Lecture 4 Financial Market Functioning and Disclosure PDF

Lecture 4 Financial market functioning and the role of disclosure Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be...

Lecture 4 Financial market functioning and the role of disclosure Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the European Commission.  Agenda Financial market functioning and the role of analysts Mandatory disclosure – Disclosure at issuance – Ongoing disclosure – The importance of gatekeepers for disclosure © Valiante Diego- 2  Financial market functioning and the role of analysts © Valiante Diego- 3  Financial market efficiency theories The theory of efficient markets is concerned with whether prices at any point in time "fully reflect" available information. (Fama 1970) – If anyone can predict prices, the expectation of that price move will cause the price to move before you can act. Only new information can move prices, but this is unpredictable. So price changes are random (i.e. random walk movements)! Depending on the form of efficiency, the time to reach the efficient price equilibrium will be different. But the ‘full reflection’ in price will eventually take place! © Valiante Diego- 4  Financial market efficiency theories - Implications 1. So markets act as if all the information is immediately and costlessly available (zero transaction costs) 2. Only new information can move prices. – So this new information, which will cause prices to change, is always reflected into prices (only the speed of response matters) 3. There is no ‘free lunch’ – Higher returns only if you take more risks – No space for systematic arbitrage 4. The more private information, the more somebody can profit by trading on it – Depending how efficient the market is: weak, semi-strong and strong. © Valiante Diego- 5  Financial market functioning and liquidity 'Liquidity’ (and market functioning more broadly) is the actual focus of attention for the EMH. A market is liquid when ‘is almost infinitely tight, which is not infinitely deep, and […] resilient enough so that prices eventually tend to their underlying value” (Kyle, 1985, p. 1317). – Three aspects emerge from this definition: 1. Tightness/speed (which is the possibility to turn over a position at the fastest speed technically possible, when needed); 2. Depth/quantity (which refers to the ability of the market to absorb quantities without having a large effect on price; it is usually not constant over time in some asset classes); and 3. Resiliency (which is the speed to which prices return to their fundamental value after a move due to regular trading or – with more intensity – to external shocks). © Valiante Diego- 6  Financial market functioning and liquidity Three similar components under the EMH: – ‘Fully reflect’ 1. Pricing process (speed) 2. Liquidity provision (quantity) 3. Available information (price resiliency) Let’s unpack these three elements further, so we can more concretely understand how regulation can guide markets towards allocative efficiency. © Valiante Diego- 7  Financial market functioning and information 1. Pricing is the process (speed/time) of incorporating information into prices (‘fully reflect’). – It involves three tasks (Gilson & Kraakman 1980): 1. Production of information – Firm specific (e.g. quality of management) – General market information (e.g. industry prospects) 2. Verification of accuracy – Explicit information (e.g. financial reports) – Implicit information (e.g. price movements or volume trading) 3. Pricing information – Analysing information (not in isolation) – Trading (transmission of information to the market) © Valiante Diego- 8  Financial market functioning and information 2. Liquidity provision in trading (quantity) involves: 1. Portfolio adjustments activity (to align with investors’ predetermined level of risks) 2. Consumption/investment adjustments (liquidating investments for consumption and viceversa) 3. Divergence of opinions adjustments (trading between large investors with lower and higher valuations) 3. Ability to reflect ‘available information’ (price resiliency) depends on the form of market efficiency – Strong Smallest set of newly ‘available information’ (price embeds inside, public and historical information) – Semi-strong Fair amount of newly ‘available information’ (price embeds public and historical information) – Weak High amount of newly ‘available information’ (price only embeds historical information) © Valiante Diego- 9  Financial market efficiency theories - Revisited Reality is that there is no stable equilibrium. Prices will always try to reflect new information, but will ‘never fully succeed’. – The presence of ‘anomalies’ make arbitrage possible, even with historical information. Grossman & Stiglitz (1980) thus suggest the following: 1. Arbitrage is costly (risk aversion, endowment and beliefs), so never equilibrium 2. Those who expend resources to obtain information do receive compensation With no or full information to gain from, markets won’t have reason to exist (F. Hayek) 3. Noise interferes with the information conveyed by the price system The greater noise, the less informative the price system is, reducing