Liquidity and dynamic leverage: the moderating impacts of leverage deviation and target instability

Abstract:
Purpose
We explore the impact of equity liquidity on a firm’s dynamic leverage adjustments and the moderating impacts of leverage deviation and target instability on the link between equity liquidity and dynamic leverage in the UK market.

Design/methodology/approach
In applying the two-step system GMM, we estimate our model by exploring suitable instruments for the dynamic variable(s), i.e. lagged values of the dynamic term(s).

Findings
Our analyses document that a firm’s equity liquidity has a positive impact on the speed of adjustment (SOA) of its leverage ratio back to the target ratio in the UK market. We also demonstrate that the positive relationship between liquidity and SOA is more pronounced for firms whose current position is relatively close to their target leverage ratio and whose target ratio is relatively stable.

Practical implications
This study provides important implications for both firms’ managers and investors. Particularly, firms’ managers who wish to increase the leverage SOA to enhance firms’ value need to give great attention to their equity liquidity. Investors who want to evaluate firms’ performance could also consider their equity liquidity and leverage SOA.

Originality/value
We are the first to enrich the literature on leverage adjustments by identifying equity liquidity as a new determinant of SOA in a single developed country with many differences in the structure and development of capital markets, ownership concentration and institutional characteristics. We also provide new empirical evidence of the joint effect of equity liquidity, leverage deviation and target instability on leverage SOA.