A study on the impact of financial market reforms on investment, financing, and governance structures of publicly traded firms in India

• This study sought to explore whether financial reforms undertaken in India in the 1990s had an effect on decisions made at the micro level by the publicly traded firms.
• We examined the effects of the creation of the National Stock Exchange (NSE) on firm liquidity and access to financial capital.
• Firm liquidity increased due to the introduction of paperless trading in shares, which, along with the NSE’s clearing system, insured against forged certificates.
• Firms’ access to capital also increased, because of the reduction of information asymmetries. However, this effect was only enduring for firms whose liquidity had also increased.
• Financial liberalisation was therefore not the most important outcome on the establishment of the NSE for shareholders.

In the early 1990s, the Government of India initiated a series of reforms to financial markets, which were intended to restore investors’ confidence following large scale stock price manipulations which led to market meltdown. A key component of the reforms was creation of a new stock market, the National Stock Exchange (NSE). The NSE initiated a series of changes in the method of trading, payment and settlement, and governance structures. For example, whereas the Bombay Stock Exchange (BSE) was owned by the brokers, the new NSE was set up by large financial institutions backed by the government.

Our study explored the impact of the new platform on (a) liquidity of the stock market and (b) financial constraints on publicly listed firms. Our first paper, ’Forgery, market liquidity, and demat trading: Evidence from the National Stock Exchange in India’, explored the question of liquidity. It analysed the impact of the establishment of a new technology on the National Stock Exchange in India that allowed trading of stocks without the need to transfer paper share certificates. This was achieved by the introduction of dematerialized trading (demat), and was intended to reduce the instance of forgery.

We found that there was a sharp increase in market liquidity following the introduction of demat, especially for stocks that were previously illiquid. We also found that that the adoption of demat trading had a larger impact on the liquidity of securities as measured by the bid ask spread. In particular we found that on average the bid ask spread dropped by around 22% and this drop was greater for those firms that had the higher bid ask spread before the adoption of demat trading. The increase in liquidity was primarily due to the elimination of the risk of being sold forged securities. This is because with the establishment of demat trading, the NSE’s clearing system took on the risk of reimbursing buyers of forged shares.

The second paper, ’Financial market integration and firms’ access to capital: Evidence from the National Stock Exchange in India’, assessed the extent to which the creation of NSE had eased the financial constraints on Indian firms. In particular, we explored whether listing on the new domestic stock exchange enabled publicly traded firms to enhance their access to capital and overcome market frictions in previously fragmented equity markets. We found that following the opening of India’s National Stock Exchange in the early 1990s, investment in dual-listed firms (those listed on both NSE and BSE) increased relatively more than in firms that remained listed only on the country’s primary market (BSE). This enhanced investment was more pronounced in firms that had previously been financially constrained. These results can be explained by larger equity offerings and reduced information asymmetries in raising new capital subsequent to cross-listing in both BSE and NSE. However, valuations of dual-listed firms that failed to sustain a more liquid trading environment for their shareholders returned to pre-cross-listing levels over time.

Taken together, the two arms of this study suggest that financial liberalisation and reforms in the Indian stock market in the early 1990s enhanced firms’ access to capital, but failed to deliver benefits to shareholders of immediately, except for in the most actively traded firms.