How History Shapes the Outcomes of Market Reform

The European Union enacted a series of regulations in the early 2000s to improve the financial markets of member states. While the new regulations were the same across the EU, member countries implemented, supervised, and enforced the new rules individually, ideal conditions for researchers looking to compare the effectiveness of different approaches.

Chicago Booth’s Hans B. Christensen and Christian Leuz and Wharton’s Luzi Hail studied the liquidity effects of two of the new regulations, finding that some countries experienced big improvements, while others saw little to no benefit. A critical determining factor: the country’s regulatory history.

The researchers focused on the Market Abuse Directive and the Transparency Directive. The MAD aimed to address insider trading and market manipulation, while the TD focused on supervising and enforcing corporate reporting and mandatory disclosure rules.

The goal for both directives: give investors more and better information and harmonize regulation across the EU countries. That would increase liquidity, which could in turn lower the cost of capital, raise market valuations, and create more efficient markets.

On average, the MAD and the TD increased liquidity in European financial markets, the research finds—each by around 10 percent relative to prior liquidity. Because trading costs fall as liquidity rises, the researchers calculate that each directive led to trading-costs savings of at least $130,000–$430,000 a year for each of the 4,846 companies in the study sample. That represents an annual benefit of between 0.1 percent and 0.2 percent of market capitalization—a benefit that compounds over time and hence is economically significant.

However, the liquidity effect varied widely with the strength of countries’ existing regulatory infrastructure. Countries with a previously solid history of implementing and enforcing financial regulations saw liquidity rise more than 20 percent, double the EU-wide average.

Countries with previously weak regulation and weak implementation of the new rules, on the other hand, saw virtually no liquidity benefits.

This disparity reflects core differences among EU countries. “A country’s past track record with respect to implementing regulation is likely revealing about its political will to put in place regulation that induces (or curbs) socially (un)desirable behavior,” the researchers note.

Rather than reconciling disparate market conditions across European countries, the harmonization of regulations actually led to larger liquidity gaps among markets by making the already strong countries stronger, whereas the weaker countries stayed the same.

“History and countries’ prior institutional conditions matter greatly for regulatory outcomes,” the researchers conclude. “Differences in these prior conditions pose a major obstacle for regulatory harmonization.”

This is of import for both the G20 (comprising the world’s largest economies) and the European Commission, both of which have proposed or implemented regulatory reforms that essentially seek to strengthen and harmonize financial rules.

The research suggests it will take more than a few isolated regulatory changes to align market conditions across the EU.