expected utility of uninformed investors (i.e. ability to make a gain) 4. Prices convey information from informed to uninformed investors © Valiante Diego- 10  Mapping types of market participants and interactions © Valiante Diego- 11  Financial market functioning and information Four categories of market participants (Goshen & Parchomovsky 2006) 1. Insiders They rely on non-public firm-specific information Unable to process general market information 2. Noise traders (De Long et al. 1990) Noise traders falsely believe that they have special information about the future price of the risky asset. They may get their pseudosignals from technical analysts, stockbrokers, or economic consultants and irrationally believe that these signals carry information. Noise trading is random… – …it can increase costs for arbitrageurs (who ultimately act in response to these traders) – …in fact, some may be even compensated for the risk that they themselves create in distorting prices deeply (anomalies; e.g. irrationality). On average, they do not lose/gain against other players © Valiante Diego- 12  Financial market functioning and information 3. Liquidity traders Do not collect information Only allocate resources between savings and consumption They mainly act with ‘buying and holding’ strategies and they only care about liquidity (bid/ask spread) 4. Information traders or analysts Professional investors (analysts) – Institutional investors, money managers and others (e.g. hedge funds) – Collect, evaluate and price both firm specific and general info Specialists or market makers – Liquidity providers setting the bid/ask spread at a price » They pass on losses against more informed traders to liquidity and noise traders via bid-ask spread – Not as informed as analysts on firm-specific information Stock pickers – Slower than analysts (often relying on analysts services) © Valiante Diego- 13  Interaction among types of traders There are only two groups that can promote market efficiency. Insiders and analysts (information traders) trade to capture the value in their informational advantage. – A trade is therefore triggered when the price change is not justified by known information (available information; which is embedded in their calculated level of that asset price) but by ‘new’ information. Result: Regulation protects analysts – Trading against a superiorly informed trader or based on fraudulent information may result in systematic losses (amplifying adverse selection issues [as informed traders are increasingly unable to price risk] and so asset mispricing, leading to a freezing of market activities) Result: Regulation prosecutes insider trading and market manipulation © Valiante Diego- 14  Interaction among types of traders Both liquidity and noise traders have only indirect impact on market efficiency, because they are, on average: 1. not losing against analysts and insiders 2. not distorting market prices ((in the medium term) 3. bearing the costs of illiquidity 4. holding the other side of the trade for informed traders (analysts). Traders who trade on information may only lose against more informed traders, but (if they lose) some other informed investor wins. This inner nature of market activity creates a constant incentive to gain an information advantage, so improving price accuracy, liquidity and overall market efficiency! © Valiante Diego- 15  Analysts Analysts (and alike) is thus the only group that promote efficient and liquid capital markets. 1. They counter the action of noise traders based on better information 2. The more they can counter price deviations, the more prices will reflect available information, the more markets will be efficient. The following caveats apply: – Deviations between price and value will always happen (analysts may need a big pocket to stay in the market) – What matters is the adjustment mechanism – Analysts are essential part of this adjustment mechanism Searching, verifying, analysing/pricing firm-specific and general info is costly The higher these costs, the larger will be the price deviation will need to be to compensate analysts © Valiante Diego- 16  The role of regulation Regulation shall aim to increase the accuracy of analysts in capturing price/value deviations by: 1. Reducing costs of pricing information or 2. Reducing risks of not capturing the deviation (e.g. misleading information) 1. Mandated disclosure rules – Reduces the probability of misevaluation by reducing the costs of pricing information 2. Prohibition of fraud and manipulation – Reduces probability of encountering misleading information (so risk of not capturing the price deviation) 3. Prohibition of insider trading – Reduces the risk of crowding out analysts, so deteriorating market quality under adverse selection All of them needs effective enforcement mechanisms to work. © Valiante Diego- 17  (1) Mandatory disclosure © Valiante Diego- 18  Mandatory disclosure The official objective of mandatory disclosure rules is to protect investors (upholding the caveat emptor principle)… – Disclosure of information in cases of offers of securities to the public or admission of securities to trading on a regulated