Corporate governance and stock market liquidity in India
P. Krishna Prasanna* and Anish S. Menon Department of Management Studies, Indian Institute of Technology, Madras, Chennai 600036, India Fax: +91-44-22574552 E-mail: [email protected] E-mail: [email protected] *Corresponding author
Abstract: Corporate governance encompasses the processes for board effectiveness and enhanced transparent disclosures. Both these requirements result in improved quality and quantity of information made available to investors, which in turn is expected to result in informed trading, reduced information asymmetry and improved market liquidity. It was empirically observed that corporate governance had a positive impact on stock liquidity; also, better governed companies had higher liquidity. A decade of governance reforms in India had definitely been beneficial for the firms’ adhering to good governance practices. Further, this study examined the relationship between the ownership pattern and the stock liquidity, and found that higher promoter holdings reduce stock liquidity. These results support the arguments of Welker (1995) and Chung et al. (2010) regarding ownership dispersion. The results also validate and strengthen the belief that foreign institutional investors and their investments provide liquidity to emerging stock markets like India.
Keywords: ownership dispersion; stock liquidity; illiquidity; corporate governance; India.
Reference to this paper should be made as follows: Prasanna, P.K. and Menon, A.S. (2012) ‘Corporate governance and stock market liquidity in India’, Int. J. Behavioural Accounting and Finance, Vol. 3, Nos. 1/2, pp.24–45.
Biographical notes: P. Krishna Prasanna is a Doctorate in Finance from the University of Madras. She is presently an Assistant Professor at the Indian Institute of Technology (IIT, Madras), Chennai. Her doctoral research is on corporate governance and she has published several papers on this subject.
Anish S. Menon is a member of the Institute of Chartered Accountant of India. He is currently pursuing his Master of Science (by research) at the Indian Institute of Technology (IIT, Madras ), Chennai.
Corporate governance and stock market liquidity in India 25
1 Introduction
Effective corporate governance helps to build vibrant and efficient capital markets. Investor’s confidence is more in those markets where companies have high standards of corporate governance. Gilson (2000) stated that equity investment requires good corporate governance and good corporate governance requires credible corporate disclosures.
Corporate governance encompasses the processes for board effectiveness and enhanced transparent disclosures. Both these requirements result in improved quality and quantity of information made available to investors. There is evidence in the recent governance literature that this information flow influences stock markets and results in informed trading, reduced information asymmetry and improved market liquidity.
Empirical research from developed markets prescribes that both internal and external corporate governance mechanisms improve stock market liquidity (Bacidore and Sofianos, 2002). Jain et al. (2008) found that the Sarbanes Oxley Act, 2002 had highly significant and positive long term liquidity effects. They asserted that these improvements were positively associated with improved quality of financial reports.
In India, market driven stock markets are just evolving, resulting in the growth of actively traded stocks. There was a remarkable improvement in both the quantity and quality of information available for an investor in the capital market since the legislation of corporate governance norms through Clause 49 of the Listing Agreement in the year 2000. This additional information should facilitate efficiency in price formation process and enhance stock market liquidity. This paper1 investigates the consequences of governance regulations and the impact of information diffusion on the Indian capital market liquidity.
The issues of corporate governance are quite varied in India compared to the west because most of the successful companies in India are family run firms with concentration of ownership. The promoter family members not only own a major portion of the equity stake but also hold key positions as directors. Besides these owners, foreign institutional investors are increasingly investing in the Indian stocks in recent years and this trading activity is presumed to impact the liquidity of the stock market. Given this background, the research questions that arise are: How does firm level corporate governance impact the liquidity of its stock? Does ownership concentration and higher promoter stake affect stock liquidity? Do the companies with higher foreign institutional investments (FIIs) experience higher liquidity?
The present study measures firm level governance quality and investigates its impact on the liquidity of the stock in the market. The paper also examines the impact of ownership structure upon the stock liquidity.
This paper provides new evidence on the relationship of market liquidity and the corporate governance mechanism in India. The results of this study contribute to the existing limited literature on stock market liquidity in India, and also contribute to the ongoing debate on costs and benefits of governance reforms.
26 P.K. Prasanna and A.S. Menon
The remaining sections of the paper are organised as follows: Section 2 presents a note on corporate governance regulations in India, the review of literature and research hypotheses; Section 3 describes the data and sample selection; Section 4 presents the empirical results and Section 5 contains the concluding remarks.
2 Note on corporate governance in India
In India, corporate governance reforms began with the legislation of Clause 49 of the Listing Agreement enacted in 2000. The Securities and Exchange Board of India (SEBI) legislated the first formal governance regulation by inserting Clause 49 in the stock exchange listing agreement with the intention of promoting and raising the corporate governance standards of Indian companies. The regulation broadly deals with the following issues: Board structure and composition; governance through board committees like the audit committee, remuneration committee and shareholders’ grievance committee and required additional disclosures to improve transparency.
