Abstract
The aim of this article is to investigate different types of supervisory approaches used in a number of financial markets, as well as their relation to market development. The focus is on certain major features of supervisory legislation. The supervisor's mandate, the enforcement arsenal, the level of supervisory independence and the number of regulatory powers given to the supervisor constitute the areas analysed. Financial market development, in turn, is perceived as the level of market growth, profitability (RoE), market values (P/E) and risk (beta/volatility). The markets investigated comprise banks, investment firms, investment fund companies and listed companies in the United States, United Kingdom, Sweden, Finland, Poland and Estonia during the years 1996–2005. Supervisory features are quantified and compared with financial market development using an ordinal correlation-based approach. The analysis suggests that there are distinctive differences between supervisory regimes. In addition, deviating from previous research results, certain regime features seem to correlate with financial market development. Strong legal obligations for the supervisor to develop legislation correlate significantly with higher company market values (better future prospects). Emphasizing economic aspects in the formulation of FSA objectives corresponds with higher market profitability. Furthermore, severe monetary sanctions applicable to company directors significantly (albeit negatively) correlate with market growth. Unexpectedly, the same is true for a high degree of supervisory independence. Although results call for further scientific support, they nevertheless add to the current debate on how the financial crisis should shape supervisory approaches. Thus far, G-20 measures have aimed to increase market stability and confidence, mainly by introducing new supervisory structures, more advanced reporting/enforcement procedures and better accounting standards. In this respect, the analysis calls for a certain degree of cautiousness. Depending on how supervision is made more stringent, effects on market development cannot be ruled out.
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References and Notes
Bagehot, W. (1873) Lombard Street. A Description of the Money Market. London: Smith, Elder, Reprint edition (1978). New York: Arno Press.
The tri-partite view on regulation in financial market research is easily identified in the introduction of La Porta, R. de Silanes, L. and Shleifer, S.A. (2006) What works in securities laws? Journal of Finance 61 (1): 1–32, whereas a corresponding general public economy perspective on regulation may be found in Polinsky, A. and Shavell, S. (2000) The economic theory of public enforcement of law. Journal of Economic Literature 37: 45–76 (the area of criminal law).
Rajan, R. and Zingales, L. (2003) The great reversals: The politics of financial development in the twentieth century. Journal of Financial Economics 69: 5–50.
Barth, J., Caprio, G. and Levine, R. (2004) The regulation and supervision of banks around the world –A new database. World Bank Policy Research Working Paper 13: 205–248, Considering how public interference in financial markets could/should be brought about, studies conducted also deal with the distinction between the various branches of government, that is, enforcement by the executive versus judiciary5.
Glaeser, E., Johnson, S. and Shleifer, A. (2001) Coase vs the Coasians. Quarterly Journal of Economics 116: 853–899.
For an example of such debates see Spamann, H. (2006) On the Insignificance and/or Endogeneity of La Porta & al's ‘Anti-Director Rights Index’ Under Consistent Coding. Harvard Law School Discussion Paper no. 7, revising ADRI results and introducing general guidelines for more consistent legislative coding.
In the article, financial market development is viewed in a manner building on Rajan, R. and Zingales, L. (2003) The great reversals: The politics of financial development in the twentieth century. Journal of Financial Economics 69: 5–50, Accordingly, the aspects of financial market development focused on link to ‘the ease with which borrowers and savers are brought together, and the confidence that they have in each other’. From such a perspective, company market values, for example, may be seen to signal a certain degree of confidence, and hence are included in the notion of financial market development.
The advantages of assessing legislation in relation to financial market development have also been acknowledged by, for example Beck, T. and Levine, R. (2003) Legal Institutions and Financial Development. Cambridge, MA. NBER Working Paper no. 10126: ‘An increasing number of legal scholars are emphasizing the importance of differences in legal traditions and structures in the form of investor protection laws, contract enforcement, and property rights when assessing financial development’. A similar development has appeared in the area of corporate law, resulting in a striving towards understanding of legal features of economic (and financial) relevance (see, for example, Djankov, S., La Porta, R., Lopez de Silanes, F. and Shleifer, A. (2001) The Regulation of Entry. Harvard Institute of Economic Research Paper no. 1904 and Kraakman et al (2004) The Anatomy of Corporate Law. A Comparative and Functional Approach. Oxford: Oxford University Press).