market is vital to protect investors by removing asymmetries of information between them and issuers. (Rec. 3, Reg. EU 2017/1129 on Prospectus) …but we now have evidence showing that investors do not read prospectus. So, investor protection can also be achieved: 1. Directly, via the role of intermediaries and professional investors (so called ‘analysts’); and 2. Indirectly, via the possibility to use this document against defrauding issuers in the enforcement of investor rights (ex post) Mandatory disclosure, in effect, reduces the costs of pricing information (searching, verification, analysis/trading) – Lower these costs are and more analysts will operate in the market, the higher is the probability to reduce gap between price and valuation. © Valiante Diego- 19  Mandatory disclosure General benefits of disclosure for the firm is a reduction of cost of capital via: 1. Showing ‘credible commitment’ (Rock 2002) In the case of issuers, especially for future ongoing disclosure (together with the role of the underwriter) Barriers to exit and public/private enforcement make this commitment to indefinite disclosure credible 2. Reducing price/value deviation (improves price accuracy), which: Improves liquidity by reducing transaction costs (bid/ask spread) from information asymmetry and creating a competitive market for analysts Lowers risk in corporate acquisitions 3. Helping to monitor management, so increasing appeal for institutional investors (relational investment) © Valiante Diego- 20  Mandatory disclosure improves liquidity Mandated disclosure reduces searching costs, avoiding duplicative efforts by analysts. Standardised formats (comparable with other firms’ info) also reduce analysis (pricing) costs. – Moreover, it reduces space for insider trading and increases availability of information that can reduce the price/value gap, so increasing the availability of analysts and so reducing noise trading. – It thus stimulates further disclosure from firms to attract analysts’ coverage. – It also stimulates (sell-side) analysts to market their analyses and this will reduce costs of analysis further for other analysts (reduction of duplicative investments). Mandated disclosure also benefits liquidity traders. – Lowers asymmetric information among traders, so gains are possible from public (not inside) information and analysts can benefit from it. – The result is lower occasions for information asymmetry and lower risk for liquidity traders to trade against more informed traders and lose (with lower bid/ask spread). © Valiante Diego- 21  Why does disclosure need to be mandatory? After all, the firm is the one that can produce firm specific information at the lowest cost and can voluntarily disclose this information to reduce its costs of capital. – In effect, opponents of mandatory disclosure claim that this is expensive and duplicative, since it is already in the interest of the firm to provide as much information as possible, because it reduces the cost of capital. Caveat: incentive only for efficient management! (Fox 1999) The reality is that there might be also reasons for the firm not to disclose (negative impact of disclosure): – Disclosing information by a firm may reveal (at least in part) its commercial strategies. – Providing value to the firm’s stakeholders (incl. creditors and employees) that can be used to improve their negotiating position. – Reducing the possibility to exclude other interested parties, like potential investors, from using it against the firm. – Mandatory disclosure increases the risk of litigation. © Valiante Diego- 22  Why disclosure needs to be mandatory? Prevailing argument. Optimal supply of information by listed companies is a public good with important externalities. – Non-rival and non-excludible positive externalities consist of: Improvements to market liquidity More efficient public pricing (incl. standardisation) More effective monitoring of management © Valiante Diego- 23  How does the system of mandatory company disclosure look like? Going public (and staying public) – Disclosure at issuance Prospectus rules Admission to listing/trading requirements – Ongoing disclosure Accounting rules Financial reporting Trading data (market microstructure) Private company – Limited Information disclosure Limited accounting rules © Valiante Diego- 24  Mandatory disclosure – Going public There are three types of primary markets issuance: a. Initial Public Offerings (IPOs) 1. ‘Beauty contest’ to select banks (arrangers & underwriters; T-6 months) 2. Due diligence and docs preparation, inc. prospectus (T-5 months) 3. Research preparation by ‘connected analysts’ first (T-8 weeks) 4. Investor education (research disclosure; T-4 weeks) 5. Management roadshow (T-15 days) 6. Bookbuilding (collection of orders & price agreement) & preliminary prospectus (day before dealings begin) 7. Pricing & admission (start dealings and admission to trading will come in the next 3-4 days) 8. Stabilisation (T+30 days) IPOs may be accompanied by ‘follow-on offerings’, which dilute (new shares) or may not dilute (existing shares) shareholders. b. Captive issuance (e.g. private placement to selected