The Benefits of Transparency

Regulators often justify new disclosure regulation by arguing that it reduces firms' cost of capital; until now, there has been little evidence to support this argument. Recent research examines how the effectiveness of a country's legal institutions and securities regulation is related to international differences in the cost of equity capital.

In response to the Asian financial crisis, the Enron scandal, and similar crises, regulators around the globe have pressed for stricter securities regulation. Regulators argue that increasing corporate transparency ultimately benefits firms, with one potential benefit being a lower cost of capital for firms. ("Cost of capital" is the compensation or return shareholders expect to receive for their investment.)

Although a link between strict disclosure regulation and firms' cost of capital seems intuitive, there has been little empirical research showing the benefits of disclosure regulation and increased transparency.

In the study "International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?", University of Chicago Graduate School of Business visiting professor Christian Leuz and Luzi Hail of the University of Pennsylvania's Wharton School address this void, investigating whether stricter disclosure regulation and stronger legal (and institutional) infrastructures offer tangible benefits to firms in 40 countries. The authors analyze differences in the cost of equity capital for these countries, with "equity capital" defined as the money invested by shareholders of the firm.

"If you want to improve the institutional infrastructure of a country or gauge the effectiveness of the existing infrastructure, the cost of capital is a natural place to look," says Leuz.

The cost of capital is important because it sets a "hurdle rate" for corporate investments; the minimum rate of return that investments must generate in order to be worthwhile. "Each economy has a limited number of projects capable of achieving a substantial return on investment," says Leuz. "If securities regulation can lower the cost of capital, then projects that were "marginal" beforehand will become worthwhile, which in turn should lead to higher economic growth for the country."

Leuz and Hail estimated the cost of capital from 1992 to 2001 for several thousand firms from 40 countries. The study is the first to analyze international cost of capital differences for such a large number of countries and to link them with cross-country differences in regulation mandating and enforcing corporate disclosure.

Comparisons between countries provide an opportunity to explore the relation between disclosure regulation and the cost of capital. However, isolating the effects of disclosure rules can be difficult, since international differences extend well beyond securities regulation. For instance, countries may also differ in their industry composition or the volatility of firms' economic activities, both of which can affect the cost of capital.

In their study, Leuz and Hail documented statistically and economically significant differences in the cost of equity capital between countries. The results indicate that a substantial portion of this variation can be explained by traditional indicators of firm risk (size, stock price volatility, and bookto- market ratio), and country factors, such as inflation or macroeconomic stability. These variables account for approximately 60 percent of country-level variation, and more than 35 percent of company-level variation in the cost of equity capital around the world.

After controlling for traditional measures of risk and differences between countries, the authors still found that the level of disclosure and securities regulation, as well as the \ overall quality of a country's legal system, was closely related to international differences in the cost of equity capital. Firms from countries with more extensive disclosure requirements, stronger securities regulation, and stricter enforcement mechanisms have a significantly lower cost of capital. Gauging the magnitude of the effect, they find that the cost of capital of firms in countries whose securities regulation ranks in the b o ttom quartile can be as much as 2 percentage points higher than the cost of capital of firms in countries whose securities regulation ranks in the top quartile.

The Link between Information and the Cost of Capital

"If investors have very little information on which to base their portfolio decisions, they will require a higher return on investment and hence impose a risk premium before investing in a firm," says Leuz. "It's this notion, albeit somewhat simplified, that links information and the cost of capital."

Securities regulation determines the minimum amount of information that firms must disclose to investors and the general public. When more information is available, investors are better able to estimate future benefits from their investments. Consequently, the cost of capital should be lower for firms in countries with tighter securities regulation.

However, rules alone are often ineffective without proper enforcement. Without legal systems enforcing the securities regulation, a company may have incentives to withhold or manipulate information, such as when that company's performance is poor. Effective securities regulation serves as a commitment device that requires firms to provide information in good times and bad, which in turn investors should reward with a lower required rate of return.