A series of changes in the regulations since 2000 have considerably altered the way Indian companies are governed. There was a gradual change in the composition of the boards of Indian companies. Many of the directors join the boards as non-executive directors who are expected to provide expert guidance to the management, but do not participate in the management process. Similarly, there has been an increase in the composition and participation of independent directors who are expected to contribute maximisation of share holder’s value and offer investors protection.
2.1 Review of literature and research hypothesis
A key aspect of information disclosure relates to a firm’s governance. Many research studies have established that information flow and stock market liquidity are closely associated.
2.1.1 Corporate governance, disclosure quality, asymmetric information and stock market liquidity
The fundamental relationship between information and stock price behaviour has been established by Grossman and Stiglitz (1980). They explained that improving cost-benefit trade-off on information collection leads to more informed trading and more informative pricing. Gompers et al. (2003) found that governance can directly influence stock prices. The effect on stock returns and prices requires link between governance provisions, disclosure requirements and information to investors.
Welker, 1995, elaborating on the relation between disclosure policy and its influence on market liquidity, stated that disclosure policy influences stock markets because uninformed investors ‘price protect’ against adverse selection and this price protection is manifested in market liquidity. He found that a well regarded disclosure policy reduces information asymmetry and hence increases liquidity in equity markets.
Brown (2007) stated that disclosure quality results in less trading by privately informed traders and reduces information asymmetry. He found a negative relation
Corporate governance and stock market liquidity in India 27
between the information asymmetry and disclosure quality of annual reports and investor relations activity. The quality of quarterly reports disclosure is found to be positively associated with information asymmetry.
Chen et al. (2007) argued that companies adopting poor information transparency and disclosure practices will experience serious information asymmetry. They empirically observed that the costs of liquidity are greater for companies with poor information transparency and disclosure practices.
Ferreira and Laux (2007) reported that better corporate governance and openness to market for corporate control leads to more informative stock prices by encouraging collection of and trading on private information. They also asserted that information flow interpretation implies that the component of volatility is related to governance.
Kanagaretnam et al. (2007) found that firms with higher levels of corporate governance have lower information asymmetry when they announce their quarterly earnings. Chung, Elder and Kim, 2010 found that firms with better corporate governance have narrower spreads, higher market quality index, smaller price impact of trade and lower probability of information-based trading. Given these results, they suggested that firms may reduce information-based trading and improve stock market liquidity by adopting corporate governance standards that mitigate informational asymmetries.
Marnet (2008) suggested that conventional proposals to reform corporate governance through legislation and codes of best practices, underestimate the pressures from conflicts of interest and bias, which reputed intermediaries face in their interaction with colleagues and clients. He also discussed research questions regarding the independence of boards of directors and external auditors.
Cai et al. (2009) observed the impact of asymmetric information on three mechanisms of corporate governance:
1 intensity of board monitoring
2 exposure to market discipline
3 pay for performance sensitivity of CEO compensation.
They found firms facing greater asymmetric information tend to use less intensive board monitoring but rely more on market discipline and CEO incentive compensation. They suggested that regulators should use caution when imposing uniform requirements on firms’ corporate governance.
Cormier et al. (2010) investigated the impact of governance on information asymmetry between managers and investors, and found that a firm’s governance maps in to the level of information asymmetry between the managers and investors. They found that governance disclosures reduce information asymmetry.
Bruno and Claessens (2010) observed that company-level corporate governance practices and country-level legal investor protection jointly affect company performance. They suggested that beyond a threshold level of country development, stringent regulation hurts the performance of well governed companies or has a neutral effect for poorly governed companies.
28 P.K. Prasanna and A.S. Menon
In 2004–2006, Cheung et al. (2010) constructed a corporate governance index (CGI) to measure the quality of corporate governance practices of the 100 largest listed firms in China, and found a positive relation between market valuation and overall corporate governance practices. Shen and Lin (2010) observed that in the case of better governed companies the relationship between fundamental signals and stock returns is strong.
Hermalin and Weisbach (2011) argued that beyond a point, additional disclosure actually decreases firm value. They found that larger firms adopt stricter disclosure rules than smaller firms, and firms with better disclosure employ more able management.
Carvalhal and Nobili (2011) investigated as to whether including a corporate governance factor in the Fama and French three-factor model helps to explain stock returns better. By constructing a broad CGI for Brazilian public firms, they documented that governance does explain average returns on stocks, and also that the governance factor seems to be more powerful than both firm size and book-to-market ratio.
Larcker et al. (2011) investigated the market reaction to legislative and regulatory actions pertaining to corporate governance. They observed that the abnormal returns to events relating to corporate governance regulations are on average decreasing; additionally, they identified that the number of large block holders and the presence of staggered boards were also decreasing.
