30 June, 2022


Stock Market Regulator: Making It A “Toothless Tiger” No Good Sign

By W.A. Wijewardena

Dr. W.A. Wijewardena

The peculiar Colombo Stock Market

 Colombo Stock Market is a peculiar place. It doesn’t create just plain news. It creates scary news.

First, it was agitations by a group of market participants, known as high net-worth investors, for the removal of the Chief Executive Officer of its watchdog, Securities and Exchange Commission or SEC, from his post. His crime: getting too tough on investors who have been alleged to have practised the crime of engaging in ‘market manipulation for personal gain’ and ‘insider trading’ at the cost of other market investors. After a do or die battle for a few weeks, they succeed and the CEO is asked to step down by authorities who are supposed to protect the watchdog. This writer analysed the story in a My View published in this paper under the title “Share Market Game: Play it According to Rules” (available here ).

The pressure on stock market regulator

Even before this hot news got cool, the Chairperson of SEC became the target of attack by the same group of investors and once again, authorities yielded to them by allowing her to leave the place, of course this time, with dignity. Then, there was a long period of uncertainty in the stock market without a CEO or a Chairperson in SEC to steer the market’s regulatory arm. The market began to show its discontent by moving down the prices, but wiping out billions of wealth belonging to investors in the process. This is because when a market is temporarily driven up by a few investors, all others rally round them like a ‘herd’ as proposed by Daniel Kahneman and Amos Tversky in their famous prospect theory. As a result, when they are active, the market goes up and when they withdraw, it slides down fast. This phenomenon was captured by this writer in a subsequent My View published in this paper under the title “Controversy over the efficiency of share markets” (available here ).

The choice before the head of SEC: yield or quit

Then, after a long period of inaction, an acting CEO is appointed to SEC from within and a chairperson is brought from outside and installed therein. At first, the new chairperson, Mr Tilak Karunaratne, appeared to be a peace-maker and the restless market investors began to show signs of contentment. But once again when the new management at SEC started to become tough, as they should be in a background of perceived wide-spread market manipulation by some, the new chairperson becomes a target of attack by the same group of investors. After both parties entered a warpath that appeared to be a fight to death, a peace-making meeting was arranged with the country’s Head of State, but according to reports, it ended without success. A subsequent meeting with the Secretary to the Treasury also proved to be unproductive. Then, all of a sudden, the newly appointed chairperson of SEC shocked the market with an unexpected announcement that he would quit his job because he was “under immense pressure” to do so perhaps, as he elaborated on it, due to the “false information fed by a mafia of high net worth investors and their crony stockbrokers who have been involved in pump-and-dump deals”

A report filed on the front page of this paper as the lead story on last Friday further elaborated on the background to the chairperson’s sudden decision to quit. It said that “though the post of SEC Chairman is a non-executive one, Karunaratne was widely portrayed as someone who has been pushing for investigations into stock market malpractices, including so-called pump-and-dump deals. He was said to have re-opened files which were previously closed on alleged instructions from outside. Karunaratne was seen as a crusader against unscrupulous investors and brokers who were described as the mafia. In short he wanted an independent hand” (available here).

According to reports, he has submitted his resignation to authorities last Friday. About the pressure group that has been responsible for his premature departure, he is reported to have told the Reuters that “I don’t even call them investors. They are crooks. The pressure from those crooks goes elsewhere and then in turn that party is exerting pressure on me” (available here). What it implies is that in the war between the share market regulator and the unnamed section of the investors, the authorities have failed to protect the regulator and allowed the investors to liberally prey upon the head of the regulator. The message delivered has been ominous for the long term development of the country’s share market: If the head cannot survive, no one else in SEC could do so and it is better for them to amend their regulatory structure just to suit the so called investor block.

SEC Chairman’s allegations are serious

What the chairperson of SEC has revealed is that the Colombo Share Market is driven by a group of mafia, they are being supported by some crony stockbrokers and they have been engaged in pump and dump deals. If chairperson’s assertions are true, then, what is happening in the share market is equivalent to cold-blooded murders taking place in a civil society terrifying the civilian population before the very eyes of the law enforcement authorities who remain totally inactive and even supportive of the murderers.

Follow David Cameron and investigate charges

This is certainly not a situation where authorities can remain silent and non-committal. Since these assertions by the departing head of SEC are hotly disputed by a section of the market participants – the high net worth investors and the stockbrokers supporting them – it is necessary that they be investigated thoroughly by an independent commission to ascertain the truth. Such a course of action will enable the authorities to take all the remedial measures necessary to restore law and order in the share market which the chairperson of SEC and another section of the investors and also stockbrokers claim are absent in the market today.Sri Lankacan learn lessons from its colonial master, theUnited Kingdom, in this regard. When the leading British bank Barclays was fined recently by the UK’s financial market regulator, the Financial Services Authority or FSA, for fixing the global benchmark interest rate London Inter-Bank Offered Rate or LIBOR for a number of years, the British Prime Minister David Cameron promptly appointed a Parliamentary Committee to investigate into the embarrassing banking sector scandal with a view to finding out whether others too are involved in it. This is because financial markets today do not operate within the domestic boundaries only and, therefore, in the eyes of the investors – both domestic and foreign – the authorities should not only be impartial and law-abiding but also display to be so through their actions.

