The Need for Both Strong Regulators and Strong Laws

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday June 1, 2012 at 9:25 am
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Editor’s Note: The following paper comes to us from Mark Humphery-Jenner of the Australian School of Business at the University of New South Wales.

In the paper, The Need for Both Strong Regulators and Strong Laws: Evidence from a Natural Experiment, which was recently made publicly available on SSRN, I analyze whether strong law is effective in the presence of weak regulatory institutions. This is a live-issue for policy setters as they attempt to reform the financial system to prevent future market misconduct. This has become particularly relevant as the EU has attempted to reform securities laws under the Markets in Financial Instruments Directive (MiFID), and the regulation of financial markets in the US has sustained recent criticism. I use a difference-in-difference methodology to disentangle the effects of the design of news laws from their actual implementation, and I find that strong law in the presence of weak regulations might actually worsen market conditions. This provides additional empirical support for the prediction in Bhattacharya and Daouk (2009) that ‘no law’ can sometimes be better than ‘good law’. This also suggests that empirical law and finance work should carefully distinguish between the mere presence of laws, and their enforcement.

Market manipulation is a key problem in China’s securities markets. One key type of market manipulation is manipulation by issuing ‘false statements’ that inflate (or deflate) stock prices. A key remedy for such false statements is a ‘Shareholder Class Action’. In 2001, their prevalence and subsequent consumption of court time induced China’s Supreme People’s Court to refuse to hear market manipulation cases. Subsequently, on 9 January 2003, China’s Supreme People’s Court (SPC) promulgated a guideline judgment that made principled legal reforms to compensation for market manipulation. The judgment has equivalent status to legislation. There were no reforms to the regulatory institutions. This problem was amplified because regulatory approval was still necessary in order for shareholders to pursue a class action. Thus, while the law became stronger, it was still difficult for shareholders or regulators to enforce it. The prevalence of market manipulation coupled with the presence of strong law and weak regulation provides a natural experiment in which to test the impact of good law in the absence of good regulation. This enables me to disentangle the effects of regulatory strength and legal strength.

China has responded to the significant market manipulation by passing principled laws to reduce it, yet has not implemented a strong enforcement framework. China has strong laws on market manipulation by false statements. China’s Supreme People’s Court (SPC) issued a guideline-type judgment on 9 January 2003 vis-à-vis private remedies for market manipulation by false statements. The rules are well thought-out, are clear, and provide principled guidance on how to establish on causation, remoteness, and mitigation. However, China has a poor reputation for securities law enforcement. China’s regulatory regime did not change following the legal change.

This paper uses the promulgation of strong false statement regulations on 9 January 2003 as a natural experiment with which to answer the question: Is good law a sufficient to improve market behavior in the absence of good regulation? I examine whether the law-reform improved the financial environment by reducing the presence of informed trade, the adverse selection component of the bid-ask spread, and the absolute order imbalance. This is based on two streams of literature. First, the legal environment can influence market microstructure and trading behavior. Second, improved disclosure can influence the firm’s information environment, as proxied by microstructure measures of information asymmetry and informed trade, and by the firm’s cost of capital. This implies that a way to test the efficacy of law reform is to test whether it improved the firm’s information environment, as proxied by intraday measures of informed trade and information asymmetry.

I test the impact of the SPC’s 9 January interpretation by using a difference-in-difference approach. The treatment sample is the set of firms that listed on the Shanghai or Shenzhen stock exchange. The control sample comprises firms listed on the Hong Kong stock exchange, Taiwan stock exchange, or Korean stock exchange (KOSDAQ). I ensure robustness to violations of the parallel trend assumption by using a propensity score radius-matching type approach and by examining various control sample compositions.

The results show that the SPC’s interpretation did not reduce informed trade. Instead, the results suggest that informed trade, as proxied by PIN and the absolute order imbalance, increased following the SPC’s interpretation. This implies that absent a strong regulatory framework, good law is not sufficient to improve the economic environment.

These results make a key contribution to the literature. First, this is the first paper to my knowledge to directly examine the impact of a strong legal change that is absent a strong regulatory environment. Thus, the paper is the first to directly show the importance of a strong regulatory environment to ensuring the implementation of a strong legal environment. Second, for policy setters, this shows that legal reform is unhelpful absent regulatory reform. Thus, the results show that institutions matter as much as laws matter. Third, for China, this illustrates that part of the reason for the failure of good laws to prevent market misconduct is the absence of a strong regulatory environment.

The full paper is available for download here.

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