Board Reforms, Stock Liquidity, and Stock Market Development

Buhui Qiu is Associate Professor of Finance and Director of Doctoral Studies and Thomas Y. To is Lecturer (Assistant Professor) of Finance at the University of Sydney Business School. This post is based on their recent paper, forthcoming in the Review of Corporate Finance Studies.

To develop financial markets, improve market liquidity and attract international capital, governments around the world are encouraged to improve their countries’ corporate governance systems and adopt internationally accepted best practices in corporate governance (e.g., OECD, 2011). However, there is little cross-country evidence in the extant literature on whether and how corporate governance reforms affect stock liquidity and stock market development. Corporate boards are arguably the most important corporate governance mechanism to protect outside shareholders from expropriation by corporate managers. Thus, over the past decades we have observed the introduction of a series of board reforms to improve board monitoring on corporate managers in numerous countries around the world and such reforms are shown to have increased firm value (Fauver, Hung, Li, and Taboada, 2017). In this study, we provide new empirical evidence on the effect of board reforms on stock liquidity and stock market development around the world.

Ex ante, the effects of board reforms on stock liquidity and stock market development are ambiguous. On the one hand, theories suggest that enhancing the strength of internal corporate governance such as board monitoring mitigates managerial incentive in information manipulation and improves corporate disclosures (e.g., Qiu and Slezak, 2019). It is well known that information asymmetry decreases stock liquidity (e.g., Glosten and Milgrom, 1985; Glosten and Harris, 1988); improved information disclosures from a firm decrease the level of information asymmetry on its fundamental value, leading to greater market liquidity to the securities issued by the firm (e.g., Diamond and Verrecchia, 1991; Coller and Yohn, 1997; Affleck-Graves, Callahan, and Chipalkatti, 2002). Thus, board reforms aiming at improving board monitoring should significantly increase stock liquidity. In turn, increased stock liquidity should help facilitate the healthy development of stock markets.

On the other hand, prior studies also suggest that independent directors often face limited access to firm-specific information, which reduces their monitoring and advising effectiveness (e.g., Raheja, 2005; Adams and Ferreira, 2007; Duchin, Matsusaka, and Ozbas, 2010; Masulis and Mobbs, 2011). Independent directors usually hold only small equity stakes in firms, which limits their financial incentives in monitoring corporate managers (e.g., Yermack, 2004; Adams and Ferreira, 2008; Harris and Raviv, 2008). Moreover, corporate managers have significant influence over the board given their significant influence over the nomination of independent directors (e.g., Bebchuk and Fried, 2003; Coles, Daniel, and Naveen, 2014). Thus, independent directors may not be really “independent”. These insights indicate that board reforms may be ineffective in improving board monitoring and corporate disclosures and thus will have no effect on stock liquidity. Therefore, the effects of board reforms on stock liquidity and stock market development are an empirical question.

We investigate this research question using a comprehensive sample of 26,787 firms (158,423 firm-years) from 37 countries around the world. We exploit a series of board reforms in 1990s and 2000s in these countries identified by Fauver et al. (2017). Each board reform involves imposing greater board independence, audit committee and auditor independence, and/or the separation of chairman and CEO positions for firms in the reforming country. Consistent with our expectation, our firm-level difference-in-differences (DID) regression results show that the first broad board reform of a country significantly and negatively decreases the effective spreads of the stocks of the country’s publicly traded firms. The magnitude of the treatment effect is economically significant. On average, effective spreads decrease by 12.7% in the five years following the onset of the first broad board reform in a country. The finding is robust to controlling for various time-varying country and firm characteristics, as well as firm fixed effects and year fixed effects. We further examine whether the treatment effect of the first board reforms on stock liquidity is driven by potential nonparallel liquidity trends before these reforms. We conduct dynamic DID tests, placebo tests, and a variety of other robustness tests, and find that the treatment effect of the first board reforms on stock liquidity is most likely causal. We also find that reforms on board and audit committee and auditor independence, but not the requirement of separating the positions of CEO and chairman of the board, are the main contributors of the market liquidity improvement.

According to the extant theories (e.g., Glosten and Milgrom, 1985; Diamond and Verrecchia, 1991; Qiu and Slezak, 2019), we conjecture that enhancing internal corporate governance decreases information asymmetry which then leads to an increase in market liquidity. Consistent with our expectation, we find that board reforms significantly decrease the absolute value of discretionary accruals, analyst earnings forecast dispersion and idiosyncratic stock return volatility. Moreover, we find that the documented treatment effect of board reforms on stock liquidity is significantly stronger for treatment firms with higher discretionary accruals volatility, higher analyst forecast dispersion or higher idiosyncratic volatility prior to a reform, suggesting that the effect of board reforms on stock liquidity is channeled through decreasing information asymmetry. We also examine the effectiveness of board reforms conditional on the quality of a country’s institutional environments. Using the rule of law, control of corruption and political stability as measures of institutional environment quality, we find that the effect of board reforms on stock liquidity is stronger in countries with weak institutional environments in the pre-reform period, suggesting that firm internal governance and institutional environment quality are substitutes when it comes to improving stock liquidity. This finding is reasonable as disclosure quality is higher for countries with strong institutional environments and corporate managers who manipulate disclosures are more likely to be detected and punished in such countries even before the adoption of board reforms. The implementation of board reforms hence should not have a large effect on stock liquidity in such countries with strong institutional environments. This finding hence compliments the finding that the positive effect of board reforms on stock liquidity is stronger for firms with higher information asymmetry.

Finally, we conjecture that the improved stock liquidity should help attract investors and firm listings, resulting in healthy development of the reforming countries’ stock markets. Thus, we further examine the effect of board reforms on a country’s stock market development in country-level DID regressions. Consistent with our expectation, we find that board reforms significantly and positively increase the reforming countries’ share value traded, stock market size, the number of initial public offerings (IPOs) per year, and the number of seasoned equity offerings (SEOs) per year. The economic magnitudes of the effects are large. On average, share value traded as a percentage of GDP increases by 44.9%, stock market size as a percentage of GDP increases by 29.1%, the number of IPOs per year increases by 111%, and the number of SEOs per year increases by 113%, in the five years following a country’s first broad board reform. Consistent with improving market liquidity resulting in healthy stock market development, we further find that the documented positive effect of board reforms on stock market development is significantly stronger for those reforming countries with lower aggregate stock market liquidity (i.e., higher aggregate effective spread) prior to the reforms.

The complete paper is available for download here.

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