As we discussed above, a fairly large body of literature exists on corporate governance. However, within that literature, there is a surprising lack of information on the relationship between corporate governance and banks’ performance.
Furthermore, the research is still at an early stage in evaluating collateralized shares, not to mention a paucity of literature on this subject. In this chapter, we initially attempt to converge and review the finding of these earlier studies. After that, we make up the literature on how to estimate credit risk and performance. At last, the contribution of this paper is presented.
2.1 Corporate Governance and the Collateralized Shares
The relevant issue of corporate governance has been wildly discussed since Jensen and Meckling (1976) introduced the agency theory and investigated the nature of the agency costs generated by the debt and equity. Over the past few decades of research on agency problem remain controversial on one question that if more delegation to agent (manager) were benefit to shareholder. Kangis and Kareklis (2001) took public and private banks for example and argued that managers in private banks showed greater interests and more mobile in their jobs because of more compensation.
It seems to imply that a strong linkage between manager and corporate is necessary.
However, more existed literature supported the argument that more delegation to manger will deepen agency problem. La Porta et al. (1999) and Claessens et al. (1999, 2000) suggested that block shareholders cause equity agency problem due to the deviation between the controlship and the ownership, especially to family-control firms. Although more free cash flows for block shareholders with controlship is significant positively related to performance and this finding is consistent with Jensen and Meckling (1976), ownership concentration will reduce corporate value. However, either block shareholders’ holding is good to the corporate or not, previous literature implied that it should be an influential factor to monitor. Several studies have supported the viewpoint that a high performing corporate is characterized by good governance system and the findings reported in the literature can be classified into following dimension: inside control efficiency, inside financial control efficiency and
outside control efficiency (Klapper & Love, 2003; Gompers et al., 2003; Khiari et al., 2007). This viewpoint, however, should be similar to the banking industry theoretically. Unfortunately, there has thus far been relatively little research into this area. Frolov (2007) reviewed the theoretical and empirical research on disclosure and explores the problem of public disclosure in banking and noted that mandated disclosure rules for banks to be a consequence of the government policy of financial safety net. Similar conclusion could be found on other studies (Singh, 2006;
Hacimahmutoglu, 2007), but their viewpoint has not been sufficiently supported by direct evident to prove that it is helpful for banks to get the batter performance.
Furthermore, although the collateralized shares give rise to wild discuss in recent years, the relationship of collateralized shares and bank risk has not been examined.
However, there are few researches to explore collateralized shares in corporate finance. Since banks are regarded as corporate with enforced regulations, the relationship between collateralized shares and corporate is examined. Seminal work on defining the collateralized shares was carried out by Chiou et al. (2002). They point out that the term “collateralized shares” referred to shareholders’ personal behavior because the separation of control right and ownership made collateralized shares seem irrelevant to the corporation, but the corporation value could be reduced and other shareholders’ right would be deprived if directors and supervisors collateralized their shares, especially during the period of recession, they could invest in riskier investment or resort to illegal conduct due to the pressure for stock disposals rather than invest in efficient investments. In the other hand, Hsiung (2000) and Chiou
et al. (2002) separate their samples into failed and non-failed corporations and
investigate the relationship of collateralized shares to the financial distress in Taiwan during the Asian Financial Crisis. They found that the higher the proportion of collateralized shares, the poorer the operating performance and thus the higher the possibility of financial crises. It shows that the directors and supervisors could exercise their power to invest in riskier investment or resort to illegal conduct during the period of recession. Kao and Chiou (2002) attempted to explain how directors and supervisors do to achieve their self-interest goal when they collateralize their shares subsequently. They suggest that directors and supervisor would announce unrealistic message to outside shareholders in order to dressing self-interest motive up throughaccounting earning management. 2 Moreover, the higher the proportion of collateralized shares, the lower the prediction power of current earnings on future earnings. In the end, earning management would diminish the credibility of accounting numbers and thus mitigate the relation between accounting earnings and stock returns. Those literatures support the argument that collateralized shares is an incentive for directors and supervisors to abuse assets and affect the attitude toward credit risk of the management because they could be invest in riskier investment.
