The effects of uncertainty and corporate governance on firms’ demand for liquidity

Abstract

We find that US corporations’ demand for liquidity is sensitive to two important factors: uncertainty facing the firm and the quality of corporate governance. Following prior research, we find that both factors have important influences on firms’ cash holdings. Our results also indicate that the interactions between uncertainty and governance measures are significant. From a policy perspective, these new findings indicate that both governance and the nature of uncertainty may play an important role in managing liquidity risks. Policy recommendations may not only be limited to changes in financial policy but may also include changes in corporate governance.

Acknowledgements

This article was completed during Boyan Liu's stay as a Visiting Scholar at Boston College, which was financially supported by National Natural Science Foundation of China, No. 70521001, and Research Fund of China Ministry of Education for PhD Development, Nos. 70821061 and 70831001. Christopher F. Baum gratefully acknowledges financial support from the Fritz Thyssen Foundation.

Notes

¹ See Opler et al. (1999) and Baum et al. (2006, 2008).

² A recent work considering interactions of corporate governance with managerial ownership is by Agca and Mansi (2008).

³ This section borrows from Baum et al. (2008).

⁴ See Bates et al. (2009).

⁵ One would expect stronger motives for corporate cash holdings to appear in imperfect financial markets where external finance involves a high premium. Adverse selection and moral hazard problems stemming from information asymmetry between lenders and borrowers would lead to costly external financing. Thus, firms – particularly those facing a high degree of informational asymmetry – would tend to accumulate more cash to avoid high costs of external finance.

⁶ See Dittmar and Servaes (2003) and Pinkowitz et al. (2003).

⁷ See Lang et al. (1991), Blanchard et al. (1994) and Harford (1999).

⁸ This expands on the sample used in Harford et al. (2008), who did not consider the 2006 IRRC data.