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Xu Chenggang:the relationship between Bolton's paper and China's economic reform


Xu Chenggang: many thanks go to the organizer for giving me the opportunity to share my understanding of Bolton and Rosenthal's paper and discuss the relationship between this paper and China's economic reform. The paper focuses on some of the important issues about market regulation, involving a number of fundamental issues, including ownership structure and others. From 1933 onwards, the United States formally introduced a variety of regulations to the financial markets, enabling the US financial market to maintain a long period of considerable stability. But this stability just lasted until the 1990s and then stopped abruptly. The important question: why did this happen? Bolton and Rosenthal's paper focused on understanding a very important part of this change: corporate governance, or company governance.


First of all, I would like to point out two basic misunderstandings, which are quite common in China. The first wrong viewpoint is that the market itself is automatically efficient and stable. But it is clear that a market lacking in rule of law is not only inefficient and unstable, but also full of deceptions and corruptions. The second wrong opinion is that supervision is omnipotent and versatile, and can solve all the problems in the financial market, making the market efficient and stable, and the stronger the supervision the better. However, when we use the word, supervision, the first thing to understand is, what exactly does is mean? Who will supervise? And how to supervise? What is the institutional basis for supervision or regulation? If we could not understand these basis questions well and simply advocate supervision or "strengthen" supervision, it can be not only one-sided, but also seriously misleading. Bolton and Rosenthal's paper has corrected these two erroneous views in a number of ways.


Bolton and Rosenthal find that companies are supervised in ways that affect their ownership of the institution. First, they discussed an important basic conceptual question: can majority shareholders or block-holders (e.g. institutional investors) replace supervision? Do the block holders really play the role of a custodian or a supervisor? This question has also been discussed a lot in China, and has become a reason for large-scale institutional investors to enter the market. This paper has done an empirical validation of the issue. The second question is, what is the nature of the investment by these majority shareholders or block holders? If they concentrate on speculative investment, is it supposed to be regulated? And how should the regulation mechanism on block holders be designed?


The historical background of the paper is about the Public Utility Holding Company Act of 1935 (PUHCA) in the United States, which restricted acquisitions between public utility companies. Thus, from 1935 to 1992, there was no merger or acquisition between the US public utility companies, and the ownership structure of the enterprises was generally highly dispersed. However, since the 1990s, the US power industry began deregulation, along with the abolition of PUHCA and emergence of M&As, and listed power companies’ ownership started to feature significantly increased degree of concentration. The research on this change and its consequences has greatly helped us to better understand the various consequences of “regulation” and deregulation. They found that with the deregulation in the 1990s, the concentration of ownership of US power companies increased, and the majority shareholders were increasingly involved in speculative investment rather than being a custodian or a supervisor as people would believe. Enron is a good example. Enron's catastrophic event itself was actually the prelude to the financial crisis in 2008. The paper concludes that block holders, such as institutional investors, are not suitable as supervisors. They found that reducing regulation on financial risks related to M&A will lead to decentralized ownership; nevertheless, merely reducing regulation on operational risks, such as influenced investment rate of return, will not lead to decentralized ownership. So what kind of regulation to design and how to design become very important issues.


But how can a financial market with highly decentralized ownership be stable? And how to reduce the chances of market manipulation? In order to solve these problems, there should be some necessary complementary regulatory systems in addition to the issues discussed by Bolton-Rosenthal. The United States Senate and House of Representatives approved two US federal securities law in 1933 and 1934 respectively, which have been the world's first national regulatory laws on financial market. The core of the 1933/34 laws is mandatory information disclosure. There was no state-level financial market regulation before 1933 in the US, and the financial crisis in 1929 triggered the establishment of financial regulations. The Securities Act of 1933 was the first rule in the United States to regulate the financial market; The Trade Act of 1934 issued the next year established a financial regulator, Securities and Exchange Commission (SEC), for the first time in the world. Bolton and Rosenthal's paper mentioned the promulgation of these two acts for multiple times and their impact on the market. Next, I will simply share the work that I and my collaborators have done, which is highly complementary with Bolton and Rosenthal’s work (Li, Sun, Xu and Zeng, 2017).