investors) c. ‘Fringe’ direct offerings (direct listing) 1. It’s cheaper (direct and indirect costs), but riskier (liquidity risk, plus higher disclosure threshold [full year guidance]) 2. No underwriting assistance by banks 3. Without new shares offerings © Valiante Diego- 25  Mandatory disclosure – Going public Source: Zheng 2020 Companies can go public also via ‘reverse merger’ (i.e. purchasing a publicly listed company and then merging in one publicly traded one), if there is no urgent need of capital. IPOs and private placement is the quasi totality of primary markets, with some notable exceptions (e.g. Spotify and Slack directly listing on NYSE). IPOs have recently left much more space for private placements © Valiante Diego- 26  Mandatory disclosure – Going public Why ‘going public’? – Benefits Lower cost of capital Increased visibility and profile with customers and suppliers Eligibility for inclusion in indexes and attract more investors Diversification of investor base Exit option for owners; Incentives for managers and employees to participate to company’ success (with shares and stock options mainly) Have a independent real time valuation of your business – Costs Administrative costs from more stringent legal obligations More dependence from exogenous factors (e.g. market sentiment) More external scrutiny and disclosure Two key sets of rules: 1. Admission to listing and trading conditions (Directive EU 2001/34 and Directive EU 2004/109) 2. Prospectus rules (Regulation EU n. 2017/1129) © Valiante Diego- 27  Disclosure at issuance © Valiante Diego- 28  Disclosure at issuance – Prospectus Regulation EU n. 2017/1129 Prospectus “to be published when securities are offered to the public or admitted to trading on a regulated market situated or operating within a Member State” (art. 1.1) – ‘offer of securities to the public’ means a communication to persons in any form and by any means, presenting sufficient information on the terms of the offer and the securities to be offered, so as to enable an investor to decide to purchase or subscribe for those securities.” (art. 2.1(d)) Prospectus Regulation’s key exemptions: – EU wide exemption for offers with total consideration below EUR 1 million over 12 months (art. 1.3) Option to go up to EUR 8 million at national level (art. 3.2(b)) – Certain types of securities (incl. units of investment funds or shares of central banks) (art. 1.2) – Certain types of offers (incl. those addressed to qualified investors, to less than 150 natural or legal persons and those denominated per unit at least at EUR 100 000) (art. 1.4) – Certain types of admission to trading (incl. shares resulting from the exercise of rights or conversion [with 20% & 12 months cap]) (art. 1.5) – An offer of securities to the public from a crowdfunding service provider authorised under Regulation (EU) 2020/1503 of the European Parliament and of the Council, provided that it does not exceed EUR 5 mn (art. 1.4) With possibility to opt-in (art. 4) © Valiante Diego- 29  Disclosure at issuance – Prospectus rules Need for pre-approval by National Competent Authorities (NCAs) – ’Approval’ means the positive act at the outcome of the scrutiny by the home Member State’s competent authority of the completeness, the consistency and the comprehensibility of the information given in the prospectus (no civil liability) Completeness means the use of correct schedules and building blocks and prospectus must reasonably address all the information items Comprehensibility means considering additional criteria when (e.g. readability) offer not solely available for wholesale Consistency relates to the relationship between different parts of a document (i.e. being coherent as a whole). Pre-approval defines ex post liability (costly legal opinions) – Civil liability for a clearly identified responsible (art. 11.2) – But not for summaries (art. 11.3) © Valiante Diego- 30  Disclosure at issuance – Prospectus rules The prospectus must contain at least the following information: 1. The assets and liabilities, profits and losses, financial position, and prospects of the issuer and of any guarantor; 2. The rights attaching to the securities; and 3. The reasons for the issuance and its impact on the issuer. To be published in a single document or divided in (art. 6.3) – A registration document (info about the issuer) or an universal registration document (voluntary annual disclosure about the issuer’s organisation, business, financial position, earnings and prospects, governance and shareholding structure) – A securities note (info on the security and all terms and conditions) – A summary (key information in 7 A4 sides that could go up to 13) “Accurate, fair and not misleading” (art. 7) Including the list of the “most material risk factors” (no more than 15; such as the level of subordination of a security), where ‘materiality’ is based on probability of occurrence and expected magnitude (art. 16) No civil liability for the summary(art. 11) © Valiante Diego- 31  Disclosure at issuance – Prospectus rules Combination of soft and hard (historical) information is key – Overreliance on historical information is misleading (e.g. over optimism