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Home > Regulation Best Practice > Costs and Benefits of Accounting-Based Regulation in Emerging Capital Markets

Regulation Best Practice

Costs and Benefits of Accounting-Based Regulation in Emerging Capital Markets

by Wang Jiwei

Table of contents

Executive Summary

  • Securities regulation is vital to the development of an efficient capital market.

  • Accounting-based regulation embeds accounting numbers as a threshold.

  • There are both benefits and costs to accounting-based regulation.

  • The costs of accounting-based regulation include opportunistic behavior by management to manipulate accounting numbers, and capital resource misallocation.

  • The benefits of accounting-based regulation include the potential to mitigate resource misallocation by preventing poorly performing firms from entering the market and to avoid “adverse selection problems” by managers.

  • Recent Chinese regulations on rights offerings and seasoned equity offerings shed light on the costs and benefits of accounting-based regulation in emerging capital markets.

Introduction

One of the most controversial debates in economic policy is: Should governments intervene in or regulate capital markets? Pure free-marketeers believe that the “invisible hand” can correct all market failures. However, advocates of intervention characterize the regulation process as one in which government intervention corrects market failures and maximizes social welfare. In the case of regulating stock issuance after initial public offerings (IPO), governments in many countries adopt a “disclosure-based approach” with limited government regulation and intervention. No official approval is needed to issue additional shares as long as companies provide adequate disclosure. There is no accounting-based profitability threshold that the company has to meet before making the stock issuance. The rationale is that such thresholds create additional costs for investors.

Costs of Accounting-Based Regulation

In a world without transaction costs, parties will naturally achieve an efficient outcome without any form of intervention. Regulation, then, is only bound to worsen the outcome, at the very least by imposing undue costs. Under regulation, governments must devote tremendous resources of money and time to screen new entrants, thus reducing social welfare. The money and time could have been allocated to other government projects that would enhance social welfare. Applicants also incur costs related to compliance. When an accounting-based threshold is embedded in a regulation, there may be agency problems for investors, as explained in the following paragraph.

Regulations based on accounting numbers, such as a minimum return on equity (ROE) threshold, can provide incentives for contracting parties to manipulate accounting data opportunistically to meet these thresholds. The reason for corporate managers to commit this opportunistic behavior is that they believe it will be costly for regulators to “undo” such behavior. If a manager opportunistically manipulates accounting data to meet criteria for issuing additional shares to the public, this action will trigger inefficient allocation of capital resources and hence diminish the welfare of investors.

Benefits of Accounting-Based Regulation

In efficient capital markets, investors are sophisticated enough to weed out poorly performing firms. Hence there is no need for accounting-based regulations to gauge the performance of new entrants. However, situations in emerging markets may be different. In these emerging market environments, accounting-based regulation may bring benefits that exceed the costs. The following three points explain why accounting-based regulations may be needed in emerging markets.

  • Emerging markets are typically portrayed as inefficient. At the early stage of capital market development, investors do not have enough sophistication to screen the “good eggs” and “bad eggs” in the market.

  • Firms can manipulate the selling price of stocks at a big discount from the ongoing price. This large discount forces existing shareholders to purchase additional shares irrespective of a firm’s performance, as otherwise their ownership will be diluted.

  • There are severe “adverse selection problems” in emerging markets, especially by comparison to developed markets. That is managers, as insiders, know more than the market about the true value of the firm and have an incentive to issue additional shares when stock prices are overvalued.

These market failures cannot be automatically corrected by the market because the market per se is inefficient. Government should act as a “helping hand” and intervene by imposing accounting-based regulation. This regulation is used to help investors to distinguish good and bad firms on the market and can minimize adverse selection by managers. These benefits may exceed the costs associated with the misallocation of capital resources.

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Further reading

Book:

Articles:

  • Chen, Kevin C. W., and Jiwei Wang. “Accounting-based regulation in emerging markets: The case of China’s seasoned-equity offerings.” International Journal of Accounting 42:3 (2007): 221–236. Online at: dx.doi.org/10.1016/j.intacc.2007.06.001
  • Zingales, Luigi. “The future of securities regulation.” Chicago Booth School of Business Research paper no. 08-27 and FEEM Working paper no. 7.2009, 2009. Online at: ssrn.com/abstract=1319648

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