Regulation of capital flows: Effects on liquidity and the role of financial reporting quality

Capital controls as restrictions on capital flows are a tool proposed as a cure to the destabilizing market movements of the 1970s (i.e., Tobin, 1978) despite the criticism that they have received (Edwards, 1999). Capital controls resurfaced during the European Financial Crisis and the restrictions imposed on capital flows in Cyprus and Greece. These were the first instances of capital control implementation in the European Union's history and had various effects on firms’ financial positions. By using a sample of EU countries and distinguishing between austerity and capital controls periods, we assess the effects of capital controls on the stock liquidity of firms. All of the sample countries have a common financial reporting framework (International Financial Reporting Standards -IFRS), and some of them implemented a range of different measures from less intensive, such as increases in tax rates, to more intensive, such as the enforcement of capital controls, in their effort to stabilize their economies. For the task at hand, we specifically engage two accounting determinants of information asymmetry, namely, conditional conservatism and the level of earnings management. Our results show that financial reporting quality as measured by higher conditional conservatism and lower earnings management is beneficial for liquidity. However, during the capital controls period, the relation between conditional conservatism and liquidity becomes negative, and this negative relation relates to less risky firms. Thus, the negative relation between conditional conservatism and liquidity is likely due to investors keeping more conservative firms in their portfolios as a measure against the crisis.