Speech by SEC Staff:
This was prepared for presentation as a Luncheon Address at the meeting of the Society for Government Economists and the National Economists Club on March 15, 2007. 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
It's a great pleasure to speak at today's meeting of the Society of Government Economists jointly with the National Economists Club, as this is an important gathering for economists in the Washington area. The participants span many of the government agencies in this area and as such the meeting is an important venue for enhancing the dialogue among Washington's economists. At the onset of my remarks, I first want to emphasize that the views and perspectives that I am expressing today are my own, and not those of the Commission or my colleagues on the SEC staff, and second I wish to thank the organizers for giving me the opportunity to speak in today's forum.
2. Importance of Economic Analysis to Regulation
A recurring debate in Washington is the role of regulatory impact analyses. How should the federal government assess the impact of proposed rulemakings? How should that assessment affect decision-making? I'd like to draw upon my experiences as Chief Economist of the Securities and Exchange Commission to focus upon a central issue in the policy process--the potential importance of economic analysis to the regulatory process and its relationship to traditional cost-benefit analysis. I'll use several examples to illustrate different aspects of this broad theme.
At the beginning of my remarks I'd like to highlight my view of economics and its importance to decision-making by both market participants and regulators. Economics provides a valuable structure for understanding both how economic agents should behave under specific situations and for predicting how they do behave. For example, the maximizing decisions of agents can provide insight about the prices and quantities that will emerge in various settings. Economics also emphasizes the implications of markets and the equilibrium implications of particular policy interventions. The theoretical tools of economics emphasize how behavior adjusts from policy interventions and price changes at or near the relevant economic margins. Economic reasoning and the tools of economic analysis can inform a wide array of policy debates and facilitate the assessment of various policy interventions. Of course, the interaction between various economic margins for determining optimal choices also illustrates some of the ways in which "unintended consequences" of regulations can arise. These have perhaps not received the attention they deserve in policy debates in my judgment. I want to emphasize that these are "consequences" of regulatory actions, which deserve strong consideration in assessing the impact of policy interventions-even if the consequences in question are "unintended."
At the same time, economics also is an empirically oriented discipline. It looks to evidence about decisions and market behavior, using sophisticated tools to extract what we can learn from market outcomes. My overall viewpoint is that the training and perspective that economists bring to the policy table is an extremely important one for properly assessing potential regulation and for reassessing actual regulation.
Within the regulatory community the role of economics often is framed in terms of "cost-benefit analyses," which in some instances has been narrowly construed to numerical counting exercises and in many instances is limited to estimates that admit to quantification. In my view the cost-benefit analysis of a rule should reflect a serious effort to use economic principles to ascertain the qualitative as well as quantitative impacts upon behavior, even when those effects do not lend themselves to easy quantification. I would argue that while a cost-benefit analysis cannot be finalized until the form of a proposed rule is determined, in fact consideration of the cost-benefit also is integral to making appropriate regulatory judgments among alternatives. The economic analysis of a rule should reflect not just why a proposed rule is better than the status quo, but also why the proposal would be an improvement over the relevant alternatives.
My own view of the role of economics is not universally shared, though many policymakers do appreciate the importance of economic input. At least some regard it as relevant simply because outside policy experts and regulated parties care greatly about the underlying economics. Along these lines, I think that it is important that the relevant dialogue for policy focus upon what is known and can be inferred from economic principles and evidence. For example, one view that I have heard expressed is the concern that economic analysis might "tie the hand" of the regulator either now or in the future. My own perspective is rather different; what could be more valuable to a regulator than understanding how economic evidence and principles bear on specific regulatory matters? Along these lines, economic analysis can help enhance the understanding of the trade-offs and consequences of potential rules and can provide tools for thinking through the cost-benefit analysis. In this sense economic analysis is complementary to cost-benefit analysis. I should note that the public comment process is not a substitute for a thoughtful economic analysis within the cost-benefit framework.