In addition, there is an extensive literature on the broader relation between financial/company law provisions and financial market development. In these studies, the main focus has been on rules regulating market participant activities more directly, rather than on rules on how supervisory authorities can/should act (see, for example, La Porta, R., Lopez de Silanes, F., Shleifer, A. and Vishny, R. (1997) Legal determinants of external finance. Journal of Finance 52: 1131–1150, Lele, P. and Siems, M. (2007) Shareholder protection: A leximetric approach. Journal of Corporate Law Studies 7: 17–50 and Armour, J., Deakin, S., Sarkar, P., Siems, M. and Singh, A. (2008) Shareholder Protection and Stock Market Development: An Empirical Test of the Legal Origins Hypothesis. ECGI Law Working Paper no. 108). Analysing the impact of legal origins on market development has constituted a major topic in these studies.
Barth, J., Caprio, G. and Levine, R. (2004) Bank regulation and supervision – What works best? Journal of Financial Intermediation 13: 205–248, For a review of the regime data see http://www.worldbank.org/research/projects/bank_regulation.htm.
In practice, this is not always the case. For example, the regulatory environment into which public enforcement measures are introduced may affect how keenly supervisors are able to address their tasks. Such knowledge interests (linking to a broader understanding of issues analysed) have been emphasized by a number of leading economists ( Pagano, M. and Volpin, P. (2001) The political economy of finance. Oxford Review of Economic Policy 17 (4): 502–519).
For an extensive overview of the relationship between public and private enforcement in the financial sector see Litan, R. Pomerleano, M. and Sundararajan, V. (eds.) (2002) Financial Sector Governance. The Roles of the Public and Private Sectors. Washington DC: The Brookings Institution.
Barth, J., Nolle, D., Phumiwasana, T. and Yago, G. (2002) A Cross-country Analysis of the Bank Supervisory Framework and Bank Performance. Economic and Policy Analysis Working Paper no. 2. For a review of the regime data see http://www.worldbank.org/research/projects/bank_regulation.htm.
In the comparison of public enforcement with bank profitability, BNPY builds on the work of Demirguc-Kunt, A. and Huizinga, H. (1999) Determinants of commercial bank interest margins and profitability: Some international evidence. The World Bank Economic Review 13 (2): 379–408, and Demirguc-Kunt, A. and Huizinga, H. (2000) Financial Structure and Bank Profitability. World Bank Policy Research Working Paper no. 2430. Bank profitability is measured as pre-tax profits divided by total assets, and control variables include certain bank-level variables, macroeconomic variables, and other country-specific variables relating to financial structure, banking industry structure and deposit insurance.
La Porta, R., Lopez de Silanes, F. and Shleifer, A. (2006) What works in securities laws? Journal of Finance 61 (1): 1–32.
For a review of the data see //post.economics.harvard.edu/faculty/shleifer/papers/securities/_data.xls.
Among the LLS financial market development variables, external market capitalization is defined as the average ratio of stock market capitalization held by small shareholders (as specified in La Porta, R. et al (1999) The quality of government. Journal of Law, Economics and Organization 15: 222–279) Control block premia are calculated taking the difference between the price per share paid for a control block and the exchange price (for a more detailed description see Dyck, A. and Zingales, L. (2004) Private benefits of control: An international comparison. Journal of Finance 59: 537–600), while the qualitative access to equity measure is an index of the extent to which business executives find it easy to raise stock capital Schwab, K., Porter, M., Sachs, J., Warner, A. and Levinson, M. (eds.) (1999) The Global Competitiveness Report 1999. New York: Oxford University Press. Ownership concentration corresponds to the degree of common shares not owned by the top three shareholders in the largest privately owned domestic firms in a given country.
Jackson, H. and Roe, M. (2009) Public and Private Enforcement of Securities Laws: Resource-Based Evidence. Cambridge, MA. Harvard University Law School Research Paper no. 4.
Courtis, N. (ed.) (2006, 2007) How Countries Supervise Their Banks, Insurers and Securities Markets. London: Central Banking Publications.
The lack of randomness as to this categorization naturally facilitates various biases. From a legislative viewpoint, Anglo-American countries are represented by a legal common-law tradition, Nordic countries by a Nordic legal tradition and European transition economies mostly by a continental European legislative culture, implying different views on how authorities should act. The possibility of such general legal features, or other societal aspects, coinciding with how financial markets develop in a broader sense cannot be foreseen.
