Regulatory Certification, Risk Factor Disclosure, and Investor Behavior

Regulatory Certification, Risk Factor Disclosure, and Investor Behavior
Ruben Cox, Peter de Goeij
Review of Finance, Volume 24, Issue 5, September 2020, Pages 1079–1106, https://doi.org/10.1093/rof/rfaa003

Externalities of Regulatory Oversight on Investor Behavior in Financial Markets

Does regulatory approval of prospectuses act as a “certification” or “approval” of securities offerings? Rational investors should generally ignore prospectus approval by regulators due to its being uninformative regarding either the quality of, or motives for, the underlying offering. However, we demonstrate using a survey experiment with 1,125 respondents that salient references to regulatory oversight in investment advertisements can lead to significant increases in willingness to invest and concomitant decreases in perceived risks.

The increases in willingness to invest (+10%) and decreases in risk perceptions (-5.9%) are economically significant and the causality of these findings is confirmed in a within-subject-within-offering analysis in which changes in disclosure are regressed on changes in investor responses. In addition, we find that the saliency of risk factor disclosure affects investors’ risk perceptions (search for additional information), but that it does not affect willingness to invest or amounts invested. We further investigate whether the certification mechanism is affected by investor experience or investor sophistication. These analyses reveal that experienced investors seem to delegate trust to the regulator and, with this evidence of regulatory oversight, are less likely to search for additional information. Additional interaction analysis with education or wealth measures does not generate additional insight regarding sensitivity to regulatory certification. Finally, regulatory certification does not affect the intention to consult the prospectus; however, the demand for additional information seems driven in part by the information provided by the advertisements.

The findings provide important insights into the side-effects of financial markets regulation. Individual investors rely heavily on marketing materials for decision-making purposes and forgo consulting the prospectus. However, marketing materials tend to be supervised following publication, and their content is less regulated in comparison to the prospectus, which is approved prior to publication. This difference creates an opportunity for issuers to frame information on regulatory oversight towards certification in order to let an offer succeed. Framing of this kind comes at the expense of conflicting with the interests of investors, who bear increasing responsibility for the welfare impact of costly investment mistakes. Moreover, regulatory approval may be used as a stand-alone decision criterion, in which case financial market supervision can reduce the quantity of fundamental information ultimately reflected in investment decisions. This negatively effects the amount of information that will be reflected in security prices.

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