Responding to Regulatory Feedback: Financial Capacity, Revenue Expectations, and Firms' Responses to the Authority's Recommendations

Abstract

In various regulatory settings, firms receive feedback (i.e., firm-specific private advice) from authorities on how to improve compliance. Although the literature sheds light on the authorities' decision of when to provide feedback, less is known about firms' decisions on how to respond. Building on research on compliance and regulation, we expect a higher level of responsiveness to feedback when the financial capacity to cover short-term costs is higher (as this allows firms to allocate resources for compliance in the current period) and when firms expect higher revenues for the upcoming period (as current non-compliance represents the risk of a larger future loss). We also expect a conditional association: having a limited financial capacity may truncate the effect of positive expectations (inability to respond), and negative expectations may truncate the effect of having a sufficient financial capacity (lack of incentive to respond). To test these hypotheses, we examine anonymized financial and regulation-related data of over 5500 financial intermediaries operating in the Netherlands during 2009 and 2010. The results of a series of tests indicate that the effects of financial capacity and revenue expectations are indeed distinct yet independent. Interestingly, responding to feedback depends on positive expectations, even when firms have a limited current financial capacity to respond.