or reference point issues) Minimum information includes (art. 13.1): a. The various types of information needed by investors relating to equity securities as compared with non-equity securities; a consistent approach shall be taken with regard to information required in a prospectus for securities which have a similar economic rationale, notably derivative securities; b. The various types and characteristics of offers and admissions to trading on a regulated market of non-equity securities; c. The format used and the information required in base prospectuses relating to non-equity securities, including warrants in any form; d. where applicable, the public nature of the issuer; e. where applicable, the specific nature of the activities of the issuer. Essential information about the issuer includes risk factors that are ‘material’ and ‘specific’ (art. 16) – These include ‘strategic risks’ (e.g. competitive and political environment, company transformation, disruptive tech), ‘operational risks’ (e.g. cybersecurity, value chain processes issues), ‘financial risks’ (e.g. currency risk, liquidity risk), ‘compliance risks’ (e.g. changes in regulation, wrongdoing, environmental regulation) There is a simplified disclosure for secondary issuance of securities ‘fungible to existing’ listed ones. © Valiante Diego- 32  Disclosure at issuance – Prospectus rules The Regulation also looks deeper into investor and issuer types: 1. Summary to be useful for retail investors 2. Growth prospectus (to reduce fixed costs on smaller issuers with a specific summary, registration document and securities note) for: SMEs Issuers with a market capitalization of less than €500 million Offers of securities not in excess of €20 million provided that no securities traded on an MTF +average of employees up to 499 © Valiante Diego- 33  Ongoing disclosure © Valiante Diego- 34  Staying ’public’ – Ongoing disclosure Two sets of (ongoing) disclosure requirements 1. Accounting standards Common language 2. Financial reporting Periodic reporting Event-driven © Valiante Diego- 35  Accounting rules © Valiante Diego- 36  Ongoing disclosure – Accounting standards Accounting standards are a common set of principles and procedures that guide the preparation of a company’s financial statement. There are two main sets of accounting standards that are benchmarks for accounting rules across the world: 1. The US Generally Accepted Accounting Principles (US GAAP), developed jointly by the Financial Accounting Standards Board (FASB) and the Government Accounting Standards Board (GASB). US law requires all ’public business entities’ (PBE), as well as any company that publicly releases financial statements, to follow US GAAPs They were created as a response to the 1929 Stock market crash and following Great Depression with the Securities and Exchange Acts of 1933 and 1934. Enforcement was given to the Securities and Exchange Commission (SEC) and development to private standard setting bodies representing the industry. 2. The International Financial Reporting Standards (IFRS) were developed by the IFRS Foundation through its International Accounting Standards Board (IASB), which are standard setting bodies co-financed by governments and industry. As of today, IFRS standards are used in 166 countries and required for listed companies in the vast majority of them. Its application is more complex, as principle-based accounting (big divergence with rule-based US GAAPs). © Valiante Diego- 37  Ongoing disclosure – Accounting standards in the EU The scope of application has a variable geometry in the EU. All limited liability companies have to prepare financial statements to provide a true and fair view of their financial situation – Under EU rules (IFRS Regulation 1606/2002), listed companies (whose shares are traded on a regulated market) must prepare their consolidated financial statements in accordance with IFRS (international financial reporting standards). Subsidiaries of the group may follow national GAAPs – Other requirements apply to non-listed companies and small businesses (mainly under national civil codes, with some principles set in the Accounting Directive 2013/34). © Valiante Diego- 38  Ongoing disclosure – Accounting standards Non-IFRS accounting rules (Directive 2013/34/EU) – Limited liability companies doing business in the EU, whatever their size, have to prepare annual financial statements and file them with the relevant national business registers. Groups have to prepare consolidated financial statements. – They should include at least: The balance sheet, the profit and loss account and a certain number of notes to the financial statements. Large and medium- sized companies also have to publish management reports. – Other requirements include: audit of financial statements the responsibility of management with regards to all above – A simplified reporting regime for SMEs (art. 14) and a very light regime for micro-companies (those with less than 10 employees; art. 36). – Enforcement is very weak in many Member States (e.g. small administrative sanctions for non-publication of annual financial statements) © Valiante Diego- 39  Ongoing disclosure – IFRS accounting rules (Regulation EC n. 1606/2002) EU listed companies to prepare their consolidated financial statements in accordance with IFRS (international financial reporting standards), previously known as IAS (international accounting standards). EU countries can opt to extend the use of IFRS to annual financial statements and non-listed companies as well Periodically, the Commission draws up a non-binding consolidated version of Regulation (EC) No 1126/2008 which includes all adopted IAS/IFRS and related interpretations, according to the regulatory scrutiny procedure (RPS). This is also called ‘endorsement process’. – The Commission is supported by the European Financial Reporting Advisory Group (EFRAG), which is a non-profit organisation established in 2001 with the encouragement of the European Commission to serve the public interest. – The full list of adopted IAS/IFRS standards is here (for info) © Valiante Diego- 40  Ongoing Disclosure – Some accounting Standards IAS 1 Presentation of financial statements IFRS 5 Non-current assets held for sale and discontinued operations IAS 2 Inventories IFRS 6 Exploration for and evaluation of mineral resources IAS 7 Cash-flow statements IFRS 7 Financial instruments: disclosures IAS 8 Accounting policies, changes in accounting estimates and IFRS 8 Operating segments errors IFRS 10 Consolidated Financial Statements IAS 10 Events after the balance sheet date IFRS 11 Joint Arrangements IAS 11 Construction contracts IFRS 12 Disclosure of Interests in Other Entities IAS 12 Income taxes IFRS 13 Fair Value Measurement IAS 16 Property, plant and equipment IFRS 15 Revenue from Contracts with Customers IAS 17 Leases IFRS 16 Leases IAS 18 Revenue IFRS 17 Insurance Contracts IAS 19 Employee benefits IFRIC 1 Changes in existing decommissioning, restoration and similar IAS 20 Accounting for government grants and disclosure of liabilities government assistance IFRIC 2 Members' shares in co-operative entities and similar IAS 21 The effects of changes in foreign exchange rates instruments IAS 23 Borrowing costs IFRIC 4 Determining whether an arrangement contains a lease IAS 24 Related party disclosures IFRIC 5 Rights to interests arising from decommissioning, restoration IAS 26 Accounting and reporting by retirement benefit plans and environmental rehabilitation funds IAS 27 Consolidated and separate financial statements IFRIC 6 Liabilities arising from participating in a specific market — IAS 28 Investments in associates waste electrical and electronic equipment IAS 29 Financial reporting in hyperinflationary economies IFRIC 7 Applying the Restatement Approach under IAS 29 Financial reporting in hyperinflationary economies IAS 31 Interests in joint ventures IFRIC 8 Scope of IFRS 2 IAS 32 Financial instruments: presentation IFRIC 9 Reassessment of embedded derivatives IAS 33 Earnings per share IFRIC 10 Interim financial reporting and impairment IAS 34 Interim financial reporting IFRIC 11 IFRS 2 — Group and treasury share transactions IAS 36 Impairment of assets SIC-7 Introduction of the euro IAS 37 Provisions, contingent liabilities and contingent assets SIC-10 Government assistance — no specific relation to operating IAS 38 Intangible assets activities IAS 39/IFRS 9 Financial instruments: recognition and measurement SIC-15 Operating leases — incentives IAS 40 Investment property SIC-25 Income taxes — changes in the tax status of an entity or its IAS 41 Agriculture shareholders IFRS 1 First-time adoption of international financial reporting standards SIC-27 Evaluating the substance of transactions involving the legal IFRS 2 Share-based payment form of a lease IFRS 3 Business combinations SIC-29 Disclosure — service concession arrangements IFRS 4 Insurance contracts © Valiante Diego- 41  Accounting Standards – IFRS 9 Measurement IFRS 9 replaced IAS 39 (Financial Instruments – Recognition and Measurement) as part of the G20 post-2008 financial crisis reforms It has two key components: measurement and impairment of financial assets. On measurement, financial assets should be classified and measured at fair value, with changes in fair value recognized in profit and loss, as they arise (“FVPL”)… – …unless restrictive criteria are met for classifying and measuring the asset at either Amortized Cost (for businesses whose objective is to hold assets to collect cash) or Fair Value Through Other Comprehensive Income (“FVOCI”), i.e. not recognised in profits and losses. – ‘Amortised cost’ means the amount at which the financial asset or liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation, plus or minus impairments. For instance: Plain vanilla loans and receivables can be measured at amortised cost (assets whose cash flow is solely payment of principal and interest). Held-to-maturity investments can also be measured at amortized cost. © Valiante Diego- 42  Accounting Standards – IFRS 9 Measurement (2) Fair value may increase volatility of profits and losses – Big implications for complex financial institutions businesses (FVPL for derivative financial assets, like options or swaps) – Debt instruments embedding a derivative → all of it at FVPL! © Valiante Diego- 43  The balance