Often, assessment of financial market supervision has implied a focus on the supervisor's de facto activities rather than de jure activities. The arguments for such an approach have been that de facto activities are usually empirically more valid, as they correspond to actual deeds, whereas de jure is ‘the law of the books’. However, in this study, the presupposition is that the national law reflects societal values, and these values are largely the same as those affecting the development of the country's financial markets, supporting a focus on de jure conditions.
For a broader theoretical concept regarding links between legislative environment types and economic conditions see Ogus, A. (1994) Regulation: Legal Form and Economic Theory. Oxford: Clarendon Press.
Though the idea of perceiving legislation as an attribute for general societal interests is widely accepted, it is also widely criticized. Citing Posner, R. (1974) Theories of economic regulation. The Bell Journal of Economics and Management Science 5 (2): 350 ‘… Turning to the empirical evidence bearing on the economic theory of regulation, there are a fair number of case studies … supporting the view that economic regulation is better explained as a product supplied by interest groups than as an expression of (more general) social interests’.
For example, in some countries the law establishes obligations for the supervisor to promote the introduction of new financial products. This is the case in the UK Financial Services and Markets Act 2000 (FSMA). It establishes a duty for the Financial Services Authority to ‘have regard to … the desirability of facilitating innovation … and the international character of financial services and markets and the desirability of maintaining the competitive position of the United Kingdom’.
As for perceptions of public supervision in previous empirical research, BCL and BNPY, focusing on the relationship among specific regulatory and supervisory practices and banking sector development, efficiency and fragility, do not discuss the formulation of supervisory objectives in a principal, value-appealing manner. The approach is more concrete, concentrating on the eventual existence of multiple supervisors and their area of responsibility. The interest in the formulation of supervisory objectives is also limited in LLS's treatment of IPOs, in which the focus is only on the coverage of the scope of the supervisor in relation to banking and securities markets (for further details see Appendix B). Neither BCL, BNPY nor LLS identifies any significant relationship among objective-related aspects of public supervision and financial market conditions.
Often, in financial market studies, enforcement is perceived in a traditional manner, such as in Berger, A. Kyle, M. and Scalise, J. (2001) Did US bank supervisors get tougher during the credit crunch. In: F. Mishkin (ed.) Prudential Supervision – What Works and What Doesn’t. National Bureau of Economic Research. Chicago: The University of Chicago Press, where the view on enforcement builds on the existing, widely acknowledged concept of the composite CAMELS-rating system and the powers linked to it.
In BCL, enforcement is mainly quantified through the Official Supervisory Power Index (OSPI) based on certain World Bank Guide questions on the FSA's relationship with banks’ management, shareholders and auditors and the Prompt Corrective Power Index (PCPI) determining whether the law establishes conditions that enforce automatic actions, such as interventions, in the case of solvency deterioration. In BNPY, public enforcement is narrowly defined as general banking sector forbearance discretion, on a 0–4 scale, while LLS enforcement distinguishes among investigative powers, administrative sanctions and criminal sanctions. Investigative powers are quantified through the Investigative Powers Index (IPI) equalling the arithmetic mean of the Document Index (DI) and the Witness Index (WI). The DI quantifies the right of the FSA to command documents in specific cases, whereas the WI deals with the right to subpoena the testimony of witnesses when investigating violations of securities laws. In the area of sanctions, the LLS approach is similarly bi-centric. The starting point for the Orders Index (ORDI) is the applicability of enforcement powers in the form of ‘stop and do’ orders to issuers, distributors and accountants. The second index, the Criminal Index (CI), focuses on criminal sanctions applicable in cases when prospectuses omit material information. Potential addressees are directors and key officers of the issuer, the distributor or its officers, and the accountant or its officers (see Appendix B).
The comparison signals a high degree of congruence despite the fact that the coverage of the indices is not fully identical, indicating that national characteristics are not limited to certain (narrow) parts of the country's enforcement legislation.
The supervisory literature reflects a keen interest in independence issues, for example, Quintyn, M. and Taylor, M. (2003) Regulatory and supervisory independence and financial stability. CESinfo Economic Studies (49): 259–294, identifies four dimensions of FSA independence, that is, regulatory, supervisory, institutional and budgetary. See also Hüpkes, E., Quintyn, M. and Taylor, M. (2005) The Accountability of Financial Market Supervisors: Principles and Practice. Washington, DC: IMF Working Paper no. 51.
BCL, BNPY and LLS all focus on supervisory independence. BCL considers the issue of operational independence for the supervisor as one official supervisory resource variable. Operational independence is defined as independence from political influence. In BNPY, the view on independence is similar to the one in BCL. LLS also considers independence as a variable of its own (see Appendix B).
