Does Regulatory Cooperation Help Integrate Equity Markets?

Roger Silvers is a former senior economist at the Securities and Exchange Commission and is currently Assistant Professor of Accounting at the University of Utah Eccles School of Business. This post is based on his recent paper, forthcoming in the Journal of Financial Economics.

The Achilles’ heel of global markets is that no single regulator has the authority to unilaterally investigate or enforce compliance with securities laws. For regulators, the only way to restore access to information and reestablish capacities that have been severed by jurisdictional boundaries is through assistance from foreign counterparts. Even when two countries individually possess effective local regulation, the ability to address cross-border issues still depends on cooperation. Thus, instead of defining institutional features—e.g., property rights, contract enforcement, and judicial quality—as country-level factors (as in prior work), I reframe institutional features as interactive, country-pair level constructs.

An extensive body of literature studies global capital markets and argues that they help firms raise more capital at lower costs, while allowing investors to diversify their portfolios and access higher yields as compared to domestic markets. However, despite the promise of widespread benefits, empirical work consistently shows a puzzling finding: relative to theoretical benchmarks, investors overinvest in local assets and underinvest in foreign ones. Much attention has been paid to understanding why this divergence from theory is the norm, and various economic frictions have been proposed as explanations.

By strengthening institutional features, cross-border cooperation between securities regulators resolves these frictions that would otherwise stifle global market participation. It enhances cross-border enforcement capacities, which in turn deters malfeasant behaviors, promotes a level playing field for information, and helps ensure that harmed investors are compensated. It also facilitates consultation between regulators, allowing them to draw on a richer set of experiences for their decision making. And it encourages nations to coordinate their regulatory requirements. This lowers compliance costs and makes ownership of foreign shares logistically easier and less costly.

I test for the effects of cooperation on foreign ownership and various proxies for capital market integration. To measure cooperation, I use signals of intent to cooperate, collaborate, and share information via arrangements called memoranda of understanding (MoUs). Although MoUs have no binding legal power, they address legal incompatibilities across jurisdictions, competence deficits, and confidentiality and privacy concerns. They also enhance a variety of regulatory tactics between the undersigned nations. Critically, MoUs provide an observable, empirical measure of enhanced cooperative relationships between specific regulatory pairs at precise points in time.

An obvious concern is that, like any institutional attribute, MoUs could arise out of an endogenous process. Typically, market forces dictate a regulator’s policy agenda, and indeed such forces may be the impetus for bilateral MoUs (arrangements that operate between only two countries). To help mitigate this issue, I draw inferences from multilateral instruments, such as IOSCO’s Multilateral Memorandum of Understanding (MMoU). The push to establish the MMoU was not market-driven, but instead came top-down from heads of state who were seeking ways to fight terrorism and terrorism-related money laundering following the events of 9/11. Consequently, the timing of a country’s MMoU admission is dictated by geopolitical agendas over which market participants and even regulators have minimal sway. Furthermore, countries admitted to the MMoU must remediate any issues that might disqualify them (e.g., laws prohibiting information sharing), as well as deficits in competence. These disqualifying characteristics are scattered across sophisticated and unsophisticated regulators, which creates additional random variation in the timing of admission. With respect to market outcomes, therefore, the country-pair links formed by the MMoU are plausibly exogenous to investors, firms, and even regulators. Moreover, the multilateral network formation creates a complex, lock-step treatment pattern that is staggered across time and country pairs. This unusual pattern helps me identify the effect of cooperation policy.

To measure market integration, I examine cross-border investment in the form of foreign portfolio investment (FPI) from the IMF’s Coordinated Portfolio Investment Survey (CPIS) from 2001 to 2017. This provides cross-border equity positions between pairs of countries on an annual basis (a country-pair-year unit of observation). The structure of this data, along with the unique staggered, network-formed nature of the treatment, enables a robust set of controls that rule out many alternative explanations. Fixed effects are variables that remove the average effect within a given set of observations. I include fixed effects for: (i) country pairs, to control for time-invariant country-pair characteristics (to account for the fact that the US and UK will clearly have different levels of cross-border investment than Slovenia and Malawi); (ii) investee×time, to control for “pull” factors (unobserved changes in an investee country’s economic conditions that change the attractiveness of a country for foreign investment, regardless of cooperation); and (iii) investor×time, to control for “push” factors (changes in outbound FPI that are common to all investee countriesdue to conditions in an investor market). This “three-way” set of fixed effects creates a powerful way to compare time-series changes in FPI for a cooperating pair with time-series changes in FPI for a counterfactual benchmark (country pairs that share either the same investee or investor country as the treated pair). This sophisticated design mitigates a variety of counter explanations—neutralizing the effects of any changes that are common to a given investor or investee country at a given point in time. Furthermore, I use state-of-the-art estimation techniques based on Poisson Pseudo-Maximum Likelihood to deal with the many zero-value observations in the data (and resulting issues of bias and inconsistency they might produce).

I find the adoption of cooperative arrangements is associated with an 11% increase in cross-border equity investment—which represents roughly $1.8 trillion of reallocated capital attributable to the effects of cross-border cooperation. A battery of other tests, including asset pricing tests, are consistent with cooperation enhancing market integration.

I conclude that cross-border investment and market integration depend, in part, on regulatory counterparts working together to extend legal and institutional capacities across borders. Thus, although legal systems—and therefore property rights, contract enforcement, judicial quality, and securities regulation—are organized at the country level, my study reveals that institutional attributes defined at the country-pair level significantly influence cross-border investment and capital market integration. Ultimately, cross-border cooperation between securities regulators appears to be a critical feature that defines foreign investment, market integration.

The complete paper is available for download here.

Trackbacks are closed, but you can post a comment.

Post a Comment

Your email is never published nor shared. Required fields are marked *

*
*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>