THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 225

CHAPTER 8

FYI

An Economic Analysis of Financial Structure

193

Has Sarbanes-Oxley Led to a Decline in U.S. Capital
Markets?

There has been much debate in the United
States in recent years regarding the impact of
Sarbanes-Oxley, especially Section 404, on
U.S. capital markets. Section 404 requires both
management and company auditors to certify
the accuracy of their financial statements.
There is no question that Sarbanes-Oxley has
led to increased costs for corporations, and
this is especially true for smaller firms with revenues of less than US$100 million, where the
compliance costs have been estimated to
exceed 1% of sales. These higher costs could
result in smaller firms listing abroad and discourage IPOs in the United States, thereby
shrinking U.S. capital markets relative to those
abroad. However, improved accounting standards could work to encourage stock market
listings and IPOs because better information
could raise the valuation of common stocks.
Critics of Sarbanes-Oxley have cited it, as
well as higher litigation and weaker share-

occurs when people who do not pay for information

take advantage of information that other people have
paid for. This problem explains why financial intermediaries, particularly banks, play a more important role
in financing the activities of businesses than securities
markets do.
5. Moral hazard in equity contracts is known as the
principal agent problem because managers (the
agents) have less incentive to maximize profits than
stockholders (the principals). The principal agent
problem explains why debt contracts are so much
more prevalent in financial markets than equity contracts. Tools to help reduce the principal agent problem include monitoring, government regulation to
increase information, and financial intermediation.
6. Tools to reduce the moral hazard problem in
debt contracts include net worth, monitoring and
enforcement of restrictive covenants, and financial
intermediaries.

holder rights, as the cause of declining U.S.
stock listings and IPOs, but other factors are
likely at work. The European financial system
experienced a major liberalization in the
1990s, along with the introduction of the
euro, that helped make its financial markets
more integrated and efficient. As a result, it
became easier for European firms to list in
their home countries. The fraction of
European firms that list in their home countries has risen to over 90% currently from
around 60% in 1995. As the importance of the
United States in the world economy has
diminished because of the growing importance of other economies, the U.S. capital
markets have become less dominant over

time. This process is even more evident in the
corporate bond market. In 1995, corporate
bond issues in the U.S. were double Europe s,
while issues of corporate bonds in Europe
now exceed those in the United States.

7. Conflicts of interest arise when financial service
providers or their employees are serving multiple
interests and develop incentives to misuse or conceal
information needed for the effective functioning of
financial markets. We care about conflicts of interest
because they can substantially reduce the amount of
reliable information in financial markets, thereby preventing them from channelling funds to those with
productive investment opportunities. Two types of
financial service activities that have had the greatest
potential for conflicts of interest are underwriting and
research in investment banking, and auditing and
consulting in accounting firms. In the United States,
two major policy measures have been implemented to
deal with conflicts of interest: the Sarbanes-Oxley Act
and the Global Legal Settlement of 2002 arising from
the lawsuit by the New York Attorney General against
the ten largest investment banks.