Regulation by Indexation? Andrew Winden

Abstract

If index fund asset managers are the new “emperors” of Wall Street, are index providers the power behind the throne? The financial press has called the indexers “kingmakers” and suggested they may soon “rule the world.” If so, why do they seem to have more influence over sovereign governments than corporate executives? Is it appropriate to think of indexers as private regulators? If so, what is the source of their regulatory power? This article answers these questions with the first theoretical model and empirical review assessing the regulatory capacity of global equity index providers.

I propose three regulatory roles through which indexers might deliver incentives or sanctions sufficient to exercise regulatory power: (1) subsidizers, delivering financial benefits to parties who follow their rules for index inclusion, (2) certifiers, delivering reputational benefits to parties who follow their rules, and (3) gatekeepers, delivering access to benefits (e.g., capital, licenses, markets) that are otherwise unavailable. I assess the influence of these regulatory channels on two groups—corporate managers, considering whether indexers can regulate corporate governance and sustainability choices, and sovereign governments, considering whether indexers can influence sovereign choices about financial market rules.

After establishing the theoretical frame, I review the empirical literature to assess the theoretical roles in three contexts: (1) corporate governance restrictions on inclusion in benchmark equity indices, (2) eligibility criteria for inclusion in ESG indices and (3) market requirements for inclusion in emerging markets indices. Empirical studies suggest that the subsidizer role is ineffective, the certifier role may provide sufficient incentives to meet eligibility criteria in some contexts if the costs are not too high, and the gatekeeper role can be very effective, even with high costs, but only if the indexers hold the keys to sufficiently valuable, otherwise unavailable assets.