Speech by SEC Staff:
Regulatory Competition, Integration and Capital Markets
by
Chester S. Spatt
Chief Economist and Director, Office of Economic Analysis
U.S. Securities and Exchange Commission
Calgary, Alberta, Canada
October 23, 2006
This was prepared for presentation as the keynote address at the kickoff of the Calgary Center for Research in Finance at the Haskayne School of Business at the University of Calgary on October 23, 2006. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
1. Introduction
It’s a great pleasure to be at Calgary for the kickoff of the Calgary Center for Research in Finance at the University of Calgary. I’d like to thank Neal Stoughton, a long standing academic colleague, for the invitation to speak today and address the nature of regulatory competition in our changing capital markets, including the interaction among regulators when multiple ones possess jurisdiction. This is a broad ranging and important issue for securities regulation given the evolution of technology and the greater integration of the financial marketplace in our global economy. At the onset of my remarks I should emphasize, that of course, the views and perspectives that I am expressing today are my own and not those of the Commission or my colleagues on the staff of the United States Securities and Exchange Commission.
The nature of our marketplace has changed substantially in recent years. As a result of both technological innovations and the greater advantages to specialized skills the financial markets have become much more integrated. Recent regulatory implications of these trends have manifested themselves in such diverse forms as the proposed rule change by the SEC concerning the conditions under which foreign issuers can deregister themselves from the United States regulatory environment, the demutualization of a number of securities markets, the interest in cross-border security exchange mergers and related regulatory consequences, the competition among self-regulatory organizations (SROs), and the relationship between the SEC and its delegation to self-regulatory organizations. But these contexts also raise fundamental issues about regulatory goals and the interaction among government regulators. After all, in the global environment policy determinations may reflect the actions of multiple regulators and decision-makers and the decisions of individual regulators lead to “external” effects on investors in other countries.
Within the United States the focus of regulation by the Securities and Exchange Commission is motivated by the goal of investor protection and promoting capital formation. However, even with a well-articulated objective there may be ambiguity about the appropriate policy as different policymakers could operationalize the objective in different manners. But the goals of all securities regulators around the world do not coincide for both cultural reasons and because of the diverse political settings in different countries.1
2. Competing Policy Makers
I think that it would be useful to step outside the securities regulation framework for understanding some basic facets of the impact of regulation. While the most basic textbook analysis of regulation in economics focuses upon situations associated with a single regulator, for a number of issues competition or interaction among regulators is important.2 A classic example of government policy with multiple jurisdictions is the competition among political jurisdictions in tax and spending policies. For example, in settings in which there are diverse preferences for public goods and services economists have addressed the competitive aspects of provision of goods in models in which different jurisdictions compete by offering different levels of public goods and taxation with the size of the political jurisdictions adjusting to clear the market in what economists often term the “Tiebout equilibrium” (e.g., see Tiebout (1956)). One of the benefits of decentralized policy-making and allowing for local provision of public goods is that this facilitates accommodating the diverse or heterogeneous preferences in the broader society. For example, different societies may have different perspectives on the costs to be incurred to protect unsophisticated investors.
In traditional economic analysis in the spirit of Adam Smith, market equilibria are Pareto optimal in the sense that allocations that clear the markets and maximize the utility of the individual consumers subject to their respective budget constraints are not dominated by other feasible allocations. However, the optimality of market allocations fails in the presence of externalities in which the utility to an agent is influenced by the utility received by others. An illustration in a governmental context is the willingness of many United States localities to subsidize the building of sports arenas because of the competition from other jurisdictions. It is hard to articulate a plausible case for public provision of sports arenas absent the pressure from rival localities, which do not currently possess a franchise in the sport. In fact, using the perspective of optimal taxation theory in a particular jurisdiction it is efficient to equate marginal distortions (see Mirrlees (1971) and Diamond and Mirrlees (1971)), which would appear to be inconsistent with the widespread prevailing subsidies to sports arenas. However, there is a strong negative externality due to the competition among jurisdictions as franchises relocate from other locations. Furthermore, I would argue that society is made worse off by the competition among jurisdictions to attract sports franchises by building new arenas. Indeed, many governments recognize that it would not be in their interest to provide special concessions to particular businesses, absent strong competition. Precisely because of the nature of the rivalry that states and localities face, the extent of special tax relief that they utilize seems much greater than at the national level.