LLS deals with this regulatory issue as a part of the Supervisor Characteristics Index (SCI). The index distinguishes between the situation in which the supervisor can issue IPO regulations without approval of other agencies, with approval and not even with approval (see Appendix B). BCL and BNPY do not deal with aspects relating to rule making.
The variables concretizing financial market development are included in the analysis partly as a result of assumed differences in their sensitivity as indicators of market development, supposing, for example, that differences in market values (P/E) emerge more easily than differences in profitability (RoE), the latter in turn eventually preceding changes in market growth. The approach potentially increases the sensitivity of the analysis, and thus also improves the preconditions for the identification of correlation between the legal variables and financial market development.
The reason for this broad coverage of financial market institutions is the aim of covering the most important types of players in the markets.
The judicial domicile of the parent/holding company is decisive in relation to the nationality of a group included in the sample, though some groups may have significant activities abroad.
In more detail, the figures for diachronic volatility for each listed market are determined by focusing on the yearly historical price volatility for each of the above-mentioned indexes for the years 1996–2005.
A quick look on the other correlations and their signs implies that market values and volatility may be lower in markets, where the FSA's mandate focuses on securing that companies obey the law. Also more generally, different and severe enforcement measures could link with limited increases in the number of market participants. Finally, wide FSA regulatory powers could link with higher company values and risk levels, as well as slower market growth.
Thirdly, one may not exclude the fact that market conditions of a specific character may induce requirements as to certain types of legislative reforms. In such situations, it is not the legislation that steers the markets, but markets that form the legislation. Proceeding further along these lines, in markets already characterized, for example, by high company market values (P/E), participants may actively try to promote rules that do not hinder future growth through innovation.
In BCL, BNPY and LLS the relationship between such value-oriented supervisory objectives and financial market development is not assessed.
Focusing on supervisory independence in BCL, BNPY and LLS, and on rule-making powers in LLS, no significant relationships as to financial market development were found.
For further conclusions on the impact of specific financial market legislation in transition economies see Pistor, K. Raiser, M. and Gelfer, S. (2000) Law and Finance in Transition Economies. Center for International Development at Harvard University. CID Working Paper no. 49.
Economics Focus, Jackson's holes, The Economist, 27 August 2009 and Mayes, D. and Wood, G. (2008) Lessons from the northern rock episode. Économie Internationale 114: 5–27.
Perceiving legal provisions as attributes for certain values, such values may, for example, comprise legislative restrictivity-permissibility, compulsiveness-supportiveness, statism-dynamism, utility orientation-risk aversiveness and directivity-adaptability. Viewing supervision as a power relation, such an approach directs the focus towards the categories of persons involved, that is, the supervisor and the supervised, and hence the balance of power. The relationship between the parties may, for example, be viewed as the degree of power-balance biasedness, the overall number of enforcement and accountability measures, the level of freedom in the application of supervisory measures (discretion/forbearance), and the various types of enforcement/accountability means. Finally, supervision may be viewed as an expression of fundamental structural conditions. These features may be more concrete/immediate and easily identifiable in supervisory arrangements (for example the structure or the financing of supervision), or may be general and have a broader impact on the shaping of supervision.
For examples, see, Carlin, W. and Mayer, C. (2003) Finance, investment and growth. Journal of Financial Economics 69 (1): 191–226, redefining structural country variables, as well as Djankov, S., McLiesh, C. and Ramalho, R. (2006) Regulation and growth. Economic Letters 92: (3) 395–401, though the approach in this latter study may be motivated by the fact that the features recognized have received stronger support in quality rankings.
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Other related indexes LLS characteristics of supervisor index (LLS, p. 7) equals the arithmetic mean of: (1)APP, (2)TEN, (3)FOCUS & (4)RUL=(US 1, UK 0.25, SWE 0,.25, FIN 0.5, POL NA, EST NA). LLS public enforcement index (LLS, p. 9) equals the arithmetic mean of: (1)characteristics of supervisor index, (2)IP, (3)ORD & (4)CRI=(US 0.87, UK 0.67, SWE 0.44, FIN 0.36, POL NA, EST NA).
Disclaimer The views expressed in this article are those of the author and do not necessarily reflect the views of the FIN-FSA or the Bank of Finland.
