An Agency Theory of Securities Regulation: A Note

Chaamjamal, Thailand 

1. In presenting the history of securities regulation we examine the rise of credit and equity financing in pre-industrial Europe and trace the evolution of regulation from the Bubble Act of 1720 through the market break of 1929 and the formation of the SEC, to the present day issues with regard to financial innovations, computerization of trading, globalization of capital markets and operational risks in emerging markets.
2. Modern finance theory is wanting a coherent theory of regulation. Scholarly work on the theory of regulation forwarded by Bennett, Bentson, Friend, Kripke, Loss, Mann, Merton Miller, Rosen, Seligman, Stigler, and others during a 30-year period (1964 to 1994) address different aspects of regulation and their theories are in conflict.
3. Much of the theoretical debate has been in the form of for and against regulation. For example, Stigler and his supporters are against regulation because, they argue, disclosure requirements impose unnecessary costs on corporations. According to this view, "disclosure increases share prices" and since managers pay is tied to firm performance it is in the self interest of managers to disclose anyway without the need for externally imposed regulation. Friend and others dispute this view and argue for regulation. They contend that "it is precisely because" of the managers self-interest in high share prices that he is likely to withhold adverse information or exaggerate positive information. Similar debates (for or against) exist for other forms of regulation such as anti-trust laws, the control of insider trades and SEC rules concerning the behavior of brokers, the operation of exchanges and new issue offereings by corporations.
4. The purpose of regulation itself is embroiled in controversy. Why does securities regulation exist? Is it to protect the individual investor? from whom? Or is it to preserve capital markets? Or to assist corporations in raising capital? In our analysis we consider all forms of regulation including uniform accounting methods, NASD and exchange internal regulations, and externally imposed regulation by legislation and we argue that regulation exists for all of these reasons. We support the argument by building a coherent model of regulation using the cost of capital to corporations in the aggregate economy as the operational variable. We then define a term called the `agency cost of capital formation and show that regulation influences the cost of capital (and therefore the wealth of the economy) by acting through this variable. Rather than argue for or against regulation our theoretical model sets the framework for an optimal level of regulation.
5. We contend that the agency cost of capital formation is a significant portion of the cost of capital to corporations. A well designed regulatory structure is necessary to reach an optimal balance between monitoring costs imposed by regulation and the reduction in agency costs achieved by regulation. In the absence of regulation, wealth transfers between shareholder, debtholders, and management may occur that drive investors from the market; and prices are not optimal and do not allocate capital efficiently. Because of the added risk investors demand additional returns. The result is an increased cost of capital to corporations, and less overall investment in productive assets. Excessive and inappropriate regulation are associated with high monitoring costs to corporations because they limit the ability of the market to attract new capital, to provide liquidity to investors, or to allow corporations to utilize the market to finance new projects.