Two recent bipartisan reports make the case that US capitalmarkets may be dangerously over regulated.
The Committee report
The first report of the blue ribbon Committee on Capital MarketsRegulation, issued on 30 November 2006, documented several typesof evidence that the competitiveness of US capital markets appears tobe eroding and made 32 recommendations to enhance thatcompetitiveness. This committee of private experts is headed by HalScott, a professor at the Harvard Law School; Glenn Hubbard, thedean of the graduate business school at Columbia University; andJohn Thornton, the chairman of the Brookings Institution. Over thenext two years, the Committee also expects to issue reports on thecompetitiveness of mutual funds and derivative markets. The majorfindings of this first report are the following:
- In 2000, 50 percent of the value of world-wide initial publicofferings was raised in the US, falling to five percent in 2005.
- The US share of total equity capital raised in the world'stop 10 markets was 41 percent in 1995, falling to about 28percent in 2006.
- The listing premiums on US stock exchanges have declinedsubstantially.
- Private equity firms, almost non-existent in 1980, sponsoredmore than $200 billion of capital commitmentsin 2005.
- Since 2003, private equity fundraising in the US has exceedednet flows into mutual funds, and going private transactionshave accounted for more than a quarter of publicly announcedtakeovers.
Some of the decline in the US share of world equity markets isprobably due to the increased efficiency of major foreign markets.The dramatic increase in the use of private US markets, however, isimportant evidence that regulation and litigation are contributing tothe flight of many companies from the public markets.
Although the findings of this report are quite dramatic, theCommittee's recommendations are surprisingly tepid. The Committeeproposed several increases in shareholder rights based on little morethan a wistful hope that this would reduce litigation. The financialregulatory organisations are encouraged "to move to a more riskbasedregulatory process, emphasising the costs and benefits of newrules" and to periodically test existing rules by the same standard.And, of course, "There should be more effective communication andcooperation among federal regulators." The most substantiveproposals would limit the authority of the federal enforcementauthorities and the liability of outside board members and the auditfirms. The report concludes that only "If the SEC finds that, even afterthe general reforms outlined above are implemented, the revisedSection 404 is still too burdensome for small companies, it shouldrecommend that Congress exempt small firms from auditorattestation." The report offers surprisingly little analysis and evidencethat their recommendations would enhance the competitiveness ofUS capital markets, and it makes no proposals to change the majorfederal regulatory laws.
The Schumer-Bloomberg Report
A second report, issued on 22 January 2007, "warned that New Yorkfinancial markets, stifled by stringent regulations and high litigationrisks, are in danger of losing businesses and high-skilled workers tooverseas competitors," estimating that US financial service revenueswould fall between $15 billion and $30 billion a year without a majorchange in the public policies affecting US capital markets. This reportwas commissioned by US Senator Charles Schumer and New York CityMayor Michael Bloomberg, prepared by McKinsey and Company, andinformed by interviews with more than 50 financial service specialists.Somewhat of a surprise, this report was endorsed at its release byEliot Spitzer, the newly elected governor of New York, who wascritical of the prior report by the Committee on Capital MarketsRegulation. The Schumer-Bloomberg report recognised "that whilemany of the causes (of the erosion of the competitiveness of UScapital markets) are due to improved markets abroad andsophisticated technology that has virtually eliminated barriers to theflow of capital, a significant number of the causes … are selfimposed,"focusing on the effects of stringent US regulations, higherlitigation risk, and restrictive immigration policy.
To my surprise, the Schumer-Bloomberg report recommends asubstantially different set of policy changes than does the prior reportby the Committee. The major policy recommendations that are quitedifferent include the following:
- Implement securities litigation reform with particular shorttermemphasis on leveraging the SEC's existing authority.
- Ease immigration restrictions facing skilled non - USprofessional workers.
- Protect US competitiveness in implementing the Basle II CapitalAccord.
- Modernise financial services charters and holding companystructures.
Potential Congressional action
The fact that two reports that addressed much the same issue led tosuch different policy recommendations will make it more difficult forCongress to resolve what to do about this problem of increasingconcern. Nevertheless, both Barney Frank and Christopher Dodd, thenew chairmen, respectively, of the House and Senate bankingcommittees, are expected to hold hearings on the issues raised andthe policy recommendations by these two reports. And the SEC hasalready made some minor changes to the implementation of Section404 of the Sarbanes-Oxley Act to respond to these concerns. The newDemocratic Congress seems willing to address these issues primarilybecause of the substantive findings of these two reports, thebipartisan endorsement of these reports, and the concentration ofthe financial industry in the northeastern states that are nowrepresented primarily by Democrats.
Major remaining problems
My primary disappointment with both reports is that they do notaddress the major conditions that limit the rate of return on US equitymarkets.
- Very few corporate boards now include a member withsufficient voting shares to be a credible threat to the incumbentmanagement. The origin of this problem is the federal WilliamsAct of 1968, which substantially increased the cost of successfultender offers and completely eliminated the potential forsurprise. Over the next several decades, corporations charteredin almost every state were authorised to implement one ormore takeover defenses, and most did so. An important 2003study by Paul Gompers and colleagues, however, found that therate of return on the equity of individual corporations has beena strong negative function of the number of takeover defensesin that firm. This issue has not been subject to a publicdiscussion and nothing has been done to correct this problem.
- The Sarbanes-Oxley Act substantially increased the role of theindependent auditing firms and created an expensive andarguably unconstitutional board to regulate these firms. ThisAct, however did not correct the major potential conflict ofinterest between corporations and their independent auditors,in that the audit firms are still paid by the corporations thatthey audit.
- The primary public rationale for the Sarbanes-Oxley Act was torestore investor confidence by improving the quality ofreported earnings, and the Committee report asserted that thishas been the effect. The best test of this effect is whetherinvestors are now willing to pay a higher price for a stock perdollar of reported earnings. The price-earnings ratio on the S&P500-stock index, however, has declined continuously since theSarbanes-Oxley Act was being drafted in the spring of 2002.Five years later, there is still no objective evidence that this Acthas restored investor confidence in the equity values of thestocks listed on US exchanges and thereby subject to theregulations required by the Act.
- The largest long-term cost of the Sarbanes-Oxley Act, however,may be more risk-averse behavior by corporate managers andboard members. Most CEOs, for example, are not accountants,and the requirement that they personally attest to the accuracyof the audits at the risk of a jail sentence is likely to divert theCEOs from more productive activities and lead to more riskaversedecisions. Individual shareholders can reduce the risk oftheir portfolio more efficiently by investing in a broad-basedmutual fund rather than by counting on individual corporationsto reduce the risk of individual stocks. Legislation designed toreduce the probability of "another Enron" may reduce USeconomic growth.
My major disappointment about this whole episode is the recognitionthat so many intelligent and informed adults do not acknowledgethat Congress has probably made a mistake that should be reversedrather than be considered a new pillar of American securities law.Michael Oxley, recently retired from Congress, was asked whether hewould have done anything differently if he knew then what now isknown about the effects of the Sarbanes-Oxley Act. "Absolutely,"Oxley answered. "Frankly, I would have written it differently, and hewould have written it differently," he added, referring to Sarbanes."But it was not normal times." Now is the time to revise or repeal theSarbanes-Oxley Act.