Monthly Archives: September 2009

How Does Internal Control Regulation Affect Financial Reporting?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, September 14, 2009
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This post comes to us from Jennifer Altamuro and Anne Beatty of the Fisher College of Business, The Ohio State University.

 

In our paper How does internal control regulation affect financial reporting? which was recently accepted for publication in the Journal of Accounting and Economics, we examine the financial reporting effects of the Federal Depository Insurance Corporation Improvement Act (FDICIA) internal control provisions. The internal control provisions of the FDICIA provide exemptions that allow us to separately identify the effects of these provisions. In particular, the FDICIA exempts institutions with assets less than $500 million from its internal control monitoring and reporting requirements. More specifically, these institutions are exempted from FDICIA’s requirements that management issue a report on the effectiveness of internal controls over financial reporting, and that their independent public accountant attest to management’s report.

We compare annual and quarterly financial reporting of banks affected by FDICIA’s internal control provisions to that of unaffected banks. Specifically, we examine changes in the validity of the loan-loss provision, earnings quality, benchmark-beating and accounting conservatism. We analyze two samples: (1) a sample of US public and private banks included in the Fed Form Y9-C Regulatory Filing database and (2) a sample of publicly-traded banks included in the COMPUSTAT database. Our difference-in-differences research design isolates the effects of the FDICIA internal controls provision by controlling for changes in financial reporting unrelated to those provisions. We validate our control samples by testing for differences between the affected and unaffected firms in the pre-regulation period.

We compare the change in financial reporting for our affected and control firms in the 7-year periods before and after the passage of FDICIA. First we examine the properties of the annual financial reports. We find that the FDICIA-mandated internal control requirements lead to improvements in the validity of the loan-loss provision. Specifically, the association between the loan-loss provision and actual loans written off for affected banks strengthened in the period after the enactment of FDICIA. This improvement addresses the GAO’s (1994) concern “that banks’ loan-loss allowances included large supplemental reserves that were not linked to analysis of loss exposure or supported by evidence.” We find a corresponding increase in both earnings’ persistence and ability to predict cash flows, and a reduction in the use of earnings management to report positive earnings growth, suggesting that reducing supplemental reserves generally improves reporting quality. However, we also find that earnings conservatism declines for affected versus unaffected banks in both samples. This reduction in conservatism is also consistent with a reduction in supplemental reserves.

Next we examine the properties of quarterly reports to determine whether the effects are larger in the interim quarters relative to the fourth quarter, when an increased auditor presence might substitute for improved internal controls. Consistent with this hypothesis, we find that the improvements in the validity of the loan-loss provision, and the increase in earnings persistence and predictability of future cash flows, are all larger in the first three quarters than in the fourth quarter.

Taken together, these results suggest that the FDICIA-mandated internal control provisions resulted in the average bank exercising less reporting discretion. This reduced discretion creates a greater association between current reported accrual numbers and future cash flow numbers. However, as a result of this improved association, the reported accrual numbers also became less conservative. Thus, the conclusion about how this regulation affected the quality of financial reports depends on one’s definition of quality.

The full paper is available for download here.

Treasury Department Proposes Bank Capital Reforms

Posted by H. Rodgin Cohen, Sullivan & Cromwell LLP, on
Sunday, September 13, 2009
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This post from H. Rodgin Cohen is based on a Sullivan & Cromwell LLP client memorandum, which is available here.

SUMMARY

Late yesterday, the U.S. Treasury Department issued a policy statement entitled “Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms” (the “Policy Statement”). The Policy Statement, which was developed in consultation with the U.S. bank regulatory agencies, sets forth eight “core principles that should shape a new international capital accord”. Six of the principles relate directly to bank capital requirements. The seventh of these principles relates to liquidity and the eighth to non-banking organizations.

