When crisis hits: The role of regulations

A broker watches his screens. (AP Photo/Michael Probst)

Xi Wu is an assistant professor in the Berkeley Haas Accounting Group. 

Even in the best of times, corporate leaders love to gripe about the costly burden of government regulations. An average hedge fund spends more than 7% of their total operating costs on various forms of compliance. For the banking industry, the compliance  cost is estimated as $270bn—10% percent of operating costs. In my paper, “Regulations as Automatic Stabilizers,” I show that regulations have a critical economic benefit: more heavily regulated companies fare significantly better during extreme economic downturns. In other words, regulations are an automatic stabilizer during economic downturns. What is more, regulations do not negatively affect firm performance during normal times.

The principal reason that I am able to study the effect of regulations on individual firms is that I construct a unique firm-level regulation index. I use firms’ references of regulation in their annual reports to proxy for their regulatory exposures. Firms that need to comply with more regulations typically have more discussions of regulation in their annual reports. To investigate the role of regulations during crises, I examine the stock and bond market performance of firms with high pre-crisis regulation relative to similar firms with less regulation before the crisis.

I find that more heavily regulated companies have fared significantly better during the COVID-19 economic turmoil. Stock and corporate bond prices of firms facing heavier regulation declined 4% to 5% less compared to those of lightly regulated firms. That is, regulations are an automatic stabilizer during crises, shielding the firms from severe declines.

To further investigate the effect of regulations during the crisis, I test whether the effect of regulations is more pronounced for firms that are more affected by the pandemic. I define a firm to be more affected by the pandemic if the firm is in one of the more affected industries, such as transportation or retail. I find that the effect of regulation is more than twice as large in the more affected industries relative to the less affected industries.

Regulations have helped stabilize firm performance not only during the current crisis but also during the 2008 Financial Crisis. Consistently, I find that stock prices of more regulated firms declined 6% to 7% percent less than those of less regulated firms during the financial crisis. The stabilizing effect of regulations is not specific to the COVID-19 crisis.

My findings show that firms with more regulations have superior performance during crises.

Why do more regulated firms perform better during market turmoil? Economic theories suggest that regulations can benefit firms during bad times by providing stability and risk reduction. The idea is that regulations can reduce opportunistic behaviors and discourage firms from engaging in excessive risk. More regulated companies are more likely to be prudent in their financial policies and thus are more stable during times of economic turmoil.

I find results consistent with this explanation. First, I show that, before the crisis, firms with high regulations held more cash, had lower leverage, and were less likely to pay dividends, which made them more resilient to the negative economic shock. Next, I find direct evidence that during the crisis, more regulated firms had less systematic risk exposure compared to less regulated firms. These results are consistent with the idea that regulations contribute to systematic risk reduction and are viewed as valuable by investors during bad times. Importantly, during the normal times the stock and bond prices of the regulated firms performed similarly to their less regulated peers.

Overall, my study suggests that the benefits of regulations outweigh the costs when market uncertainty and volatility surge sharply. Regulations may serve as an important mediating factor when macroeconomic shocks affect firm performance. These findings show that regulations can mitigate the impact of adverse exogenous shocks, and thus highlight an under-explored benefit of regulations.