Can Markets Predict Enforcement Action of Securities Regulators ?

Abstract

Using the random selection policy of inspection in firms’ financial misconducts by Chinese securities regulators, I show that market reactions at the selection results announcement date have significant predictability to the upcoming punishments. The firm’s stock price fell by 1% in response to each additional regulatory letter issued by regulators in the year following the selection. I further show that this predictability can be explained by the private information of firms' ex-ante violations. A 1% decrease in market reaction driven by private information significantly predicts 0.575 additional regulatory letters issued by regulators. Moreover, private information-based market reaction specifically predicts punishment relating to capital manipulation and illegal stock trading. Unlike typical market reaction study of misconducts, I find market price impounded information of violation long before the punishment, suggesting that regulators can take advantage from the market for efficient detection.