To summarize the analysis so far, policy competition can be useful for promoting efficient outcomes and accommodating diverse preferences among jurisdictions, but as the sports arena example suggests policy competition can also lead to a “race to the bottom.” Of course, the sports franchise will select among the available locations based upon the overall attractiveness of these alternatives, just as a firm will choose the most attractive regulatory regime available in the specific context. In the presence of multiple available regulatory regimes this is sometimes termed “regulatory arbitrage,” which is a natural consequence of regulatory competition.
This type of regulatory competition, especially if it manifests itself as a “race to the bottom,” may make it difficult to address some contexts that would benefit from strong regulatory intervention. An example where strong regulation has broad support is the desirability of strong rules and actions against securities fraud. To the extent that there are multiple competing jurisdictions, however, there could be a “race to the bottom” to attract activity and avoid substantial regulatory costs. Consequently, there may be difficulties in sustaining high regulatory standards, even when appropriate to do so. On the other hand, when regulation is desired by the market there can be a “race to the top;” Tafara (2006) highlights some features of Sarbanes--Oxley that have been mimicked abroad.
Some U.S. firms have argued in recent years that aspects of the current regulatory environment place them at a competitive disadvantage. For example, some U.S. financial institutions have strongly criticized the Patriot Act, whose “know your customer” rules require financial institutions to proactively investigate the source and legitimacy of customers and their funding rather than simply identifying for the government the specific transaction or party. This can impose considerable costs on the financial institutions. Critics of these rules from the financial services industry suggest that they place U.S.-based financial institutions at a competitive disadvantage, even relative to its many allies in the “war on terror.” Part of the difficulty is that the ability to pass along the resulting costs to customers would be limited for customers in the global arena because the financial institution’s global competitors do not face similar costs. Indeed, that suggests the importance of trying to define and negotiate these rules and obligations on a more global basis. For example, to the extent that these types of rules are useful they should be promoted to a country’s allies and the unwillingness of other nations to adopt such standards could be relevant to their domestic evaluation.3 One way to summarize the overall point is that the relevant domestic policy margins are impacted by the global economy.
An interesting, but non-traditional form of regulatory competition occurs when multiple regulators have jurisdiction simultaneously. In such an instance the regulated firm may not get to choose the regulatory regime, but instead could be jointly governed by various regulators. For example, in order to induce the respondent to settle enforcement matters in which there are many regulators with potentially overlapping claims, regulators often recognize that they need to jointly settle. From the respondent’s perspective partial settlement with some regulators can be problematic, both because (a) such settlements would not proportionately reduce one’s direct defense costs and (b) concern that the information generated by the partial settlement would be utilized indirectly in the remaining cases (even though typically such settlements would formally be structured so as to not be formal admissions for other situations). Consequently, in this context coordination among regulators is a natural response.
Another interesting issue for which multiple regulators are central is the appropriate form of accounting standards. There are obvious advantages to greater commonality and standardization to avoid duplication of cost, but yet there still may be some heterogeneity of regulatory objectives.
3. Sarbanes--Oxley
There also has been extensive discussion recently about the Sarbanes-Oxley framework, especially the certification of material weaknesses required under its Section 404, including whether that places the U.S. at a competitive disadvantage. Though much of the discussion of Sarbanes-Oxley in recent times focuses upon the costs required to meet the statutory requirement, it’s important to simultaneously judge the benefits such as reducing the adverse selection and moral hazard costs of governance, though they tend to be harder to measure. Of course, the costs incurred by the firm, whether it be out-of-pocket fees charged by auditors and others or the opportunity costs associated with the allocation of executive and staff time, are ultimately borne by the shareholders. Consequently, the net benefits of these requirements for the shareholders depend upon costs as well as benefits. Differential price responses across firms during the adoption of the legislation may shed light on this.4
Critics of Sarbanes-Oxley have noted in recent weeks the movement of initial offerings to other parts of the world and have suggested that the costs of the U.S. regulatory structure are at the core. Of course, it’s plausible that if the United States regulatory framework placed the U.S. at a disadvantage that global firms would respond by instead listing in other markets. The issue in my mind is not simply one of comparable cost, but of net benefits; which regulatory arrangement do investors value the most net of the costs? The listing decision is a crucial margin for firms to respond to the differences in regulatory regimes across jurisdictions. Of course, changes in listing behavior can relate to other causes as well—such as the high IPO fees in the United States, greater integration and liquidity of the European markets in recent years and cultural causes related to the origin of the firm.5 Consequently, changes in listing decisions by European and global companies can reflect a number of considerations, besides the regulatory costs of the U.S. structure.