The Policy Statement expands substantially upon the preliminary indications of Treasury’s thinking regarding regulatory capital reform as reflected in its June 17 white paper on financial regulatory reform, “A New Foundation: Rebuilding Financial Supervision and Regulation”, and makes clear that Treasury is contemplating a fundamental revamping of capital standards, both internationally through the Basel Committee process and in the United States. It would involve substantial revisions to, if not replacement of, major parts of the Basel I and Basel II capital frameworks and affect all regulated banking organizations, large and small, as well as institutions of systemic importance that are not currently regulated as banking organizations.

The Policy Statement:

  • Proposes higher capital requirements “across the board” for all banking firms — and even higher capital requirements for systemically-important financial firms — and that these requirements be designed to protect the stability of the financial system as a whole as well as the solvency of individual firms.
  • Emphasizes the importance of the quality of capital, stressing the need for common voting equity to constitute a “large majority” of tier 1 capital and for tier 1 capital to constitute a “large majority” of total regulatory capital.
  • Addresses the so-called “procyclicality” of current capital standards.
  • Expresses skepticism as to the reliability of credit ratings and internal models as tools for measuring capital requirements.
  • States that risk-weightings of some assets and exposures — including credit derivatives, structured asset-backed and mortgage-backed securities, off-balance-sheet vehicles, trading positions, and equity investments — should be a function of not only their own risk characteristics but “also should reflect the systemic importance of the various exposure types”.
  • Acknowledges that the existing capital standards “too often are a lagging indicator of financial distress” and suggests the consideration of “supplemental triggers” for prompt corrective action based, for example, on non-performing loans or liquidity.
  • States that capital requirements “should reflect more forward-looking, through-the-cycle considerations” and rely less on value-at-risk models and point-in-time rating systems.
  • States that a leverage ratio, although “a blunt instrument”, must be utilized.
  • Calls for a new “conservative, explicit liquidity standard”.
  • Proposes a number of actions to prevent the “re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability”.

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Proposed Pay Reform Rules Raise Questions

Posted by Joseph E. Bachelder III, Law Offices of Joseph E. Bachelder, on
Saturday, September 12, 2009
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This article by Joseph E. Bachelder III previously appeared in the New York Law Journal.

On July 17, the Securities and Exchange Commission (SEC) published in the Federal Register proposed changes in proxy statement disclosure rules affecting executive compensation as well as other matters. On July 31 the House of Representatives passed the Corporate and Financial Institution Compensation Fairness Act of 2009 (H.R. 3269) (the Compensation Fairness Act or the act). The bill, received in the Senate Aug. 3, has been referred to the Senate Committee on Banking, Housing, and Urban Affairs. It is not known when, after the recess, the committee plans to take up consideration of the bill. This column will examine both of these developments (discussion of the SEC proposals is limited to those involving executive compensation).

Proposed Disclosure Rules
The proposed new rules affecting disclosure of executive compensation by companies subject to the disclosure rules of the Securities Exchange Act of 1934 (the 1934 Act) concern (a) disclosure of the impact of compensation policies and practices generally on risks of the employer, (b) the reporting of stock option and other equity awards in the Summary Compensation Table and (c) the reporting on compensation consultants.

Reporting on Risk-Related Aspects of Compensation. The proposed rules require companies to evaluate in the Compensation Discussion and Analysis (CD&A) those risks arising from general compensation policies and overall practices at the company that may have a material effect on the company. 17 CFR 229.402(b)(2). Disclosure is not limited to compensation arrangements with named executive officers. The proposed rules describe situations that may require particular attention in the CD&A such as compensation policies at business units that carry a significant share of the overall enterprise’s risk or units that vary significantly from the risk/reward structure of the company.

The proposed rules also suggest examples of issues that should be addressed such as compensation policies that may have special impact on risk (e.g., short-term versus long-term awards and how they relate to business results, short-term versus long-term), policies involving adjustments for changes in risk evaluation and how the company monitors its own responsiveness to changes in its risk environment. The proposed rules emphasize that the situations and the examples of issues described are illustrations only and not exclusive statements as to what should be disclosed.

