Agency Problems are Ameliorated by Stock Market Liquidity: Monitoring, Information and the Use of Stock-Based Compensation

51 Pages Posted: 16 Feb 2002

See all articles by Gerald T. Garvey

Gerald T. Garvey

Blackrock

Peter L. Swan

University of New South Wales (UNSW Sydney; Financial Research Network (FIRN)

Date Written: May 28, 2002

Abstract

Recent theoretical models have shown that liquid stock markets can improve the alignment of managers' and shareholders' interests even though high stock turnover would seem to be incompatible with the traditional view of monitoring of management by a stable set of shareholders. We test the prediction of Holmstrom and Tirole (1993) that managers' compensation is more closely tied to shareholder wealth when the firm's shares trade more actively. It is strongly empirically supported using a sample of over 45,000 executive years and numerous tests. In virtually all specifications, the effect of liquidity is at least as great as that of size, risk, industry, year, the existence of growth options, leverage, the existence of cash constraints, firm focus, or the presence of government regulation, existing option holdings and stock holdings. In fact, utilizing 900 simulations across different sample sizes, three liquidity variables account for between 67% and 79% of the explained variation with the remainder accounted for by 17 traditional variables. By contrast, accounting-based bonus incentives are employed by more illiquid firms and have more the characteristics of a substitute rather than a complement. We conclude that boards delegate monitoring of executives to active market traders when the stock is liquid and undertake internal monitoring using bonus schemes when the stock is relatively illiquid. Given greater efficacy of external monitoring, this implies that stock market liquidity sets bounds on the size and complexity of diversified firms.

Keywords: Pay-performance sensitivity, Executive options; Incentives; Liquidity; Information content; Monitoring, Bonus schemes

JEL Classification: J33; G32

Suggested Citation

Garvey, Gerald T. and Swan, Peter Lawrence, Agency Problems are Ameliorated by Stock Market Liquidity: Monitoring, Information and the Use of Stock-Based Compensation (May 28, 2002). EFA 2002 Berlin Meetings Presented Paper; UNSW School of Banking and Finance Faculty of Commerce, Available at SSRN: https://ssrn.com/abstract=300579 or http://dx.doi.org/10.2139/ssrn.300579

Gerald T. Garvey

Blackrock ( email )

Level 37, Chifley Tower
2 Chfiley Square
Sydney, NSW 2000
Australia
+61 2 9272 2388 (Phone)

Peter Lawrence Swan (Contact Author)

University of New South Wales (UNSW Sydney ( email )

School of Banking and Finance
UNSW Business School
Sydney NSW, NSW 2052
Australia
+61 2 9385 5871 (Phone)
+61 2 9385 6347 (Fax)

HOME PAGE: http://https://www.business.unsw.edu.au/our-people/peterswan

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
791
Abstract Views
4,299
rank
44,598
PlumX Metrics