In order to measure the effectiveness of securities regulation, Leuz and Hail relied on prior research and constructed a series of proxies that captured the status of rules and regulations governing security issuance. The database included indices that accounted for several aspects of prospectus disclosure in securities offerings, the procedural difficulties in recovering losses from the issuer and its directors in civil liability cases, and the level of market supervision by the regulator and its investigative powers and sanctions.

The next step was to link these measures of disclosure regulation to the cost of capital. However, measuring the expected return on equity is far more challenging than measuring the yield on a loan or bond, which is governed by contracts that explicitly state required interest payments. To overcome these challenges, Leuz and Hail used a new methodology that allowed them to estimate the cost of capital that is implied in share prices and analyst forecasts. The authors plugged share price and analyst forecasts into four equity valuation models and then inverted them to obtain the cost of equity capital. For every year in the sample, Leuz and Hail took all firms in the economy with available data, computed the cost of capital for each firm, and then determined the average cost of capital per country and year.

Using this data, the authors found strong support for the hypothesis that both the effectiveness of securities regulation and the overall quality of a country's legal system is associated with a lower cost of equity capital.

To confirm their findings, the authors performed several additional analyses, including ruling out the influence of growth differences across countries. The authors measured the sensitivity of their results to different assumptions about long-run growth. They found that the influence of growth differences, while present, does not appear to be the main force behind their results. Additional analyses ruled out other factors, including equity market size, tax rates, and analyst forecast properties.

These results offer important insights to regulators about the potential benefits of securities regulation. They suggest that tight securities regulation manifest in firms' cost of capital. These benefits then have to be weighed against the costs of introducing and enforcing such regulations.

"Research like ours helps regulators understand how legal institutions affect capital markets and the economy as a whole," notes Leuz. "Understanding these effects puts regulators in a better position to evaluate changes to the rules."

The Role of Capital Market Integration

The effects of securities regulation on the cost of capital may depend on the extent to which a country's capital market is integrated with global capital markets. If markets are integrated, capital flows freely across markets and countries. However, many developing countries have segmented"rather than integrated" markets, with restricted capital flows between domestic investors and the rest of the world. In extreme examples, citizens only can invest in their own capital markets and foreigners cannot.

In such markets, investors are fully exposed to the weaknesses (or strengths) of their country's institutional infrastructure, suggesting that the cost-of-capital effects of the infrastructure should be more pronounced, compared to integrated markets. Put differently, if investors can invest freely in stocks around the world, it is easier for investors to find similar stocks from different countries. This diversification across firms from different countries reduces some of the risks facing an investor and the degree to which they are exposed to the quality of a country's institutional infrastructure. Consequently, capital market integration should mitigate the effect of securities regulation on firms' cost of capital.

To test this hypothesis, Leuz and Hail measured each country's level of capital market integration and found, consistent with theory, that the effects of strong regulation on the cost of capital are substantially smaller, and in many cases statistically insignificant, as capital markets become more globally integrated. Correspondingly, the estimated effects of disclosure regulation and related enforcement mechanisms are much larger in segmented markets.

Emerging Markets

The finding on capital market integration sends an important message to regulators. It implies that improved securities regulation and legal systems may not be a worthwhile investment for all economies. Leuz notes that their results may be most relevant to regulators in emerging and segmented markets, where improving the institutional infrastructure would have relatively larger benefits.

This conclusion is particularly interesting in light of the East Asian crisis of 1997-98 that many have blamed, at least to some ext e n t, on poor firm transparency and corporate governance. In the aftermath of the crisis, improved disclosure r e gulation has been a particular focus and many countries are considering tightening their securities regulation and moving towards equity-market oriented economies. Along the same lines, the Organization for Economic Cooperation and Development (OECD) has pushed for regulatory reforms to increase transparency and make information available to foreign investors and increase foreign investors rights. Recent OECD initiatives have focused on the role of international investment in economic development.

"The benefits of securities regulation are somewhat muted in highly integrated economies," notes Leuz. "For emerging market economies, however, the benefits of improved transparency can be substantial. Thus, improving the institutional infrastructure might be a sound investment and should be carefully evaluated."