Journal of Financial Economics 34 (1993) 31-51. North-Holland The hidden costs of stock market liquidity* Amar Bhide Haward Unioersity. Boston. MA 02163, USA Received January 1991, final version received December 1992 The seemingly unrelated problems of stock market liquidity and manager-stockholder contracting are closely intertwined. Active stockholders who reduce agency costs by providing internal monitor- ing also reduce stock liquidity by creating information asymmetry problems. Conversely, stock liquidity discourages internal monitoring by reducing the costs of ‘exit’ of unhappy stockholders. The U.S. has exceptionally many actively-traded firms with widely-diffused stockholding because public policy has favored stock market liquidity over active investing. And, the benefits of stock market liquidity must be weighed against the costs of impaired corporate governance. 1. Introduction In 1984, then-SEC Chairman John Shad wrote: ‘Fifty years ago, in the depths of the depression, the nation’s securities markets were demoralized. Today they are by far the best capital markets the world has ever known - the broadest,’ the most active and efficient, and the fairest. The Securities and Exchange Commis- sion has played an important role in the restoration of public confidence . . . [and] has discharged with distinction its mandate to protect investors and maintain fair and orderly markets’ [SEC (1984, p. l)]. The limited liquidity and breadth of many European markets, where secu- rities regulation is relatively weak, seem consistent with Shad’s claims. ‘For years’, The Economist (3/30/91, p. 79) reports, ‘investors have complained that the Correspondence to: Amar Bhide, Baker Library 365, Harvard Business School, Soldiers Field Road, Boston, MA 02163, USA. *This article has substantially refined the basic ideas contained in EfJicient Markets: Deficient Governance (HBS working paper, March 1990). I am greatly indebted to Michael Jensen, who read numerous subsequent drafts, offered invaluable criticism and suggestions, and provided constant encouragement. Howard Stevenson was similarly generous with comments and time. Sugato Bhattacharyya, Warren Buffett, Alfred Chandler, Iain Cockburn, Paul DeRosa, Steve Kaplan, Arthur Rock, Andrei Shleifer (a referee), Clifford Smith (the editor), and numerous colleagues at Harvard Business School provided useful comments and suggestions. ‘Breadth usually refers to the number of issues that enjoy liquid markets. 0304-405X/93/$06.00 c 1993---Elsevier Science Publishers B.V. All rights reserved