The foreign issuer deregistration context indirectly raises the issue of the goals and objectives of the regulator. This is especially germane in situations when multiple regulators are potentially relevant, as in the case of foreign issuers. It seems reasonable to suspect that the goals of different regulators could diverge because of differences in objective and philosophy. The recent SEC proposal to broaden the set of foreign firms that could de-list from the United States and its regulatory regime reflects some of the related tensions. The motivation for this proposal should be viewed in terms of the interests of United States investors as the mission of the Securities and Exchange Commission is defined in relevant part in terms of the best interests of these investors. Allowing greater departures from the United States regulatory system in the long-run may increase the ex ante willingness of firms to subject themselves to these regulations, which may lead to benefits in terms of protection of U.S. investors and reductions in net costs by the firms’ that choose to exit.
The Sarbanes-Oxley framework appears to be unfavorably regarded overseas. At the heart of the issue could be differential assessment among countries of the benefits and costs and the underlying goals of regulation. In recent months there even has been considerable public discussion of the proposed merger of the New York Stock Exchange and Euronext in the context of the Sarbanes-Oxley framework. European regulators and listed firms have publicly sought assurance that the merger would not by definition scope European firms within the United States regulatory framework. From an exchange perspective, the potential trans—Atlantic merger also highlights the nature of the impediments to international access to securities trading, such as the ban on general solicitation of non-registered securities and foreign trading screens in the United States, the lack of developed clearance and settlement mechanisms in at least some markets and differences in the regulatory environment for security trading. The international barriers to investment are arguably declining faster than the regulatory barriers. For example, intermediaries may wish to trade international products to compete—which would limit the degree of regulatory competition.
4. Self-Regulatory Organizations and Competition
In economic theory regulation often is motivated by attempts to internalize the effects of externalities or to limit the exercise of monopoly power. As an example consider the case of specialists on the floor of the New York Stock Exchange, who typically have had both special rights and responsibilities in the trading process. In the hybrid design that the New York Stock Exchange now is beginning to implement on a pilot basis there are major changes to the role of the specialist and the fundamental character of the platform as there is an effort to integrate a fully electronic system with the trading floor. The design changes have emerged as a byproduct of the exchange customer’s demands, the exchange’s demutualization and the dramatic changes to its ownership structure and governance, the evolution of technology and regulatory pressures. Historically, the motivation for regulation of the behavior of the specialist reflects an attempt to limit the scope of the residual market power that they possess. However, the optimal regulation would depend upon the precise form of the trading mechanism and the nature of the market power possessed by the specialist. More broadly, while regulation can be very useful to ensure that market power is not excessively exploited, the appropriate regulatory approach should be guided by the specific context.
At this juncture I think that it would be helpful to turn to a more specific example in securities markets in which there are a variety of regulators. The structure of oversight with respect to securities in the United States involves not only oversight from the Securities and Exchange Commission, but also oversight through self-regulatory organizations (SROs). For example, the SROs operated by the National Association of Securities Dealers and the New York Stock Exchange provide much of the first-line oversight of exchanges and broker-dealers with monitoring of the SRO surveillance process by the Securities and Exchange Commission. This indirect structure of monitoring by the Securities and Exchange Commission illustrates the role of multiple monitors in several dimensions. The hierarchical structure of review and inspection allows those closest to the business to develop the basic review and inspection procedures, while the statutory securities regulator has ultimate oversight authority and critiques the work of the front-line regulator. As a consequence of the demutualization of the exchanges of the NASDAQ and the NYSE, the self-regulatory organizations associated with these markets have been somewhat separated organizationally to limit the perceived conflict of interest.
