Regulations as Automatic Stabilizers During Crises

Even in the best of times, corporate leaders gripe about the cost of government regulations. An average hedge fund spends more than 7 percent of its total operating costs on various forms of compliance.[1] For the banking industry, compliance  expenses are estimated at $270 billion –10 percent of operating costs.[2]  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 automatic stabilizers during economic downturns. What is more, regulations do not negatively affect firm performance during normal times.

I construct a unique firm-level regulation index, using references to regulation in a firm’s annual reports as a proxy for its regulatory exposure. Firms that need to comply with more regulations typically have more references to them 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 a crisis.

I find that more heavily regulated companies have fared significantly better during the COVID-19 pandemic. Stock and corporate bond prices of firms facing heavier regulation declined 4 percent to 5 percent less compared with 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 those firms as the ones in industries most affected by the pandemic, such as transportation or retail. I find that the effect of regulation, measured by the responses of stock and bond prices, is more than twice as large in the more affected industries than in the less affected industries.

Regulation has helped stabilize firm performance in the 2008 financial crisis as well as the pandemic. Consistently, I find that stock prices of more regulated firms declined 6 percent to 7 percent less than those of less regulated firms during the financial crisis.

Why do more regulated firms perform better during market turmoil? Economic theories suggest that regulations provide stability and reduce risk. The idea is that regulations can discourage opportunistic behavior and excessive risk-taking. More regulated companies are more likely to be prudent in their financial policies and thus more stable during 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 with 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 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 regulation outweigh its 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 underexplored benefit of regulations.


[1] “The Cost of Compliance: 2013 KPMG/AIMA/MFA Global Hedge Fund Survey”, available at:

[2] FT, Banks’ AI plans threaten thousands of jobs, 2017.

This post comes to us from Professor Xi Wu at the Haas School of Business, University of California Berkeley. It is based on her recent paper. “Regulations as Automatic Stabilizers,” available here.

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