1has worked as an analyst and lawyer at the Finnish Financial Supervisory Authority (FIN-FSA) since 2002. He has been Adjunct Professor of Law at the Helsinki School of Economics since 2004, with a special focus on legislation evaluation. Previously, he was a researcher at the Bank of Finland and a national expert at the European Central Bank, and has held positions in the Finnish banking sector. His publications cover financial market legislation, in particular effects of regulation on the development and stability of markets, as well as rules relating to the handling of banking crises.
Appendices
APPENDIX A
Quantification of legal variables
NORMAT is an indicator of how strongly the aim of ensuring that markets obey the law appears in the legal formulations of FSA objectives in respective markets. NORMAT is more accurately defined as ‘The number of legally formulated FSA objectives aiming to ensure that supervised entities comply with the law and other regulations. The measure is relative, weighing the amount of normative elements with the amount of other objectives established in the respective national laws concerning FSA activities’. In the quantification, all objectives directing FSA activities are seen as being of three types: economic, financial or legally oriented. Economic objectives aim to enhance market efficiency, competition and/or market attractiveness/growth. Financial FSA objectives consider market stability, confidence, volatility and/or risk-levels, while legal FSA objectives deal with ensuring that supervised entities obey the law. In Table A1, the NORMAT scores for each country/market are listed using a 0–5 scale. References are made to those national laws covered by the assessment. The quantifications of REFORM and ECON VAL follow corresponding principles.
ENF WIDTH, takes account of the variety of legal enforcement means provided by the respective supervisory regimes. Administrative monetary sanctions (max. 2 points), prohibitions/injunctions (max. 2 points) and publicity-based informational sanctions (1 point) constitute the enforcement arsenal focused on. The imposition of a type of measure on company versus company individuals is viewed as two measures in the case of monetary sanctions and prohibitions/injunctions. As for administrative monetary sanctions, conditional fines are also considered. Hence, the existence of these tree types of sanctions applicable to these two groups of recipients in the legislation will add to the national sectoral score on the 0–5 scale (see Table A2).
The legal variable severity of monetary sanctions applicable to companies, SEV COMP, focuses on the maximum penalty that, according to the national legislation, may be issued to a bank, investment firm, investment fund company or listed company for any type of unlawful or similar activity. In countries where such legal limits are absent, a rough estimate of the actual level of the penalty imposed is made. The special features of conditional fines (that is their conditionality) has resulted in them not being considered in the data. The national scores are given according to the following (0–4) scale: 1 (EUR 1–4.999), 2 (EUR 5.000–99.999), 3 (EUR 100.000–499.999) and 4 (from EUR 500.000 onwards). The corresponding scale for the legal variable severity of monetary sanctions applicable to individual company representatives (directors and so on), SEV IND, is 1 (EUR 1–9.999), 2 (EUR 10.000–49.999), 3 (EUR 50.000–99.999) and 4 (from EUR 100.000 onwards).
Supervisory independence, INDEP, deals with the distance between the supervisor and politics. INDEP is quantified by focusing on the average of three dimensions with equal weight, that is, the allocation of the supervisor as part of the public sector (subordination or dependency) (1/3), the nomination of the supervisor's board members and the director general (localization of appointment powers) (1/3), and the removal of these persons (provisions on criteria) (1/3). As for the allocation of the supervisor, explicit autonomy or the central bank sphere are considered apolitical environments, whereas a supervisor being a part of a ministry is seen to reflect major political dependence. Nomination and removal of board members and director general by the country's formal leader and parliament are characterized as less political than nominations and removals made by other levels of government. Another decisive factor is the amount of discretion left to the decision-maker according to the law (when assessing nominations/removals). Here, national scores follow a 0–5 scale (see Table A3).
The last of the legal variables analysed is REG MAND, an indicator of the width of the supervisor's regulatory mandate (that is the number of regulatory powers). The assumption is that a wide mandate could improve regulatory financial market conditions and enhance market growth by enabling the supervisor/regulator to quickly respond to changing market conditions, for example product innovations. Here, the national legislation for each market is classified into five categories, taking into account changes in the mandate over time. The categories (national scores) are: unlimited (4), general (3), broad but specific (2), narrow and specific (1) and no (0) regulatory powers (see Table A4).
APPENDIX B
Comparison of regime variables
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Granlund, P. Supervisory approaches and financial market development: Some correlation-based evidence. J Bank Regul 11, 6–30 (2009). https://doi.org/10.1057/jbr.2009.13
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DOI: https://doi.org/10.1057/jbr.2009.13