatory authority to mandate enhanced disclosure for securities that have potential systemic effects (e.g., those issued in CDOs and RMBS markets).

Potential systemic failures also call for the Federal Reserve to establish margin requirements for contracts in Credit Default Swap markets. Additionally, private equity funds and hedge funds above a certain size should be subject to a delayed disclosure requirement. For these intermediaries, contemporaneous disclosure can be excessively costly, since it can reveal some proprietary strategy. But delayed disclosure has none of these costs, while it achieves almost all the benefits, particularly in terms of increased transparency and allowing statistical analysis, which will improve the efficient allocation of savings.

Editors' note: This column is a Lead Commentary on Vox's Global Crisis Debate page; see further discussion on Vox’s “Global Crisis Debate” page.

References

Jackson, Howell (2008). “The Trilateral Dilemma in Financial Regulation,” in Improving the Effectiveness of Financial Education and Savings Programs (Anna Maria Lusardi, ed.) (University of Chicago Press 2008)

Zingales, Luigi (2008). “The Future of Securities Regulation”. Chicago Booth School of Business Research Paper No. 08-27 (December 1, 2008).

Topics: Financial markets
Tags: corporate governance, financial integration, financial regulation, regulations

Robert C. McCormack Professor of Entrepreneurship and Finance, University of Chicago and CEPR Research Fellow