Capital conundrum: maintaining the risk-reward balance in twenty-first century capital markets

Citation

Gentle, C. (2006), "Capital conundrum: maintaining the risk-reward balance in twenty-first century capital markets", Journal of Risk Finance, Vol. 7 No. 3. https://doi.org/10.1108/jrf.2006.29407caf.001

Capital conundrum: maintaining the risk-reward balance in twenty-first century capital markets

Capital conundrum: maintaining the risk-reward balance in twenty-first century capital markets

Risk and reward is the engine of capital markets. The last two decades have seen an unprecedented growth of the world’s money markets. In recent years the extraordinary increase of new asset classes such as hedge funds, private equity and credit derivatives have fuelled capital market expansion. This shifting centre of gravity raises significant questions about the future efficient and effective operation of financial markets.

Perhaps the most significant challenge faces regulatory authorities. The dynamism of twenty first century capital markets poses a challenge for regulators about how to rapidly allocate resources and people across investment activities. This conundrum is likely to grow rather than decline, requiring all stakeholders in capital markets – from auditors to investors – to play their role in making regulation more adaptable.

The key points that will drive this debate in future will include the following five items.

(1) Big is not always best: differences in regulation are eclipsing economies of scale in determining the competitiveness of markets

For all the talk of globalization and global markets, it can be easy to forget that the world’s capital markets remain largely tied to specific locations and financial instruments. What globalization has brought, though, is an increase in cross-border capital flows. As a result, different markets, based around different instruments and geographies, are increasingly competing for capital.

The relative success of different markets is driven by a number of factors, including innovation, the ability to satisfy a wide range of stakeholders, the level of competition from other markets, and regulation, especially listing rules and corporate governance regulations. Despite the presence of significant economies of scale, some smaller markets have thrived at the expense of larger markets. One of the reasons for this is the presence of regulatory imbalances: in recent years the largest markets have become among the most heavily regulated.

Regulators have an important impact on all participants in markets through, for example, protecting investors, improving confidence, and reducing financial crime. However, achieving the right balance between over-regulation and under-regulation is difficult, particularly as markets evolve rapidly. Many feel that the pendulum has swung too far in recent years. Compliance can be so burdensome that some companies have been deterred from listing on the largest markets: foreign companies have had second thoughts about listing on the New York Stock Exchange, and the number of companies listed on the London Stock Exchange’s main market has fallen by a third since 1997.

(2) Diminishing returns: increasing levels of regulation can be a drag on economic growth

The reasons for introducing new layers of regulation – particularly in the wake of the corporate collapses seen at the turn of the century – are understandable, but the benefits are not always clear. Full comparisons of the costs and benefits of regulations are notoriously difficult, though analysis suggests that whilst greater regulation in developing economies brings clear benefits in terms of a lower cost of equity, in developed economies there is little clear relationship between the cost of equity and heavier regulation. Indeed, the cost of equity in larger, more liquid markets is often little different from smaller markets. This is not to say that incremental regulation is bad, but if the purpose is purely to reduce the cost of capital, it may be ineffective. In these instances, the onus ought to be on regulators and policy makers to demonstrate comprehensively why new regulations should be introduced. An important challenge for regulators and policy makers is to regulate effectively whilst minimizing the cost of capital.

(3) Bringing the outside in: how regulators are aligning with other stakeholders

Recent developments in corporate governance have done much to improve the way companies are run and enhanced value. Nevertheless, there are times when regulators and investors sometimes appear to be misaligned: for example, the stock market performance of companies found to have a Sarbanes-Oxley Section 404 “material weakness” has been shown to be little different from the rest of the market, suggesting that in this instance investors pay little heed to regulators’ concerns. In addition, regulators and policy makers rarely have an overview of the multiplicity of regulations that affect investors and other stakeholders: quite naturally they focus on the specific instruments and geographies for which they are responsible. However, the result is that investors and other market participants are left to pick their way through a landscape of regulations that can be overlapping or inconsistent, and to cope with implications that may be unforeseen, particularly if they fall outside the regulators’ own borders. We are beginning to see evidence that this situation is changing – regulators and policy makers are talking more and more with their counterparts in other markets.

(4) Shifting centers of gravity: regulatory challenges arising from the emergence of new asset classes and investment vehicles

As markets evolve, new types of financial instruments and investment vehicles have come to the fore. In the last few years, for example, hedge funds have grown spectacularly to the extent that they now account for up to 50 per cent of turnover on the London and New York Stock Exchanges. Yet hedge funds and instruments such as derivatives are lightly regulated, despite representing potential sources of significant systemic risk, given their complexity. Financial regulators and policy makers not only need to be agile to keep with the level of market evolution, but make strategic decisions about the appropriate relative level of regulation across different investment types. Within this context, issues around attracting talent and allocating regulatory resources are increasingly important.

(5) The end of the beginning: developing a wider debate on the role of regulation in capital markets

It is common to hear complaints about regulators. However, these are often unfair: for example, in many cases regulators are merely responding to objectives set by others. In addition, the responsibility for running capital markets lies with a wide range of bodies.

Nevertheless, the confluence of increasing levels of cross-border capital flows, the ever-faster evolution of economic instruments and the fragmentation of investment vehicles mean that capital market regulators and policy makers will face greater pressures in the future. We are coming to the end of the age when inwardly focused national and regional regulators provide the best oversight for the world’s markets. International harmonization of regulations is one way to address this, but full harmonization will never be achieved, partly because of practical difficulties and also because of the strategic opportunities open to countries that adopt different regulatory practices. As a result, regulatory imbalances will be here to stay, whether we like it or not.

A major challenge for regulators and policy makers will be to balance multiple goals such as protecting investors, enabling international economic growth and enhancing national competitiveness in a regulatory landscape in which their control could overlap with many other regulators.

Within this context, regulators and policy makers will need to address a range of difficult questions. For example:

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  How should the dynamics of competition and co-operation between different markets be managed to optimize wealth creation?

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  How should regulators best measure the costs and benefits of regulation, particularly across different geographies and market types?

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  How should the systemic risks arising from regulatory imbalances best be managed?

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  How should regulatory resources be best allocated in the light of rapidly evolving markets?

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  How can the needs of widely divergent segments of investors and borrowers best be served by regulation: should different types of investors be subject to radically different regulations?

Chris Gentle