TCS Daily

The Super Market

By Lynne Kiesling - July 31, 2002 12:00 AM

In an environment of congratulatory back-slapping in Washington Tuesday morning, President Bush signed a new piece of legislation designed to reduce corporate accounting fraud and reward companies and CEOs who are transparent and above reproach. The problem is that market processes are already doing exactly that, and legislative and political responses have, as usual, lagged market-based responses to revelations of alleged accounting fraud.

These market processes, grounded in existing rules regarding financial disclosure, are sending loud and clear messages to companies - investors are watching and scrutinizing corporate actions much more than we did over the past five years.

Most observers agree that transparency of and accountability for corporate financial results are the core outcomes that these political responses are supposed to create. But political responses -- either through increased regulation, new legislation, or both -- are static and slow-moving responses to the desire for these outcomes. In fact, capital markets have been moving us, very quickly, toward these outcomes. What is the mechanism? Stock prices.

Enron's unprecedented demise and the ensuing flood of corporate bankruptcies and earnings restatements indicate that free markets ultimately reward transparency. Expectations of future profit are the mechanism by which this reward exists. Companies that display more financial transparency -- and particularly those that couple transparency with entrepreneurship -- are better able to attract investors and their capital over the long run. Companies lacking transparency may earn short-run profits, but in competitive markets those profits get squeezed, and investors respond to undisclosed business dealings by moving their money elsewhere. The truth will eventually come out in functioning markets because markets are mechanisms for the transmission of information. Note how investors have been selling stocks in the past few months; those sales show how markets enable investors and companies to act on expectations. Better to avoid the market comeuppance by providing transparency in the first place - market enforcement of financial transparency works through expectations and deterrence to change future company behavior.

Oversight Agencies

One important aspect of our functioning financial markets has been the stable and not generally intrusive regulatory oversight of the Securities and Exchange Commission. Clearly, the existing SEC regulations encourage transaction transparency. But doesn't such a colossal failure of transparency show that financial markets need more regulation? No. Companies with questionable financial accounting have been punished for their lack of oversight, as H. L. Mencken said, good and hard.

Last summer, as soon as the SEC's investigation of Enron became public knowledge, its stock price started to drop, well before any Congressional hearings commenced. Institutional investors who are accountable to both their companies and their shareholders for the returns they generate are typically the first to vacate stocks that begin to look fishy. To attract further capital investment and get those investors to return, a company has to present valid, verifiable evidence that its numbers are legit. Enron could not do that; nor could Worldcom, Adelphia, Tyco, ImClone, Qwest, and a handful of energy companies.

Private Institutions

Another part of the monitoring web is the for-profit private institutions, like the NYSE, NASDAQ, and the bond-rating agencies. Such information and reputation transmission institutions can move markets. Especially for bond-rating companies, it is in their profit-making interest to bring to light any transparency and debt structure problems of publicly-traded companies - that's what investors pay them for. It is the bedrock of their reputation for providing quality information to market participants.

Publicly-traded firms rely on such information mechanisms to transmit their reputations to potential investors and creditors, and investors find that rating institutions help them manage their risk and maximize the returns on their investments. Of course, consumers also benefit from the fact that bond-rating firms reduce transaction costs in financial markets and investment, because enabling investment to occur more seamlessly brings more innovative products, services and opportunities to consumers. Thus free markets provide an information mechanism that benefits all parties in the long run and encourages companies to focus on the long-run benefits of financial transparency. These private institutions did not deter all fraud, but that does not mean that these institutions failed; in fact, 100 percent deterrence would probably be prohibitively expensive. These private institutions have learned -- again good and hard -- that they have to engage in more scrutiny to deter more of such problems.

Investors Punish

What matters is what investors believe, and how they act on those beliefs. Prices communicate valuable private knowledge (like how much a given investor believes a company's financial statements) to a wider audience, and induce companies to take those beliefs into account. That's effective regulation, and it happens more quickly and more flexibly than legislated approaches.

Market processes are all about the transmission of information, learning from that process, and seizing opportunities to create value. The behavior of stock markets in the past nine months indicates that investors are learning, companies are discovering that unless their financials are spotless their share prices will fall if there is any skepticism about how they got their results

Over the long run, such free market punishments serve as deterrents to other firms who would keep their records so opaque. Investors and equity analysts learn from incidents like this, and incorporate that learning into their expectations of transparency and profitability from future potential investments. SEC investigations, customer exodus, and debt downgrades get captured in stock prices, which also gives investors incentives before the fact to encourage managerial oversight, board of directors oversight, and financial transparency.

Regulated transparency would not benefit companies, investors and consumers to the extent that the existing market mechanisms do. Imposing further regulated transparency beyond existing SEC regulations would weaken the network of private incentives that generate long-run efficiency through communicating information among firms, investors and consumers about their ideas, costs and resources. This web of private and public monitoring underpins the most liquid and profitable stock market in the world. We should not let legislation undermine these market processes.

Lynne Kiesling is Director of Economic Policy at Reason Public Policy Institute and Senior Lecturer of Economics at Northwestern University.

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