Securities Laws, Disclosure, and National Capital Markets in the Age of Financial Globalization

I have recently completed a paper titled Securities Laws, Disclosure, and National Capital Markets in the Age of Financial Globalization. The paper examines the following question: If capital can move freely between countries to take advantage of the best investment opportunities, are national capital markets still relevant?

With complete capital market integration across countries, there would be no national interest at stake for a country in having well-functioning capital markets. If capital can flow freely among countries, firms raise capital where it is cheapest. In a fully integrated world, we would therefore expect national capital markets to be irrelevant. If a country’s capital markets functioned poorly in such a world, firms would simply ignore these capital markets as sources of capital. The welfare consequences from having poorly functioning national capital markets would be extremely limited because firms and investors could bypass these markets freely.

As far as the trading of securities is concerned, the role of location has decreased dramatically because of the replacement of pit trading with electronic trading. With electronic trading, the location of the trader is operationally irrelevant and so is the location of the exchange.

The fact that portfolios of investors are still heavily biased towards securities issued and traded in their own country, a phenomenon described as the home bias, shows that, despite the free flow of capital, we are far from a fully integrated world in which countries are irrelevant for the issuance and trading of securities. A major reason for why countries are not irrelevant is that they have different laws and enforce them differently. The laws that apply uniquely to publicly traded securities are securities laws.

I construct a model where I show that securities laws can reduce agency costs and therefore increase share prices. I model a firm led by an entrepreneur who decides whether to take the firm public or not. I show that the entrepreneur wants to commit ex ante to a level of disclosure that is not optimal for her ex post. By committing to disclosure, the entrepreneur increases the cost of consuming private benefits and of taking decisions that are not optimal for shareholders. After the IPO, the entrepreneur would like to consume private benefits and would like to take decisions that are optimal for her but not for shareholders. It is therefore optimal for the entrepreneur to renege on disclosure commitments after the IPO. I examine private solutions to this problem and show that under some circumstances strong securities laws dominate private solutions. Strikingly, securities laws help entrepreneurs in the model rather than shareholders. Shareholders buy the shares for what they are worth, so that poor securities laws do not hurt them. Poor securities laws hurt entrepreneurs because they reduce the value of the firms that they take public.

I use the model to show that differences in securities laws across countries explain differences in share values and in the distribution of share ownership. In the model, some firms from countries with poor securities laws will choose to subject themselves to stronger securities laws. Some have argued that U.S. laws protecting shareholders have become too costly and inefficient. I model this argument by considering the case where strong securities laws have deadweight costs. I show that, to the extent that firms can choose the securities laws they are subject to, firms with poor growth opportunities choose weak securities laws with no deadweight costs while firms with strong growth opportunities choose strong securities laws even if they have some deadweight costs.

A key conclusion of my paper is that securities laws are more beneficial if they are not at risk of being watered down over time through lobbying by incumbents. However, incumbents have strong motivations to reduce the strength of securities laws since doing so increases their ability of consuming private benefits.