Using panel data on U.S. public firms, we document a positive effect of board independence on corporate innovation. This effect is concentrated in firms that are larger in size, in the non-technical industries, facing less product market competition, and using more debt, where managers are more likely to be excessively risk averse. We establish causality of board independence on innovation using a difference-in-difference approach that exploits an exogenous shock to board composition, namely, the mandate of a majority of outside directors on company boards by NYSE and NASDAQ in response to the passage of Sarbanes-Oxley Act in 2002. We further examine incentive compensation as a possible mechanism. We show that firms with more independent boards use more equity-based compensation, especially stock options, to promote managerial risk-taking.

We explore theoretically and empirically the relationship between firm productivity and liquidity management in the presence of financial frictions. We build a dynamic investment model and show that, counter to basic economic intuition, more productive firms could demand less capital assets and hold more liquid assets compared to less productive firms when financing costs are sufficiently high. We empirically test this prediction using a comprehensive dataset of Chinese manufacturers and find that more productive firms indeed hold less capital and more cash. We do not, however, observe this for US manufacturers. Our study suggests a larger capital misallocation problem in markets with significant financing frictions than previously documented.