Price et al. (2011) examined the influence of Mexico’s efforts to improve corporate governance on firm performance and transparency. They used the compliance data disclosed annually by public firms in Mexico as a measure of corporate governance strength, and documented significant increase in compliance over 2000–2004, indicating that Mexican companies consider non-compliance a costly matter. They found no association between the governance index and firm performance with transparency.
Braga-Alves and Shastri (2011) constructed a corporate governance composite index that combines six proxies for the main governance practices targeted by Bovespa’s reforms in Brazil. They found that higher scores of index are related to greater market value and better operating performance.
Tang and Wang (2011) examined the cross-sectional relation between corporate governance and firm liquidity in the Chinese stock market and found strong evidence that the level of corporate governance is positively related to firm liquidity.
Hypothesis 1 Ideally, corporate governance through tougher disclosure regulation should contribute to less fluctuation in stock prices. Indian companies are now transparent, not by choice but because there are structures in place that facilitate the market participants to gather information which gets reflected on prices. This information should facilitate the quality of price formation and should ideally result in improving the liquidity in the capital markets.
Corporate governance and stock market liquidity in India 29
Figure 1 Impact of corporate governance on the stock market liquidity
CORPORATE GOVERNANCE
Board effectiveness
Disclosure requirements
Results in improved
quantity and quality of
information disclosures to
traders
Reduces information asymmetry
Improves liquidity
Reduces volatility
DEMANDS
H1 Companies with higher level of corporate governance will experience improved stock market liquidity.
2.1.2 Corporate governance, firm ownership and stock liquidity
Corporate governance advocates believe that ownership dispersion is desirable and that it would provide market liquidity. It is believed that ownership concentration results in limited information made available to the investors in the capital markets; and hence investors consider such firms as high risk entities. Retail investors do not desire to provide funds to such firms which will result in illiquid stock markets. Gaspar and Massa (2007) investigated how a firm’s ownership pattern affects the liquidity of its stock, and found that informed ownership improves governance and induces value enhancing decisions. Becht (1999) counter argues that ownership dispersion will de-motivate the individual investors to exercise proper controls on the management which will have negative effect on stock liquidity. Rhee and Wang (2009) examined the Granger causality between foreign institutional ownership and stock market liquidity and found that foreign holdings have a negative impact on future liquidity. Their observation challenges the view that foreign institutional ownership enhances liquidity in small emerging markets.
Bae and Goyal (2010) reported that equity market liberalisations open up domestic stock markets to foreign investors. They used cross-firm variation in corporate governance in Korea to test whether governance can explain the extent to which firms benefit when countries liberalise. They observed that better-governed firms experience significantly greater stock price increases upon equity market liberalisation. They also found foreign ownership in firms with strong corporate governance was significantly higher than that in firms with weak governance.
30 P.K. Prasanna and A.S. Menon
Henry (2010) observed that the beneficial influence of voluntary governance compliance on agency costs was independent of firm ownership structure. Thus, there are arguments in all the directions in the literature, throwing open the research questions relating to the impact of ownership pattern upon the stock liquidity. In a majority of Indian firms, the promoter families own a major stake of equity capital. Recent economic growth in India has resulted in large amounts of FIIs. In this context this paper examines the following null hypothesis;
H2a Higher FII investments do not result in higher liquidity.
H2b Higher promoter holding will not have any impact on stock liquidity.
3 Data and variables
3.1 Sample selection and data sources
The study sample consists of all the non-banking firms included in the Bombay Stock Exchange (BSE) 100 index, which represents all the actively traded stocks in the Indian capital market. The BSE-100 index is a broad-based index launched in 1989 and has 1983-84 as the base year. The index is well diversified with companies representing 43 industries (list given in Appendix 3).
About 4,990 companies are listed in the BSE. As on December 22, 2010 the total market capitalisation of all these companies is Rs. 6,963,116.67 crores (source: CMIE database). The top 100 liquid companies are included in the BSE 100 index. The market capitalisation of all the BSE 100 index (our sample) companies put together is 4,755,169.98 crores (as on December 22, 2010), which is 68.29% of the total market capitalisation. This shows that the sample adequately includes all the actively traded stocks and covers around 70% of the population. The data-set consists of the cross-sectional annual data of 90 companies for the financial year 2009–2010.
The data of the closing price, daily market capitalisation (in rupees) and daily turnover (in rupees) was collected from the official website of the BSE.
The detailed ownership pattern of the companies as on 31st March, 2010 was collected from the ‘prowess’ database of the Centre for Monitoring Indian Economy (CMIE); the data on governance variables from the Corporate Governance reports of the sample companies, and the financial data regarding the sample firms from the capital line database.
