Capital-Market Effects of Securities Regulation

Christian Leuz is the Joseph Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago.

In the paper, Capital-Market Effects of Securities Regulation: The Role of Implementation and Enforcement, which was recently made publicly available on SSRN, my co-authors (Hans Christensen of the University of Chicago and Luzi Hail of the University of Pennsylvania) and I examine capital-market effects of changes in securities regulation. We focus on two key EU capital-market directives pertaining to market abuse and transparency regulation. As there were prior EU directives and national laws banning insider trading and requiring financial reporting, the two directives can be viewed as tightening and harmonizing existing EU securities regulation, particularly its enforcement. We use this setting to highlight that implementation and enforcement of regulation play an important role for regulatory outcomes. Our empirical identification strategy exploits the staggered implementation of the two directives across EU countries. This feature allows us to control for general market movements and other potentially confounding events that occurred within and outside the EU over the sample period.

Overall, the results show that stronger securities regulation can have significant economic benefits. Specifically, we find that market liquidity increases and firms’ cost of capital decreases as the two EU directives become effective in the member states. The results are economically significant for both proxies but are, on balance, more robust for market liquidity than for the cost of capital. The latter is perhaps not surprising considering that an analysis of market liquidity is better suited for our setting given that the cost of capital is a more anticipatory measure, for which it is harder to pinpoint changes.

Furthermore, we provide strong evidence of hysteresis in regulatory outcomes. The liquidity effects of the two directives are stronger in countries with a history of higher regulatory quality and with traditionally stronger securities regulators. We also provide evidence that stricter implementation and enforcement of the two directives result in larger liquidity effects, but these effects stem largely from countries with strong prior regulatory quality and that already have relatively well-staffed securities regulators. One explanation for these findings is that countries that have put more resources into securities regulation and that have a better track record of implementing and enforcing regulation are more willing and better able to implement the new EU directives. Put differently, it is important to recognize that the same forces that limited the strength of past regulation are likely still at work when new rules are introduced. In addition, there may be complementarities between existing and new regulation, especially considering that the two new directives primarily improve the enforcement regime of existing market abuse and transparency regulation.

In sum, our findings support the notion that the success of regulation depends critically on how regulation is implemented and enforced and not just on how it is designed. Thus, policy debates should pay particular attention to implementation and enforcement issues. Our finding that the two EU directives did not make member states with weaker securities regulation “catch up” with their EU peers with stronger securities regulation raises concerns about the likely success of regulatory harmonization in the EU and around the world. More generally, the existence of hysteresis has important implications for the expected outcomes of regulatory reforms. In closing, we note an important caveat about our study. While our results suggest substantial economic benefits from securities regulation, the analysis does not consider the costs of regulation. Thus, we cannot show that the directives are beneficially net of costs. For the same reason, our results do not imply that countries with weaker implementation and enforcement of securities regulation “leave money on the table.” We need more research to assess these issues and establish the welfare consequences.

The full paper is available for download here.

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