Financial regulation notes

DISCLOSURE

Disclosure is one the key strategies used to manage asymmetric information. Why are asymmetries in information problematic in the capital market? To answer this question, we have to distinguish between primary and secondary markets.

Primary market: market for the first issuance of securities. The issuers ask the investors for money. The relationship is issuers vs investors.

Secondary market: market where the securities already issued are exchanged. The market is done by investors with another investor. The relationship is between investors and investors.

How does asymmetry in information work in primary market? Issuers have superior information and the main problem is adverse selection. The investors cannot distinguish between good and bad issuers. Therefore, they offer a price with a discount. When a company goes public and raise capital with the market, the typical feature of an IPO is the under-pricing. Under-pricing means that the price paid by the investors is less.

than the real price because the price in IPOs suffers of adverse selection by the investors. Therefore, there is a kind of discount. The problem with under-pricing is that the entrepreneurs are not available to sell at such a low price. The stronger the asymmetry in information is, the greater is adverse selection and therefore the greater is under-pricing and the higher the cost of capital is. But when under-pricing is severe, a project which could be very profitable can be given up because the issuer doesn't want to de-value and waste its project for nothing. Asymmetry in information is a source of higher cost of capital because you are supposed to give more to get less money.

How does asymmetry in information work in the secondary market? In the secondary market, there are three parties: the issuer, investor A and investor B. The issuer does nothing, investor A sells and investor B buys. The problem is that investor A doesn't know how much informed is investor B and vice-versa. So,

Every investor suspects that the other is a cheater and this becomes asymmetry in information. Investor A may think that investor B has more information about the price than he has, so A will offer less. Because of the asymmetric information, the seller will ask for more and the bidder will ask for less bid-ask spread. Bid-ask spread is the difference between the price offered by the bidder and the price required by the seller. The larger the bid-ask spread, the lower is the liquidity. The lower the liquidity, the higher the cost of capital is because if I want to enter a market which is very poor in terms of liquidity, I will ask for a premium and therefore the borrower of the money will have to pay more. Asymmetry in information is a bad deal for the whole market because it means that a wide bid-ask spread is generated which generates less liquidity and higher cost of capital inefficiencies.

Disclosure avoids these problems. Disclosure of information corrects the asymmetry in

Information is crucial in financial markets. When information is disclosed, everyone has access to it, eliminating the problem of adverse selection. This means that good projects will be financed, while bad ones will not. As a result, the bid-ask spread will be low, liquidity will be high, and the cost of capital will be lower. Disclosure is seen as a solution to the asymmetry of information, aiming to reduce the cost of capital.

Disclosure also has other advantages. It helps to mitigate agency costs, as everyone has access to the same information. This reduces the opportunity for agents to engage in opportunistic behavior, resulting in lower agency costs and overall increased efficiency.

However, there are costs associated with disclosure. Compliance costs, such as adhering to laws and regulations, can be significant. Additionally, individuals may be reluctant to disclose personal information.

publicofficers are obliged to do, to avoid the envy of other people. Disclosure has costs of compliance and implies for the issuer opportunity costs: you lose the opportunity to keep your info secret to avoid third party behaviour. In a relationship-based system there is the monopoly of information about you by the banks, which is a cost but the bank will support you as a client. When a company, which is typically financed by banks, decides to go public, the information that at the time were subject to the monopoly of the bank, becomes public. Therefore, the bank loses the competitive advantage on information. When is disclosure efficient? When it is provided on voluntary basis. Because you know that asymmetry in information is bad for you, you can disclose the information on your interest. Therefore, you are in the best position to evaluate whether benefit and the costs of the disclosing are okay or not. Because disclosure comes with costs, voluntary disclosure is the smartest solution toproviding incomplete or misleading information. In the secondary market, disclosure is crucial for maintaining market efficiency and ensuring fair trading. Disclosure allows investors to make informed decisions and reduces information asymmetry between market participants. It promotes transparency and accountability, which are essential for the proper functioning of financial markets. However, disclosure also comes with costs. Companies incur expenses in gathering, preparing, and disseminating information. Moreover, excessive disclosure requirements can lead to information overload and make it difficult for investors to distinguish relevant information from noise. Therefore, it is important to strike a balance between the benefits and costs of disclosure. The optimal level of disclosure should be determined by market forces, rather than imposed by regulatory authorities. Voluntary disclosure allows companies to tailor their information to the specific needs of investors and avoids unnecessary burdens. However, in some cases, mandatory disclosure is necessary. This is particularly true when transaction costs are high, making it inefficient for market participants to negotiate individual disclosure agreements. Mandatory disclosure helps manage transaction costs and ensures that all investors have access to essential information. In conclusion, disclosure is essential for the proper functioning of financial markets. It promotes transparency, reduces information asymmetry, and allows investors to make informed decisions. While voluntary disclosure is preferable in most cases, mandatory disclosure is necessary in certain situations to manage transaction costs and ensure fair and efficient markets.