3.2 Measure of firm-level corporate governance: CGI
There is huge body of corporate governance literature using constructed CGI as proxy of firm level governance quality (Gompers et al., 2003; Jiraporn and Ning, 2006; Jo and Pan, 2009; Officer, 2006).
Researchers have adopted various measures to construct the governance index; some constructed their index based on responses to survey questions (e.g., Black et al., 2005). In Brazil, Da Silveira and Barros (2007) constructed from the survey response of 20 questions on four important aspects of corporate governance:
Corporate governance and stock market liquidity in India 31
1 access to information
2 information content
3 board structure
4 ownership structure for the year 2002.
A few authors used corporate governance ratings given by independent rating agencies (Mitton, 2004). Bruno and Claessens (2010) used the Institutional Shareholder Services (ISS) data to measure and assess firm-level corporate governance attributes of cross sectional firms.
Tang and Wang (2011) constructed an overall governance index for all the listed firms in China, to measure the quality of corporate governance, based on the disclosed governance-related information in their annual financial reports. They have assessed the impact of governance using the fixed effects model of panel data analysis.
Ammann et al. (2011) used the principle component analysis to identify key governance variables that can be included in the index. They used the dynamic panel GMM (generalised method of moments) to analyse cross country and time effects in the corporate governance data of 23 countries. All these papers use additive indices, giving equal weightage to each considered governance attribute.
For this paper, the CGI was constructed from the data provided in the corporate governance reports published as part of Annual reports of the listed companies in India. Though Ammann et al. (2011) used 64 attributes to measure the index, it was found that in the Indian context, most of the information reported in the governance report/ website is standardised across firms as it is mandatory for the companies to report what is required by Clause 49 of listing requirement.
Hence, the 13 governance attributes that exhibited variance across the firm level were considered for the purpose of constructing this index. These attributes broadly cover Board composition and independence, Board performance measured from the attendance in meetings, effectiveness of governance committee structure and access to information. These variables have been grouped into two categories for the purpose of scoring.
• Set 1: Based on the following variables the governance practices of the companies have been rated as poor, good and very good. A score of 3 has been given if they were found to be very good and 2 and 1 respectively for good and poor rating.
List of variables: 1 % of the number of non-executive independent directors in the board 2 number of board meetings 3 % of independent director’s attendance in board meetings 4 % of independent director’s attendance in the annual general meeting 5 number of audit committee meetings 6 number of members in audit committee meetings 7 % of audit committee member’s attendance in the audit committee meetings 8 chairman of the company (whether executive/non-executive/independent
director).
32 P.K. Prasanna and A.S. Menon
• Set 2: The following variables were rated on an ordinal scale; a score of 2 has been given for positive practice and 1 otherwise.
List of variables: 1 duality of chairman 2 disclosure regarding retiring director’s profile 3 existence of compensation committee 4 disclosure regarding compensation committee membership and meetings 5 disclosure regarding shareholders’ grievance committee membership and
meetings.
The total corporate governance score has been obtained by the summation of the scores of all the attributes. Thus, the maximum total score a firm can get is 34. Using this score as a proxy for firm level governance, cross sectional analysis was made with the help of ordinary least squares (OLS) regression.
i iLIQ CGIα β μ= + +
Apart from the composite corporate governance score, the issues related to directors pay benefits and compensation have been deliberated in the recent governance literature. Hence, total director’s remuneration has been considered as an independent variable to assess cross firm variation in stock liquidity.
Another governance attribute assessed independently was the ownership pattern. The age of share holding by various groups of owners has been taken as an independent variable. The impact of share holdings by promoters, domestic institutions, foreign institutional investors and retail investors upon the liquidity of the stock has been analysed in this paper.
3.3 Measures of stock liquidity
Empirical market microstructure literature suggests alternative ways to measure stock market liquidity. Brennan et al. (1998) used trading volume to measure liquidity while Datar et al. (1998) used turnover. Another widely used measure in recent studies is the ‘Amivest’ liquidity, which is defined as the average of daily ratio of volume to absolute return (Chan et al., 2008). This ratio is proxy for market depth. Amihud (2002) demonstrated that the inverse of this ratio, referred as illiquidity ratio, can be used to measure the price impact.
Many of the research studies referred to in previous section have used the bid-ask spread as a measure of liquidity (Kanagaretnam et al., 2007; Chung et al., 2010; Chen et al., 2007; Welker, 1995). In an order driven market (like India), lack of transaction data leads to lack of information for measuring the bid-ask spread. Hence, this study used the ‘illiquidity ratio’ as proposed by Amihud (2002) and its modified version as proposed by Bortolotti et al. (2007) to measure the stock liquidity.
