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Corporate Governance and Liquidity

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes to us from Kee H. Chung of the State University of New York (SUNY) at Buffalo, John Elder of North Dakota State University and Jang-Chul Kim of Northern Kentucky University.)

In our paper, Corporate Governance and Liquidity, which was recently accepted for publication in the Journal of Financial and Quantitative Analysis, we examine how corporate governance affects stock market liquidity. We conjecture that corporate governance affects stock market liquidity because effective governance improves financial and operational transparency, which decreases information asymmetries between insiders (e.g., mangers and large shareholders) and outside investors (e.g., outside owners and liquidity providers), as well as among outside investors. Governance provisions may improve financial transparency by mitigating management?s ability and incentive to distort information. These provisions make it less likely that management, acting in its self-interest, does not fully disclose relevant information to shareholders or discloses information that is less than credible.

We examine the effect of corporate governance on liquidity using an index of governance attributes that are likely to affect financial and operational transparency. Our governance index, which is based on data compiled by Institutional Shareholder Services (ISS), consists of 24 such governance attributes. Our measures of liquidity include quoted spreads, effective spreads, and an index of market quality for a large sample of NYSE/AMEX and NASDAQ stocks. To examine the relation between corporate governance and information asymmetries more directly, we also estimate two measures of information-based trading, the price impact of trades and the probability of information-based trading.

Our results show that stocks of companies with better governance structure exhibit narrower quoted and effective spreads, higher market quality index, smaller price impact of trades, and lower probability of information-based trading. The estimated improvement in liquidity is economically significant, with an increase in our governance index from the 25th to 75th percentile decreasing quoted spreads on NASDAQ by about 4.5%. Our results are robust to different estimation methods (including fixed effects and error component model regressions), across markets, and alternative measures of liquidity. In addition, we find that changes in our liquidity measures are significantly related to changes in governance scores over time. These results suggest that firms may alleviate information-based trading and improve stock market liquidity by adopting corporate governance standards that mitigate information asymmetries.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on July 31, 2009 (boomark / email).