THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 225

CHAPTER 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 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 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 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 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