sheet of a major financial institution Source: Deutsche Bank © Valiante Diego- 44  Accounting Standards – IFRS 9 - Impairment of financial assets 2. Impairment of financial assets is another key area, as it aims at accelerating credit loss recognition. A loss allowance is now estimated for all credit exposures that are evaluated at amortised cost, whether actually impaired or not (compared to the IAS 39, i.e. allowance only for impaired exposures) IFRS 9 moves from incurred loss to expected credit loss (ECL) – ECLs should be regularly recognised over the lifetime of a financial assets since initial recognition Expected credit losses are required to be measured through a loss allowance at an amount equal to a – 12-month expected credit losses (expected credit losses that result from those default events on the financial instrument that are possible within 12 months after the reporting date); or – A loss allowance for lifetime expected credit losses (expected credit losses that result from all possible default events over the life of the financial instrument) instead is required for a financial instrument if the credit risk on that financial instrument has increased significantly since initial recognition » But there is large discretion on what “significant deterioration in credit risk” means among member states’ authorities within the Banking Union (vs US).. » In the past, the definition of ‘loss event’ led to large discrepancies in the definition of ‘Non-performing loans’ (NPLs), then rectified by the ECB Asset Quality Review in 2014 for the Banking Union. © Valiante Diego- 45  Accounting Standards – IFRS 9 Impairment – This change of approach aims at reducing procyclicality to idiosyncratic risk (‘too little, too late’, but not to broader economic slowdowns. Big step especially for banks relying on Standardised Approach (standardised risk evaluation models) © Valiante Diego- 46  Financial reporting © Valiante Diego- 47  Ongoing disclosure – Financial Reporting A regular flow of disclosure of periodic and event-driven regulated information and timely dissemination to the public is vital for investment decisions. This ongoing disclosure includes: 1. Financial reports; 2. Information on major holdings of voting rights; and 3. Information disclosed under market abuse rules. Transparency Directive [TD] 2004/109/EC requires issuers of securities traded on regulated markets within the EU to make their activities transparent, by regularly publishing: – Periodic reporting Yearly and half-yearly financial reports (public for at least 10 years) – Event-driven Major changes in the holding of voting rights (starting from 5% up to 75%) Other event-driven disclosure – Inside information (Market Abuse Regulation EU n. 596/2014, art. 17) – Insiders’ list (MAR) – Managers’ transactions (MAR art 19) – Net short position in share (0.5% and 0.1% increments afterwards; Short Selling Regulation EU n. 236/2012, art 6) © Valiante Diego- 48  Ongoing disclosure – Financial Reporting Information must be released in a manner that benefits all investors equally across Europe. Access to company filings is important (e.g. EDGAR in the USA) – Each EU country to establish a storage mechanism to ensure the public can access the information disclosed by listed companies. – However, different national databases are not sufficiently interconnected. – ESMA mandated to create a European portal for company filings (the European Single Access Point, ESAP) © Valiante Diego- 49  The ‘inexplicable’ fall of IPOs (case study) © Valiante Diego- 50  8,000 NASDAQ 1997: 7,428 7,000 AMEX (n.a. before 1962) NYSE 6,000 Case study – The ‘inexplicable’ fall of IPOs 5,000 4,000 2017: 3,581 3,000 2,000 1,000 0 © Valiante Diego- 51 Source:Ljungqvist, Persson, and Tåg(2018)  Case study – The ‘inexplicable’ fall of IPOs Source: Ljungqvist (2018 ECMI Annual Conference) © Valiante Diego- 52  Key findings Financial repression – low interest rates on other funding tools (debt) Greater availability and cheaper alternative funding options or alternative exits for risk capital ventures (e.g. private equity funds) – Firms tend to delay listing (Doidge et al 2015). Trading going global/continental leads to consolidation – Less firms out there ready to list (Doidge et al 2015). © Valiante Diego- 53  An alternative view – Short-termism (Ljungqvist) Reporting frequency – Increased reporting frequency → reduced corporate investment (Kraft et al. 2018) Managerial incentives – Managerial incentives become more short‐term → cut long‐term investment (Ladika & Sautner 2018) – Long‐term incentives → increase in firms’ investments in long‐term strategies such as innovation and stakeholder relationships (Flammer & Bansal 2017) – Faster equity investing → reduced R&D and CAPEX (Edmans et al. 2017) Shareholder pressure – Inflow of short‐term institutional investors → firms cut R&D to report higher earnings (Cremers et al. 2018) – But: Activist hedge fund campaigns → firms improve productivity, investment, and innovation (Brav et al. 2018, Bebchuck et al. 2015) © Valiante Diego- 54  The role of gatekeepers in disclosure © Valiante Diego- 55  Gatekeepers and information intermediaries