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Overcoming Short-termism: A Call for A More Responsible Approach to Investment and Business Management

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on
Friday, September 11, 2009
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This post is a statement by the Aspen Institute Business & Society Program’s Corporate Values Strategy Group, of which John Olson is a signatory, along with 27 other business, investment, academic, & labor leaders.  The complete list of signatories is available here.

Introduction
We believe a healthy society requires healthy and responsible companies that effectively pursue long-term goals. Yet in recent years, boards, managers, shareholders with varying agendas, and regulators, all, to one degree or another, have allowed short-term considerations to overwhelm the desirable long-term growth and sustainable profit objectives of the corporation. We believe that short-term objectives have eroded faith in corporations continuing to be the foundation of the American free enterprise system, which has been, in turn, the foundation of our economy. Restoring that faith critically requires restoring a longterm focus for boards, managers, and most particularly, shareholders—if not voluntarily, then by appropriate regulation.

A coalition has been working for several years on what business and investors can voluntarily do to address market short-termism, including the reform of executive compensation to focus on long-range value creation (See Appendix). A new administration in Washington and unprecedented public attention to business and financial markets, offer a unique opportunity for public policy recommendations in pursuit of long-term wealth creation to gain visibility, and to obtain real traction.

Others will study and recommend actions to be taken by boards, managers and regulation to restore long-term focus. The recommendations in this document, directed at influencing the behavior of shareholders, present an important step towards an integrated approach to ensuring long-term wealth creation.

Shareholder Short-Termism
The word “shareholders” evokes images of mom-and-pop investors saving for their retirement or their children’s college tuition. Individual investors do participate directly in the market, but they are mostly passive and unorganized and their role has diminished in recent years. The largest and most influential shareholders today are institutions — including pension funds, mutual funds, private investment (or “hedge”) funds, endowments and sovereign wealth funds — many of which serve as agents for the providers of capital, their ultimate investors. For example, one-third of U.S. corporate equity today is held by mutual funds and hedge funds.

The diversity of investment vehicles contributes to healthy competition and liquidity and is a strength of our capital markets. Properly incentivized institutions of different kinds can contribute to long-term wealth creation. However, the influence of money managers, mutual funds and hedge funds (and those intermediaries who provide them capital) who focus on short-term stock price performance, and/or favor high-leverage and high-risk corporate strategies designed to produce high short-term returns, present at least three problems:

  • First, high rates of portfolio turnover harm ultimate investors’ returns, since the costs associated with frequent trading can significantly erode gains.
  • Second, fund managers with a primary focus on short-term trading gains have little reason to care about long-term corporate performance or externalities, and so are unlikely to exercise a positive role in promoting corporate policies, including appropriate proxy voting and corporate governance policies, that are beneficial and sustainable in the long-term. Risk-taking is an essential underpinning of our capitalist system, but the consequences to the corporation, and the economy, of high-risk strategies designed exclusively to produce high returns in the short-run is evident in recent market failures.
  • Third, the focus of some short-term investors on quarterly earnings and other shortterm metrics can harm the interests of shareholders seeking long-term growth and sustainable earnings, if managers and boards pursue strategies simply to satisfy those short-term investors. This, in turn, may put a corporation’s future at risk.

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Regulation Fair Disclosure and the Cost of Equity Capital

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, September 11, 2009
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This post comes to us from Zhihong Chen of the City University of Hong Kong, Dan Dhaliwal of the University of Arizona, and Hong Xie of University of Illinois at Urbana-Champaign.

 

Regulation Fair Disclosure (hereafter, Reg FD) was adopted by the SEC in 2000 to prohibit the selective disclosure of material information. The SEC was concerned that selective disclosure enables a privileged few, who are privy to the information, to profit at the expense of the investing public and that this unequal access to information will inevitably lead to individual investors’ loss of confidence in the integrity of the capital markets. The SEC believed that Reg FD would increase investor confidence in market integrity and thus “encourage continued widespread investor participation in our markets, enhancing market efficiency and liquidity, and more effective capital raising” (SEC 2000). In our forthcoming Review of Accounting Studies paper Regulation Fair Disclosure and the Cost of Equity Capital, we empirically investigate the effect of Reg FD on the cost of equity capital.

