Does Better Corporate Disclosure Boost Markets?

Stronger financial reporting standards seem to mean more for growth of countries’ credit markets than their stock markets

Financial markets are, at heart, about faith in numbers: The more investors trust the veracity of the data they’re given about companies and economies, the likelier they are to feel confident about putting money to work in stocks, bonds and other assets.

That’s the logical assumption, anyway. But is there a direct link between confidence in a country’s financial disclosure rules and the growth of its capital markets? UCLA Anderson’s Henry L. Friedman took a close look at that relationship, and found that stronger disclosure requirements registered differently in countries’ credit markets (that is, bonds and bank lending) than in stock markets — and not in the way many investors probably would think.

In a study published in the Journal of Financial Reporting, Friedman began with a global survey of corporate executives undertaken each year by the World Economic Forum. Since 2002 the survey has asked executives in approximately 150 nations to rate the strength of financial auditing and reporting standards (known as SFARS) in their home countries. The ratings scale ranges from 1.0 (extremely weak) to 7.0 (extremely strong).

Most respondents are CEOs or at a comparable executive level in their countries. “As such, respondents are expected to be sophisticated market participants,” Friedman writes, though he cautions that their views might differ from institutional investors.

Confidence in disclosure quality under SFARS is defined as “the expectation that firms in general will provide more and/or better information — i.e., information that is more accurate and less biased,” the study says. “This allows market participants to expect lower future uncertainty” about the companies, which in turn should boost willingness to engage in the market as buyers or sellers.

Not surprisingly, large unexpected declines in SFARS ratings from year to year tend to be associated with accounting scandals, corporate governance concerns and civil unrest, while large unexpected increases in SFARS often are associated with positive capital markets reforms or corporate reforms, and periods of civil calm. Measured since 2002, South Africa, Finland and New Zealand have the highest average SFARS scores, at 6.35, 6.27 and 6.22, respectively, while Myanmar and Angola are lowest, at 2.47 and 2.74. The U.S average is 5.65, compared with the global average of 4.70.

Friedman compared the executives’ grading of SFARS in their countries over time with five main proxies for capital markets development: number of stock-exchange-listed firms relative to population; stock market capitalization; stock trading volume; credit provided to the private sector from banks; and credit provided to the private sector from all sources, including bond markets. The latter four all were measured as a percentage of gross domestic product.

Friedman also tracked changes in 12 other economic gauges, including countries’ political stability and capacity for innovation, as “controls” to reduce the risk of other influences confounding results.

Overall, the study suggests that high SFARS ratings are a big deal to money lenders — but much less so to stock investors.

Executives’ SFARS scores are “significantly associated” with expansion of credit markets, meaning increased bank lending and bond issuance, Friedman writes. The data showed a direct correlation between countries’ rising SFARS ratings and growth in credit provided to private-sector borrowers.

By contrast, the study’s results “do not consistently imply that SFARS is associated with larger or more active stock markets,” Friedman writes.

“The stronger association between SFARS and credit market development relative to equity market development may be surprising, given that equity is usually considered more information-sensitive than debt,” the study says.

Then why should rising SFARS ratings do more to boost a country’s credit market development than stock market development? One answer, Friedman suggests, is that equity markets in many countries simply don’t have enough critical mass to be moved much by improved disclosure, compared with the size of credit markets. Worldwide, credit markets are far larger than stock markets: Total global bond market capitalization was $103 trillion in 2018, compared with $75 trillion for global stock market capitalization. Bank lending adds many trillions of dollars more to credit markets’ total size.

What’s more, stock markets “may be more prone to short-term booms and busts than credit markets,” which could weaken the association between disclosure confidence and equity market growth relative to credit market growth, Friedman writes. Debt markets also stand to benefit directly if improved corporate disclosure gives lenders more confidence in the value of loan collateral and in companies’ ability to maintain debt covenants, such as minimum profit levels.

For stock markets, there’s also a flip side to the otherwise laudable effects of government-imposed strengthening of corporate reporting standards: “A downside of greater confidence in disclosure quality is that interventions improving such confidence may be costly” for companies, impairing equity markets’ growth, the study says.

Case in point: The Sarbanes-Oxley Act of 2002, passed by Congress in the wake of the corporate scandals of the early 2000s (Enron, Worldcom), mandated significant new disclosure and governance requirements for publicly listed firms. The result was a jump in smaller U.S. companies’ suddenly delisting their stocks rather than spending money complying.

Still, a government’s failure to address corporate fraud with stronger regulation could pose a serious threat to individual investors’ faith in the stock market: Friedman notes that a 2016 study by Giannetti and Wang found that when corporate fraud in individual states is revealed, households in those states cut their stock holdings across the board. “Households decrease their stock holdings in fraudulent as well as nonfraudulent firms. Even households that do not hold stocks in the fraudulent firms decrease their equity holdings,” the study said.