Regulatory quality, financial integration and equity cost of capital

• Author: Priya Nagaraj,Chuanqian Zhang
• DOI: http://doi.org/10.1111/roie.12403
• Date: 01 August 2019
• Published date: 01 August 2019

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© 2019 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/roie Rev Int Econ. 2019;27:916–935.

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INTRODUCTION

There are many benefits of financial integration. Financial openness reduces the net risk as a result

of risk pooling and increases the availability of foreign capital, which reduces the domestic cost of

capital (Bekaert, Harvey, & Lundblad, 2005). International financial integration makes foreign capital

available to the private sector and encourages domestic private investment (Alfaro & Hammel, 2007;

Henry, 2000).

The benefits of financial integration come from not just financial openness but also the externali-

ties of financial integration (Kose, Prasad, Rogoff, & Wei, 2006), such as improvement in institutional

and regulatory quality, and improvement in private and public governance. These externalities of

financial integration improve allocative efficiency, which in turn encourages greater flow of financial

capital across borders, thus magnifying the effects of financial integration. The study of the effects of

Received: 29 March 2018

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Revised: 22 December 2018

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Accepted: 21 March 2019

DOI: 10.1111/roie.12403

ORIGINAL ARTICLE

Regulatory quality, financial integration and equity

cost of capital

PriyaNagaraj1

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ChuanqianZhang1,2

1Department of Economics, Finance

and Global Business,William Paterson

University, Wayne, New Jersey

2Department of Finance and Economics,

Yangtze Normal University, Chongqing,

P.R. China

Correspondence

Chuanqian Zhang, Department of

Economics, Finance and Global Business,

William Paterson University, Wayne, NJ

07470.

Email: zhangc4@wpunj.edu

Funding information

This project is funded by the 2016 Business

Policy and Practice Research grant from

the Cotsakos College of Business, William

Paterson University. Chuanqian Zhang

would also like to thank National Science

Foundation of China (No. 71702013) for

the financial support

Abstract

We study the impact of international financial integration

on firm‐level equity cost of capital in the presence of regula-

tory differences. International financial integration reduces

the domestic cost of capital in the presence of well‐defined

regulations that make it easier for foreign firms to overcome

information asymmetry. We study this relationship for 55

countries for the period 2002 to 2014. Using multilevel

mixed estimations, we find a negative relationship between

cost of capital and both financial openness and regulatory

quality. However, economies with better regulatory quality

have a positive relationship between financial openness and

cost of capital. Our results inform policy on the cost of

higher level of regulations on firms’ equity cost of capital,

especially when an economy has a high level of financial

openness.

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financial integration would therefore, gain from a joint analysis of financial integration, and institu-

tional/regulatory improvements on economic outcomes.

There is a small body of literature on the effect of financial integration and improvement in institu-

tional quality on economic growth.1

For instance, Klein (2005) finds an inverted U‐shaped relation-

ship between economic growth and financial openness, and institutional quality. However, very few

studies investigate the relationship between financial openness and regulatory quality on the domestic

cost of capital. In this paper, we contribute to this sparse literature on the effect of financial openness

on firms’ equity cost of capital in the presence of country‐level heterogeneity in regulatory quality.

Foreign firms have to adhere to the local institutions of the host economy to succeed. One of the

risks that foreign investors face is information asymmetry. Well‐defined and less complex regulations

make it easier for foreign firms to overcome this information asymmetry. Unfavorable business reg-

ulatory environment and lack of supervision fosters a lack of transparency, which increases the risk

of doing business. Such regulatory conditions discourage foreign investment (Hornberger, Battat, &

Kusek, 2011), inhibit financial openness, and therefore increase the cost of capital. We study the

effect of financial openness on cost of capital in the presence of such regulatory differences between

countries.

There are many studies on the effects of individual regulations on domestic cost of capital. For

instance, scholars have studied the impact of banking, accounting or financial regulations on cost of

capital (Barth, Konchitchki, & Landsman, 2013; Bhattacharya & Daouk, 2002; Kisgen & Strahan,

2010). We believe that regulations impact firms not only in an incremental and marginal fashion

but also in a comprehensive manner. Every new regulation is an addition to an existing system of

regulations and is often linked to regulations in other sectors as well. Our analysis, therefore, con-

tributes to the literature by using two comprehensive measures of regulatory quality—the Business

Freedom Index and the World Governance Index. To our knowledge, this is the first study on the

interaction of financial openness and a comprehensive measure of regulatory quality on firm‐level

cost of capital.

An investigation into the relationship between financial integration, regulatory quality, and cost of

capital is not only valuable as an academic study but is also imperative for its contribution to policy,

especially those intended for reforms and/or bilateral or multilateral negotiations.

Developing and emerging countries have large potential gains from international integration. While

considering policies to open up to the international financial markets, policymakers need to weigh the

costs and benefits of financial openness. However, emerging and developing countries—including

those with a relatively open de jure regime—might find it difficult to integrate financially in the

presence of poor institutional quality, as foreign investors are discouraged by inadequate regulations.

Such regimes will benefit from an investigation into this interaction between financial integration and

regulatory quality on the cost of capital.

In constrast, advanced countries are better integrated with the international financial markets and

have a higher quality regulatory system. However, there is evidence of costly and time‐consuming

regulations affecting growth.2

This is true for both Europe and the US and disparately affects small

and medium sized businesses. This study informs policymakers in such countries of the effects of

regulatory quality and financial openness on the average cost of capital.

Multilateral trade and investment agreements often require countries to commit to opening up of

their capital accounts and to improve regulatory quality. Not just the contentious CPTPP and T‐TIP

agreements but other agreements such as the CAFTA also require countries to follow some interna-

tional standards and regulatory procedures. The results of this study would aid in such trade negotia-

tions by elucidating the effects (positive or negative) of regulations on domestic cost of capital and the

relative importance of financial openness and regulatory quality.