RACE TO THE TOP OR TO THE BOTTOM?
Trends in financial regulation
By Professor Arturo Bris (September, 2006)
In parallel with the current trend towards financial globalization, a single system of regulation is fast becoming de rigueur for an increasing number of countries.
This trend is primarily fueled by companies seeking to raise financing abroad, and secondly by investors wishing to diversify risk and find new investment opportunities in other markets.
While there are currently still many different systems out there, the US model is winning the race by several lengths, as much in China as in more developed economies. While, however, the US system has proved extremely useful as an export to other countries, there is no “one size fits all” solution.
In Europe, there is a very small percentage of shares held by minority shareholders, so consequently a system that protects them against top executives is not required. There is a greater need for a system that protects them against institutional investors.
Originated by international organizations, like the World Bank or the IMF, the late nineties was an interesting period of tremendous effort by regulators to deliver reform in all countries of the world.
And thanks to the positive spin offs that come with it, the dream of worldwide convergence to the US model, which has also resulted in a tremendous increase in diversification potential, is becoming a reality with blinding speed.
With convergence, countries like Brazil and Argentina that were not doing well in terms of diversification potential in the nineties, had completely turned around by 2001, by which time one could do as well by investing in Brazil as by investing in the US or the UK.
With regulation comes governance
With increased regulation, comes increased corporate governance. The cost of setting up and maintaining the accompanying internal controls, however, has resulted in certain companies packing up their US listings and moving home. Such was the case of the British TV station, ITV, in 2005. Still others, notably some as big as BMW or Samsung, refused for a long time to join the listing party and, when they did, elected not to list in the US. There are two very important factors that companies take into account when making a listing decision. Firstly – and possibly most importantly – is whether they need to list in a foreign market to use the new stock as acquisition currency.
Surprisingly, and despite the cost factor, one of the key arguments made in favor of listing in the US is precisely the commitment to a better system of corporate governance. In reality, despite the fact that Latin American firms are the ones who need to send their shareholders the message that they are complying with regulation, the latter in fact account for the minority of companies listed in the US. Almost three-quarters of all companies listed in the US are French, British or Scandinavian – and the ones that need compliance the least.
Traditionally, one of the main reasons for companies to list there is that in order to make an acquisition with stock in the US, the stock needs to be leased first. This is a legal requirement that companies cannot bypass. The cost of doing this is in compliance with a more stringent level of corporate governance, but the trade-off that companies have faced. Says Professor Bris, “In the US, you have 50 percent of the total world market for capitalization. If I want to expand globally, I need to go to the US market." Another reason for listing in the US might be the need for funds by companies so constrained in their home country that they need to raise funds in the US – either through equity, or through debt. In order to do this, they need to list in the US.
And finally, despite being constrained to comply with US corporate governance rules and regulations, an added attraction for foreign companies in the US is that they are not required to comply with local US insider trader regulations – providing a big advantage over their domestic competitors.
There’s no place like home
Should a refusal to list in the US because of regulation constitute a “red flag” for investors? Professor Bris doesn’t think so. Investors will generally not penalize companies because they don’t have a good corporate governance system in place, and good corporate governance is not necessarily synonymous with good performance.
Despite the trend of convergence to a single system of regulation, there will also always be room for small domestic exchanges. This is due, on the one hand, to many smaller companies not being able to afford the cost of going to a foreign market and, on the other, to national pride - or “local investor bias” - coming to the fore. Irrespective of the risk return profile of companies, investors will always tend to invest in firms that have the familiarity of home, although making patriotic assumptions can be misleading. Who, after all, would ever be able to tell that Volvo is not a Swedish company!
Professor Bris teaches on several IMD programs including the Strategic Finance, Managing Corporate Resources and MBA programs.