Stock illiquidity is defined as the average ratio of the daily absolute returns to the (rupee) trading volume of the day. It is the ratio of the return per day to the daily traded volume in rupees. This value is then averaged across the number of trading days in a year to get proxy for stock liquidity. Amihud (2002) says that the ratio is closely related to the Amivest ratio and also follows Kyle’s (1985) concept of illiquidity, which is the response
Corporate governance and stock market liquidity in India 33
of price to order flow. Marcelo and Quiros (2006) commented that the illiquidity ratio has a strong theoretical appeal and considers it the best proxy for illiquidity.
( )1 0
0 :
P PDaily return R
P−
= (1)
where R is the daily return, P1 is the current day’s closing price and P0 is the previous day’s closing price. The absolute values of these returns were taken to compute the following illiquidity ratio:
iyd
iyd
RStock illiquidity
VOLD= (2)
where Riyd is the return on stock i on day d of year y and VOLDiyd is the respective daily volume in rupees (Amihud, 2002).
This value was then multiplied by 108 to aid in computational convenience. This was then averaged over the period of working days in the financial year
1
1iyD
iy iy iyd iydt
ILLIQ D R VOLD=
= ∑ (3)
Another variant of the Amihud illiquidity has been formulated by Bortolotti et al. (2007). Here illiquidity is computed as the ratio of the absolute return to turnover.
For the purpose of this paper, the Bortolotti et al. (2007) version of the Amihud ratio was calculated (hereafter called the modified Amihud ratio):
1 iyd
dtd
RILLIQ D
TURNOVER−
⎧ ⎫⎪ ⎪= ⎨ ⎬⎪ ⎪⎩ ⎭
∑ (4)
The modified Amihud ratio was calculated as the ratio between the absolute daily return and the daily turnover ratio as calculated above. Turnover in this case is equal to the total value of shares traded scaled by total daily market capitalisation; this was averaged over the period of the total working days in the financial year.
A high value of this measure indicates that the market is illiquid because there is a considerable price change in the stock in response to a comparatively small change in the turnover.
4 Empirical results
4.1 Descriptive statistics
4.1.1 Board composition and leadership
Table 1 presents the board composition related statistics. 50% of the directors in the sample companies are independent, which is as required by the legislation. Their participation in the board room decisions primarily can be gauged from their attendance in board meetings. On an average, 76% of them attend the board meetings. There is also a conscious split in the leadership of management and the board. Out of the sample
34 P.K. Prasanna and A.S. Menon
companies nearly 50% of companies had a non-executive chairman, while the other 50% of them are promoter non-executives. Table 1 Descriptive statistics – board composition of sample companies
Notes: Legend: DS – descriptive statistics TND – total number of directors EPD – number of executive promoter directors NNEPD – number of non-executive promoter directors NNIPD – number of non-executive independent directors PID – percentage of independent directors in the board TBM – total number of board meetings IDPB – independent directors – percentage attendance in board meetings IDPA – independent directors – percentage attendance in annual general meeting NAM – number of audit meetings MAC – number of members in audit committee.
Table 2 Chairmanship of companies
Executive directors 26 Executive promoters 19 Non-executive promoters 21 Non-executive and independent directors 24 Total sample 90
Board effectiveness can also be assessed from the functioning of the sub-committees and their reviews. All the sample companies had audit committees, shareholders grievance committees and remuneration committees. The meeting schedules, agenda and participation have been disclosed in their governance reports.
The reforms also resulted in a significant improvement in the disclosure practices of Indian companies. The relevant information regarding important corporate actions is made available through their web pages of investor relations. Further information about the board meetings, directors’ profiles, chairman’s speeches, CEO interviews, press meetings and analyst’s reports are posted on the companies’ websites.
4.1.2 Corporate governance score
Taking the board composition, board quality and effectiveness and governance committee functioning as the key parameters the CGI has been constructed for each sample company. The cumulative total of this index is referred as CG score and is used for analysing impact of corporate governance on the company’s stock liquidity. Table 3 presents the descriptive statistics and Appendix 1 provides the detailed scoring scheme.
