Regulation For the Sake of All Stakeholders

(Editor’s note: This post forms part of the month-long HBR Debate, “Finance: The Way Forward.” It is the third post on this week’s topic: “Who is regulation for — the individual or society?”)

Who is regulation for? This is a question that always intrigued me ever since I got involved in my research passion: share buybacks. Although American companies repurchased shares for hundreds of billions of dollars in the eighties and nineties, buybacks were basically illegal in many European countries such as Germany until 1998, in spite of the fact that research on U.S. data showed (and still shows) that buybacks are, on average, good for stock prices.

The stated motivation against buybacks was that it is a form of market manipulation and insider trading and the public should be protected against this socially irresponsible activity. Now, the interesting fact is that this reasoning suddenly was abandoned in 1998 when buybacks became legal in Germany and France. As a result repurchases have become popular outside the U.S. as well.

What were the driving forces behind the regulation and the change? I cannot imagine that the public at large cared about regulating or de-regulating buybacks. A more plausible explanation is that regulation and deregulation is a result of pressure brought to bear by small, but well organised special interest groups.

In the case of buybacks, the different regulatory regimes were consistent with the relative power and incentives of various stakeholders. While buybacks benefit shareholders, they are typically disliked by other stakeholders. Managers don’t like to return cash to investors as most empirical evidence shows a strong positive correlation between CEO compensation and firm size, which creates a strong demand for using excess cash for investments and mergers and acquisitions. Bondholders obviously don’t like buybacks as it increases the default risk of the company and for slightly similar reasons workers prefer that the company uses the cash to create more jobs or increase salaries.

The fact that in Germany banks and labor union representatives sit on corporate Boards created a united anti-buyback front in Germany. In countries with an Anglo-Saxon corporate governance system (such as the UK) where Boards and managers have a fiduciary duty to maximize shareholder value and are compensated with stock options and stock grants, buybacks were legal.

What created regulatory change? I believe the main trigger was the adoption of stock option compensation plans for both managers and employees. Evidence from U.S. studies shows that the adoption of stock option plans is strongly positively correlated with the adoption of buyback programs. A repurchase can prevent the dilution of control by the increase in the numbers of shares issued as a result of option exercise; it also becomes a more desirable payout mechanism than dividend payments as when a dividend is paid the stock price falls with the dividend per share on the ex-dividend day. So managers and other employees became changed their views accordingly.

So what does this tell us about banking regulation, which is usually designed not in the interests of shareholders and managers (bankers), but to protect debt holders, or to those who protect the debt holders (depositors) against default: the government (i.e. the tax payer)?

In order to protect debt holders the regulator imposes minimum capital requirements and restricts the riskiness of a bank’s assets. As these restrictions are perceived as going against the interests of managers (bankers) and shareholders they create a large incentive to get around them through regulatory arbitrage. Tens of thousands of regulators are involved in regulating the banking industry around the world and nevertheless we have ended up in the largest financial crisis since 1930. In spite of this regulatory failure the answer to the crisis seems to be: more of the same, i.e. regulatory proposals that are generally perceived against the interest of the banks, which will create a massive lobbying effort to undo the costly aspects of it, or get around it afterwards.

I believe that what is needed is a regulatory framework that is perceived to be in the best interests of shareholders as well as bondholders, i.e., in the interest of maximizing overall firm value, rather than either equity value or bondholder value.

This requires convincing banks that more leverage is not always better. The theory of finance would argue that the main advantage of debt is the tax deductibility of interest. So one remedy would be simply to abolish the tax deductibility of interest or, alternatively, allow the cost of equity to be tax deductible (as is currently the case in Belgium).

Banks could also be encouraged to finance themselves with debt instruments that reduce the costs of financial distress. One such instrument is the “coco” bonds, debt that converts automatically into equity whenever the debt/equity ratio falls below a certain level. Using these instruments could in theory eliminate the need for taxpayer bailouts.

Regulation that incorporated measures like these would, I submit, be a more sustainable regulatory solution than the current more antagonistic approaches that seem to favor one interest group over the others.

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