Does the threat of enforcement of financial regulations affect the cost of equity in weak institutional environments?

Abstract

Using the imposition of annual on-site inspections of publicly listed firms by local China Securities Regulatory Commission (CSRC) offices as a quasi-natural experiment, we examine how the threat of potential enforcement of financial regulations affects firms' implied cost of equity in weak institutional environments. In a staggered difference-in-differences (DID) framework, we show that compared with firms subject to the lottery of prospective on-site inspections, firms that are exempt from on-site inspections for three consecutive years display an average increase of 210 basis points in the cost of equity. This effect is more pronounced for firms with regulatory penalty records, firms domiciled in jurisdictions with more actions imposed on listed firms as a result of on-site inspections in the past, firms located closer to their respective local CSRC offices and state-owned firms (SOEs). Further analysis suggests that the exemption from on-site inspections increases firms' cost of equity through the channels of increased tunnelling activities from controlling shareholders, reduced financial reporting quality and more severe information asymmetry faced by external investors. Thus, the valuation of exempt firms decreases. Our findings suggest that in weak institutional environments, the threat of financial regulators' enforcement ex ante increases firm value by reducing external investors' estimation of firms’ long-term risks.