At the same time I want to acknowledge that not every rule-making situation lends itself to simple conclusions from economic evidence and principles. For example, in some instances the details of rule-makings are guided by statutory imperatives. Of course, in other instances regulations are adopted that sound beneficial, but which are not likely to have the intended effect because of the ability of economic agents to circumvent certain types of restrictions. Rather than discussing these themes abstractly, I think that it would be useful to focus upon some concrete examples to illustrate the relevance of economic analysis to several issues in the securities markets.
3. Regulation SHOThe Securities and Exchange Commission's process for evaluating the possibility of removing pricing restrictions on short sales is an excellent example of the potential value of economic analysis in the rule-making process. When the Commission evaluated the possibility of removing pricing restrictions such as the "up tick" test, it decided to set up a natural experiment in which these restrictions were initially removed on 1/3 of the Russell 3000 securities. Working with the Division of Market Regulation, the Commission's Office of Economic Analysis, under my direction, set up a stratified sample so that a within-sample analysis as well as a before and after analysis could be performed. In order to facilitate an analysis of short-sale pricing restrictions, market centers publicly disseminated short-sale data in conjunction with the high frequency trades and quotes data that are used by academics in evaluating market structure questions. The Commission's Office of Economic Analysis and several independent academic teams undertook analyses of the impact of short-sale pricing restrictions, which concluded that removing the pricing restrictions would not create substantive difficulties.1 Relying upon these analyses, the Commission issued a formal proposal to remove the pricing restrictions. At the public roundtable organized by our office, distinguished participants viewed the approach to rule-making as a model for incorporating data and economic analysis. Of course, the nature of the context made it especially conducive to the very powerful approach of structuring a natural experiment.
4. Options Expensing
The SEC's Office of the Economic Analysis helped to develop the implementation guidance with respect to both models and markets prepared by the SEC's staff for options expensing. While the appropriateness of expensing is widely agreed upon by economists as illustrated by the analysis by Bodie, Kaplan and Merton in the Harvard Business Review (2003), it had been a very controversial subject in Washington, D.C.
Curiously, some of the companies for whom options grants represented a significant portion of their compensation program were among those that argued the most strongly that they didn't know how to value the options. It seems surprising that companies that apparently didn't understand the cost of a particular compensation tool would be inclined to use that instrument to an especially large extent. Alternatively, some critics have argued that under FAS 123(R) that the amount required to be expensed is too high and in excess of the benefit derived by the employees. However, economic principles suggest that under the compensation plan selected by the firm the benefits derived by the firm must ultimately be even larger than the costs incurred by the firm. In any case, corporate accounting ultimately concerns the costs incurred by the firm and its stockholders rather than the employees' benefits. This was precisely the measurement objective suggested by the FAS123(R) accounting standard.
As a result of our training and experiences as economists we intrinsically appreciate that financial options are valuable in a rich array of contexts; this is not as widely recognized in the broader population. Because of the efficiency of our financial markets, I would not expect options expensing to lead to substantial changes in the valuation of companies that have significant option programs. However, one potential impact from options expensing and arguably an "unintended effect" may be to reduce the potential overuse of these grants in compensation programs by educating boards of directors as to the potential ex ante cost to these grants and removing the natural bias in favor of a compensation tool that was not reflected previously on the profit and loss statement.2
Critics of options expensing have also criticized the modeling of employee stock options, so I also think that it would be helpful to make a few observations about this. While the employee's stock option is not readily hedgeable and most employees are risk averse, the valuation cost to the employer of the resulting liability can potentially be assessed. One method of valuing employee stock options is clear from the history of the market for mortgage-backed securities. This analogy is instructive because of the lack of transferability of the mortgage obligation and the importance of the mortgage borrower's risk preferences. Interesting predictions about exercise and forfeiture behavior can be obtained from the mortgage-backed securities perspective and the use of arbitrage principles3 and the valuation tools of modern financial economics can be adapted to the employee stock option context. The tools for developing the valuation of mortgage-backed securities were developed decades ago4 and in recent years a number of interesting papers have explored the valuation of employee stock options.5 Just as these modeling approaches have been very successful in the context of mortgage-backed securities, I would expect that analogous tools for employee stock option valuation that take into account the relevant frictions would be similarly successful.