Therefore, in the monitoring mechanism’s place, we need to realize how to estimate the risk on banks’ loan next after catching on the concept of the collateralized shares.
2.2 How to Estimate the Risk on Banks’ Loan and Performance?
There are comprehensive exist literature which discussed how to estimate the risk on banks’ loan, namely, credit risk. Rose (2002) give bank credit risk a clear concept, they point out that credit risk plays the major role of all kind of risk3 because the largest asset item in the banking industry is loan, which generally account for half to almost three-quarters of the total values of bank assets. The probability that some of bank’s assets, especially to its loans, will decline in value and perhaps become worthless is known as credit risk. Furthermore, 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 reveals managers’
attitude. Therefore, in our study we examine the relationship between credit risk and the collateralized shares. Our purpose is to realize if personal leverage behavior affects bank credit risk when the block shareholders own and the controlship of the bank and employ collateralized shares as their leverage approach. Reviewing the theoretical and empirical research on the variables used to evaluate the credit risk, the ratio of nonperforming loans to total loans is generally used to evaluate credit risk (Bratanovic and Greuning, 2000; Rose, 2002).4 We adopt this ratio because bankers’
2 Schipper (1989) suggested that the earning management is a self-interest behavior, the directors and supervisors reach their goal on the strength of influencing the financial statements.
3 Rose (2002) suggested that bankers are concerned about six types of risk. These are credit risk, liquidity risk, market risk, interest rate risk, earnings risk and solvency risk and can be grouped as credit risk, market risk and operational risk.
4 Actually, the ratio of loan loss provision to total loans is other ratio to evaluate credit risk generally. The reason we refuse this ratio is that loan loss provision is an item banks set up by themselves and related to subjective judgment of credit risk. For this reason, we adopt the ratio of nonperforming loans to total loans to evaluate credit risk.
attitude toward credit risk of the management is related to the problem that whether the inner censorship on nonperforming loans is strict or not. Furthermore, nonperforming loans is an item which was happened and the monitoring mechanism can realize if banks operation is well-regulated or not in accordance with this item.
On the other hand, the main objective of bankers is to maximize a bank’s risk-adjust rate of return. To realize if banks were profitable and stability, in our study we serve risk-adjust rate of return as the measure of performance. We introduce some familiar measures of bank performance that give thought to risk. Two measures are risk-adjusted rates of return which are defined as a bank’s average performance (measured as the mean) divided by the volatility of performance (measured as the standard deviation) This method was introduced by William F. Sharpe in 1966 and so-called the “Sharpe Ratio”, and then Stiroh (2004) developed another Sharpe Ratio in terms of originally ideas.5 Stiroh (2004) defined risk-adjusted return on equity, RARROE, and on assets, RARROA, as:
RARROE ＝
σ
ROEROE
(1)RARROA ＝
σ
ROAROA
(2)where ROE is the mean return on equity (net income divided by equity),
σ
ROE is its standard deviation, ROA is the mean return on assets (net income divided by assets), andσ
ROA is its standard deviation. Those ratios can be viewed as profits per unit of risk and a higher ratio indicates batter Risk – adjusted profits. However, prior studies implied that ROA is a batter measure of performance than ROE. 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 based5 The original Sharpe Ratio is a market-derived ratio, which defines risk-adjusted returns as market returns divided by the standard deviation of returns and needs to take account of the risk-free rate of return. But we can’ t get market returns because of market data are not available for all banks, so we adopt the Sharpe Ratio developed by Stiroh (2004). By the way, the risk-free rate of return would not affect the results if it is constant across all banks.
