Tuesday, March 20, 2012

Under Japanese model, repealing disclosure laws seems reasonable

One of the consequences of pursuing the Japanese models for handling a bank solvency led financial crisis is policymakers and financial regulators get comfortable with the idea that it is acceptable for banks to hide losses on and off their balance sheets.

It is a small step from this act of deception to the idea that maybe disclosure isn't needed for other firms.

With this small step, policymakers begin the repeal of the securities laws that were set in place in the 1930s.  Securities laws that were designed to prevent specific abuses that contributed to the Great Depression.

The last time our policymakers and financial regulators chose to repeal a 1930s era security law was Glass-Steagall and the separation of commercial and investment banking.  With the current financial crisis, we know how badly repealing that law has worked out.

In a Huffington Post column, Professor Simon Johnson takes on the notion of repealing disclosure requirements for small businesses.

With the so-called JOBS bill, on which the Senate is due to vote Tuesday, Congress is about to make the same kind of mistake again -- this time abandoning much of the 1930s-era securities legislation that both served investors well and helped make the US one of the best places in the world to raise capital. We find ourselves again on a bipartisan route to disaster....
The idea behind the JOBS bill is that our existing securities laws -- requiring a great deal of disclosure -- are significantly holding back the economy.
In practice, as discussed under the FDR Framework, that great deal of disclosure is the fundamental building block for our financial system.
The bill, HR3606, received bipartisan support in the House (only 23 Democrats voted against). The bill's title is JumpStart Our Business Startup Act, a clever slogan -- but also a complete misrepresentation. 
The premise is that the economy and startups are being held back by regulation, a favorite theme of House Republicans for the past 3 ½ years -- ignoring completely the banking crisis that caused the recession. Which regulations are supposedly to blame? 
The bill's proponents point out that Initial Public Offerings (IPOs) of stock are way down. 
That is true -- but that is also exactly what you should expect when the economy teeters on the brink of an economic depression and then struggles to recover because households' still have a great deal of debt. And the longer term trends over the past decade are global -- and much more about the declining profitability of small business, rather than the specifics of regulation in the US (see this testimony by Jay Ritter). 
Professor Ritter, a leading expert on IPOs, put it this way: 
"I do not think that the bills being considered will result in a flood of companies going public. I do not think that these bills will result in noticeably higher economic growth and job creation." 
In fact, he also argued that the measures under consideration "might be to reduce capital formation." 
Professor John Coates hit the nail on the head: 
"While the various proposals being considered have been characterized as promoting jobs and economic growth by reducing regulatory burdens and costs, it is better to understand them as changing, in similar ways, the balance that existing securities laws and regulations have struck between the transaction costs of raising capital, on the one hand, and the combined costs of fraud risk and asymmetric and unverifiable information, on the other hand." (See p.3 of this December 2011 testimony.) 
In other words, you will be ripped off more. Knowing this, any smart investor will want to be better compensated for investing in a particular firm - this raises, not lowers, the cost of capital.  
The effect on job creation is likely to be negative, not positive.
Sensible securities laws protect everyone -- including entrepreneurs who can raise capital more cheaply. The only people who lose out are those who prefer to run scams of various kinds.
Investor protection is good for growth and essential for sustaining capital markets....
But remember, the Japanese model explicitly involves banks, with the blessing of the financial regulators, not disclosing their true condition.

It is entirely consistent with the idea that deceiving investors is okay that legislation like this bill seems reasonable.
Perhaps the worst parts of the bill are those provisions that would allow "crowd-financing" exempt from the usual Securities and Exchange Commission disclosure requirements. 
A new venture could raise up to $1-2 million through internet solicitations, as long as no investor puts in more than $10,000 (section 301 of HR3606). 
The level of disclosure would be minimal and there would be no real penalties for outright lying. There would also be no effective oversight of such stock promotion - returning us precisely to the situation that prevailed in the 1920s. 
This might well pump up the value of particular stocks -- that was the experience of the 1920s, after all. But ephemeral stock market bubbles are not without real consequences. The crash of 1929 was made possible by the lack of constraints on what stock promoters could say and do. Combined with excessive leverage, this led directly to the Great Depression....
Where are the supposed guardians of our financial system?...
All of them have been captured by the process of implementing the Japanese model.

It is hard to defend disclosure when actively engaged in a massive cover-up of the banking system.
The securities industry special interests are naturally out in force ... Reports of the death of Wall Street lobbying power have been greatly exaggerated.
Financial deregulation was the result of decades-long delusion and bipartisan consensus. A major undermining of our securities law seems likely to take place on Tuesday - in a rushed moment of legislative madness.
Yet another victory for Wall Street's Opacity Protection Team.

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