Of course, firms need not rely explicitly upon models for the purposes of determining the expenses for employee stock valuation. Indeed, FAS 123(R) points to the possibility of using valuations from liquid markets were these to arise. A few alternatives have been suggested to develop instruments that attempt to replicate the valuation of these options from the perspective of a market instrument. The potential advantages of such market-based instruments would include facilitating the ability of firms to hedge their compensation exposure and to make feasible new alternative forms of employee option compensation. Of course, the underlying measurement goal of the accounting standard is to obtain a valuation that reflects what a willing buyer and seller would pay with respect to the cost of the firm's exposure. Therefore, economic principles suggest that there could be a real tension between the desires and claims by product innovators that a particular design of a market instrument and mechanism will lead to valuations that are a fraction of model prices and the language of the accounting standard, absent an obvious problem with the model. It's also worth emphasizing that model prices are not hypothetical, but have a strong influence upon market valuations; after all, professionals who trade derivatives rely heavily upon model-based valuations making model and market prices closely intertwined. Of course, I want to note that I applaud the development of new designs and innovations in this important space, especially in light of the centrality of option grants to the cost structure of many firms.6
5. Executive Compensation and Disclosure
Perhaps the most basic example of market regulation that is highlighted in the teaching of microeconomics is the case of rate of return regulation in public utility rate-setting.7 In such settings the regulator specifies an allowed return on capital, but if the rate of return is set at an attractive level the firm will select too much capital (e.g., the Averch-Johnson effect). This illustrates the important point that changes in effective relative pricing among alternatives can lead to distortions and substitutions in the resulting quantities.
An interesting example along these lines concerns the effect of the surtax on non-contingent compensation over $1,000,000 (Section 162(m) of the Internal Revenue Code) that was enacted in 1993 in an attempt to restrain compensation. While this consequently became a binding ceiling on the base salaries in many cases, firms substituted alternative compensation in order to be able to pay prospective employees their equilibrium compensation level. One could argue that an "unintended" consequence of such legislation was to increase executive compensation. This resulted from the substitution to risky compensation caused by the very high tax price of using non-contingent compensation over the threshold. Given the executive's risk aversion, this implies that more than one dollar of expected (risky) compensation would be required as a substitute for one dollar of fixed compensation. Consequently, a tax "intended" to reduce executive compensation would actually increase expected compensation. Perry and Zenner (2001) show that real compensation increased substantially after the enactment of Section 162(m), despite the apparent Congressional intent. This may reflect the risk-bearing argument presented above as well the Congressionally induced substitution to riskier compensation during what proved to be a strong market climate.
Another important regulatory intervention in the early 1990s with respect to executive compensation was the SEC's 1992 executive compensation disclosure requirements. Some firms and their executives appear to have been anxious to avoid disclosure. Therefore, a byproduct of these disclosure requirements may have been an increase in the use of forms of compensation for which the required disclosures would not be very transparent. For example, under the 1992 rules the number of option grants, but not their values, would be identified. In addition, executive pensions would not be very transparent. Bebchuk and Fried (2004a, 2004b) suggest that the use of executive pensions became more prevalent in response to these disclosure requirements, because of the limited disclosure of this form of compensation.8 Consequently, these disclosure requirements also induced a variety of substitutions in the form of compensation, which certainly would appear to be an "unintended consequence." These disclosure requirements may have been easier to evade on some dimensions as compared to others, potentially inducing substitutions into the design of the compensation structure.
