Speech by SEC Staff:
This was prepared for presentation as the Keynote Address at the Washington Area Finance Conference at George Washington University on March 17, 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.
It's a great pleasure to speak at today's Washington Area Finance Conference at George Washington University as the conference is an important gathering for the financial economics community in the Washington area. The participants at the conference span many of the universities and government agencies in this area and as such the conference is an important venue for enhancing the dialogue and discussion between university and government economists. I'd like to thank the organizers for giving me the opportunity to speak in this forum and would like to use the occasion to talk about the motivations for and especially the impacts of financial regulation in terms of economic principles. At the onset of my remarks I should 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, several of whom are attending the conference today.
At the beginning of my talk I'd like to discuss the motivation for financial regulation in terms of basic economic principles. Then I'd like to turn to the interaction between various economic margins in the context of several regulatory examples, which will illustrate some of the ways in which "unintended consequences" can arise.
In motivating the role and impacts of financial regulation I'd like to briefly discuss some of the traditional views of regulation in microeconomics more broadly. In my view the most fundamental idea in microeconomics is what's sometimes called the "invisible hand theorem" of Adam Smith or in more technical terminology, the fundamental theorem of welfare economics. The basic idea is that in markets without externalities or market frictions that (competitive) equilibrium allocations are Pareto optimal or efficient and furthermore, that optimal allocations can be sustained as equilibria for some distribution of endowments. In effect, in markets without frictions or externalities regulation would be unnecessary. Yet in the environment in which we live there are significant frictions and regulation can play a potentially beneficial role in at least some situations. In the financial markets these frictions include various types of misrepresentations and failures to disclose relevant information, outright fraud, and fundamental conflicts of interest and incentives, which economists term "agency problems." The underlying theme of investor protection is very important in securities market regulation by the SEC.
Pursuing the classic economist's treatment of regulation I'd like to note that under the "theory of the second best" directly removing a particular constraint or friction can, under some conditions, actually reduce welfare. Analogously, introducing an additional instrument into an incomplete market structure can, under some conditions, actually make investors worse off.1 I view these classic notions as indirectly pointing to the importance in economic decision-making of how economic actors respond across different economic margins.
As a microeconomic and financial theorist I regard economic incentives as central to understanding the underlying behavior of economic decision-makers. For example, in microeconomic analysis the theme of agency theory, which highlights the differential incentives of a decision-maker and the underlying beneficiary of those decisions, is a central paradigm. Given the widespread nature of delegated decision-making in financial markets, it is not surprising that potential conflicts of interest can be pervasive in various aspects of our investment process. Among the areas in which the potential for conflicts are often recognized are the selling and distribution of investment products, trade execution in retail brokerage, soft dollar payments to financial advisers directing commission flows, delegated analysis of information by portfolio managers or stock analysts, conflicts inherent in multi-product and multi-client firms as illustrated by the allocation of securities both within fund families and among the potential purchasers of under-priced IPOs and the potential simultaneous relationship of Wall Street firms with both security purchasers and their issuers and the conflicts of interest inherent between senior executives and their boards in board selection and specifying executive compensation. In fact, some facets of the financial service industry are designed to either take advantage of the incentives associated with specific conflicts such as payment for order flow or pursue opportunities created by regulatory responses to the conflicts as illustrated by the issue of independent research.
While regulators often view themselves as benevolent, I think it's also helpful to point to the "regulatory capture" perspective on regulation that has been emphasized by the "Chicago School" (Stigler (1971)). In particular, regulation can be a tool that directly serves the interests of industry by facilitating coordination or standardization and even as a vehicle to limit entry or otherwise restrict competition through constraints on the contracting or trading process. As this illustrates, whether regulation is beneficial to consumers depends upon the broader context and obviously, the specifics of the regulatory proposal. Of course, the regulatory capture hypothesis can be valid in part, even if portions of the regulatory program are hotly contested by industry.
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.2 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 in the form of compensation from the very high tax price of using non-contingent compensation over the threshold as well as the executive's risk aversion, which would imply that more than one dollar of risky compensation could be required as a substitute for one dollar of fixed compensation. Consequently, a tax "intended" to reduce executive compensation could 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.
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 so 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 and 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. 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. Recently, the SEC proposed new executive compensation rules, reflecting concerns about the current effectiveness of the 1992 disclosure requirements. This new proposal 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, the current SEC proposal reflects less than complete satisfaction with the current performance of the 1992 executive compensation disclosure requirements. This highlights an interesting aspect in assessing proposed rules 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.
Another question suggested by the compensation example is the impact of disclosure requirements on the overall level of compensation. From the perspective of economic theory, will disclosure requirements reduce or alternatively, increase the equilibrium structure of compensation? While one intuition is that 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.3 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 led to enhanced incentives and through that to higher compensation.
The discussion of executive compensation is a good introduction into the subject of options expensing. The SEC's Office of the Economic Analysis, which I lead, helped to develop the implementation guidance prepared by the SEC's staff. 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 and perhaps inconsistent with their responsibilities to their shareholders 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.
