Are we about to see the next blame game!

Being a capital market participant in Sri Lanka, I have had the opportunity to associate the stockbroking community and other participants who are active in the market (some are people who may not be actively engaged but keep examining the markets). With this encounter I noticed one thing about most of these participants, especially the stockbrokers and the not so sophisticated participants (not the Institutional investors, capital markets experts, etc), that is there is little bit more enthusiasm, energy and good words about the markets at the moment. Why was it noticeable? Because there was a time, 2012 to 2013 end, that everyone was blaming Securities & Exchange Commission of Sri Lanka (SEC) for not properly regulating the markets, Colombo Stock Exchange was not doing the right things, etc. Every one was blaming someone. Some people even left the entire capital market. The reason was that soon after the end of the war the Sri Lankan market moved up very sharp for about two and half years and then started the steep down fall. The extent was such that in 2010 and 2011 CSE was among the top performing markets globally and similarly in 2012 it was one of the worst performing markets worldwide. The reasons are obvious for the different behaviors of participants, when things are good there is no one to blame (well there shouldn't be! Everyone is a winner with a smile on face) and when things are bad someone else is responsible for that.

Why is there are smile on faces?
There is an answer for that question. The Sri Lanka's only exchange, Colombo Stock Exchange (CSE) has rallied this year as a result of a variety of reasons. For instance, the All Share Price index, which measures the movement of all the listed stocks on the CSE, gained 15% ytd and 20.6% from May 2013 to date. The S&P SL20 index, which captures the movement of most liquid blue chip companies, increased 15.1% ytd and 16.8% from May 2013 to current date. Consequently, the market is at present priced at 18.3 times the Earnings and 2.1x the book value (on trailing figures). If that is a too stretched a price for Colombo? Well that is a discussion I would reserve for a future post!

Given below are the price movement charts for All Share Index followed by S&P SL 20 Index.

Who gets blamed?
Needless to say that Regulators are the first to be blamed when the blame game kicks in. Hence, SEC takes the bulk of it and ironically they also do things that make them vulnerable to that. For instance, when the markets started behaving anomalous and crashing in 2012, SEC started introducing many ad-hoc rules in a desperate move (I doubt if there was stakeholder consultation to introduce some of those rules,  because usually we see some consultative paper floating around to extract comments) A careful evaluation of the SEC web page (Directives and Circulars section) from 2009 through 2014 gives some insights in to differences in frequency of market regulation.

Rebuilding the trust.
Then the Regulators start doing things to rebuild the lost reputation, trust, confidence. In the rebuilding process, lot or organizational reorganization takes place where we witness SEC chairman quitting the job, new appointments, staff reshuffling, etc.  

Well, I don't blame SEC for that and understandably this is the case even in the most developed markets like USA. (during the GFC we heard news of many regulations, insider trading cases, etc which we don't hear that often at present) I guess this is how markets evolve over the years.

As part of the rebuilding process, the SEC embarks on rapid market development drive (which includes investor forums, interfering with market forces, etc) SEC Annual reports will give some context to this, I'm sure.This has now resulted some market participants to ask; is SEC's role regulation of market or development of market? Isn't it CSE's role to develop market and SEC to regulate it?

Bottomline
Of course these questions remain unanswered for the time being. However, there seems to be certainly a role conflict. But, what you and I have to understand is that those who were late to appreciate this market situation will soon jump on the blame game. So be prepared for that and take necessary actions (rather than react) Simply, if the umpire in a Cricket match become a player, it's not a good thing.

Regulatory Capture

Recently, I and my colleague were walking out of a meeting with a CEO of a company. As we were walking out, we were discussing on Regulatory Capture which we have both learned while we were pursuing an educational qualification. What led us to the discussion was that the particular CEO of the insurance company we met was previously an officer at the regulatory body (Insurance Board of Sri Lanka) which acts as the regulator of the insurance industry in the country. Today, a discussion on the same subject matter appeared on the newspaper, which prompted me to write this piece. As pointed out in the article there and as we have encountered, there are several examples that we can point out to this fact.

The Role of the Regulators

Be it the Central Bank of Sri Lanka, Securities and Exchange Commission of Sri Lanka, Insurance Board of Sri Lanka, Consumer Affairs Authority or any other regulatory body, their main role, simply, is to look after the public interests or the interests of the individual consumers of the regulated industry’s products, i.e., Financial Products, Securities, Insurance Products, etc. In academia, this is identified as the “public interest” hypothesis which conceives that government regulation benefits consumers of goods and services. The contrary argument is the “Capture” hypothesis which theorize that producers of goods and services receive net benefits from government regulation. 

Capture Hypothesis

A theory of regulatory behavior that predicts that regulators will eventually be captured by special interests of the industry being regulated. In the Capture Hypothesis it is argued that regardless of why a regulatory agency was set up, eventually special interests of the industry it regulates will capture it. This happens when the regulators become key personnel at the firms they are entrusted with regulating or personnel from industry become regulators. 

Is this a problem found only in Sri Lanka? No. It has not been a phenomenon seen only in Sri Lanka. Across the globe there are instances of regulatory capture where questions were raised as to how effective the regulatory bodies are in protecting the interests of the public. It is also reported in media that regulatory capture was responsible even for the recent financial crisis.   

The other question is whether the prevalence of this, of regulators ending up at entities they used to regulate, is bad for the Sri Lankan markets or not?  Well this is a question that has not been answered objectively by anyone (as far as I know) and neither do I am in a position to answer this question. However, a bit of news analysis will definitely show that this has not been good for the markets either. For instance, the resigning of SEC DG Malik Cader, SECchairperson’s subsequent resignation, Tilak's resignation as SEC chairman, etc. While it is not right to say that all these things were as a result of regulatory capture alone (rather as a result of a plethora of things), I believe that a proper study will reveal that there was a certain element of regulatory capture that was responsible for some of these issues. 

Are they not supposed to work!

The other question is; are these regulators not supposed work after they complete their respective tenures with the regulators? My belief is that they shouldn’t be joining the entities that they used to regulate, at least for certain period of time. (there would be a question raised by anyone against this on the basis that they know better the industries they regulated and how are they going to work for a totally different sector which they don’t know!!!) 

The bottomline

The economic rationale for regulation is that it offers benefits; albeit not measureable. These benefits from a capital market perspective may, broadly, include efficient markets, efficient capital flow, investor protection, etc. Potential beneficiaries are investors, issuers and other market participants. However, these benefits don't come free, they incur a cost. End of the day the taxpayers finance the regulatory agencies and hence they should be benefiting from it rather than a select industry group.