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Regulatory Intensity, Crash Risk, and the Business Cycle

Xuan Tam (), Eric Young () and Bo Sun ()

No 416, 2014 Meeting Papers from Society for Economic Dynamics

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.

Date: 2014
New Economics Papers: this item is included in nep-cta, nep-dge and nep-mac
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