Arthur F. Burns Fellow Peter J. Wallison

Peter J. Wallison, AEI's Arthur F. Burns Fellow in Financial Policy Studies, notes that the Treasury Department's recent plan for a new financial regulatory structure, while commendable for its regulatory reform proposals, fails to deal with the problem of excessive regulation and litigation risk.

The Treasury's plan for a new financial regulatory structure deserves considerable praise. It recognized that the financial services industry--made up of banks, securities firms, and insurance companies--was in fact one industry and should be regulated that way.

The Treasury proposed the long overdue step of taking holding company regulation away from the Federal Reserve Board and placing it where it belongs, with the regulator of the banking component of a financial holding company. And it proposed to eliminate the so-called separation of banking and commerce, which protected the banking industry against competition.

But as far-reaching and visionary as it was, the plan fell far short of its original purpose. The Treasury began its study a year ago to address a problem that was just then attracting significant attention--a gradual erosion of American pre-eminence in the world financial markets. At that point, it was becoming apparent that financial transactions, particularly public offerings of securities, were increasingly moving abroad, primarily to London but also to Hong Kong and other growing financial markets.

Since the Treasury began its study in 2007 the situation has continued to deteriorate. The loss of financial activity to markets abroad has now been documented in four reports by respected groups: the U.S. Chamber of Commerce, the Financial Services Roundtable, the Committee on Capital Markets Regulation, and a joint report by Senator Schumer and Mayor Bloomberg. All noted the gradual withdrawal of initial public offerings from U.S. markets and again laid the cause at the door of excessive regulation and private class actions lawsuits.

The most recent information comes from the second study by the Committee on Capital Markets Regulation. Their December 2007 report, focusing on the public securities markets, shows that the trend away from America is growing more pronounced.

One of the most stunning statistics in the report is the proportion of all IPOs by U.S. companies occurring overseas, primarily in London. The number was negligible before 2005, and a little over 1% in 2006. But now it is slightly more than 4%. The fact that U.S. companies would feel compelled to offer their shares to the public for the first time in a foreign market speaks volumes about conditions in America today.

Other data in the committee's report are equally worrisome: Equity raised by foreign issuers in the U.S. private markets, which averaged 6.8% of all equity raised in the U.S. public markets between 2000 and 2005, was at 31.2% in 2006--indicating that foreign companies are avoiding U.S. public listings in favor of private financing. And 12.4% of foreign companies delisted from American markets in 2007, compared to an average of 5.2% between 1997 and 2005.

As bold as it is, the Treasury plan sidesteps the important substantive issues of regulation and litigation that underlie this trend. Not coincidentally, they both have serious political implications--the unremitting desire of many in Congress to exercise control over the financial markets and the governance of public companies, and the strong financial support for the Democratic Party from the plaintiffs' bar.

These costs and risks are the underlying reasons for the gradual withdrawal of IPOs--American as well as foreign--from our public securities markets. But because they are politically controversial they remain unaddressed by either the administration or Congress.

A Treasury plan that was true to its original purpose would have provided the leadership necessary to effect policy changes, particularly with respect to the excessive litigation risk that the current system creates.

There is no policy justification for private securities class actions. Virtually all studies show that they provide no significant benefits to any group other than the plaintiffs' bar. When they are settled by corporations--and most of them are settled rather than litigated because of the litigation costs--they amount to a transfer from the innocent shareholders who didn't trade to those who did.

In making clear that litigation risk was a key reason for foreign company withdrawal from our public markets, the Bloomberg-Schumer report noted: "Not only did 2005 set a new record for the highest-ever number of securities class-action settlements, but the overall value of these settlements overshadowed every prior year. The total bill for securities settlements in 2005 was $3.5 billion (omitting WorldCom-related settlements of approximately $6.2 billion), up more than 15 percent over 2004, and nearly 70 percent over 2003."

One of the commendable elements of the Treasury's plan was that it did not cater to the politics of the present. The drafters knew that their recommendations would not be accepted, or even seriously debated, while they were in office. Instead, they were laying out a road map for a more sensible regulatory structure in the future

As welcome as this is, it is sad that the agency did not close the circle that it opened. Regulatory structure is important, and the current structure needs reform. But the direct costs of today's excessive regulation and litigation risk will be what determines the competitiveness of America's financial markets today and tomorrow.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.