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On the Effects of Capital Markets’ Regulation on Price Informativeness: an Assessment of EU Market Abuse Directive

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Abstract

This study assesses the impact on price informativeness of the market abuse directive adopted by European economic area member-states. Price informativeness is measured by the future earnings response coefficient that captures the ability of stock prices to reflect firms’ fundamentals and future profitability. A difference-in-differences analysis is performed to compare the evolution of this coefficient in countries that adopted the directive with that of countries from a control group. The preliminary findings suggest a decline in information content of stock prices about firms’ future profitability in the aftermath of the directive’s entry-into-force. Further exploration suggests however that the detrimental impact is concentrated on countries that neither improved the quality of enforcement regimes nor reinforced the supervisory powers and resources available to national financial authorities following the Directive’s adoption. The pre-existing state of the legal framework has also influenced the obtained results. The impact was particularly detrimental in countries with weaker legal institutions that did not undertake a shift in enforcement with respect to the new law, suggesting that the negative influence of inefficient bureaucracy and weak legal institutions on price informativeness was exacerbated by the adoption of the new rules.

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Notes

  1. Prices send public signals to economic agents, potentially influencing their decisions (Hayek 1945). As Fama (1970) also argued, price signals in markets guide the allocation of resources. Therefore, the influence of capital markets regulation is not circumvented to financial market outcomes as the role of stock prices on allocation means that new regulation could also have a real economic impact.

  2. In effect, liquidity shocks could stoke noise trading, thus raising mispricing in certain contexts. The model developed by Calcagno & Heider (2008) predicts higher mispricing after (positive) liquidity shocks when the new equilibrium sparks noise trading. According to De Long et al. (1990), if the proportion of noise traders in the market exceeds a crucial level, this effect causes noise trading to increase vis-à-vis informed trading, eventually dominating the market. Greene & Smart (1999) and Bloomfield, O’Hara, & Saar (2009) report higher levels of uninformed trading and mispricing even in the presence of liquidity improvements.

  3. MAD replaced Directive 89/592/EEC on insider trading.

  4. Their results suggest that the same forces that have hindered the effectiveness of securities regulation in the past are still at play, when new rules are introduced.

  5. The application of the filters in conjunction with missing data for some key covariates decreased the sample size by 68,787 firm-year observations.

  6. More precisely, it assumes the value of one if MAD was effective in the beginning of fiscal year t.

  7. CESR. 2007. Report on CESR members’ powers under the Market Abuse Directive and its implementing measures, #CESR/07–380. Committee of European Securities Regulators, Paris.

  8. CESR. 2010. Review panel report: MAD options and discretions 2009, #CESR/09–1120. Committee of European Securities Regulators, Paris.

  9. CESR. 2008. Report on administrative measures and sanctions as well as the criminal sanctions available in member states under the Market Abuse Directive (MAD), #CESR/07–693. Committee of European Securities Regulators, Paris;

    CESR. 2009. Final report of the review panel concerning the updated self-assessment and peer review of CESR’s Standard No.1 on financial information, #CESR/09–374. Committee of European Securities Regulators, Paris.

  10. Price informativeness fosters market discipline and effectiveness of monitoring (Holmstrom and Tirole 1993), facilitates the functioning of the market for corporate control, improves the effectiveness of management compensation-schemes based on market data (Faure-Grimaud and Gromb 2004), or simply increases knowledge about the health of the firm available to the board of directors (Ferreira, Ferreira, and Raposo 2011). Moreover, Lambert, Leuz, and Verrecchia (2007) demonstrate that more efficient prices help lower investors' risk of estimating the intrinsic value of a firm, thereby diminishing cost of capital. A new stream of literature has also emphasized the role of managerial learning in that stock prices influence management decisions, and particularly investment (Dow and Gorton 1997; Subrahmanyam and Titman 1999). According to this view, prices are a source of incremental information to managers, helping and guiding their decision-making processes.

  11. The explanatory power of the FERC model is three to six times larger vis-à-vis the traditional ERC model. Furthermore, the authors find that the estimated coefficient for future earnings was greater than that for current earnings.

  12. The introduction of future returns in the regression aims at capturing changes in expectations about future earnings after the current period, thereby reducing concerns about measurement error (Lundholm and Myers 2002). The choice of utilizing up to three leads on future earnings and returns (k = 3) is consubstantiated by the fact that adding further leads of those variables added little explanatory power to the regression (Collins et al. 1994).

  13. In a supplementary test, we estimated Eq. (1) separately for each country, using data for the period preceding MAD’s entry-into-force, and concluded that the median FERC for the whole sample of countries is around 0.32. Thus, one interpretation of our results is that the median country in terms of price informativeness before MAD would fall to the (upper bound of the) bottom quartile (0.26) after the Directive’s entry-into-force.

  14. Apart from \(LOSS\), these variables are converted into fractional rank variables between zero and one within country-year cells.

  15. The interactions of \(ShiftEnf_{C}\) and covariates from the baseline FERC model were suppressed. We assumed that decision on the results obtained in an auxiliary regression similar to that reported in column [3] of Table 2. That is, we run a regression of current returns (\(R_{t}\)) against a constant, one-year lag of earnings (\(X_{t - 1} )\), current earnings (\(X_{t}\)), the sum of earnings for year t + 1 through t + 3 (\(X3_{t}\)) (all scaled by lagged market capitalization), three-year ahead returns (\(R3_{t} )\), and interactions of the former with \(ShiftEnf_{C}\). Our aim was to ascertain whether the FERC of firms located in countries with a shift in enforcement is the same as in those located in countries that adopted MAD without a shift in enforcement before the passage of the new law—the regression is thus restricted to firms located in the EEA and to the period 1997–2006. Notably, the interaction of \(ShiftEnf_{C} {*}X3_{t}\) is not statistically meaningful in that setting, suggesting that the FERC in the two sets of firms was not different prior to the event. We adopted a similar setting with respect to supervisory powers and staff growth, and conclusions were similar. In view of such results, and to avoid collinearity issues provoked by the presence of multiple interactions, more parsimonious models were adopted.

  16. The sample is first divided by the rule of law index. Then, we compare firms from the treatment and control groups in each partition, subdividing the sample of the treated based on the existence of a shift in enforcement.

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Acknowledgments

The authors gratefully acknowledge valuable comments from an anonymous reviewer and financial support from Fundação para a Ciência e a Tecnologia (UIDB/04007/2020).

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Authors and Affiliations

  1. CEFAGE, Universidade de Évora, Palácio Do Vimioso, Largo Marquês de Marialva 8, 7000-809, Évora, Portugal

    Paulo Pereira da Silva & Isabel Vieira

  2. CMVM, Portuguese Securities Commission, Rua Laura Alves no. 4, 1064-003, Lisbon, Portugal

    Paulo Pereira da Silva

  3. ISCAL - Lisbon Accounting and Business School, Avenida Miguel Bombarda, 20, 1069 - 035, Lisbon, Portugal

    Paulo Pereira da Silva

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da Silva, P.P., Vieira, I. On the Effects of Capital Markets’ Regulation on Price Informativeness: an Assessment of EU Market Abuse Directive. Financ Mark Portf Manag 36, 125–157 (2022). https://doi.org/10.1007/s11408-021-00392-6

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