How Do Informational Frictions Affect the Firm’s Choice of Asset Liquidity? The Effect of SOX Section 404

Although existing theories predict a causal link between informational frictions in financial markets and a firm’s choice of asset liquidity, the lack of an exogenous and clean measure of informational frictions hinders the precise identification of this link. Using the discontinuous requirement of financial reporting introduced by Section 404 of the Sarbanes-Oxley Act, we identify a causal effect of informational frictions on the holding of liquid assets. By employing the cash ratio as a measure of corporate liquidity, we show that firms that comply with Section 404 and provide more reliable information to the financial markets reduce their holding of liquid assets compared to observationally similar firms. In the cross-section, the reduction in asset liquidity is more pronounced among firms that face financial constraints and agency conflicts, consistent with such firms having a high opportunity cost of funds. Finally, firms that comply with Section 404 and hold less cash present a higher expenditure in R&D relative to firms not complying with the rule. This difference sheds light on the opportunity cost of holding cash. ∗I am grateful to Radhakrishnan Gopalan, Ohad Kadan, Mark T. Leary and Anjan Thakor and to participants of the Brown Bag Seminar at the Olin Business School for their helpful and valuable comments on an earlier draft. I alone am responsible for any errors. †PhD Student in Finance, Olin Business School, Washington University in St. Louis. Email: [email protected]