Recent securities regulation, like Sarbanes-Oxley and Dodd-Frank, has been criticized for taking a costly one-size-fits-all approach. The critics suggest that, instead, regulation tailored to different firms, industries, or sectors is beneficial as it reduces compliance costs and the costs that arise from constraining firms’ operating and financing choices. In our paper, The Merits of One-Size-Fits-All Securities Regulation, which was recently posted on SSRN, we develop an analytical model to highlight indirect effects caused by choosing an individualized or generalized regulatory regime.
Securities regulation is enacted to reduce the potential for managers to extract rents from their firm’s investors. We model a regulatory agency that is in charge of securities regulation and can be influenced by two groups: investors and managers. Managers can reduce the extent of regulation by lobbying the agency, which helps them maintain their ability to extract rents. The existence of rents, however, reduces the payouts from firms to investors and this translates into negative political consequences for the regulator. The regulatory agency chooses the quality of securities regulation taking into consideration both the firms’ lobbying and investors’ interests. Our model of an economy with two firms can be interpreted as a multi-industry or multi-sector economy where each firm represents an industry or sector. We compare two regulatory regimes, one in which the regulator is constrained to define a general regulatory quality for both firms or industries (the one-size-fits-all approach) and one where the agency may set different regulation for different firms.
To our knowledge, we are the first to compare the two regimes. Clearly a one-size-fits-all approach is costly because it forces homogeneous behavior on heterogeneous firms. Individualized regulation, on the other hand, leads to a multiplication of efforts because it forces investors and regulators to adjust to different types of regulation. While we believe that these are important factors, their implications are straightforward and they are not the only factors relevant to the debate. Specifically, aside from causing direct costs and benefits, the regulatory regime affects the strategic interaction among firms. Our model highlights such an effect by investigating managerial lobbying to secure rents. With this emphasis, we identify a novel effect relevant to the debate on securities regulation.
The lobbying we focus on is a socially wasteful activity that increases managers’ opportunities for diverting cash flows. In this setting, our main finding is that constraining the agency to define equal regulation for both firms limits managerial lobbying and, therefore, leads to greater welfare. Intuitively, the reduction in lobbying results because when all firms face the same regulation, there is an externality related to lobbying effort resulting from the fact that each firm’s lobbying directly affects the regulation that both firms face. Both firms hold back on their lobbying efforts to not crowd out the other firm’s efforts. Since lobbying is costly to the economy, it is welfare-decreasing and the economy benefits from free riding on lobbying. This result extends to the literature on lobbying for trade protections or subsidies (e.g., Grossman and Helpman 1994, “Protection for sale” in American Economic Review 84, 833-850) where lobbying is beneficial for a firm’s own investors but is detrimental to the economy as a whole.
Our reduced-form model of securities regulation and lobbying yields two primary contributions. First, we provide a novel counter-argument to the claim that individual regulation is generally preferable, based on political economy in general and managers’ pro-diversion lobbying activities in particular. This is not meant to suggest that the one-size-fits-all approach unambiguously dominates individualized regulation. In fact, in an extension to our basic model, we discuss how direct benefits of individualized regulation can outweigh its lobbying related costs. As a second contribution, we generate several empirically testable claims that relate securities regulation and lobbying to investors’ political participation and both product-market and capital-market interactions between firms. For example, we show that when the agency problem is more severe, managers have a stronger incentive to lobby the regulator, exacerbating the free-rider problem between managers and, therefore, increasing the benefit of the one-size-fits-all approach in curtailing lobbying. Furthermore, we show that the effect of one firm’s reported performance on the market value of the other firm tends to decrease in the severity of the agency conflict.
The full paper is available for download here.