We use two approaches to estimate the ex ante or implied cost of equity capital for all U.S. firms with required data. The first approach simultaneously estimates the cost of capital and long-term growth for a portfolio of firms at a particular point in time (Easton and Sommers 2007). The second approach estimates the cost of capital for a firm at a particular point in time using assumed long-term growth (Gebhardt, Lee, and Swaminathan 2001; Claus and Thomas 2001; Gode and Mohanram 2003). These two approaches complement each other. Using the portfolio-specific cost of capital estimates, we find some evidence that the cost of capital declines after Reg FD, on average, for a broad cross-section of U.S. firms and that the reduction in the cost of capital is significant for medium and large firms but is not significant for small firms. Our findings based on the firm-specific cost of capital estimate are stronger and generally consistent with those based on the portfolio-specific cost of capital estimates.

We further examine whether the reduction in the cost of capital in the post-FD period relative to the pre-FD period is systematically related to firm characteristics indicative of selective disclosure prior to Reg FD. We find that the reduction in the cost of capital post Reg FD, in general, is more pronounced for firms with low book-to-market ratios, positive R&D expenditures or high levels of institutional ownership, i.e., firms that tend to provide more selective disclosure before Reg FD. This cross-sectional variation in the reduction in the cost of capital post Reg FD increases our confidence in attributing the observed decrease in the cost of capital to Reg FD rather than to unknown confounding factors.

We also examine the change in the cost of capital for a sample of American Depositary Receipts and U.S. listed foreign firms (hereafter, ADRs). ADRs are legally exempt from Reg FD. We find little evidence that the cost of capital is significantly decreased post Reg FD for ADRs but continue to observe some evidence of a significant decrease in the cost of capital for a matched sample of U.S. firms. This further increases our confidence in attributing the observed decrease in the cost of capital post Reg FD for U.S. firms to Reg FD. To summarize, our results do not support a conclusion in recent studies that the cost of capital has increased post Reg FD and, if anything, suggest the opposite.

The full paper is available for download here.

Elements of Effective Systemic Regulation

Posted by Lloyd C. Blankfein, Chairman and Chief Executive Officer, The Goldman Sachs Group, Inc., on
Thursday, September 10, 2009
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The post below by Lloyd Blankfein is a transcript of his remarks at the Handelsblatt Banking Conference on September 9.

In the wake of the financial crisis, there has been no shortage of approaches to regulatory reform, both here in Germany and globally. In a relatively brief period, we have witnessed a number of proposed changes to the rules and regulations that govern our industry and markets more broadly.

Driving these are several common themes, but I want to touch on three that seem particularly prevalent: a backlash against complexity in financial products and markets, the need for macro-prudential regulation to address systemic risk and re-working compensation practices to dis-incentivize excessive risk taking.

First, the industry let the growth and complexity in new instruments outstrip their economic and social utility as well as the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

That is one reason why Goldman Sachs supports the broad move to central clearing houses and exchange trading of standardized derivatives. Clearly, there is general agreement on the necessity of central clearing for derivatives. A central clearing house with strong operational and financial integrity will reduce bi-lateral credit risk, increase liquidity and enhance the level of transparency through enforced margin requirements and verified and recorded trades. This will do more to enhance price discovery and reduce systemic risk than perhaps any specific rule or regulation.

The debate gets harder when defining what should be traded on or off an exchange. We believe that all liquid OTC derivatives should be centrally cleared. And, where trading volumes are high enough and price discovery mechanisms can be established, regulators should strongly encourage exchange trading. In less liquid markets, prompt reporting of aggregated pricing and clearing is necessary to improve transparency.

More generally, it is incumbent upon financial institutions to recognize that we have a responsibility to the financial system which demands that we should not favor non-standard products when a client’s objective and the market’s interests can be met through a standardized product traded on an exchange.

