Stock Market and Investment: The Governance Role of the Market

March 1996 Sooner or later policymakers worldwide must confront the increasing institutional ownership of corporate equity. Suitable policy frameworks should be devised to encourage activism by institutional investors. 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: 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. 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 (its domination by institutional investors rather than individuals) happened gradually in the United States and some other industrial countries and may happen gradually in developing countries as their financial markets are reformed and deepened. ° There is a fundamental conflict between liquidity and control as objectives on institutional investment. In the United States, 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...