Herstatt fiasco prompting global common action

Financial markets are regulated throughout the globe by their respective governments. Since global markets are interdependent, since mid 1970s, there have been attempts at harmonising the financial market regulation and supervision by the international community. The need for such unified global action arose with the collapse of Herstatt Bank in Germany in 1974 giving rise to what is now known as ‘Herstatt Risk’ or failure of one country to fulfil its obligation to discipline financial markets thereby causing a series of market instability throughout the globe. In the Herstatt case, when the German bank regulators closed this private bank because of bankruptcy, other banks had delivered Deutsch Marks to this bank in Frankfurt in anticipation for payment in US dollars inNew York. Yet, due to the time zone difference, Herstatt failed to do so because when the New York Market opened it had been closed down inGermany. In this instance, German bank regulators washed off their hands saying that it was not their responsibility to regulate Herstatt affairs outside their country. Thus, the counterparty banks lost dollar payments but it sowed the seeds for common global action for harmonising financial market regulation.

Government’s job is to protect investors

Investors throughout the globe cause private savings to flow from one market to another in search of better returns and fuelling, in the process, the finance-based economic prosperity which the world is having today. Governments are facilitating this process by maintaining law and order in the markets and if there are market manipulations, by applying laws equally and impartially to those who are guilty of same. The latter is known as the observance of the Rule of Law. Hence, in the domestic regulatory structures, share market manipulations such as insider trading and front running have been categorised as criminal activities because they permit one investor to enrich himself at the expense of other investors, an act similar to robbing of one person by another. So, it is the duty of the governments to protect the property rights of those who save, invest and help countries to grow in the process by facilitating the market regulators to do their jobs properly.

If governments do not do that, how can the investors protect their investments? Economists have not attempted to answer this issue, but political scientists have sought to explain the phenomenon by using economic principles.

David Andrew Singer: Beware of political dimension of regulation

One such study has been done by David Andrew Singer, Professor of Political Science at the Massachusetts Institute of Technology, commonly known as MIT, in a paper he published in 2004 under the title ‘Capital Rules: Domestic Politics of International Regulatory Harmonization’ (available here).

What has been presented by Singer could be explained in simple language as follows:

Financial market regulators are created by politicians because societies demand them to do so as societies want financial system stability, a kind of an important public service provided by governments today given the importance of the financial systems in domestic as well as global economies. The regulators have a set of policy tools to deliver this service such as introducing regulations, supervision of the markets to prevent malpractices, preventing one investor from harming other investors and thereby maintaining law and order in the markets. In their action, they have to observe the Rule of Law so that all market actors have to be subject to the same laws and regulations without discrimination or preferential treatment. Such a course of action by regulators brings discipline to the market and that discipline makes a positive contribution to the wellbeing of the markets and their actors in the long run. This is because when market actors realise that their misdeeds are not tolerated by regulators and they are subject to penalties without discrimination or preferential treatment, they seek to operate within the regulatory framework set by the regulators for the larger good of the markets. It is in fact a reverse operation of the famous Gresham’s Law: Law abiding actors in the market will promote more law abiding actors.

Regulators serve societies and not politicians

Thus, regulators serve societies but not the politicians.

However, in practice, politicians come to the picture representing society and its members. If society has no voice or its voice has been subdued or its voice has been distorted through carefully crafted propaganda schemes, politicians may seek to realise a set of objectives of their own quite different from that of societies. They may even force the regulators to twist the regulatory framework to suit the realisation of their objective-set thereby creating mayhem in the market. This is again a reverse version of the famous ‘Principal-Agent Problem’ in economics. It is a reverse version because the principal here seeks to realise an immoral objective since it is against the society’s wish overriding the moral objective which the regulator as the agent seeks to realise for society.

Immoral objective of politicians

According to Singer, the objective of politicians is to maximise the contributions they receive from private parties for their political campaigns plus aggregate welfare while the regulator seeks to maintain its policymaking autonomy. The politicians set a boundary for regulatory action with the threat that they intervene in the regulator’s autonomy if he tries to overstep that boundary. Hence, it is an eternal conflict between the two parties and with sovereign powers at the disposal of the politicians, they are in a position to assume an upper hand in the conflict. Accordingly, if the regulator enacts a policy which is counter to the objective of the politicians, Singer says, that politicians can take some action to tame the regulators and bring them under control.

What politicians should not do

The politicians can intervene and change the policy so adopted by the regulators. The effects of such interventions have been described by Singer as follows: “Political intervention is the bane of a regulator’s existence. When politicians attempt directly to influence regulatory policy—for example, by holding hearings and publicly criticizing the decisions of regulators, or by legislating new regulations—they threaten the agency’s autonomy and prestige. Intervention may also affect regulators’ future job prospects, especially for an agency head who is forced to resign. The prospect of intervention by legislators therefore creates ex ante constraints on regulators’ discretion, which ensures that the principals can maintain some control over the agent. Regulators will use all strategies at their disposal to minimize the possibility of intervention”. (p 535)

Yielding hand regulators equally bad

But Singer has not examined another possibility in the conflict between politicians and regulators. That is, regulators becoming a ‘yielding hand’ to the wishes of the politicians and thereby twisting the regulatory framework for the benefit of politicians against the wishes of society. This they do in order to win favours from politicians and protect their jobs. In this case, the principal-agent problem is completely turned upside down because both the politicians and regulators, in collusion with each other, seek to realise a common immoral objective which society, as their true principal, has not bestowed on them. The danger of this possibility is that society comes to know of it only after the bending of the regulatory framework by regulators at the instance of politicians and at that stage it is too late to take any corrective action.

In either case, society has no redress except raising its voice. That voice, if raised sufficiently loud, will caution both the recalcitrant politicians and yielding regulators.

Otherwise, the toleration by society the reduction of the regulators to the status of ‘toothless tigers’ will not be good for its objective of attaining financial system stability.

(Writer is a former Deputy Governor – Central Bank of Sri Lanka and teaches Development Economics at the University of Sri Jayewardenepura. This article first appeared in Daily FT  – W.A. Wijewardena can be reached at waw1949@gmail.com )

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