STANFORD GRADUATE SCHOOL OF BUSINESS -- There has been much discussion in corporate and regulatory circles about what and how much financial information firms should be forced to disclose. Market watchers have argued that strict disclosure laws lead to more efficient securities markets and reduce the cost of capital for corporations. So if it's such a good idea for the market, how come companies don't do it voluntarily? Why is regulation needed?
Stanford Business School professors Anat Admati and Paul Pfleiderer took a closer look at those questions after taking part in the School's Financial Research Initiative forum. Participants had engaged in a lively discussion about disclosure in the emerging markets, where firms face a higher cost of capital because they don't release enough information. Without more financials, investors simply aren't willing to buy stock at higher prices, market liquidity is low, and money for corporate expansion is more difficult to raise. Pfleiderer and Admati, who both are professors of finance and economics, decided to develop a model that would help assess the need for disclosure regulations.
Proponents of regulation often maintain that American companies have a relatively easy time raising money and enjoy a highly liquid stock market because the United States imposes fairly stringent disclosure laws. But many business people and some economists argue that there is no reason for the government to intervene because firms will take into account all of the benefits of disclosure and will determine the optimal amount to reveal based on the cost of disclosing. In other words, if a firm knows it will benefit, it will bear the cost in order to fetch a higher price for its stock. If the cost is too high, the firm won't disclose. "The idea is that I will reveal information up to the point where the cost will be equal to the savings that I get by selling the security at the higher price," says Pfleiderer, who is the William F. Sharpe Professor of Financial Economics.
Admati and Pfleiderer claim that this argument for leaving disclosure decisions to firms ignores the fact that information in modern financial markets has spillover effects. Information disclosed by one firm is often useful in valuing another. An example of this can be found in the pricing of stock in initial public offerings. The initial stock price is often based on information available about similar stocks already trading. The more information other firms release, the easier it is to price a new one. But there's little incentive for companies to release information that will help others. "We get underproduction of information because I don't get paid for the benefit I'm creating for someone else," says Pfleiderer. "This spillover effect leads to a potential justification for a government to regulate and force disclosure."
Admati and Pfleiderer believe they have developed the first economic model to analyze the potential benefits of regulation when spillovers are present. While their work reveals that there are good reasons for regulation, they find that the regulation must be finetuned to work effectively. The amount of information a firm should release is a complex function of its cost and its relation to other firms. A slight change in the cost structure or degree of correlation among firm values can create major changes in the amount of information that should be released. Given that complexity, coming up with the right rules will be a challenge. The coauthors conclude it is unlikely that a uniform regulation across all industries or countries would work and it could even make things worse than no regulation at all. "It's going to be difficult to get it right," says Pfleiderer.
For more information, contact Barbara Buell at [email protected] or 650 723-3157
11/2/98
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