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

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