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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Mon, 18 Jun 2012

Questioning the benefits of 1930s US securities reforms

Cheffins, Bank and Wells posted an interesting paper earlier this month on SSRN (“Questioning ‘Law and Finance’: US Stock Market Development, 1930-70”) arguing that the creation of the US SEC and the associated legislation did not energize the development of the US securities markets.

After this long period of stagnation and decline, the US stock markets began to recover and grow in the late 1950s and early 1960s. Cheffins et al. argue that the SEC cannot claim any credit for this: Seligman’s influential history describes the SEC during the 1950s as having “reached its nadir” when “its enforcement and policy-making capabilities were less effective than at any other period in its history.” (Seligman, Joel. The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance. Boston: Houghton, Mifflin, 1982, page 265).

One counter-argument could be that the decline of the stock market development in the two decades after the formation of the SEC was due to the Great Depression and the World War and not due to the reforms themselves. Unfortunately for this view, the under-regulated “over the counter” (OTC) market grew from 16% to 61% as a percentage of total national stock exchange sales between 1935 and 1961.

Cheffins et al. add to the sceptical literature going back to Stigler and Benston about the contribution of the SEC and the 1930s reforms for the securities markets (Stigler, George J. (1964) “Public Regulation of the Securities Markets”, The Journal of Business, 37(2), 117-142 and Benston, George J. (1973) “Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934”, The American Economic Review, 63(1), 132-155).

One could also argue that broader macroeconomic governance reforms have played a bigger role than micro regulatory reforms. Sylla, for example, gives credit to the Hamiltonian reforms of the 1790s for the remarkable growth of securities markets in the US. Sylla points out that by the early nineteenth century, “the United States led the world in the proportion of financial assets held in the form of corporate stock.” and that “By the third and fourth decades of the nineteenth century, there was probably no place in the world as ‘well banked’ and ‘security marketed’ as the northeastern United States.” (Sylla, Richard (1998) “U.S. Securities Markets and the Banking System, 1790-1840 ”, Federal Reserve Bank of St. Louis Review, May/June 1998, 83-98).


masters in financeIf I may now indulge in some self promotion, MastersinAccounting.info have put my blog in their list of Top 10 Finance Professor Blogs. Their review says: “... Varma writes a comprehensive series of posts on his subject of choice and does so with real insight and obvious passion for the topic. A professor at the Indian Institute of Management, Varma studies financial markets and the regulation of markets throughout the world and uses his knowledge and experience to give readers a perspective on current issues as well as the history of world markets.”

Posted at 17:42 on Mon, 18 Jun 2012     View/Post Comments (2)     permanent link


Wed, 13 Jun 2012

Regulation as a response to state failure

Normally, one thinks of regulation as a response to market failure, but Luigi Zingales has a piece (behind a paywall) in the Financial Times earlier this week (“Why I was won over by Glass-Steagall”) in which the principal argument seems to be that a regulatory separation between commercial banking and investment banking is required to deal with a state failure. Zingales argues that:

Under the old regime, commercial banks, investment banks and insurance companies had different agendas, so their lobbying efforts tended to offset one another. But after the restrictions ended, the interests of all the major players were aligned. This gave the industry disproportionate power in shaping the political agenda.

The result according to Zingales was “a demise of public equity markets and an explosion of opaque over-the-counter ones.”:

With the repeal of Glass-Steagall, investment banks exploded in size and so did their market power. As a result, the new financial instruments (such as credit default swaps) developed in an opaque over-the-counter market populated by a few powerful dealers, rather than in a well regulated and transparent public market.

Adam Levitin at Credit Slips makes the same point in greater detail with some good examples:

Glass-Steagal also split the financial services industry politically and enabled the different parts of the industry to be played against each other. Commercial banks, investment banks, and insurance companies fought each other for turf for decades. This mattered in terms of regulation because regulation is a political game.

Because of Glass-Steagal, the financial services industry did not present a monolith in terms of lobbying, and a Congressman could afford to take a stand against one part of the industry because there would be campaign contributions forthcoming from the other parts of the industry. This is how William O. Douglas got the Trust Indenture Act of 1939 passed – he made concessions to the commercial banks in order to get their support for legislation that kept the investment banks out of the indenture trustee business. In the agencies, each part of the industry had its pet group of regulators who would push back against other regulators when they thought that there was an encroachment on their turf, which is the basic nature of deregulation – allowing greater activities than previously allowed. And it even mattered in the courts, as the insurance and investment banking industries financed major litigation challenges to commercial bank deregulation.

... Sarbanes-Oxley passed in part because of a split between the Business Roundtable and the US Chamber of Commerce. And in the financial institutions space, the Durbin Interchange Amendment passed because it posed banks against another heavy duty group, retailers.

One can dispute several elements of this narrative. Zingales’ CDS example is perhaps easiest to refute. Insurance companies should according to the Zingales-Levitin theory have strenuously argued that CDS is an insurance contract and therefore should be their exclusive preserve. Their lobbying and litigation should have prevented the commercial and investment banks from walking away with the CDS market. Despite the repeal of Glass Steagall, most of the big insurers were independent of the leading players in the CDS market, yet they made no serious attempt to block the growth of CDS prior to the crisis. Even after the crisis, much of the movement for regulating CDS as insurance has come from academics and regulators and not from insurance companies.

