Security regulations, access to capital markets, and firm performance: Evidence from China

• Author: Xing Xiao,Kun Wang,Zhe Wei,Kunpeng Sun
• DOI: http://doi.org/10.1111/jbfa.12432
• Published date: 01 July 2020
• Date: 01 July 2020

DOI: 10.1111/jbfa.12432

Security regulations, access to capital markets,

and firm performance: Evidence from China

Kun Wang1Zhe Wei2Xing Xiao1Kunpeng Sun3

1School of Economics and Management,

TsinghuaUniversity, Beijing, China

2College of Economics, Shenzhen University,

Shenzhen, Guangdong, China

3School of Public Finance and Tax,Central

University of Finance and Economics, Beijing,

China

Correspondence

ZheWei, College of Economics, Shenzhen Univer-

sity,Shenzhen, Guangdong, China.

Email:weizh@szu.edu.cn

Fundinginformation

NationalNatural Science Foundation of China,

Grant/AwardNumbers: 70132048, 71472101

Abstract

This study explores the cost of security regulations in China, where

firms are required to meet a certain profitability benchmark before

applying for permission to raise more equity via secondary equity

offerings (SEOs). Using a difference-in-differences setting, we show

that firms affected by the regulation (i.e., firms with high external

financing demands (EFD) but profitability lower than the regulatory

requirement) significantly underperform their counterparts, while

unaffected firms do not. The affected firms’ performance decline

increases (decreases) when the requirement of profitability is more

(less) restricted. Consistently, the three-day cumulative abnormal

return (CAR) of firms with high EFD is significantly negative (posi-

tive)when the regulation is tightened (loosened). Our study provides

evidence on how the cost of regulation affects companies that have

growth opportunities.

KEYWORDS

capital market, cost of regulation, externalfinancing demands (EFD),

firm performance, secondary equity offerings (SEOs)

JEL CLASSIFICATION

G38, M41

1INTRODUCTION

One of the main objectives of security regulations is to protect investor benefits, particularly those of small, less-

informed investors. While some studies support the argument that security regulations are welfare-enhancing (e.g.,

Glaeser & Shleifer, 2003; Greenstone, Oyer,& Vissing-Jorgensen, 2006), others recognize that many security regu-

lations can lead to significant negative consequences (Asthana, Balsam, & Sandaraguruswamy, 2004; Stigler, 1964;

Zhang, 2007). It is difficult, if not impossible, to measure all the costs and benefits of a specific regulation. Therefore,

providing more evidence on either the costs or the benefits of regulations is important. This study contributes to the

literature byproviding additional evidence on the cost side of regulation. Specifically, we show that, due to the changes

in the equity-offering regulation in China, a number of firms were blocked from equity financing and, as a result, their

performance suffered.

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2020 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2020;47:1034–1058.

WANG ET AL.1035

The China Securities Regulatory Commission (CSRC) issued this equity offering regulation in 1993 and has since

revised it severaltimes. In addition to the requirements surrounding firm legality and disclosure quality, this regulation

mandates a minimum level of returnon equity ( ROE)for listed companies before they can apply for permission to raise

equity via secondary equity offerings (SEOs), including rights offerings and seasoned equity offerings. The CSRC con-

siders ROEto be an important determinant of investmentopportunity, which in turn signals the quality of the firm. The

introduction of this regulation in 1993 was meant to prevent listed companies from engaging in rights offerings, with

the ultimate goal of preventing a stock marketdecline.1

Although initiated with good intentions, this regulation has been criticized by both the market and academics. The

common criticism is that the regulation induces earnings management. Indeed, studies have shown that some firms

have managed their earnings upward to circumvent the profit restriction and gain access to the equity market (e.g.,

Chen & Yuan,2004; Haw, Qi, Wu, & Wu, 2005). Therefore, the regulation might result in ineffective capital allocation.

Regulators have taken this feedback from academic findings into considerationand have revised profitability criteria

to strengthen screening processes, with a focus on reducing earnings management.

However,the strengthened probability requirement might lead to another negative consequence that has not been

fully discussed by prior literature; i.e., to the extent that earnings management is expensive to some firms, the regu-

lation prevents them from obtaining equity capital. Capital structure theory suggests that it is generally cheaper for

growing and less profitablecompanies to rely on equity financing instead of on debt financing (e.g.,Harris & Raviv, 1991;

Jensen & Meckling, 1976; Kim & Sorensen, 1986; Ross, 1977; Stulz, 1990). Therefore, the regulation prevents firms

with high growth potential and good projects, but low profitability, from obtaining the equity capital they need. As

a result, these regulation-affected firms may be unable to access the required financing for future growth and thus

would bear the corresponding adverse consequences of the regulation.2

Our study documents the adverse consequences of this regulation by showing that the performance of firms with

highexternal financing demands (EFD) but lower profitability than the regulatory requirement (i.e., regulation-affected

firms) declined significantly because of financing restrictions. We first identify the regulation-affected firms that have

high EFD but lower profitability (treatment sample), and then match these firms with those that have the same EFD

and pre-earnings management performance but that obtained equity financing through upward earnings management

(control sample).3Tothe extent that these two groups of firms have similar ex-ante firm characteristics, differences in

ex-postperformance can be attributed to the fact that the regulation prevented the firms in the treatment sample from

accessing external capital.

The underlying assumption, when interpreting the regulation-affected firms’ performance decline as the cost of the

regulation, is that these firms could haveperformed as well as their matched firms had the regulation not been in place.

There are two alternative explanations for our findings. The first is that the CSRC actually separatesgood firms from

bad ones during the SEO approval process. The second explanationis that firms with SEOs always perform better than

those without. To rule out these alternative explanations,we include a sample of firms with lower EFD and further

separate them into an SEO group versusa matched non-SEO group. Thus, our sample includes firms with both high and

low EFD, and with and without SEOs.

Using a difference-in-differences (DiD) setting, we show that firms affected by regulation underperform their

counterparts significantly, while unaffected firms do not, supporting our argument regarding the cost of regulation.

1TheShanghai Composite Index rose over 1500 in the middle of February 1993. After four days, the Indexstarted to decline significantly. In the fourth meeting

of the Shanghai Stock Exchangein March 1993, Hongru Liu, Chairman of the CSRC, announced several policies to rescue the stock market from decline. This

equityoffering regulation with tight control over the rights offerings of listed companies was one of the new policies.

2Dueto an undeveloped banking system, it is particularly difficult for these firms to obtain debt financing (Chen et al., 2010).

3Tomake the identification easier,we first identify the control sample. Specifically, among all SEO firms from 1996–2010, we identify 382 firms that engaged

in upward earnings management to meet the profitability requirement in the years before their SEO application. Among these firms, 207 observations with

higherexternal financing demands were defined as the control sample of regulation-affected firms. For each firm in the control sample, we identify a matching

firm(treatment sample) that did not apply for SEO; the identification is based on industry, size, EFD and pre-earnings-management performance. The matched

non-SEOfirms are regulation-affected firms. Details on sample selection are introduced in Section 3 (Sample selection).