Ebook Capital Market Governance: Do Securities Laws Affect Market Performance?
The laws that govern a country’s security markets are potentially important determinants of the riskiness and liquidity of these markets. Investors rely on a country’s judicial/legislative system to mitigate the informational advantage of corporate insiders, ensure the integrity of financial reports, monitor the activities of financial intermediaries, and generally protect their claims to an enterprise’s future cash flows. In all these endeavors, investors rely on the protection offered by a country’s securities laws, and the efficacy with which these laws are enforced.
Recent academic studies have examined the impact of corporate governance on a wide variety of phenomena including shareholders’ value, the size of stock markets, and financial crises (e.g. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998, 2000, 2001)). While these efforts have added to our understanding of the legal and institutional determinants of governance, they have focused largely on the regulation of corporate behavior (block holdings, proxy fights, board membership, the role of audit committees, and so on). How markets are affected by capital market regulations, and the vigor with which these regulations are enforced, is much less understood.
In this paper, we examine how capital market regulations and their enforcement might affect several key characteristics of equity markets. We focus on exchange-based (or market-related) regulations, and coin the term capital market governance (CMG) to describe this aspect of a country’s regulatory environment. Using detailed data collected from individual exchanges, we construct a composite CMG index that varies over time, thus reflecting inter temporal variations in the quality of market governance in each country. We then examine the relation between changes in the CMG index and changes in variables designed to capture important dimensions of market performance, including: the cost-of-capital (both implied and realized), trading volume, market depth, foreign ownership by U.S. investors, and price synchronicity.
Our study consists of two-stages. In the first stage, we use a unique data set gleaned from market regulators, exchange officials, and industry contacts, to construct a comprehensive index of capital market governance. Specifically, we exploit innovations developed in several recent studies to measure three dimensions of capital market governance: (1) a composite earning opacity measure, (2) insider trading laws and their enforcement, and (3) rules against short-selling. In the second stage of this project, we assess the impact of capital market governance on key market characteristics.
In an increasingly integrated global economy, interest in (and awareness of) good capital market regulation is on the rise. While presumption of the damaging effects of bad capital market governance is widespread, direct evidence on its economic consequences has been more difficult to document. Contributing to this problem is the elusive nature of governance. Because the quality of capital market governance may be associated with a number of other country-level phenomena, its direct impact on the performance of stock markets may be difficult to isolate.
Our paper tackles this empirical challenge in several ways. First, we carefully construct a composite measure of capital market governance. Securities laws cover a wide spectrum of areas, including the distribution of securities, takeovers, stock market manipulations, insider trading, stock exchanges, and the activities of financial intermediaries. Our CMG index incorporates three key aspects of these rules and regulations: earnings opacity, insider laws, and short-selling restrictions. We examine how each of these laws individually affects market performance, and we evaluate their combined effect using a CMG index.
Second, we focus on the practice and enforcement of governance rules, as opposed to their mere existence. Recent studies show that it is often not the existence of laws per se, but their enforcement, that matters to market participants (e.g., Bhattacharya, Daouk, Jorgenson and Kehr (2000), and Bhattacharya and Daouk (2002)). We examine the effect of the introduction and first actual enforcement, of exchange-related, or market based, regulations such as short selling prohibitions, earnings opacity, and prosecution by exchange commissions of illegal insider trading.
Third, the CMG index captures not only country-level variations, but also inter-temporal changes in a country’s securities laws. Our goal is to develop a timely metric that allows us to monitor improvements/declines in a country’s overall market governance mechanism. This approach lends considerably more power to our tests. In fact, by estimating most of our models with fixed country effects, our research design uses each country as its own control. We are thus able to isolate inter-temporal fluctuations in the CMG index, and evaluate the effect of changes in a country’s CMG index on changes in its cost-of-equity, market liquidity, and market depth over time.
Fourth, we assess the effect of capital market governance on a number of different market performance metrics. These metrics focus on what the investors demand for their returns (cost-of-equity), how much they trade (trading volume), the liquidity of the market (market depth), the efficiency of the price discovery process (price synchronicity), and how attractive each market is to U.S. investors (U.S. foreign stockholdings). In estimating changes in the cost-of-capital, we use both an implied approach based on discounted cash flows (Bekaert and Harvey (2000); Lee, Ng, and Swaminathan (2003))and an estimate based on a country’s average realized returns. The consistency of our results across different estimation methods adds to their interpretability.
Finally, our research design incorporates a number of additional control factors expected to explain cross-border differences in the cost-of-equity capital or market liquidity. Specifically, we adopt a version of the Bekaert and Harvey (1995) international asset pricing model to control for country level risk differences. We also control for the level of integration of a country with the global market, its exposure to foreign exchange risk, and the degree to which its markets are “liberalized” or open to foreigners (Bekaert and Harvey (2000)).
Our results show that after controlling for other factors, changes in the CMG index are reliably correlated with changes in all five market performance measures. Specifically, improvements in the CMG index are associated with economically significant decreases in the cost-of-equity capital (both implied and realized), as well as lower price synchronicity (suggesting increased price efficiency). While not all three components are individually significant in every regression specification, the directional inferences are always the same: improvements in earnings opacity, insider trading, and short-selling laws result in lower costs of capital and reduced price synchronicity.
In addition, we find that improvements in the CMG index are also positively correlated with three measures of market liquidity. Specifically, improved CMG is associated with increases in trading volume, market depth (i.e., volume divided by volatility), as well as the level of U.S. stockholdings (suggesting that countries with improving governance laws attract more U.S. investors). Once again, all three components of the CMG index contribute to these overall results. The directional inferences are consistent for the earnings opacity, insider trading, and short-selling variables, even when each is individually included in the same regression.
Overall, our findings support the view that improved capital market governance is associated with lower costs-of-equity capital, increased market liquidity, improved price efficiency, and increased stock ownership by U.S. investors. To the extent that these directional changes are deemed desirable, our results should be of interest to market regulators.
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