The Stock Market Response to a "Regulatory Sine Curve"

Abstract

We construct new indicators of financial regulatory intensity and find evidence that a "regulatory sine curve" generally exists: regulatory oversight increases following a recession and wanes as the economy returns to normalcy. We then build an asset pricing model, based on the idea that regulatory oversight both deters incentives to commit fraud ex ante and reveals hidden negative information ex post. Our calibration suggests that these mechanisms can be quantitatively important for stock price dynamics.

Keywords: Cyclical financial regulation, Stock crash risk, Gradual boom and sudden crash

JEL Classification: G12, G30, K20