Corporate governance and stock market liquidity in India 35
Table 3 Corporate governance score
Mean 24 Median 25 Mode 26 Minimum 16 Maximum 30 Count 90 Mean 24
4.2 Corporate governance and stock liquidity
This study examines the relationship between firm level corporate governance and its stock liquidity. While the previous studies which examined this relationship have taken the bid-ask spread to proxy the liquidity affect of stock, this study has used the illiquidity ratio (Amihud, 2002) to measure stock liquidity. Table 4 presents the bivariate relationship between the computed CG score and the stock illiquidity ratio. The CG score has a statistically significant impact on both the illiquidity ratio and the modified Amihud ratio. The negative regression coefficients explain that higher the CG score, lower is the Illiquidity ratio, implying higher CG score, higher the stock liquidity. These results are consistent with this paper’s hypothesis that better governed companies will have higher stock liquidity. Total remuneration paid to directors has been taken as another governance variable. The remuneration includes the salary paid to executive directors as well as the commission and sitting fees paid to non-executive directors. This has a negative impact on stock liquidity. However it was not found significant. Table 4 Corporate governance and stock liquidity
Dependent variable
Independent variable
R square F Significance F Coefficients t stat P-value
IR CGI 0.042 3.7288 0.0568 –1.3849 –1.93 0.056 MAR CGI 0.0469 4.1864 0.0438 –25.3777 –2.04 0.043 MAR TDR 0.0179 1.4199 0.2370 –1.91334 –1.91 0.237
Notes: CGI – corporate governance index, MAR – modified Amihud ratio, IR – illiquidity ratio, TDR – total remuneration paid to all the directors
To moderate the differences in the firm size, total assets were considered as a controlling variable. Table 5 reports the interaction between the firm size and stock liquidity. Firm size had a negative impact on illiquidity ratio indicating that the bigger the firm, the higher the liquidity. The modified ratio also had a negative impact; however it is not statistically significant. While computing the modified Amihud ratio, the turnover is scaled to the size of market capitalisation and this turnover rate is taken as the denominator. In this context the firm size gets moderated while computing the modified Amihud ratio. Hence, firm size did not show additional significant impact on the stock liquidity.
36 P.K. Prasanna and A.S. Menon
Table 5 Firm size and stock liquidity
Dependent variable
Independent variable
R square F Significance F Coefficients t stat P-value
IR TA 0.045 4.1487 0.0447 –0.0001 –2.0368 0.0447 MAR TA 0.0027 0.2367 0.6278 –0.0004 –0.4866 0.6278
Notes: MAR – modified Amihud ratio, IR – illiquidity ratio, TA – total assets
Table 6 contains the results of the multivariate tests incorporating the total assets to control firm size. The impact of CG score is still statistically significant confirming this study’s Hypothesis 1. Table 6 Impact of corporate governance up on the stock liquidity controlling for firm size
Dependent variable
Independent variable
R square F Significance F Coefficients t stat P-value
MAR CG 0.0477 2.105 0.1282 –24.9423 –1.982 0.050 TA –0.0003 –0.263 0.792
Note: Modified Amihud ratio and CGI controlling for firm size.
Mean 50 18 13 19 Median 50 15 11 18 Minimum 0 0 1 0 Maximum 99 65 43 78 Count 90 90 90 90
B: Promoter categories
Particulars Family holdings (%)
Government holdings (%)
Foreign promoter (%)
Joint ventures
(%) Mean 46 73 54 51 Median 46 76 53 53 Minimum 0 51 37 18 Maximum 90 99 68 80 Count 62 9 12 7
C: Promoter codes
Type of promoter Categorical variable code Number of companies Indian 1 62 Foreign 2 9 Government 3 12 Joint venture 4 7 Total 90
Corporate governance and stock market liquidity in India 37
4.3 Ownership pattern and stock liquidity
Tables 7A and 7B present the descriptive statistics about the sample companies’ ownership patterns. On an average, 50% of the equity capital is owned by the promoters; Foreign Institutional Investors and retail public own 19% and 18% respectively; and the domestic institutions own 13%. Further, the sample companies comprise of four types of promoters. In the majority of sample companies (62), it was the business families holding the major stake; in 12 companies the Indian Government was the promoter; and foreign firms were the shareholders in nine companies. A categorical variable was included to understand whether the difference in ownership makes any impact on stock liquidity.
