Abstract
We examine how firms’ aggregate regulatory exposure affects investor information asymmetry. Using a text-based measure of firm-specific exposure to federal regulations, we find that greater regulatory exposure reduces information asymmetry, as evidenced by narrower bid-ask spreads and decreased insider trading. This reduction arises because regulations constrain managerial discretion and stabilize firm operations, decreasing earnings volatility. However, these benefits weaken during periods of elevated policy uncertainty, under lax enforcement, and for politically active firms. Greater regulatory exposure also diminishes voluntary disclosures, suggesting regulatory constraints substitute for managerial transparency. Our findings highlight that the very regulations that raise firms’ operating costs also make their markets more liquid, narrowing spreads by leaving investors less to disagree about.
Key Findings
Regulation Narrows Spreads
A one-standard-deviation increase in regulatory exposure is associated with a 0.056 percentage-point decline in bid-ask spreads (a 3.1% reduction relative to the mean) and less opportunistic insider trading—greater exposure lowers, rather than raises, information asymmetry.
Operational Uncertainty Smoothing
The mechanism is predictability. By constraining managerial discretion, regulation lowers future cash-flow volatility (3.77%), earnings volatility (3.33%), and stock-return volatility (1.15%) per standard deviation of exposure, and raises earnings persistence—leaving investors less to disagree about.
Only When Constraints Bind
The spread-narrowing effect depends on regulations being expected to persist: it weakens by about 39% under high policy uncertainty, and is muted under lax enforcement and for politically active or White House–aligned firms.
A Substitute for Disclosure
Because external constraints already reduce uncertainty, higher regulatory exposure lowers the probability that managers issue a forecast by 0.8 percentage points (2.2% relative to the mean)—regulation substitutes for voluntary managerial disclosure.
Research Contribution
The paper shows that firms’ broader exposure to the full body of federal regulation—not just disclosure mandates—shapes their capital-market information environment. Using a time-varying, firm-level text measure of regulatory exposure (Kalmenovitz 2023) for public firms from 1995 to 2020, it documents an overlooked spillover: operational regulations reduce investor disagreement and improve liquidity, an effect the literature on disclosure rules has largely missed.
The results speak directly to the deregulation debate. The case for rolling back rules rests almost entirely on their costs to firms; these findings surface an offsetting capital-market benefit that calculus omits. Because the effect operates only where constraints credibly bind, a regulation’s market impact is a property not of the rule alone but of the institutional environment—policy stability and enforcement—that makes it stick.