This example highlights several other aspects of the regulatory process. Last year, the SEC adopted new executive compensation rules, reflecting concerns about the effectiveness of the 1992 disclosure requirements. This new rule emphasizes the disclosure of appropriate dollar values on "all" compensation, which could potentially reverse substitutions in the form of compensation that may have been artificially induced by the 1992 compensation disclosure requirements. This example points out that regulatory changes may be an evolving process. Practitioners design structures to optimize their goals in the face of current taxes and regulatory restrictions. The response of practitioners to regulation may lead regulators to introduce additional changes to the regulatory framework. Arguably, last year's SEC rule-making reflects less than complete satisfaction with the performance of the 1992 executive compensation disclosure requirements. This highlights an interesting aspect in assessing proposed rules that is quite relevant to cost-benefit analysis-to what degree will the practices adjust in response to new rules and regulations?
This type of dynamic is widely understood in the tax arena where sophisticated practitioners identify a range of tax-advantaged strategies under the prevailing rules, but recognize that the underlying tax rules are not fixed indefinitely. Indeed, the Internal Revenue Service identifies what it views as "loopholes" based upon prevailing practices, seeking to change the relevant rules to tighten these "loopholes." In a different context in Washington, D.C. much of the debate in the assessment of the impact of tax legislation concerns the appropriateness of "dynamic scoring" techniques for evaluating the revenue consequences of tax proposals that are anticipated to change behavior.
As there is considerable evidence that market participants take seriously mandated firm disclosures, another question suggested by the compensation example is the impact of disclosure requirements on the overall level of compensation.9 From the perspective of economic theory, will disclosure requirements reduce or alternatively, increase the equilibrium structure of compensation? While one intuition is that increased disclosure might reduce compensation by reducing the extent of the agency conflict, there also are implications for the bargaining process between the firm and senior executive. For example, if the more complete disclosure of compensation resulted in an executive being less willing to serve in such roles due to his reduced privacy, then the equilibrium compensation would increase due to a compensating differential.10 How would disclosure of executive compensation alter the bargaining power between the parties by changing their information about the compensation of other executives?-While some information is available through paid compensation consultants, often used on both sides of the negotiation, the nature of the available information would be enhanced by public disclosure of executive compensation. Notice that the effect being highlighted is actually a cross-firm effect, i.e., the compensation for the executive of a particular firm is potentially altered by the disclosure of compensation statistics of other firms. This is an issue that seems ripe for interesting analysis by microeconomic and financial theorists. More broadly, the impact of enhanced disclosure on market equilibrium is not fully resolved, but is an important issue. The recent analysis by Swan and Zhou (2006) provides some Canadian evidence that greater executive compensation disclosure there in the early 1990s led to enhanced incentives and through that to higher compensation.
6. Mutual Fund GovernanceSince much has been said about the Commission's proposal to require an independent chairman and 75% independent directors, I will simply note that the current status of the rule making is that the Commission released for public comment at the end of 2006 a pair of papers prepared by the staff of the Office of Economic Analysis that review existing relevant literature and analyzed the statistical properties of mutual fund returns and potential limitations inherent in any empirical analysis designed to identify a relationship between mutual fund returns and fund governance. The Circuit Court's opinion regarding fund governance reflects the importance of economic analysis and such considerations as efficiency, competition and capital formation in the rule-making process and brought this to the fore in the public debate.
7. Daylight Savings Time
My final example is not a financial one. Instead, an interesting example of a legislative action that illustrates some of the nuances of sensible cost-benefit analysis was the decision by Congress to shift the timing of the start and end of daylight savings time in the United States. This shift changed the time treatment during just four of our 52--week year. In turn, evening daylight is extended by just one hour and morning daylight is reduced by one hour during those weeks. Yet some advocates suggested that this would reduce United States energy consumption by as much as several percent annually. My own view is that just because potential costs and benefits can be quantified under strong assumptions, does not necessarily imply that these should be the sole focus in a proper cost-benefit analysis. Incidentally, some of us have recently witnessed one type of unintended consequence associated with the shift in daylight savings time-some of our computers have been subject to repeated patches in recent weeks and considerable difficulty in achieving harmonization between desktop and handheld electronic calendars.
