Better Corporate Governance Means More Market Liquidity

Market liquidity is an important aspect of financial markets since it affects firms' cost of capital and allows financial markets to function as intended, so that each security is priced appropriately. In financial markets with high concentration of ownership, such as Italy and other European countries, better corporate governance mechanisms and earnings management both affect firms' market liquidity.

Sasson Bar-Yosef and Annalisa Prencipe (Department of Accounting) analyze the joint effects of corporate governance mechanisms and earnings management on market liquidity in the Italian setting, characterized by high ownership concentration. They report and explain their findings in The Impact of Corporate Governance and Earnings Management on Stock Market Liquidity in a Highly Concentrated Ownership Capital Market (Journal of Accounting, Auditing and Finance, vol. 28, n. 3, July 2013,doi: 10.1177/0148558X13492591).

Using a sampleof 130 nonfinancial companies listed in the Italian stock market from 1999 to 2004, the authors find that better corporate governance relate positively to liquidity (measured through bid-ask spread and trading volume). These findings confirm that, even in a context of high concentration of ownership which may reduce the effectiveness of corporate governance mechanisms, the effect of the latter on information asymmetry is significant.

The authors also find that earnings management is significantly associated to trading volume, but not to the bid-ask spread. This might indicate that market makers are not concerned too much with earnings management once corporate governance has been controlled for, but that disagreement between investors increases because the actual value of the firm becomes less apparent.

These findings are relevant for several European markets, as these are characterized by high non-institutional ownership concentration. The results help to shed light on the importance of better corporate governance in such settings and their impact on the cost of capital of firms, and consequently on their market value. Also, corporate governance tends to have a stronger impact than earnings management on investor disagreement. Therefore, companies need to be aware of the consequences of their decisions related to the corporate governance structure. At the same time, regulators can use these findings to determine optimal policies in issuing regulations that will better protect investors in such capital markets.