Knowledge that Transforms

Tariffs are commonly used to protect domestic firms from foreign competition. Using 25 major trade reforms implemented in 17 countries around the world since 1990, we document that firm value significantly increases following reductions in import tariffs. This value enhancement is concentrated in emerging markets and countries with stronger ex-ante competition laws. We identify two channels driving the increase in firm value: an increase in firm efficiency and profit margins due to lower input costs, and an increase in CEO turnover-performance and pay-performance sensitivity driven by increased competition. Overall, our findings underscore the importance of trade liberalization, while also highlighting the critical role of institutional support in fostering competition from foreign firms to stimulate private sector growth.

Using comprehensive regulatory intensity metrics from 1993 to 2019, we document that increased regulatory burden significantly reduces stock liquidity in U.S. public firms. To establish causality, we exploit exogenous variation in regulatory intensity following state ruling party changes. This identification strategy confirms that the negative relationship is causal rather than merely correlational. Our analysis reveals that information asymmetry serves as the primary mechanism, as regulatory intensity increases uncertainty about firms’ future operations, exacerbating information asymmetry between investors and companies. The liquidity deterioration is particularly pronounced for firms with higher investment irreversibility, greater financial constraints, and those without government customers. These findings contribute to understanding how regulatory burdens affect market functioning.

Banks play a central role in the financial system and benefit the real economy by managing risk, and providing finance to households, small and medium-sized enterprises, large corporates and governments. However, their complexity, opacity and interconnectedness can elevate bank-level and systemic risks, posing dangers to the financial system and real economy. This was evident during the global financial crisis where taxpayer funded bailouts were used to rescue ailing banks, which in turn led to an overhaul of regulation and supervision. Consequently, safeguarding bank stability and addressing systemic risks via well designed regulations is essential for ensuring economic resilience and societal well-being. This study uses a quasi-natural experimental research design in the form of the Dutch Liquidity Balance Rule (LBR) to evaluate the impacts of liquidity regulation on bank-level stability and systemic risk. Our findings show that following the introduction of liquidity regulation, the stability of Dutch banks increases significantly relative to counterparts in neighbouring countries unaffected by the regulation. The observed reduction in risk stems from improved capitalization and reduced leverage, which contribute to greater financial stability. Systemic risk also decreases. Our findings have relevance beyond our research setting for policymakers tasked with implementing and monitoring the impacts of similar forms of liquidity regulation (such as bank liquidity coverage ratios) post global financial crisis.

This paper introduces the ``limited arbitrage'' asset pricing mechanism into a pure exchange general equilibrium economy. The ``limited arbitrage'' model insists on the role of financial intermediaries in conducting fire sales. In our model, financial markets are incomplete, and households face uninsured idiosyncratic endowment risks. Given such market incompleteness, financial intermediaries can gain arbitrage profits by issuing risk-free debts and investing in risky assets. However, the margin requirement ratio limits the amount of debt. Shocks to intermediaries' balance sheets force them to repay debt and sell shares, causing stock prices to deviate from fundamental levels. We investigate how the risk of a fire sale affects the desirable financial regulation. Lowering the margin requirement ratio has the following trade-offs for welfare. On the one hand, it exaggerates a decline in stock prices due to fire sales, which deteriorates welfare. On the other hand, it improves welfare by providing households with sufficient self-insurance measures against their idiosyncratic endowment risks. Our numerical examples show that a natural debt limit under a laissez-faire economy is undesirable. Governments can improve welfare by introducing financial regulations (raising the margin requirement ratio).