8. Concluding Comments
In summary, I have tried to provide an economist's perspective on some of the rationales for and consequences of financial market regulation. In several different contexts I have attempted to provide perspective on some of the surprising effects induced by regulatory changes. Behavior can be altered along a variety of different margins, sometimes leading to unintended effects of the regulation. I would argue that it is important for a well-executed cost-benefit to reflect such broader economic consequences of the rule making and that it go beyond what is readily quantifiable.
Obviously, I have not attempted in my remarks to sort out some of the pragmatic challenges in the cost-benefit process such as the standards for review of outstanding rules and the interesting organizational challenges associated with both the role of various participants and the rewards to outcomes rather than processes.
I welcome your questions and feedback.
Alexander, G. and M. Peterson, 2006, (How) Do Price Tests Affect Short Selling? Working paper, University of Minnesota.
Averch, H. and L. Johnson, 1962, "Behavior of the Firm under Regulatory Constraint," American Economic Review 52, 1052-69.
Bebchuk, L. and J. Fried, 2004a, Pay without Performance: The Unfulfilled Promise of Executive Compensation, Harvard University Press, Cambridge, MA.
Bebchuk, L. and J. Fried, 2004b, "Stealth Compensation via Retirement Benefits," Berkeley Business Law Journal 1, 294-326.
Bettis, J.C., J. Bizjak, and M. Lemmon, 2005, "Exercise Behavior, Valuation, and the Incentive Effects of Employee Stock Options," Journal of Financial Economics 76, 445-470.
Bodie, Z., R. Kaplan and R. Merton, 2003, "For the Last Time: Stock Options Are an Expense," Harvard Business Review 81, 63-71.
Carpenter, J., 1998, "The Exercise and Valuation of Executive Stock Options," Journal of Financial Economics 48, 127-158. Diether, K., K. Lee and I. Werner, 2006, "It's SHO Time! Short-Sale Price-Tests and Market Quality," Working paper, Ohio State University.
Dunn, K. and J. McConnell, 1981, "Valuation of GNMA Mortgage-Backed Securities," Journal of Finance 36, 599-616.
Dunn, K. and C. Spatt, 1999, "Call Options, Points and Dominance Restrictions on Debt Contracts," Journal of Finance 54, 2317-2337.
Edwards, A., T. McCormick, S. Mayhew and A. Zebedee, 2007, "Economic Analysis of the Short Sale Price Restrictions Under the Regulation SHO Pilot," Staff report of the Office of Economic Analysis, Securities and Exchange Commission.
Hall, B. and K. Murphy, 2003, "The Trouble with Stock Options," Journal of Economic Perspectives 17, 49-70.
Marquardt, C., 2002, "The Cost of Employee Stock Option Grants: An Empirical Analysis," Journal of Accounting Research 40, 1191-1217.
Merton, R., 1973, "Theory of Rational Option Pricing," Bell Journal of Economics and Management Science, 4, 141-183.
Perry, T. and M. Zenner, 2001, "Pay for Performance? Government Regulation and the Structure of Compensation Contracts," Journal of Financial Economics 62, 453-488.
Richard, S. and R. Roll, 1989, "Prepayments on Fixed Rate Mortgage-Backed Securities," Journal of Portfolio Management 15, 73-82.
Securities and Exchange Commission, Office of Economic Analysis Memorandum, "Economic Perspective on Employee Stock Option Expensing: Valuation and Implementation of FAS 123(R)," March 18, 2005. http://www.sec.gov/interps/account/secoeamemo032905.pdf
Swan, P. and X. Zhou, 2006, "Does Pay Competition Engendered by Executive Compensation Disclosure Promote High Pay at the Expense of Incentives?" working paper.
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