We investigate the empirical relation between corporate governance and stock market liquidity. We find that firms with better corporate governance have narrower spreads, higher market quality index, smaller price impact of trades, and lower probability of information-based trading. In addition, we show that changes in our liquidity measures are significantly related to changes in the governance index over time. These results suggest that firms may alleviate information-based trading and improve stock market liquidity by adopting corporate governance standards that mitigate informational asymmetries. Our results are remarkably robust to alternative model specifications, across exchanges, and to different measures of liquidity.

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Investors rely heavily on the trustworthiness and accuracy of corporate information to provide liquidity to the capital markets. We find that the rash of financial scandals caused a severe deterioration in market liquidity in the form of wider spreads, lower depths, and a higher adverse selection component of spreads vis-à-vis their benchmark levels. Regulatory responses including the Sarbanes-Oxley Act of 2002 (SOX) had inconsequential short-term liquidity effects but highly significant and positive long-term liquidity effects. These liquidity improvements are positively associated with the improved quality of financial reports, several firm-specific variables (e.g., size), and market factors (e.g., price, volatility, volume). Copyright (c) 2008, The Eastern Finance Association.

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