The Future of Domestic Capital Markets in Developing Countries

Chapter 6. Supervision at the Micro Level: Do Disclosure-Based Regimes Work?

 Supervision at the Micro Level: Do Disclosure-Based Regimes Work? 6 My background is as a former practitioner of regulation, now subject to regulation, rather than as an academic, but in recent years, since giving up the active practice of regulation, I have been fortunate to observe very closely capital market regimes in both developed and emerging markets . This experience has convinced me that disclosure-based regulation remains the preferred regulatory approach for developing markets to adopt as quickly as possible, despite the perceptions of its recent failings in developed markets. But developing markets do need to understand its full ramifications—namely, that the credible threat of enforcement is needed to ensure that such a system works—and that is the hard part. I do not claim that any of this is original thinking on my part. Consider the following quotation: Securities markets are the capital-raising vehicle of choice today for companies in both developed and developing countries. New markets are springing up around the globe as countries move towards market economies. Indeed, both as vehicles for governmentsponsored privatisation or simply as means for capital raising, the role of bank financing has been vastly overshadowed by the direct use of the securities markets.1   1. Mann (1993, p. 178). That was the then-head of international relations for the U.S. Securities and Exchange Commission (SEC), Michael Mann, speaking in 1993. The same approach was followed in many emerging markets through the rest of the 1990s, actively supported by the aid programs of governments and international financial institutions and by less formal aid from the securities commissions of the major markets, bilaterally or through the International Organization of Securities Commissions (IOSCO). But was bank financing effectively replaced, or did it even experience meaningful competition from the capital markets in that period? First, I look at some of the theory and recent practice of disclosure versus merits regulation in the fund-raising context in emerging markets and in my own market, Australia. I then note the recent loss of confidence in disclosure as a regulatory tool in other market contexts and its consequences . Finally, I address some of the difficulties that adoption of a pure disclosure model (if that were possible) might have in emerging markets in particular. Recent Experience with Disclosure Regulation in Fund-Raising and Some Theory Capital markets are critical to the future of developing countries, and their development, in turn, depends on a system of supervision that involves disclosure. A review of the Asian financial crisis sums up the position in these words:2 The relative immaturity of many East Asian capital markets contributed significantly to the financial crisis. Many enterprises relied on foreign borrowing, volatile foreign portfolio flows, and highly leveraged short-term bank loans. Therefore, strengthening Asia’s capital markets is important to prevent further financial crises and mobilise funds to assist sustainable recovery. Deeper capital markets also will improve investment efficiency and expand funds for longterm investment. Bank loans dominate financing in East Asia. . . . However, healthy capital markets are critical to sustain recovery. They reduce reliance on predominantly short-term local and foreign bank borrowing, as   2. Department of Foreign Affairs and Trade, East Asia Analytical Unit (1999, p. 103). primary equities and bonds markets allow issuers to raise long-term funding. . . . Secondary markets in equities and bonds also are important in allowing investors to restructure the maturity and level of their share and bond holdings. . . . Healthy secondary markets also will help keep East Asian capital in the region rather than encouraging its flow to highly liquid markets like the United States. . . . Welldeveloped capital markets also put competitive pressure on banks to cut their lending margins. . . . Over time, well-supervised capital markets can improve corporate governance and disclosure standards. This suggests that we need to look beyond the dominance of bank lending to the role played by international lending, but it does not address the question of what style of capital markets might be appropriate. I argue that well-supervised capital markets do not improve corporate governance and disclosure standards so much as require such improvement. Emerging markets might be tempted to abandon or delay their transition to a disclosure philosophy because “disclosure” has had a few troubled years—and certainly not just in the United States. Some of the difficult issues with disclosure were glossed over during the long bull market of the 1990s, as discussion of disclosure tended to...