Stock Market and Investment: The Governance Role of the Market

Abstract

Institutional investors have become tremendously important in U.S. capital markets in recent years. But a study of 557 U.S. manufacturing firms (1985-90) shows the role of such investors to be mixed. Results show the following: 1) institutional ownership has a positive effect on capital spending but apparently a negative effect on research and development spending and no effect on advertising expenditures. So, institutional ownership might contribute to a firm's underinvestment in intangible assets and hence exacerbate managerial myopia; 2) institutional investors are complex institutions, so the regulatory and investment environment in which they operate must be carefully designed. The institutionalization of the stock market happened gradually in the U.S. and some other industrial countries and may happen gradually in developing countries as their financial markets are reformed and deepened; 3) there is a fundamental conflict between liquidity and control as objectives on institutional investment. In the U.S., liquidity has been the dominant objective and"exit"rather than"voice"has been the preferred option of institutional investors on corporate governance issues. But recently"voice"has begun to be a more important objective; 4) institutional investors'monitoring and disciplinary activities may (through corporate governance) substitute for the disciplinary and signaling roles of debt. But there is no definite evidence that institutional ownership by itself improves firm performance. Still, activism by institutional investors has replaced takeovers as the central mechanism of corporate government in the U.S. in the 1990s. The implication for developing countries: encourage institutional ownership of equity, and promote activism among institutional investors. The U.S. experience cannot always be generalized to other countries, but it does demonstrate that such activism can be a viable alternative to takeovers as a vehicle for corporate governance. It is also important for curbing the excesses of managerial discretion and maximizing shareholder values.

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