Table 8 presents OLS estimates between the promoter holdings and the illiquidity ratio. It was found that the higher the promoter holding, higher is the illiquidity ratio interpreting lower stock liquidity. However, the impact was not statistically significant. Table 9 presents the OLS results between the promoter holdings and modified Amihud ratio. The negative impact between the promoter holdings and stock liquidity was statistically significant even after controlling for firm size confirming Hypothesis 2a of this study. Initially the type of promoter seemed to have a significant impact, however when taken with other variables it was not significant. Table 8 Promoters’ holdings and stock liquidity OLS estimates using illiquidity ratio
Dependent variable
Independent variable
R square F Significance F Coefficients t stat P-value
IR TPH 0.0072 0.6338 0.4281 0.0787 0.7961 0.428 IR TA 0.0564 2.5994 0.0801 –0.0001 –2.1306 0.035 PHP 0.0997 1.0236 0.308 IR TPH 0.0217 0.9644 0.3853 0.0967 0.9681 0.335 TOP –2.554 –1.1371 0.258 IR TA 0.0806 2.5132 0.0638 –0.0001 –2.3475 0.021 PHP 0.1255 1.2781 0.204 TOP –3.3341 –1.5051 0.136
Notes: TPH – total promoter holdings, PHP – promoter holdings percentage, TOP – type of promoter (categorical variable)
Table 9 Promoters’ holdings and stock liquidity OLS estimates using modified Amihud ratio
Dependent variable
Independent variable
R square F Significance F Coefficients t stat P-value
MAR TPH 0.158 16.5134 0.0001 6.413 4.0637 0.0001 MAR TPH 0.195 10.5343 0.0001 3.7751 1.8529 0.0673 TOP 113.54 1.9984 0.0488 MAR TA 0.0564 2.5994 0.0801 –0.0001 –2.1306 0.0359 PHP 0.0997 1.0236 0.3089 MAR TA 0.1758 6.1166 0.0008 –0.0009 –1.0822 0.2822 PHP 6.8423 4.2437 0.0001 TOP –35.7905 –0.9842 0.3278
Notes: TPH – total promoter holdings, PHP – promoter holdings percentage, TOP – type of promoter (categorical variable)
38 P.K. Prasanna and A.S. Menon
Table 10 presents the regression results between the FII holdings and stock liquidity. Higher investments from FII improve stock liquidity. This relationship was not found in the initial illiquidity ratio. The FII investments had statistically significant negative impact on the stock modified Amihud ratio. This implies that higher FII investments contribute to increased stock liquidity. This confirms Hypothesis 2b of this study. Table 10 FII investments and stock liquidity
Dependent variable
Independent variable
R square F Significance F Coefficients t stat P-value
IR FII 0.0017 0.1525 0.6971 –0.0649 –0.390 0.697 IR FII 0.0491 2.2458 0.1119 –0.1001 –0.610 0.543 TA –0.0001 –2.081 0.040 MAR FII 0.0814 7.8025 0.0064 –7.7231 –2.793 0.006 MAR FII 0.0881 4.2032 0.0181 –7.9522 –2.854 0.005 TA –0.0007 –0.797 0.427
Notes: FII – foreign institutional investors, TA – total assets
Table 11 presents the impact of investments made by domestic institutional investors upon the stock liquidity. They had a negative impact that is not significant. Higher investments from domestic institutions result in reducing illiquidity ratio and increase stock liquidity. The retail investors had significantly negative impact on the on the modified Amihud ratio; they provide more liquidity to stock. Table 11 Domestic and retail investors and stock liquidity
Dependent variable
Independent variable
R square F Significance F Coefficients t stat P-value
IR DII 0.0024 0.2116 0.6466 –0.1021 –0.46 0.646 MAR DII 0.0271 2.4526 0.1209 –5.9524 –1.56 0.120 MAR OI 0.0271 8.4594 0.0046 –9.1955 –2.90 0.004 MAR DII 0.0954 4.5865 0.0128 –3.2914 –0.85 0.392 OI –8.4288 –2.56 0.012
Notes: DII – domestic institutional investors, OI – other investors (individuals)
Table 12 presents the correlation matrix between the different owners of equity capital. Promoters’ holdings had a significant negative relationship with all the other groups. It was found that the higher the promoters’ holdings, the lower the contribution from the foreign institutional investors, domestic institutional investors and the retail investors. Also, higher promoters’ holdings result in lower dispersion in ownership.
Corporate governance and stock market liquidity in India 39
Table 12 Correlations
PR FII DII OI
Pearson correlation 1 Sig. (2-tailed)
PR
N 90 Pearson correlation –.638 1
Sig. (2-tailed) .000 FII
N 90 90 Pearson correlation –.599 .020 1
Sig. (2-tailed) .000 .854 DII
N 90 90 90 Pearson correlation –.678 .063 .271 1
Sig. (2-tailed) .000 .554 .010 OI
N 90 90 90 90
4.4 Panel data results
A sub-sample of 55 companies was part of the BSE 100 index consistently from the year 2007–2010. Panel data was collected regarding ownership variables and illiquidity ratio was computed for 12 quarters from 2007–2010. The total number of observations was 660. This panel data was analysed and the results were not different from that of cross section analysis presented in the previous section. Table 13 Panel data regression (random effects)
Modified illiquidity ratio Promoter’ holding 0.1292 0.001
The promoters’ holdings as well as the shares cornered by domestic institutions were not traded widely. Higher holding by these groups resulted in higher illiquidity ratio, implying less stock liquidity. Table 14 Panel data regression (random effects)
Amihud illiquidity ratio FII –0.227 0.923 Modified illiquidity ratio FII –0.298 0.816
FII had a negative impact on the illiquidity ratio; however, this relationship is not statistically significant. This implies that higher FII results in higher liquidity in the stock market.
40 P.K. Prasanna and A.S. Menon
4.5 Limitations and scope for further research
Measuring firm level governance was a challenging task in the Indian context as corporate governance ratings were not available. The findings of this paper can be generalised with a panel data analysis of CGI constructed from the year 2003 for all the sample companies. Since 2003 all the listed Indian companies have been required to follow Clause 49 of the listing agreement on corporate governance. Similarly, ownership pattern was examined with cross sectional data. Analysis of time series data from 2003–2010 for all the sample companies will strengthen the empirical observations.
