Race to the Bottom?

1. Race to the Bottom? By Michael W. Zhang

2. Race to the Bottom • In government regulation, a race to the bottom is a theoretical phenomenon which occurs when competition between nations or states leads to the progressive dismantling of regulatory standards. • In financial regulation, regulation setters might want to reduce to cost of firms to make their own regulations more attractive.

3. Cost of Regulation(Disclosure) • Predator cost • Mandatory disclosure reveals information of the firms • Documentary cost • Papers and accountants are not free • Internal control cost • Resources are directed, monitored, and measured • Punishment if “caught” • Earnings management

4. Benefit of Regulation(disclosure) • Investors’ confidence • Investors are risk averse • The variance of firms becomes less, the discount could also be less • Stability of market • Less bad apples • Allocation of capital • The investors have information before making investment • Race to the top • If the benefit dominates the cost, ……

5. Possible outcomes • Race to the top • Optimism • Race to the bottom • Pessimism • One totally dominate the others • Monopoly • Separating Equilibrium • NYSE vs. NASDAQ

6. Worst Cases • Monopoly • Local firms still have preferences of local markets and regulation • Race to the bottom • People are short horizon, cost dominates benefit in short run • Consequences • Bad capital allocation • Volatile stock market • Poor investors

7. My Experiment • Goal • To test which outcome is the result of competition between regulators • Race to the bottom exist or not • Schemes • Ztree program • 3 types of players: Regulation setters, firms(IPO) and investors • Second-price, sealed-bid auction • Results

8. Players • Firms: • Observation: Firm’s own signals and all public info • Objective: To maximize the sell price • Choices: Different regulators with different requirement of disclosure • Investors: • Observation: Public info, their own bids • Objective: To maximize the profit • Profit = liquidation value – Price • Choices: Bid price

9. Liquidation Value • There is a discount for disclosed information • is the discount rate

10. Players • Regulators: • Observation: Public info • Objective: To get as many firms as possible • I assume a firm will pay a fix amount a fee to the regulator • This amount is relatively small comparing to the firm value • Choices: Different level of disclosure • Each firm has five signals, the regulator will set the disclosure level of the firms

11. Information • Public information • Disclosed information by firms • Winning price of the bids • Firms’ choices of regulators • Regulation setters’ choices of disclosure level • Private information • Investors’ own bid • Firms’ undisclosed information

12. Timeline of the Experiment • Regulators decide the disclosure level • Firms observe their signals, then choose one regulator or “ventral capital” • The first firm’s disclosed information becomes public knowledge, and it is sold to public in second-price, sealed-bid auction • The price and the profit of the winner becomes public knowledge • The second and following firms are sold

13. Information Asymmetry and Liquidation Value • When the disclosed signals does not convey any information about undisclosed signals • The discount rate is crucial (<1/2 , =1/2, >1/2) • When the disclosed signals does convey information about undisclosed signals • Different firms have different distributions of signals • Disclosed information might reveal the underlying distribution of the firms’ signals

14. Program • Background • Number of players • Firms • Investors(Regulators) • Firm’s signal • 5 signals • Timeline of Experiment

15. Use of Time

16. Choices of Regulators

17. Top and Bottom of Regulators

18. Choices of the Firms

19. Further Work • Improve the efficiency of the program to save some time • Make people excited (too much idle time) • Add enforcement as a parameter • Design of information • Secondary market ??