Liquidity, Governance, and Transparency: International Evidence

We examine whether reduced transparency induced by poor firm-level and country-level corporate governance is an important channel that raises a firm‟s cost of capital through its effect on stock market liquidity. Using discretionary earnings smoothness as a proxy for reduced transparency, we find in a global sample of firms that discretionary earnings smoothness is mitigated by strong investor protection, more stringent accounting standards, greater monitoring by capital market participants, and greater regulatory oversight over financial reporting. We also find that discretionary smoothness is associated with lower liquidity, as measured by the frequency of zero-return days and average bid-ask spreads. On the flip side, fundamental earnings smoothness that results from firm operating characteristics, and which should therefore improve transparency, is correlated with higher liquidity. We also find some evidence that the effects of discretionary and fundamental smoothness on liquidity are more pronounced when country-level investor protections and disclosure requirements are poor. Taken together, our results suggest that poorly governed firms that excessively smooth earnings are potentially increasing their cost of capital as a result of this liquidity effect.