Unenforced laws more harmful than no laws at all: study

October 8th, 2009 - 3:38 pm ICT by IANS  

By Arun Kumar
Washington, Oct 8 (IANS) Insider trading laws that are not enforced can hurt shareholders and economic vibrancy in emerging markets even more than having no securities laws at all, according to a study led by an Indian American researcher.

The study - “When No Law is Better Than a Good Law” - from the Indiana University Kelley School of Business was co-authored by Utpal Bhattacharya, associate professor of finance with Hazem Daouk of Cornell University.

With sweeping financial market reforms impending worldwide, especially in executive compensation, the findings indicate that policymakers should think twice about establishing or bolstering regulations without corresponding enforcement efforts.

In recent years, research has shown that in many emerging markets trading based on “inside” information is common practice.

The Kelley research goes further, revealing that weakly enforced insider trading regulations not only put law-abiding shareholders at a disadvantage, they make the equity marketplace more expensive to raise money for businesses, making them a less potent place for capital generation and economic stimulus.

Specifically, businesses have to pay an extra five percent return to their shareholders in countries that do not enforce their insider trading laws.

“The explanation is that a less transparent, unequal marketplace tends to disadvantage outsiders, and disadvantaged outsiders demand a higher return on their investments,” said Bhattacharya.

“The irony is that governments that turn a blind eye to insider trading - often to benefit the relative few - are hurting their economies overall.”

The best route is for countries to strictly enforce their insider trading rules, noted Bhattacharya, an Indian Institute of Technology, Kanpur graduate with an MBA from Indian Institute of Management, Ahmedabad and a PhD from Columbia University. However, he said, this may not be a realistic expectation where there are incompetent, under-funded or corrupt financial regulators, which is often the case in emerging markets.

In such situations, the more feasible course of action would be to eliminate the weakly enforced laws - giving everybody access to the same information and making the market more open and efficient.

“Our study serves as a caution to policymakers who believe that welfare can be improved just by instituting good laws,” said Bhattacharya.

“Clearly, enforcement, not the law itself, will ensure market efficiency and protect shareholders. A country’s ability to enforce securities laws should dictate whether to have laws at all.”

Fully 70 percent of emerging markets have enacted insider trading laws similar to those in established markets, but without corresponding enforcement efforts.

“This unwise ‘cut and paste’ approach makes it increasingly difficult for stockholders to earn a profit, a major setback in this economic climate,” said Bhattacharya.

“Governments should not hinder free markets with new laws that they cannot or will not enforce, but they should take very seriously the need to enforce existing laws that promote market fairness.

“If they don’t, the equity markets and their power to generate much-needed capital for the local economy are hurt - and only the outlaws win.”

For the study the authors collected and analysed monthly stock market indices from Morgan Stanley Capital Market International for 22 developed markets, and from International Finance Corporation for 33 emerging markets.

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