Thursday, January 25, 2007

Global Forces Undercut Case for Regulatory Reforms

In prior posts (here, here and here), I argue that the Committee on Capital Markets Regulation (popularly known as the Paulson Committee) made a “weak case” in its Interim Report for regulatory reform. Virtually all of my points apply equally to the recently released Bloomberg/Schumer report as well. The themes I sounded in my earlier posts are underscored in a January 25, 2007 Wall Street Journal article entitled “In Call to Deregulate Business, a Global Twist” (here, subscription required), which suggests that “the changing nature of global finance,” rather than the U.S regulatory environment, explains U.S. markets’ declining share of global finance business.

The Journal article explores at length the improved competitiveness of foreign markets, which in recent years have closed their “quality gap” with the U.S. markets. Developing world markets are “deep enough and liquid enough” that listing companies no longer have any financial imperative to list or trade their shares on U.S. exchanges, as they may have had in the past.

The article also zeroes in on one of the prime points cited to justify regulatory reform – that is, the declining U.S share of global IPOs. With the exception of the London’s Alternative Investment Market (AIM), IPOs are down on all developed countries’ exchanges – “the London Stock Exchange’s blue-chip Main market has seen foreign listing decline 23% since 2000. The Deutsche Borse is down 58%; Tokyo down 39%.” In other words, the declining IPO volume “is hardly an American disease.” And even with respect to AIM, the article points out that many of the AIM companies don’t “meet U.S. requirements” or are “too small to attract interest from U.S. underwriters and investors.” (My prior post, here, reviews the Bloomberg/Schumer report’s discussion of the AIM and the report’s conclusion that the U.S. markets should not lower its standards to compete for more of AIM’s business.).

The article also shows that overseas companies are now able to trade their shares freely, and even attract U.S. investors, without the need for a U.S. listing – or the need to pay the $1 million NYSE listing fee. In addition the article examines the fact that increased private equity takeover activity is a global phenomenon, not just a U.S. trait, and that rather than reflecting U.S. companies’ interests to “go private” and avoid public company regulation, the high level of private equity activity is simply a reflection of the fact that private equity firms have so much cash.

At the same time as global markets have become better, they have also closed the regulatory gap with the U.S. The article quotes the director of the SEC’s office of international affairs as saying that Sarbanes-Oxley has “not competitively disadvantaged U.S. markets, simply by virtue of the fact that they have been widely adopted elsewhere.” Even though the U.S. regulatory burden has risen, the same is true for most countries’ markets.

The article gives the advocates for regulatory reform an opportunity for rebuttal. The best that Glenn Hubbard, the chair of the Paulson Committee, can offer, is the declining “investment premium” enjoyed by foreign companies based in developed countries that cross list their shares on U.S. exchanges. Hubbard argues that the declining investment premium for these developed world companies shows that for companies already meeting their more stringent governance standards at home, the costs of meeting the U.S. benefits exceeds the costs.

I have extensively examined the investment premium issue before (here), but it is worth noting here what a total non sequitur Hubbard’s argument is. First, it concedes that there is still an investment premium for companies based in developing countries – that is, the countries with the growing economies that are most likely to be the source of increased economic activity in the years ahead. Second, while the investment premium for companies based in developed countries has declined, it has not gone away, there is still an investment premium for listing on U.S. exchanges, and that is because of the integrity of the U.S. markets, which would be eliminated if regulation were relaxed. And third, to the extent the investment premium has declined, isn’t it obvious that it is because the integrity of many foreign markets has improved? If that is the case, then why does that argue in favor of weakening U.S markets’ regulation? It just seems to me that the only conclusion that can be drawn from the investment premium issue is that we would be best served by striving to maintain the integrity of our markets, not weakening our regulatory rigor in a race for the bottom.

All of this underscores the point I have made in prior posts that business interests in the U.S. may be seizing on the effects of the changing global finance environment as a pretext to undermine regulatory requirements that may occasionally prove uncomfortable because the requirements actually have teeth. The advocates for regulatory reform may want to advance U.S. competitiveness, but steps that threaten to weaken the integrity of the U.S regulatory structure could remove the greatest advantage the U.S. markets enjoy – that is, the U.S. markets are the most highly regarded precisely because they are the most tightly regulated.

That is not to say that none of the reformers’ ideas have validity. To the contrary, the Bloomberg/Schumer report’s suggestions for immigration reform and immediate adoption of the Basel II Capital Accords are sound and should be pursed, as should many of the report’s suggestions for harmonization of competing U.S. regulatory structures, and the harmonization of U.S and international accounting standards. But aggressive revision of the U.S regulatory and legal structure, at least in the name of the competitiveness of the U.S. markets, could represent a misplaced effort that could do more harm than good.

It is worth noting that the Journal article contains an interesting quote from former Treasury Secretary Lawrence Summers, who says that “well-functioning capital markets are central to the success of the economy. What faction of capital market transactions runs through New York is of much less broad-based significance.” Summers’ observation is one that is not being heard much, but it is a point worth keeping in mind. Perhaps we should be more focused on adapting to the new reality of the global marketplace, rather than attempting to preserve the benefits of market advantages that no longer exist.

Finally, it is worth noting that several of the overseas companies discussed in the Journal article mentioned the high listing fees for U.S. exchanges. While the two task force reports released so far have tried to downplay the importance of listing fees and U.S underwriters’ fees (which also tend to be higher than European fees, as much as twice as high), evidence and logic suggest that these fees and costs are a factor affecting overseas companies’ willingness to list on U.S. exchanges. As I have argued before, the U.S. financial industry, rather than sniping at a regulatory structure that other countries are imitating, perhaps they should overhaul their cost structure, which the rest of the world has substantially improved upon.

UPDATE: The January 26, 2007 New York Times has an article (here) that raises many of the same themes as the Journal article linked about, including specifically the point that the U.S. should not be stressing about the loss of very small companies to the AIM.

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