The European Union (EU) enacted a series of regulations in the early 2000s to improve the financial markets of member states. While the new regulations were formally the same across the EU, member countries must individually implement, supervise, and enforce them. Our paper, recently published in the Review of Financial Studies and available here, uses this situation to estimate the causal effect of securities regulation on market liquidity and also to examine how prior conditions, implementation, and enforcement affect the results of new regulation.
In our study, we examined the liquidity effects of two EU directives on securities regulation. We focused on the Market Abuse Directive (MAD) and the Transparency Directive (TPD). The MAD aimed to address insider trading and market manipulation, while the TPD focused on supervising and enforcing corporate reporting and mandatory disclosure rules.
The goals for both directives were to give investors more and better information and harmonize regulation across the EU countries. These changes were predicted to increase market liquidity, which could in turn lower the cost of capital, raise market valuations, and create more efficient capital markets.
Our study finds that, on average, the MAD and TPD increased liquidity in European financial markets—each by around 10 percent relative to prior liquidity. Because trading costs fall as liquidity rises, we calculate that each directive led to trading cost savings of at least $130,000 to $430,000 a year for the more than 4,800 companies in the study’s sample. That represents an annual benefit of between 0.1 and 0.2 percent of market capitalization—a benefit that compounds over time and, hence, is economically significant.
Interestingly, however, some countries experienced significant improvements, while others had little to no liquidity benefits. Perhaps more surprisingly, a country’s regulatory history predicts these differences. That is, countries that have a history of higher regulatory quality and a better track record of implementing and enforcing rules saw liquidity rise more than 20 percent, double the EU-wide average. Countries with a weak track record saw virtually no liquidity benefits. The effects were also stronger in countries with stricter implementation and enforcement of the new EU directives, but again primarily in countries that already had shown higher regulatory quality in the past.
As a result, rather than lifting less liquid markets and thereby bringing markets more in line across European countries, the harmonization of regulations actually led to larger liquidity differences by making markets of already strong countries more liquid, while the markets in weaker countries stayed the same.
The findings pose a conundrum: What can countries with low regulatory quality in the past do to catch up? The results suggest that strict implementation and enforcement are not enough. Prior regulatory conditions matter. But then, how did the countries with high regulatory quality get to where they are? One potential explanation is that the same forces that limited the effectiveness of regulation in some countries in the past were still at work when the new EU rules on securities regulation were introduced. These forces could span a wide range of factors, including lack of institutional fit, resource constraints, political pressures, and inefficient bureaucracies.
These differences are not easily overcome by new regulation in an isolated area such as securities regulation. Instead they may require a concerted effort across several areas, because many elements of countries’ institutional infrastructures interact with each other. Put differently, to catch up, countries with low-quality prior regulation would have to make a series of coordinated institutional changes.
The insight that imposing the same regulation in countries with different prior regulatory conditions can result in countries drifting further apart is of great importance for the G20 and the European Commission, both of which have proposed regulatory reforms that essentially seek to strengthen and harmonize financial rules around the world and in Europe, respectively. History and countries’ prior institutional conditions matter greatly for regulatory outcomes and pose a major obstacle for regulatory harmonization. This finding suggests it will take more than a few isolated regulatory changes to align market conditions across the G20 and the EU.
Hans B. Christensen is an Associate Professor of Accounting and Christian Leuz, is the Joseph Sondheimer Professor of International Economics, Finance and Accounting, both at the University of Chicago’s Booth School of Business.
Luzi Hail is an Associate Professor of Accounting at the University of Pennsylvania’s Wharton School.
This is based on their recent paper, ”Capital-Market Effects of Securities Regulation: Prior Conditions, Implementation, and Enforcement,” available here. This post has also been published on the Columbia Law School Blue Sky Blog.