investors vis-à-vis with the issuer. In secondary market, we would have a larger bid-ask spread and then less liquidity in the market. In both cases, we would have a higher cost of capital, which instead disclosure may reduce.

Theoretically, we could assume some forms of voluntary disclosure: issuers have an incentive in disclosing information, but there are a lot of transaction costs. We apply the Coase's theorem to demonstrate that sometimes mandatory disclosure makes sense in the capital markets because a pure market mechanism is affected by so many transaction costs that at the end the outcome could be inefficient.

Who is the one who makes use of the disclosed information? The issuers should disclose all the relevant material information, then the investors will elaborate on the disclosed information and will take an investment decision. That's the naïve model, the idea that disclosure is crucial to give to each investor that information needed to take an informed decision.

This approach is as unsophisticated as investors that is supposed to protect. In fact, not all the investors have the competence to understand disclosed information, the transaction costs to elaborate and process this information are so high that is unconceivable that the little investor will take the disclosed decision and elaborate an investment decision based on this information, it is too complicated. Transaction costs in this field are too high, nobody reads the hundreds of pages of the prospectus. Financial analysts ("buy, sell or hold") are those people whose job is to read financial information provided to the market and getting an idea about the issuer providing this info. The job of financial analysts is to buy when the shares are under-priced. If the shares go down too much, you start buying because based on your information it is time to buy. At a certain point, you will reach an equilibrium. You stop buying when you get to the fair price. What will you stop buying? When,

Based on all available information, the price is fair. This means that, if the market works like this, at a certain point the price reflects all the available information. Because of arbitrage, you get to an equilibrium where the price is the fair price because it reflects all the available information. We can assume that at any moment, the current price reflects all the available information. This means that the market is efficient Efficient Capital Markets Hypothesis (ECMH). This is the hypothesis under which capital markets are efficient, meaning that at any time prices reflect all the available information because any new information disclosed to the market is immediately processed by some financial analysts, which buy or sell to the point that the price immediately adjusts to the level capable to reflect the available information. If we have this hypothesis in mind, we understand why mandatory disclosure is meaningful. Mandatory disclosure is for the informed traders and through it.

The market generates prices which reflect all the available information. Therefore, the little investor is protected because he can freeride on the job done by the informed traders. Mandatory disclosure doesn't aim at giving all the investors the tools for an informed decision, but aims at creating correct prices so that everybody can freeride on these prices. Until the crisis of 2008, ECMH was a mantra. Now, this model is very controversial.

Parmalat case: Parmalat went bankrupt in a day. Before the drop, the price was stable, why?

1. Herd effect: everybody follows the leader. Some informed traders didn't realize about the strangeness in the balance sheet and everybody followed them. This phenomenon is common in capital markets: many traders follow the lead traders whatever they do because they are the "smart guys". This is a cognitive limitation. This happened in 2008 too.
2. Conflict of interests: Bank of America was the leader of the banks lending money to

Parmalatand made billions of commissions and interests over the years with Parmalat. It financedParmalat repeatedly because it made billions in revenues by lending to Parmalat. Clearly,the very moment in which Parmalat went bankrupt, Bank of America lose money they lendand they had a huge interest in keeping the securities at high price to make the story goingon. Probably, this was a way of artificially inflating the price of Parmalat to make thebusiness for the lenders going on, to avoid the disaster. This is a form of marketmanipulation.

The problem with the ECMH is that the hypothesis suffers from cognitive limitations by investorsand doesn't consider the possibility of conflicts of interests. When the market price suffers ofcognitive limitations or conflicts of interests, the ECMH doesn't work. In information, there is asignificant amount of noise in the market prices. Market prices are influenced by availableinformation and by a significant degree of noise. If there is

A significant degree of noise, you cannot keep market prices as something on which you can base a whole legal building.