But, we should also recognize that underlying the development of the derivatives markets was client demand for individually-tailored solutions. During the financial crisis, credit-default swaps, many of them customized, actually worked as they were intended to. They increased the ability of market participants to diversify their credit exposure in companies — some that were financially strained or ultimately went bankrupt — by swapping default risk with others. In that vein, these instruments represent an important economic and social purpose.

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Why Financial Pay Shouldn’t be Left to the Market

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, September 9, 2009
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(Editor’s Note: This post is Lucian Bebchuk’s most recent column in his series of monthly commentaries titled “The Rules of the Game” for the international association of newspapers Project Syndicate, which are available here.)

Although some financial firms are reforming how they pay their employees, governments around the world are seriously considering regulating such firms’ compensation structures. The Basel Committee on Banking Supervision has recently come out in favor of such regulations, and the United States House of Representatives has voted to require regulators to set compensation rules.

Perhaps not surprisingly, many financial bosses are up in arms over such moves. They claim that they need the freedom to set compensation packages in order to keep their most talented people – the ones who will revive the world’s financial system. So, should governments step back and let financial firms reform themselves?

The answer is clearly no. In the post-crisis financial order, governments must take on the role of monitoring and regulating pay in financial firms; otherwise, the perverse incentives that contributed to the current crisis could easily recur.

It is important to distinguish between two sources of concern about pay in financial firms. One set of concerns arises from the perspective of shareholders. Figures recently released by New York’s attorney general, Andrew Cuomo, indicate that nine large financial firms paid their employees aggregate compensation exceeding $600 billion in 2003-2008 – a period in which their aggregate market capitalization substantially declined. Such patterns may raise concerns among shareholders that pay structures are not well designed to serve their interests.

Even if financial firms have governance problems that produce pay decisions deviating from shareholder interests, however, such problems do not necessarily warrant government regulation of those decisions. Such problems are best addressed by rules that focus on improving internal governance processes and strengthening investors’ rights, leaving the choices that determine compensation structures to corporate boards and the shareholders who elect them.

But pay in financial firms also raises a second important source of concern: even if compensation structures are designed in the interests of shareholders, they may produce incentives for excessive risk-taking that are socially undesirable. As a result, even if corporate governance problems in financial firms are fully addressed, a government role in regulating their compensation structures may still be warranted.

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FDIC Final Policy Statement Onerous and Unclear

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on
Tuesday, September 8, 2009

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This post from Margaret E. Tahyar is based on a David Polk & Wardwell LLP client memorandum by Luigi De Ghenghi, John Douglas, Randy Guynn, Arthur Long, Bill Taylor, and Reena Agrawal Sahni.

At a meeting of the Board of Directors of the FDIC on August 26, 2009, the FDIC adopted a Final Statement of Policy on Qualifications for Failed Bank Acquisitions. The final policy statement establishes standards and requirements for private investors acquiring or investing in failed insured depository institutions, including through holding companies formed for that purpose. While the final policy statement is a substantial improvement over the proposed policy statement issued on July 2, 2009, it nevertheless subjects private investors to more onerous requirements than those applicable to existing banks, thrifts and their respective holding companies, which explicitly remain the FDIC’s preferred buyers of failed insured depository institutions. Just how onerous these requirements will be is unclear, as the final policy statement leaves a number of terms and concepts undefined and thus subject to the discretionary interpretation of the FDIC. The FDIC Board of Directors has not only reserved the right to modify the policy statement in specific situations, but also agreed to revisit the policy statement in six months.

Highlights

Scope. The policy statement will not apply to private investors with 5% or less of total voting power; nor will it apply to pre-existing investments in failed depository institutions.

Term. Upon application to the FDIC, investors may seek relief from the policy statement if the institution invested in has maintained a composite CAMELS rating of 1 or 2 continuously for seven years.

Capital. The FDIC backed off its proposed 15% Tier 1 leverage requirement, but instead imposed a minimum 10% ratio of Tier 1 common equity to total assets. While the 10% requirement probably will not eliminate private capital bids for failed banks, at least in the near term, it represents a financial penalty that will reduce any potential bid, thus hindering private investors.