In my view broad, if not necessarily specific, conflicts between the SRO and the exchanges’ members or owners are potentially a real issue. This is illustrated by the need for further guidance from the Commission to the SROs on a variety of matters such as how to attempt to identify certain problematic practices, conflicts about access fees, the interests of platforms in retaining their regulatory responsibilities and the desires of members or owners of a platform to influence potential rule-making by the platform’s SRO. It’s also a natural consequence of membership or ownership structure in which the SRO is expected to closely monitor the activities of the exchange’s members or owners. These issues are now more explicit as a result of the for-profit status of several exchanges. In my mind one fascinating aspect of the structure of trading platforms has been the interest of large broker--dealers to invest in a range of specific trading structures over the years. Of course, portfolio theory emphasizes the virtues of investors’ diversifying broadly and that all investors should share the risks in specific ventures. This contrasts with the concentration of ownership in platforms by broker-dealers and natural partners over time and the relative lack of investment in such platforms by others. It also points to underlying business considerations, such as the development of specific synergies and the desire to have close ties and even control rights with whatever systems emerge. This need not reflect a desire to exploit conflicts of interest—indeed, sufficient investment in a variety of related platforms and technologies instead, could be motivated as an attempt to ward off being exploited by virtue of conflicts of interest of one’s rivals. However, I do feel that the prevalence of strategic (rather than diversified portfolio) investing in this arena is striking.
Recently, some other financial intermediaries have been encouraging consolidation of the SROs to reduce overall costs. The market structure for SROs—such as whether there are competing regulators—is an interesting and potentially important question. It appears that the views about consolidation proposals by SROs, such as the NASD and NYSE—Regulation, reflect one’s perspective on which organization would likely survive. This may reflect the importance of the underlying incentive conflicts and the role of the SRO in the broader business context of exchanges. It also highlights in a concrete setting such features as whether regulatory competition is healthy, the potential for scale economies in regulation and what factors would engender a “race to the bottom.” This discussion emphasizes the importance and critical underpinning of the ownership structure of the exchanges and our markets.
5. Concluding Comments
By way of conclusion I should emphasize that the globalization and integration of our markets and new ownership and market structures pose important new challenges to regulators about the objectives and underpinnings of regulation and the constraints that individual regulators face. Reflection about the nature of our regulatory framework and its application to new contexts suggest important issues facing both regulators and academics. For example, from an academic perspective models of local public goods may help shed new light on the nature of regulatory competition and regulatory arbitrage. Focusing upon the specific underlying frictions and constraints also may help identify ways to enhance regulatory coordination and strengthen regulatory practice.
I welcome your questions.
References
Chhaochharia, V. and Y. Grinstein, 2006, “Corporate Governance and Firm Value: The Impact of the 2002 Governance Rules,” Journal of Finance, forthcoming.
Dell’Ariccia, G. and R. Marquez, 2006, “Competition Among Regulators and Credit Market Integration,” Journal of Financial Economics, 79, 401-430.
Diamond, P. and J. Mirrlees, 1971, "Optimal Taxation and Public Production Efficiency," American Economic Review 61, 8-27.
Mirrlees, J., 1971, "An Exploration in the Theory of Optimal Income Taxation," Review of Economic Studies 38, 175-208.
Statman, M., 2006, “Local Ethics in a Global World,” unpublished working paper, Santa Clara University.
Tafara, E., 2006, “A Race to the Top: International Regulatory Reform Post Sarbanes-Oxley,” International Financial Law Review.
Tiebout, C., 1956, “A Pure Theory of Local Expenditures,” Journal of Political Economy, 64, 416-424.
1 The importance of culture for defining business ethics is discussed in a recent paper by Statman (2006).
2 Regulatory competition and the tradeoff between coordinated and decentralized regulation is examined in a banking context by Dell’Ariccia and Marquez (2006).
3 This comment may reflect an unrealistic perspective about the potential for cooperation. The history of the Corrupt Foreign Practices Act is a relevant case in point.
4 This theme is explored by Chhaochharia and Grinstein (2006).
5 For example, a major state-owned Chinese firm is currently listing in Hong Kong.
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