Gatekeepers can be defined as: – “[...] reputational intermediaries who provide verification and certification services to investors. These services can consist of verifying a company's financial statements (as the independent auditor does), evaluating the creditworthiness of the company (as the debt rating agency does), assessing the company's business and financial prospects vis-a-vis its rivals (as the securities analyst does), or appraising the fairness of a specific transaction (as the investment banker does in delivering a fairness opinion when underwriting)” (Coffee, 2002, p. 1405). This definition also includes lawyers when they provide their reputation to validate the legality of a financial transaction (Partnoy, 2001; Fisch & Rosen, 2003; Coffee, 2002, 2003). Plus, information intermediaries: – Financial press – Data (service) providers © Valiante Diego- 56  Gatekeepers Risk management tools can be categorised in three main areas: 1. Internal risk assessment (e.g. statistical models); 2. Market-based measures (e.g. index); 3. Third-party assessments (e.g. credit ratings, due diligence). Gatekeepers provide third party assessments, in the form of risk signalling mechanisms to reduce adverse selection and due diligence and verification services to reduce monitoring costs that could lead to moral hazard. Due to their business’ reliance on reputation capital that was supposed to keep incentives aligned, these entities have largely gone unregulated (self-regulated) since the Enron scandal in 2000 (for some; e.g. auditors like Arthur Andersen) and 2008 financial crisis (for others; CRAs). © Valiante Diego- 57  Gatekeepers – Typical failures 1. Regulatory license effects – Overreliance on ratings in regulation – Overreliance on audited accounts by law – Certification and verification role of underwriters 2. Conflict of interests – Issuer-pays model (e.g. ratings paid by issuers) – Auditors’ consulting vs auditing functions – Sell-side securities analysts’ recommendation & prop trading activities 3. Market power and concentration – Business activity relies on reputational capital and high fixed costs, which leads to market concentration © Valiante Diego- 58  Gatekeepers – An example of regulatory action Key regulatory actions for gatekeepers are mainly under Regulation EU n. 1060/2009 for CRAs, Directive 2006/43/EC for auditors, Markets in Financial Instruments Directive n. 2014/65/EC for investment firms. 1. Greater disclosure (e.g. methodology behind ratings or other offered service, as well as conflicts of interests) 2. Separation of conflicting functions in the company 3. Limits in case of clients’ ownership of the gatekeeper (e.g. if owning shares above 10%, no rating for that client/issuer) 4. Promote alternative services to reduce over-reliance on that specific gatekeeper For ratings, warranties or integrating credit evaluations with market-based measures) 5. Ensure some level of liability through regulation (e.g. CRAs not liable for their ‘opinions’) 6. Rotation obligations (auditors and rating analysts within CRAs) 7. Forcing the use of smaller gatekeepers with, for example: Rotation obligation Double credit ratings for securities products(art. 8c CRAR) If more than one CRA, 2 nd one should have less than 10% market share 8. Removal of references to ratings, etc in EU regulation (partially done) or putting in place provisions mitigating risks of sole and mechanistic reliance (e.g. requirements for own credit risk assessment on top of the rating use) © Valiante Diego- 59  Gatekeepers – More fundamental questions What alternatives to an ‘issuer’ or ‘subscriber-pays’ model? 1. Investor-pay model 2. Government agency 3. Independent body redistribute revenues from issuers by selecting the gatekeeper that will provide the service © Valiante Diego- 60  Recommended readings Grossman, S. J., & Stiglitz, J. E. (1980). On the impossibility of informationally efficient markets. The American Economic Review, 70(3), 393-408. Ogus A. Regulation: Legal Form and Economic Theory (chapter 7 for this lecture) Goshen, Zohar, and Gideon Parchomovsky. "The essential role of securities regulation." Duke LJ 55 (2005): 711. Armour J., D. Awrey, P. Davies, L. Enriques, J. N. Gordon, C. Mayer and J. Payne, Principles of Financial Regulation, OUP, 2016 (Chapter 5, 6 and 8) Other readings – Pagano, M, Panetta, F and Zingales, L. 1996. 'Why Do Companies Go Public? An Empirical Analysis'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=1332 – Armour, John and Enriques, Luca and Wetzer, Thom and Wetzer, Thom, Mandatory Corporate Climate Disclosures: Now, but How? (November 1, 2021). European Corporate Governance Institute - Law Working Paper No. 614/2021, Columbia Business Law Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3958819 – Alexander Ljungqvist and John Asker and Joan Farre-Mensa (2015). Corporate Investment and Stock Market Listing: A Puzzle?. Review of Financial Studies, vol. 28, pp. 342-390 – Accounting standards adopted by the EU https://eur-lex.europa.eu/legal- content/EN/TXT/?qid=1476262996158&uri=CELEX:02008R1126-20160101 © Valiante Diego- 61  Diego Valiante LEIF Master Programme [email protected] www.unibo.it