1.1 Research Background
After several disclosures of serious financial crises in the 1990s, establishing a strong monitoring mechanism is one of the priorities of the government and investors.
The Financial Supervisory Commission (FSC), founded in July 2004, is one of the main authorities of all financial institutions. The objectives of the FSC are not only to consolidate the supervision but also institute a regulator of the banking industry.
Nevertheless, after several cases of failure banks such as the financial distress of the Chinese Bank and the disclosure of the scandal in the Chinatrust Bank Holding Company, FSC was asked to enforce banks’ supervision. The bank industry is a
“concessionary” in opposition to other enterprises that operate with lower equity capital. Corresponsively, banks are going to failed easily then other enterprises if they suffer financial crises. In the other hand, the government, corporations, shareholders and taxpayers would suffer a huge loss if banks go bankrupt. For those reasons, monitoring mechanism must ensure that banks can operate in safety, reliability and stability. Particularly to the commercial bank, the financial monitoring mechanism must ensure that the family block shareholder utilize bank’s assets well when their objectives are not only to facilitate the circulation of money but earn profit.
In recent years considerable concern has arisen over corporate governance issues in corporates’ supervision since Jensen and Meckling (1976) introduced the agency theory. One of the major preoccupations of this issue has been investigating if corporate governance were benefit to performance and risk. The last decade we have seen mounting evidence of well corporate governance mechanism is contributive to performance and risk-decreasing (La Porta et al., 1999; Claessens et al., 1999).
However, this viewpoint has not been sufficiently supported by direct evident to prove that this causal relationship is identical in the banking industry. While no one denies the plausibility of this hypothesis, little empirical evidence has been gathered to support it. The agency problem is often associated with self-interest behaviors such as inside trading, cross-shareholding or overinvestment. One of the more intriguing
issues prevailing throughout the last few decades of empirical researches is the question of why banks’ owners/block shareholders misapply assets outrageously. To this question, the deviation between the controlship and the ownership is applicable to elaborate it. Viewing those questionable Taiwanese banks, it should be noted a phenomenon that banks’ owners/block shareholders use little money to own shares with controlship of the bank. Financial institution assets come from depositor and policyholder mainly. However, block shareholders can make use of assets totally even if they own little proportion of the total assets. In other words, they’re not responsible for all debts if the corporate suffer financial crises. Such a curious situation that the deviation between the controlship and the ownership would be dangerous because it could give block shareholders an incentive to misapply assets due to the self-interest mindset and arising other financial distress.
The shares collateralized, served owing share as collateral for the loan, is also a financial leverage approach but could be an incentive for block shareholders to misapply assets due to the deviation between the controlship and the ownership.
Chiou et al. (2002) provide a feasible definition to the collateralized shares and point out that the term “collateralized shares” referred to shareholders’ personal behavior and it is irrelevant to the corporation. However, it could be a factor for block shareholders to abuse assets due to self-interest motive. The share collateralized is also an important issue to the banking industry in recent years due to the cases such as the Chinese Bank and the Chinatrust Bank Holding Company. In fact, FSC was concerned with this issue and constituted related regulations1and it shows that FSC believe a relationship between collateralized shares and the credit risk on banks’ loan.
Since the family block shareholder use little money to own shares with management controlship, whether the financial leverage approach affect the attitude toward credit risk of the management would be important. However, The Securities and Futures Bureau (SFB) had already asked all banks to do that before FSC. It is thus clear that monitoring mechanisms are not in agreement on the shares collateralized. After all, the cases of the Chinese Bank and the Chinatrust Bank Holding Company are just particular cases or the share collateralized is an incentive for block shareholders to
1 On November 2006, FSC announced that the board of directors and block shareholders of all banks need to show up the information that how many stocks they collateralize if the proportion of collateralized shares is as half as their own stocks.
misapply assets. It is a serious problem for monitoring mechanisms.
1.2 The Objectives, Incentives and Major Findings
Although FSC was concerned about the problems of collateralized shares in recent years, there are only few literatures discussed in this issue in the academia (Chiou et al., 2002; Kao and Chiou, 2002; Hsiung, 2000) and those researches, developed in terms of listed company samples, can’t apply to our study totally. In fact, the relationship of collateralized shares and bank risk has not been examined before.
The banking industry is a special case in opposition to other enterprises due to the lower equity capital compared to corporations. Banks will go bankruptcy easily then other enterprises if they suffer financial crises. Under the situation that the deviation between the controlship and the ownership, could the collateralized shares be a factor for the board of directors and block shareholders to misapply bank’s assets? When the block shareholders own the controlship of the bank and employ collateralized shares as their leverage approach, will their personal leverage behavior affect bank credit risk?
It is a critical problem for the monitoring mechanism and it intrigues us to put emphasis on this issue.
In light of these concerns, the objective of this study is to examine whether the attitude of the board of directors toward risk will affect the bank risk and performance.
Return on Assets (ROA) and Return on Equity (ROE) are generally used to evaluate performance. Barber and Lyon (1996) and Core et al. (2006) argued that ROA is a preferred measure of operating performance because it is not affected by leverage, extraordinary items and other discretionary items. However, in this study we followed two ratios created based on the Market-Derived Shape Ratio to evaluate the Risk-adjusted performance: Risk-Adjusted Return on Equity (RARROE) and Risk-Adjusted Return on Asset (RARROA) (Stiroh, 2004). To compare with difference between ratios adjusted in terms of the risk before and after and make a comprehensive result, we adopt both measures in our study. Furthermore, Rose (2002) argued that credit risk plays the major role of all kind of risk because the largest asset item in the banking industry is loans. Gompers et al. (2003) also noted that weak governance might encourage managers to behave in a less risk-averse manner. For bank managers, what criteria and volume about a loan reveal managers’
attitude. Therefore, in our study we also examine the relationship between the shares collateralized and credit risk. Empirical results in this study are in line with previous researches (Chiou et al., 2002; Kao and Chiou, 2002) that the financial leverage approaches such as collateralized shares affect the attitude toward credit risk of the management and performance, higher proportion of shares collateralized is significant positively related to credit risk and negatively related to risk-adjusted return. Since the objectives of the monitoring mechanism are to consolidate the supervision and ensure the safety of the banking industry, the findings in our study may disclose some information of bank risk and performance. Overall, the focus of analyses presented in this paper is to provide empirical evidences related to our main issue and attempt to address this issue of concern by shedding light on the nature of the problems.
1.3 Research Framework
To achieve these objectives, this study is structured as follows. The first section deals with the research background, objectives and incentives in this study. Literature review offers theoretical foundations for the development of the research and our expectations will be shown in the second section. After which research methodology is presented with full details of procedures for the collation of data, results are then presented with a thorough description of the relationship among the collateralized shares, credit risk management and performance in the domestic banking industry.
Finally, results are discussed and conclusions are drawn.