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Regulatory Intensity, Crash Risk, and the Business Cycle

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  • Xuan Tam

    (Cambridge University)

  • Eric Young

    (University of Virginia)

  • bo sun

    (GSM, Peking University)

Abstract

Regulatory investigations affect information in financial markets through two channels: (i) investigations detect financial manipulation and reveal hidden negative information;(ii) regulatory investigations impose adverse consequences for executives involved in manipulation and deter managerial incentives to manipulate ex ante. Moreover, regulatory intensity varies over time, depending on the aggregate state of the economy. We propose a model to study the implications of cyclical regulatory intensity for stock market dynamics, and show that countercyclicality in financial regulation can lead to countercyclicality in crash risk in the stock markets. We also provide evidence that a strong relation between stock crash risk and the business cycle exists in the data. In addition, our model illustrates a unifying mechanism that contributes to a number of stylized facts including gradual booms and sudden crashes in the financial markets, increased crash risk, and countercyclical stock volatility.

Suggested Citation

  • Xuan Tam & Eric Young & bo sun, 2014. "Regulatory Intensity, Crash Risk, and the Business Cycle," 2014 Meeting Papers 416, Society for Economic Dynamics.
  • Handle: RePEc:red:sed014:416
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    References listed on IDEAS

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    1. Rui Albuquerue & Neng Wang, 2008. "Agency Conflicts, Investment, and Asset Pricing," Journal of Finance, American Finance Association, vol. 63(1), pages 1-40, February.
    2. Bo Sun, 2014. "Asset Returns Under Periodic Revelations Of Earnings Management," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 55, pages 255-282, February.
    3. Lo, Kin, 2003. "Economic consequences of regulated changes in disclosure: the case of executive compensation," Journal of Accounting and Economics, Elsevier, vol. 35(3), pages 285-314, August.
    4. Ramanna, Karthik, 2008. "The implications of unverifiable fair-value accounting: Evidence from the political economy of goodwill accounting," Journal of Accounting and Economics, Elsevier, vol. 45(2-3), pages 253-281, August.
    5. Tracy Yue Wang & Andrew Winton & Xiaoyun Yu, 2010. "Corporate Fraud and Business Conditions: Evidence from IPOs," Journal of Finance, American Finance Association, vol. 65(6), pages 2255-2292, December.
    6. Yael V. Hochberg & Paola Sapienza & Annette Vissing‐Jørgensen, 2009. "A Lobbying Approach to Evaluating the Sarbanes‐Oxley Act of 2002," Journal of Accounting Research, Wiley Blackwell, vol. 47(2), pages 519-583, May.
    7. Karpoff, Jonathan M. & Lee, D. Scott & Martin, Gerald S., 2008. "The Cost to Firms of Cooking the Books," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 43(3), pages 581-611, September.
    8. Paul Povel & Rajdeep Singh & Andrew Winton, 2007. "Booms, Busts, and Fraud," Review of Financial Studies, Society for Financial Studies, vol. 20(4), pages 1219-1254.
    9. Mele, Antonio, 2007. "Asymmetric stock market volatility and the cyclical behavior of expected returns," Journal of Financial Economics, Elsevier, vol. 86(2), pages 446-478, November.
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