SEC regulation of short-term borrowing disclosure

The 2008 financial crisis, triggered, in part, by excessive bank borrowing, led to the failure of a number of major financial institutions, including U.S. investment bank, Lehman Brothers. Investigating the reasons for Lehman’s failure, the bankruptcy examiner determined that the bank had improperly moved $50 billion off its balance sheet by misclassifying short-term trades as sales, whereas, in fact, they were a form of borrowing. This, and similar “window-dressing” at other major banks, precipitated an SEC inquiry. In April 2010, the SEC informed Congress that it was considering new rules to discourage financial firms from reducing borrowing in anticipation of their quarter-end reports.

Subsequently, in September 2010, the SEC unanimously voted for a proposal requiring increased disclosure about short-term borrowing. The rules would apply to all SEC registrants, with most disclosure required of financial firms and a broad definition of what constituted a financial firm. The proposed regulation was posted for public comment, with a specific request for comments on the benefits to investors and costs to registrants.

The comments received were, with one exception, from SEC registrants or their representatives. Moreover, the response was mixed, with some comments favouring enhanced disclosure and others expressing concern about the resulting cost. Only one comment was received from an investor, the importance of that constituency notwithstanding.

Here we attempt to obtain a broad assessment of investor opinion by investigating the market reaction to the SEC’s announcement of its intention to consider stricter disclosure (the “announcement date”: April 21, 2010) and the reaction to the SEC’s unanimous vote in favour of enhanced disclosure (the “voting date”: September 17, 2010). We interpret a positive market reaction to either event as indicating that the benefits of the proposed rule exceed the costs.

Portfolios of 2,450 financial and 3,970 non-financial SEC registrants were used to compute the mean cumulative abnormal returns for periods prior to, around, and after each of the announcement and voting dates. Results for various subsets, including commercial banks and savings institutions, bank holding companies, size quartiles, and exchange-listed and OTC registrants were also examined and compared. In general, they confirm expectations. Thus, for example, for the entire financial registrant portfolio, we find that the market reaction is positive and significant at the announcement date and negative and significant at the voting date. Moreover, the results generally are robust to alternate specifications using value-weighted portfolios.

This study appears to be the first to examine market reaction to proposed, as opposed to enforced, SEC regulation. It also provides an indication of the usefulness of the disclosure from the vantage point of users, including evidence that a “one-size-fits-all approach” to regulation is undesirable. The results also quantify the impact of the proposed rule on stockholders, and indicate that they are economically significant. Finally, on the question of short-term borrowing disclosure, the study complements the survey information gathered by the SEC.