Cross Guarantee. The FDIC backed off its initial proposal to impose cross-guarantee liability where there is majority common ownership, increasing the common ownership threshold to 80% and clarifying the intent to impose that liability on common owners directly. While the 80% test is a significant improvement, it still represents a deterrent for prospective private investors.

Source of Strength. The FDIC completely eliminated the proposed source of strength requirement, but underlined the source of strength obligations of a depository institution’s holding company by deeming an insured depository institution “undercapitalized” for purposes of prompt corrective action if its Tier 1 common equity ratio drops below 10%.

Transactions with Affiliates. The final policy statement goes well beyond Section 23A of the Federal Reserve Act by flatly prohibiting transactions with private investors, their investment funds and any of their respective affiliates and by defining affiliates by reference to a 10% level of ownership.

Bank Secrecy Jurisdictions. The FDIC retained the ability to refuse to allow investors from so-called bank secrecy jurisdictions to participate.

Holding Period. The FDIC retained the minimum three-year ownership requirement, although it will permit transfers to affiliates that agree to the provisions of the policy statement, subject to FDIC consent, and it excluded mutual funds from this minimum holding period requirement.

Prohibited Structures. The FDIC retained the ability to preclude ownership structures that the FDIC determines to be “complex and functionally opaque.”

Precluded Investors. The policy statement retains a prohibition on investors that hold 10% or more of the equity of an institution in receivership from bidding on that institution.

Disclosures. Investors subject to the policy statement are required to provide substantial information to the FDIC in connection with any proposed bid.

Despite the compromises reflected in the final policy statement, the FDIC Board was unable to achieve unanimity, with the final policy statement being approved by a 4-1 vote. John Bowman, Acting Director of the Office of Thrift Supervision, cast the opposing vote, stating that the lack of empirical data supporting the policy statement made it impossible to evaluate its benefits.

In the memorandum, FDIC Extends Cautious Welcome to Private Capital Investments in Failed Banks, Davis Polk analyzes the final policy statement in greater detail. Because of the ambiguities in the final policy statement and the FDIC’s discretion to interpret and apply the statement, it will be more important than ever for prospective investors to engage the FDIC very early on in the process of any proposal to acquire a failed insured depository institution.

Capital Structure as a Strategic Variable

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, September 7, 2009
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This post comes to us from David Matsa of the Kellogg School of Management, Northwestern University.

 

The standard corporate finance paradigm posits that a firm determines its optimal capital structure by making tradeoffs between the tax advantages of debt, the expected costs of financial distress, the impact of asymmetric information, and the implications for managerial incentives. But when financial policy affects a firm’s competitive position in product or input markets, the firm has an incentive to set its capital structure strategically to influence the behavior of competitors, customers, or suppliers. Although this argument is well understood in theory, its empirical relevance is much less clear. My forthcoming Journal of Finance paper, Capital Structure as a Strategic Variable: Evidence from Collective Bargaining, fills an important gap by showing that strategic incentives from labor markets have a substantial impact on financing decisions.

Delta Air Lines’ recent experience exemplifies how too much flexibility can hurt a firm’s bargaining position with workers. With a strong market position and a history of fiscally conservative management, Delta weathered the airline industry downturn after September 11, 2001 by building up cash and liquidity. But greater liquidity also reduced the need to cut costs and hurt Delta’s bargaining position with workers (Perez (2004)). By 2004, Delta found itself far behind the other big carriers in restructuring, and in severe financial distress.

I begin my analysis through a theoretical framework that illustrates how collective bargaining affects a firm’s optimal debt policy. This framework shows that collective bargaining interacts with variability in a firm’s profits to give the firm a strategic incentive to increase its debt. The firm must consider the tradeoff between gains from improved bargaining power when the cash flow shock is positive and losses from increased costs of financial distress when the shock is negative. Greater profit variability has an asymmetric impact on this tradeoff, because the union earns rents only on inframarginal realizations of the shock. While greater variability exposes unionized and nonunionized firms to similar costs in periods of financial distress, it increases liquidity and hence a unionized firm’s exposure to union rent seeking when a cash flow shock is positive. Thus, a unionized firm with high profit variability has greater strategic incentive to use debt to shield liquidity from workers in bargaining and thus a higher optimal debt ratio than an otherwise similar nonunionized firm.