As a result of our training and experiences as financial 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 moderate the use 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.4
The corporate voting mechanism is one of the ways in which shareholders can attempt to influence corporate governance and decision-making. At the same time the incentive of investors to invest in assessing the appropriate vote is much less than their incentive to form an improved portfolio. In particular, the investors receive all of the benefits of forming a better portfolio, while to the extent that their votes improve the choices made by the companies in which they invest, the investors receive only the portion of the resulting benefit associated with their proportional holdings. Consequently, investors may under-invest in producing information that can help them improve their voting decisions.5 Several years ago the SEC implemented a requirement that mutual funds disclose their votes on corporate proxy issues, potentially increasing the incentives of funds to invest in decision-relevant information. However, the disclosure of votes to investors in the fund is accompanied by disclosure of votes to the remainder of the public. In particular, because the firm and interested third parties, such as special interest groups, can observe the fund's vote and potentially punish voting behavior with which it does not approve, there can be unintended effects from the disclosure of the voting decisions by mutual funds that could even diminish the quality of their choices.6
Because their voting decisions are publicly revealed, at least some fund organizations may be anxious to improve the quality of their decisions. Since there is a scale economy in voting information, it is natural for funds to retain the services of intermediaries to help them improve the quality of their voting decisions. Indeed, this practice has become widespread. Of course, this in turn creates additional potential distortions. Specifically, is an intermediary well positioned to provide input to the fund making these judgments? Of course, having the same entity offer advice to many investors overcomes some aspects of the public goods problem. On the other hand, the incentives of the intermediary adviser are not necessarily aligned with those of the mutual fund organization. Indeed, these intermediaries sell governance advice to the corporate community, so a firm whose issue is being voted upon may also be a client or potential client of the intermediary.
To the extent that the goal is improved corporate decision-making to raise the value of the firm's stock, one could alternatively imagine providing relatively greater power to activist investors. While on some dimensions this could be desirable, the interests of such activist investors can depart from value maximizing passive investors for example, the activist investor may be interested in negotiating a greenmail arrangement that would benefit itself, so that agency problems would not necessarily be resolved.
Inherently, the introduction of new regulations is often oriented to specific types of markets or investment agents. For example, suppose that cash markets are more heavily regulated than over-the-counter derivatives markets and that some types of market participants, such as mutual funds and broker/dealers, are more heavily regulated than others, such as hedge funds. The introduction of new regulations, if they are perceived as burdensome, can lead to the unintended consequence of transactions substituting towards the less regulated markets and toward investors who themselves are less heavily regulated. The form of transactions potentially responds to the system of regulation in place.
Focusing upon the impact of regulation can help explain the form of our market processes. For example, an interesting and longstanding puzzle to many observers of the offering process has been the predominance of a fixed-price mechanism rather than an auction to determine IPO allocations and pricing. In some of my own research I offered an explanation for the use of a fixed-price procedure. Spatt and Srivastava (1991) show that a fixed-price mechanism preceded by pre-play communication and participation restrictions leads to the same allocation as the optimal auction design. In particular, if the seller allocates the offering securities to those investors whose indications of interest during the road show had the largest values, then even though these indications are not binding, the same allocations as in an optimal auction arise. More specifically, in many contexts a second-price mechanism in which the high bidder wins and pays the second highest bid is an optimal auction procedure. Under this procedure the bidders will bid their true valuation rather than strategically under-winning because their bid only influences the scenarios in which they receive the allocation, but not the price to be paid in the event of winning. Now consider the fixed-price mechanism augmented by pre-play communication and participation restrictions. If the bidders understand that their indications of interest, though non-binding, will be used by the seller to allocate the security, then the fixed-price procedure will result in the same bids and allocations as the optimal auction that maximizes the seller's expected revenue.
Of course, at the time of our work the potential importance of agency conflicts in IPO allocations was not appreciated.7 Consequently, in our theoretical analysis we had not distinguished between the role of the issuer and the investment banking firm advising that issuer and allocating the offering securities. I think that the agency dimension is quite important to the IPO allocation issue and leads to the question of why a fixed-price mechanism is used in settings in which the agency aspect of the allocation process is potentially rather important. With this in mind a natural question for economists to ask is whether aspects of the SEC's and the Self-Regulatory Organization's offering regulations have the "unintended" effect of discouraging the use of auctions in the offering process and if so to identify the specific sources of impediments. For example, there are bounds on revisions in the offering price that can lead to the need to re-file with the SEC and delay the transaction, as well as NASD bounds on underwriter compensation. At the same time I should note that to many observers the experiences to date with auction procedures in the IPO process have not been overwhelmingly successful and that the clients of investment banking firms do not appear to be strongly pushing for regulatory reforms or market innovations for the offering process.
In my remarks 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 is sometimes altered along a variety of different margins, sometimes leading to unintended effects of the market regulation as different economic actors may be close to different economic margins.
I welcome your questions and feedback.
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.
Bodie, Z., R. Kaplan and R. Merton, 2003, "For the Last Time: Stock Options Are an Expense," Harvard Business Review 81, 63-71.
Hall, B. and K. Murphy, 2003, "The Trouble with Stock Options," Journal of Economic Perspectives 17, 49-70.
Hart, O., 1975, "On the Optimality of Equilibrium when the Market Structure is Incomplete," Journal of Economic Theory 11, 418-443.
Perry, T. and M. Zenner, 2001, "Pay for Performance? Government Regulation and the Structure of Compensation Contracts," Journal of Financial Economics 62, 453-488.
Reuter, J., 2006, "Are IPOs Allocations for Sale? Evidence from Mutual Funds," Journal of Finance, forthcoming.
Spatt, C. and S. Srivastava, 1991, "Pre-Play Communication, Efficiency, and Initial Public Offerings," Review of Financial Studies 4, 709-726.
Stigler, G., 1971, "The Theory of Economic Regulation," Bell Journal of Economics and Management Science 2, 3-21.
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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