Yet, I think the idea that market fragmentation guards against state failure is a very interesting perspective on how one should go about designing a regulatory architecture. After all, the life cycle of financial market bubbles is much shorter than that of political bubbles (to borrow an elegant phrase from the George Soros speech about Europe earlier this month). Market failures can be very ghastly, but perhaps they correct faster than state failures.

Posted at 07:33 on Wed, 13 Jun 2012     View/Post Comments (0)     permanent link


Sun, 10 Jun 2012

Elected Regulators

Rose and LeBlanc posted a paper last month (Rose, Amanda M. and LeBlanc, Larry J. , Policing Public Companies: An Empirical Examination of the Enforcement Landscape and the Role Played by State Securities Regulators (May 23, 2012). Available at SSRN: http://ssrn.com/abstract=2065378) showing that in the US elected regulators (typically attorneys general) at the state level were far more aggressive in pursuing securities related enforcement than non elected regulators:

states with elected enforcers brought matters at more than four times the rate of other states, and states with an elected Democrat serving as the securities regulator brought matters at nearly seven times the rate of other states.

Of course, this is completely consistent with the incentive structures facing elected and appointed regulators. Appointed regulators do not gain much from pursuing complex matters; as many of the reports about the SEC failures during recent years have shown, SEC enforcement staff are incentivized to pursue a numbers game – pursuing a large number of easy, low risk and low cost was the best way to make the internal appraisal reports look good. On the other hand, elected regulators have incentives to pursue high risk, high stakes actions. Success could help the elected regulator move on to a higher political position – Spitzer became Governor of New York after a very controversial stint as attorney general.

The difficulty with this model (as with any other high power incentives) is the possibility of harassment of innocent people to gain political mileage. The solution is obviously an appellate process that limits the ability of the regulator to unilaterally destroy legitimate businesses and people. The US has got this reasonably right, but regulators can still put pressure on regulatees to pay fines and settle cases that lack merit to avoid expensive litigation.

The big issue with the paper is whether the empirical results are driven entirely by New York. Tables T.7 and T.8 (page 23) show that the effect remains very strong even if New York is excluded. But the statistical regressions reported in the paper do not use a New York dummy.

Posted at 19:00 on Sun, 10 Jun 2012     View/Post Comments (0)     permanent link


Thu, 07 Jun 2012

Sovereign default and international law

The ongoing sovereign debt crisis in Europe and elsewhere has made it necessary for finance professionals to understand the legal niceties of sovereign defaults. I have been reading Michael Waibel’s book Sovereign Defaults Before International Courts and Tribunals, Cambridge University Press, 2011 which covers sovereign defaults and international law over the last two centuries.

Chapter 4 of the book dealing with “Monetary reform and sovereign default” is particularly interesting in the context of the current difficulties in the euro zone. From my point of view, the problem with this chapter (and the book in general) is that it is too narrowly focused on the law – the book discusses the legal arguments and outcomes of a legal dispute extensively, but it has very little discussion about the underlying financial transaction or the movement of exchange rates. This makes it difficult to understand the economic significance of many of the disputes.

One of the interesting things that I learnt from this book is that defaulting on a debt does not violate any international law at all. Mere non payment of debt when it falls due is only a breach of contract; there is a violation of international law only if the sovereign repudiates the debt. Waibel quotes Feilchenfeld’s very elegant phrasing of this distinction: “... international law will guarantee to the creditor the existence of debt and of a debtor, but not the existence of a good debt or a rich debtor”. (page 299)

The book devotes a whole chapter to the doctrine of “financial necessity” as an excuse for non performance of an obligation. It quotes the judgement of the tribunal in the Russia Indemnity Case (Russia v Turkey) that the states’s “first duty was to itself. Its own preservation was paramount” (page 97). Similarly, another tribunal held that “the duty of a government to ensure the proper functioning of its essential public services outweighs that of paying its debts” (page 98).

As a practical matter, this principle is of help to a sovereign only if its debt is governed by its own ‘municipal law’. (International law uses the term ‘municipal law’ to denote everything except international law – it includes national, provincial and local laws). For example, until the restructuring earlier this year, most of the Greek debt was governed by Greek law; but post restructuring, most of the debt is now governed by English law.

When sovereign debt is governed by foreign law, the sovereign usually is bound by the jurisdiction of a foreign court and the dispute is then resolved according to the ‘municipal law’ of that financial centre – usually London or New York. One of the developments in international law during the last century has been the progressive erosion of sovereign immunity in international law when it comes to sovereign debt. This trend is very nicely discussed by Panizza, Sturzenegger, and Zettelmeyer in a recent paper in the Journal of Economic Literature (“The Economics and Law of Sovereign Debt and Default”, Journal of Economic Literature, 2009, 47:3, 1-47).

In short, the only relevant law appears to be the ‘municipal law’ under which the debt was issued – international law is by and large irrelevant. For any financial institution that has bought a lot of local law sovereign debt of almost any sovereign in the world, this is not very good news.

Posted at 16:02 on Thu, 07 Jun 2012     View/Post Comments (6)     permanent link