Using Hostages to Improve the Quality of Financial Disclosure
Abstract: In a well-functioning stock market, issuing firms publicly disclose all relevant information to investors and prices approximate the true value of those firms. This disclosure generates liquidity as investors large and small engage in trading. While it is tempting to take this “good equilibrium” for granted, the current banking crisis suggests a “bad equilibrium” in which disclosure is suspect so banks stop lending to each other and small investors flee the market. In this paper, we argue that a good equilibrium was in place when the New York Stock Exchange operated as a non-profit organization. We argue that far from being an outdated and elitist holdover, the mutual form allowed underwriters, who dominated NYSE membership, to extract hostages from managers of firms listed on the NYSE. That is, managers were expected to invest personal funds in shares of other listed firms, including new issuers (“IPOs”). Since the hostage arrangement was tied to the non-profit form of the NYSE, we predict a decline in information quality after the NYSE became a for-profit firm in March 2006. By comparing the bid-ask spread before and after demutualization, we show that information quality did indeed decline. This finding holds after controlling for market-level variation measured by the bid-ask spread of the NASDAQ National Market. We believe our results can help shed light on the current banking crisis, which originated in areas of the financial system that lack a hostage structure.
