Financial Regulatory Actions over the Cycle

Abstract

This paper shows that regulatory actions against misconduct in the financial industry are driven by business cycles. Using text mining techniques, we construct a new database of regulatory actions based on US investment advisor filings distinguishing between state, federal, and self-organized regulators. Our data cover 9,750 regulatory actions and fines across 49 states over the 1990-2019 period. We then show that the number of regulatory actions responds to the business cycle with a lag. It is consistently lower following economic boom periods and higher following busts. To establish causal evidence, we combine our data with information on 24 million federally administered military contracts that affect state-level business cycles. Exploiting these contracts, we find that after a positive state-level output shock, regulatory actions decrease up to 60 months at the state regulatory level, but increase at the federal-level. Measures based on regulatory fines mirror this pattern. Our findings suggest that state-level regulatory actions are pro-cyclical, and federal-level regulatory actions are counter-cyclical, suggesting that different levels of regulatory agencies respond differently to business cycles.