I then provide empirical evidence for the strategic use of debt using two estimation strategies. In the first approach, I analyze cross-sectional correlations between debt and the percentage of employees covered by collective bargaining (a direct measure of union power) for a sample of mostly manufacturing firms from the 1970s, 1980s, and 1990s. The results suggest that union bargaining power leads firms to increase financial leverage: on average, the ratio of debt to firm value is 80 to 110 basis points higher when an additional 10% of employees bargain collectively. According to these estimates, a firm with a 50% unionized workforce is associated with 15% to 20% greater financial leverage than a typical nonunionized firm. Furthermore, these differences are larger at firms with more variable profits. However, this result may be affected by omitted variable bias: unions are more likely to organize in established, profitable firms and industries, which may also have a greater capacity for debt.

To overcome this problem, I employ a second empirical approach, which uses states’ adoption of right-to-work laws in the 1950s and states’ repeal of unemployment insurance work stoppage provisions in the 1960s and early 1970s as sources of exogenous variation in union power. I find that after states adopt legislation to reduce union bargaining power, firms with concentrated labor markets reduce debt relative to otherwise similar firms in other states. In fact, the ratio of debt to firm value decreases by up to one-half after a right-to-work law is passed. These effects are again linked to variability in firm profits. While the ratio of debt to firm value decreases by up to one fifth after a work stoppage provision is repealed for firms with profit variability that is one standard deviation above the mean, there is little effect among firms with low profit variability. As a falsification test, I show that these changes in labor laws do not seem to affect financial policy at firms in industries with low union presence. Various tests confirm the robustness of the profit variability interaction.

The full paper is available for download here.

SEC Commissioner Sets Out Principles for Harmonization

Posted by Luis A. Aguilar, Commissioner, U.S. Securities and Exchange Commission, on
Sunday, September 6, 2009
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(Editor’s Note: The post below by Commission Aguilar is a transcript of his remarks at the Joint Meeting of the Securities and Exchange Commission and Commodity Futures Trading Commission last week.)

Good morning. I, too, would like to welcome the panelists and the members of the public present here, as well as those observing by webcast.

I am delighted to be here for these unprecedented meetings and I welcome these upcoming discussions.

As some of you know, I have been supportive of combining the SEC and the CFTC. Among other reasons, it would permit more comprehensive and coordinated oversight of financial markets that are increasingly interconnected, and would reduce the concerns and uncertainty about jurisdiction.

Although the SEC has many unique responsibilities, such as oversight of capital markets offerings and financial reporting, some market and intermediary oversight by the CFTC and SEC involve similar tasks. Holding these joint meetings can accomplish some of the same purposes as combining the agencies, and I believe it will result in improvements to our markets.

For example, harmonized rules could enable more consistent recordkeeping by regulated entities. And investors who seek to engage in both securities and futures transactions may be able to better manage their affairs and have their needs met more efficiently.

It is true that harmonization will not make sense in every case because of the different needs of market participants. As a result, as this process unfolds, it would make sense to consider harmonization consistent with some key principles. In particular, harmonization should be pursued where doing so would advance the public interest by enhancing investor protection, by providing a fair and competitive market structure that facilitates informed decision making, and where harmonization would further both agencies’ efforts in vigorous law enforcement. Investor protection is the animating purpose at the SEC, and it will help guide our work in this project.

And even where harmonization would not be appropriate, these meetings will assist our ongoing efforts to coordinate with one another.

My thanks to the staffs of both agencies for their work in organizing this two-day meeting. And thanks again to the panelists for agreeing to share their views with us, and to our respective Chairmen and my fellow Commissioners at the SEC and at the CFTC for agreeing to hold these meetings.

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