Financial regulation policy uncertainty and credit spreads in the US

• This study quantifies the effects of financial regulation policy uncertainty (FRPU).
• I focus on the reaction of credit spreads and key US macroeconomic variables.
• I use linear and nonlinear VARs and find asymmetric effects over the business cycle.
• FRPU shocks act as negative demand shocks and trigger credit spread increases.
• Credit spreads rise three times more during recessions than in non-recessions.

This paper investigates the linear and nonlinear effects of financial regulation policy uncertainty shocks on US macroeconomic aggregates within a Vector Autoregressive (VAR) framework. Financial regulation policy uncertainty (FRPU) is quantified with a news-based index developed by Baker et al. (2013). Particular attention is paid to the reaction of corporate credit spreads to FRPU shocks. The linear VAR results suggest that exogenous increases in the FRPU index trigger increases in the cost of external finance as well as a persistent negative impact on the real economy. By using a nonlinear (Smooth-Transition) VAR model, I then show that these effects are asymmetric over the business cycle, i.e., credit spreads are estimated to rise three times more during recessions than in non-recessionary periods. Importantly, in both the linear and nonlinear models, FRPU shocks account for large shares of the variability of unemployment and credit spreads. My findings are supported by various robustness checks.