5 Concluding remarks
This study examines the relationship between the firm level corporate governance and stock liquidity in the Indian market. The CGI was constructed through the content analysis of annual corporate governance reports of the listed Indian companies. This study used the illiquidity ratio suggested by Amihud (2002) and its modified form used by Bortolotti et al. (2007) to measure the stock liquidity. It was empirically observed that corporate governance had a positive impact on stock liquidity, because better governed companies had higher liquidity. One positive finding for the cross section of governance players (both for policy makers as well as the listed companies) is that a decade of governance reforms has definitely been beneficial for the firms’ adhering to good governance practices. Further, this study examined the relationship between the ownership pattern and the stock liquidity, and found that higher promoter holdings reduce stock liquidity. These results support the arguments made by Welker (1995) and Chung (2010) regarding ownership dispersion. The results also validate and strengthen the belief that foreign institutional investors and their investments provide liquidity to emerging stock markets like India. This study supports the theory postulated by Gaspar and Massa (2007) that ownership dispersion is essential for improving the stock liquidity.
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Notes 1 This paper is presented in 2nd finance and corporate governance conference organised by
La Trobe University at Melbourne, Australia during the 28th and 29th of April, 2011.
Corporate governance and stock market liquidity in India 43
Appendix 1
Table A1 Corporate governance score
Particulars Scoring scheme
30%–50% – 1 50%–65% – 2
Number of non-executive independent directors in total (percentage)
Above 65% – 3 4 and Less than 4 – score 1
5–7 – score 2 Total number of board meetings
8 and above – score 3 60% and Less – score 1
61%–80% – score 2 81%–90% – 3
Independent directors-percentage attendance in board meetings
Above 90% – 4 Less than 50% – score 1
51%–80% – score 2 Independent directors-percentage attendance in annual general meeting
81%and above – score 3 Same – 1 Chairman/managing director – same or
different Different – 2 4 and less than 4 – score 1
5–6 – score 2 Number of audit committee meetings
Higher than 7 – score 3 3 and less – score – 1
4–6 – score 2 Number of members in audit committee
7 and above – 3 Not given – 0
Less than 75% – score 1 76%–90% – score 2
Percentage of audit committee in audit committee meetings
91% and above – score 3 Independent non-executive – 3
Independent executive – 2 Chairman of company
Promoter executive – 1 Not given – 1 Retiring directors profile
Given – 2 Not given – 1 Number of share holders general meetings
Not given – 1 Number of compensation meetings Given – 2
44 P.K. Prasanna and A.S. Menon
Appendix 2
Table A2 Ownership pattern among sample companies
Ownership pattern among sample companies Number of companies
Central government – commercial enterprises 9 Foreign promoters 12 Tata Group 8 Birla Aditya Group 6 Reliance Group 5 Adani Group 2 HDFC Group 2 India Bulls Group 2 Om Prakash Jindal Group 2 Vedanta Group 2 Other promoter groups owning single company 40 Total number of companies 90
Appendix 3
Table A3 BSE 100 index companies: industry composition
Sr. no. Industry name No. of companies
1 Aluminium and aluminium products 1 2 Auto finance services 1 3 Automobile ancillaries 1 4 Banking services 11 5 Beer and alcohol 1 6 Boilers and turbines 2 7 Cement 3 8 Commercial complexes 2 9 Commercial vehicles 2 10 Computer software 6 11 Copper and copper products 2 12 Cosmetics, toiletries, soaps and detergents 1 13 Crude oil and natural gas 2 14 Dairy products 1 15 Diversified 1 16 Drugs and pharmaceuticals 8 17 Electricity distribution 1 18 Electricity generation 6 19 Fertilisers 1
Corporate governance and stock market liquidity in India 45
Table A3 BSE 100 index companies: industry composition (continued)
Sr. no. Industry name No. of companies
20 Generators, transformers and switchgears 3 21 Hotels and restaurants 1 22 Housing construction 2 23 Housing finance services 2 24 Industrial construction 1 25 Infrastructural construction 2 26 Infrastructure finance services 3 27 Investment services 2 28 LNG storage and distribution 1 29 Media-broadcasting 1 30 Minerals 2 31 Other asset financing services 1 32 Paints and varnishes 1 33 Passenger cars and multi utility vehicles 2 34 Pesticides 1 35 Refinery 5 36 Shipping transport infrastructure services 1 37 Steel 5 38 Synthetic textiles 1 39 Tea 1 40 Telecommunication services 4 41 Tobacco products 1 42 Trading 2 43 Two and three wheelers 2 Total 100
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