The basic consensus between economists and jurists is that the rule of law is a necessary prerequisite for financial markets. But there is no sufficient evidence for a consensus on the impact of introduction of financial regulation, more specifically speaking, the impact of the two acts in 1933 and 1944 on the financial market.  


Figure 1 Most listed firms disclose voluntarily NYSE, 1933 (Moody’s Manual, 1934, p. a44)


Figure 2 The most commonly disclosed 15 items before the Act (Li, Sun, Xu, Zhao, 2017; Moody’s Manual 1934)

Prior to the adoption of the Securities Act of 1933, US listed companies disclosed their information voluntarily. Scholars opposing supervision believe that under the rule of law, listed companies would take the initiative to disclose information for their own interests. So there was no need for regulation. Figure 1 demonstrates the actual disclosure of information by listed companies prior to the enactment of the act in 1933. Figure 2 shows that before 1933, most companies would take the initiative to disclose a lot of information, despite there being no regulations compelling them to do so. However, the US financial crisis in 1929 made the legislators aware that the financial crisis occurred because of the manipulation of the market, partly due to the fact that some companies had chosen not to disclose information. So they decided to establish the laws, requiring mandatory information disclosure to stabilize the market. We systematically studied whether the market volatility was significantly reduced after the implementation of the Securities Act of 1933/1934. Figure 3 illustrates volatilities at the enterprise level and at the market level. In the figure, the time node, June 1934, is marked, and that is when the Securities Act and the Trade Act were performed and SEC was established. We can clearly see that, whatever point of view is adopted to measure, the market volatility after June 1934 declined more significantly than any time before.


Figure 3 1934 Securities Act vs. Volatilities (Li, Sun, Xu, Zhao, 2017)

Our series of very carefully done econometric work all statistically confirm the presentation of Figure 3. If you only see the date of market volatilities in pure time sequence, such as Figure 4, the explanation may be simpler and clearer. We use the algorithm developed by Bai Jushan to identify two structural mutations. The time of the first mutation is when the Securities Act of 1933 was enacted, and the second structural change arose when the Trade Act of 1934 was performed. The implementation of these two laws significantly reduced the volatility of the NYSE market. The summary is that after the implementation of the two laws in 1933 and 1934, the volatility of the market was greatly reduced, and the stability of the market managed to continue until the early 1990s.


Figure 4.Sharp declines of NYSE market volatility after enacting of the Acts in October 1933 and August 1934

Finally, let me share the experiences and lessons that China should and can learn from this. First, the rule of law is the cornerstone for a financial market that is functioning properly. What does the rule of law mean? First, there should be an independent and neutral court. Only a neutral court can ensure law enforcement, and in order to maintain the neutral position of the court for law enforcement, the court can only conduct ex post facto law enforcement in a passive way, relying on chilling effect. In the case of incomplete laws, ex post facto passive law enforcement will lose the optimal chilling effect. Thus, in the society with rule of law, it is necessary to introduce supervision or regulation, i.e. ex ante facto preventive law enforcement. In other words, regulation must be a tool to supplement and complete the rule of law system rather than to replace the dominant position of the rule of law.


To sum up, over the more than 200 years before 1929, despite there being no financial supervision or the rule of law as a basis, property rights were still basically protected and most companies would disclose their information, and the financial market could run properly. At the same time, we must see that the role of financial regulation, as a supplement to law enforcement, is fairly important. Bolton and Rosenthal's evidence suggests that a great deal of dispersed corporate ownership helped to stabilize the market after PUHCA implementation in 1935. But we must realize that this act just established regulation on the basis of fully protected private property rights. Our evidence suggests that the implementation of the two acts on securities and trade in 1933 and 1934 significantly reduced market volatility; similar to PUHCA in 1935 established on the basis of the rule of law, both acts were supplements to the existing regulations. In short, regulation cannot replace an independent court, but a supplement to an independent court for law enforcement. Moreover, regulators must be independent as well, so that it can become a fair supplementary mechanism for law enforcement.


Thank you!

◆please indicate the source if authorized: National Economics Foundation

◆photo:National Economics Foundation