Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Wed, 26 Jul 2006

IPO Quiet Periods

There has been a lot of discussion in the press about the reported move by the Securities and Exchange Board of India to introduce a “quiet period” prior to public offering of securities. Ajay Shah blogged in support of this idea here. The financial press in India also seems to have been largely supportive. Sandeep Parikh provides links to several press reports in his blog. Sandeep Parikh himself has been supportive of the quiet period.

The quiet period is a long established practice in the United States though as Sandeep Parikh points out, US regulations have been dramatically liberalized this year. The purpose is clearly to ensure that securities are sold using a carefully written prospectus and not on the basis of advertisements and other marketing material.

While the goal may be laudable, I think that the quiet period is basically a bad idea. First of all, I am very sceptical about any restraints on the freedom of speech. To my mind, free speech comes much higher in the hierarchy of rights than the right to property. Therefore, if somebody’s free speech conflicts with somebody else’s property rights, I would think that normally it is the free speech that must prevail. I can understand the desire to ensure that any advertising is not misleading, but I cannot understand a ban on general corporate advertising.

Secondly, in practice, the ban extends only to written material. The SEC has now clarified that written material includes videos placed on a website but it excludes communications that are carried live and in real-time to a live audience. This is immensely anti competitive and benefits only a cosy club of investment banks and other financial intermediaries. What it means that an issuer can carry a “soft” advertising message to the investor only through road shows to investor groups. Typically, it is only an investment bank that can organize these road shows. All that the SEC is doing is helping these banks collect their rents. To understand the implications of this, let us take this out of the securities setting. Imagine a rule that said that soft drinks cannot be advertised but live road shows to live audiences are allowed. The Cokes of the world would then have to pay the Walmarts to do road shows in their various retail stores and the Walmarts would surely lobby vigorously for such a rule to be kept in place. Or imagine a rule that said that election meetings and door to door campaigns are allowed but no election related advertising is allowed. Cadre based parties would love this because it increases the entry barrier for new political formations.

These general principles applies to the securities industry as to any other industry. Restrictions on advertising are anti competitive. They favour incumbents. They allow intermediaries to earn rents. Unfortunately regulators are captured by these intermediaries and it is often this regulatory capture that leads to such anti competitive regulations. Sadly, all this is done in the name of consumer protection or investor protection.

Posted at 18:05 on Wed, 26 Jul 2006     View/Post Comments (1)     permanent link


Thu, 20 Jul 2006

FSA as a Regulatory Role Model

Ajay Shah discusses the regulatory successes of the UK’s Financial Services Authority (FSA) in an article in the Financial Express and on his blog. The discussion is related to the common law versus civil law orientation that I blogged about a few days ago.

So is the FSA more common law oriented than other securities regulators? That depends on whom you compare it with. I would imagine that Ajay Shah was comparing the FSA with the Indian regulators (the Securities and Exchange Board of India and more importantly the Reserve Bank of India) and perhaps also with the US Securities and Exchange Commission. If these were his benchmarks, then Ajay Shah is undoubtedly right. The conclusion would also remain valid if the comparison is with the other super regulator that all UK institutions have to contend with - the European Commission. By these benchmarks, the FSA has been a success story that other regulators could seek to emulate.

However, these reference points set the bar too low. I would put forward three other reference points against which the FSA’s performance looks much less impressive.

  1. The first and most obvious comparison would be with the regulator across the border in Ireland which has established itself as a global centre of excellence for hedge funds and other alternative investment vehicles. Most people that I have talked to agree that the IFSRA is one of the smartest and most flexible securities regulators in the world. Before the formation of the IFSRA, the Central Bank of Ireland also had a similar well deserved reputation. In comparison to the IFSRA, the FSA comes across as much more of a check-box or civil law oriented regulator.
  2. Another comparator is the plethora of self regulatory organizations that existed prior to the formation of the FSA. Most observers think that the formation of the FSA saw the emergence of a more rule oriented regulation than what existed earlier. A large part of the staff of the FSA came from the Bank of England and brought with them a more heavy handed regulatory style. The FSA of course had to operate within the limits of its statute and this prevented an excessive civil law orientation.
  3. The last point of reference is the US SEC in its heyday. All regulators are more flexible and competent in their youth. As they age, they tend to ossify and lose their brilliance. Since the FSA is in its early days of existence, a comparison with the Douglas or Landis SEC would be appropriate. A comparison across such a long time gap is problematic. Markets have become more complex and therefore there is a case to be made for more complex regulations. Yet, as I read the situation, the SEC of those days was probably smarter and more flexible than the FSA of today. Though the SEC was a product of a civil law era in US administration (the New Deal), Douglas made the SEC the most successful and least civil law oriented of all the New Deal agencies.

I do have an uneasy feeling that both Ajay Shah and I are relying on anecdotal evidence and an intuitive understanding of how the FSA and other regulators function. There is a need for a more rigorous academic evaluation based on measurable and quantifiable parameters.

Posted at 08:15 on Thu, 20 Jul 2006     View/Post Comments (0)     permanent link


Tue, 18 Jul 2006

Legal Origins and Modern Stock Markets

Mark Roe has written a fascinating paper at SSRN challenging many of the conclusions of La Porta, Shleifer and others that a common law regime favours the development of stock markets and a civil law regime impedes it.

Roe’s first line of attack is to show empirically that the intensity of labour regulation is a better predictor of financial market development than legal origin. Roe goes on to link this with the devastation that the core civil law countries suffered in the world wars. “Early twentieth century ruin strongly predicts late 20th century financial markets’ strength. It may explain both post-World War II strong labor policy in the devastated nations and the weaknesses of securities markets in the same nations.” Roe has a nice theoretical argument to provide the linkage: “If a nation’s middle class’ financial savings were devastated first by inter-war hyper-inflation and depression and then by war-time destruction of the underlying physical assets, then voters for decades after 1945 could have cared little about financial capital because their well-being was tied more to their human capital. ”

The second line of attack is to deny that modern securities regulation in common law countries has any common law characteristics left anymore. I think Roe is on strong ground here when he says that SEC regulations are more in the civil law tradition than in the common law tradition. People like me who thought that was merit in the common law approach would then have to conclude that the direction in which the SEC has taken securities regulation in the last few decades is a big mistake.

All said, Roe has written a very thought provoking paper

Posted at 20:32 on Tue, 18 Jul 2006     View/Post Comments (1)     permanent link


Mon, 10 Jul 2006

Accounting Standard Setters Capitulate to Financial Economics

The International Accounting Standards Board and the US Financial Accounting Standards Board have issued preliminary drafts of the first two chapters of their proposed joint Conceptual Framework for Financial Reporting. This available at the FASB web site.

The draft document appears to me to represent the triumph of financial economics over traditional accounting. For example:

Posted at 15:55 on Mon, 10 Jul 2006     View/Post Comments (0)     permanent link