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 estimate a comprehensive result, we adopt both measures in our study. Furthermore, we following Barber and Lyon (1996) advocated operating income before depreciation because this measure is not affected by managerial discretion in depreciation policy. Therefore, we prefer operating income before depreciation as a measure of performance in our study.
2.3 Other Related Issues in the Banking Industry
In the banking industry, the capital adequacy ratio, the percentage of a bank's capital to its risk-weighted assets, has seen increased attention in recent years. There are several researches to explore the concept of capital adequacy. Sharpe (1978) defines the capital as the difference between assets and deposits, the deposits will be safe when the ratio of capital to assets is large enough, and it means that capital would be "adequate". Lackman (1986) employ three different capital adequacy constraints to examine the relationship between capital adequacy and bank portfolio and find that the higher capital adequacy ratio will always reduce the variance of return on equity and causes a shift of bank portfolios towards less risky assets, but to varying degrees among different banks and will increase the probability of losses. Karels et al. (1989) examine the relationship between bank capital adequacy and market measures of risk and find that higher levels of capital adequacy correspond with lower risk measures.
Although there are some literatures which provide evidence to show the relationship between capital adequacy and risk, Daesik and Anthony (1988) challenge the effectiveness of the traditional capital ratio regulation. They suggest that it ignores the individual banks' different preference structures and allows "risky" banks to circumvent the restrictions. However, up to now, the capital adequacy ratio is still a convictive criterion to evaluate whether banks operate safety. According to Basel II, there is a new and significantly accurate framework to calculate this ratio.
Bank size is another factor which is essential to performance. The relevant research on bank size and performance includes cost and revenue performance, as well as the abilities of banks of different sizes to provide retail services in which both large and small banks compete. Early research on bank cost scale economies generally
finds very little scale economies at very small sizes, typically well under $1 billion in assets (Berger et al., 1987). Later research suggests that there may be more extensive cost scale economies in the 1990s, with average costs declining up to asset sizes of
$25 billion or more (Berger and Mester, 1997). Furthermore, other research suggests that large banks may have also gained relative to small banks in terms of revenues.
Profit efficiency studies and other studies including revenues find that M&As increased profits and revenues through improved risk-expected return frontiers (e.g., Akhavein et al., 1997; Hughes et al., 1999). Some evidence also suggests that U.S.
banks involved in M&As improved the quality of their outputs in the 1990s in ways that increased costs, but still improved profit productivity by increasing revenues more than costs (Berger and Mester 2003). However, some evidence also suggests that large banks may not be equivalent to batter performance. Hubris hypothesis, introduced by Roll (1986), suggested that mangers might overestimate M&As synergy and recognize higher goodwill in the financial statement in order to take first-moving advantage, then result in huge lost and bankruptcy. Summarizing these arguments, there is obviously no single solution to the problem that how large a bank is suitable. In our research, we served the capital adequacy ratio and bank size as control variables. Theoretically, the capital adequacy ratio is negatively related to risk.
Furthermore, because research on the relationship between performance, size and the capital adequacy ratio remain controversial, we attempt to detect their patent and provide explanation but not to anticipate single in our study.
2.4 The Expectations of the Study
As noted by Jensen and Meckling (1976), the nature of the agency costs can be generated by the debt and equity. Observably, the equity problem fits in with our case.
Jensen and Meckling (1976) argued that the agency problem would be diminished by higher proportion of director shareholders’ holding. Kangis and Kareklis (2001) argued that managers in private banks showed greater interests and more mobile in their jobs because of more compensation. However, more existed literature supported the argument that more delegation to manger will deepen agency problem. Shleifer and Vishny (1989) advanced the entrench effect and argued that managers would entrench themselves by making manager-specific investments that make it costly for shareholders to replace them. For this reason, managers can reduce the probability of
being replaced extract higher wages and larger perquisites from shareholders, and obtain more latitude in determining corporate strategy. La Porta et al. (1999) and Claessens et al. (1999, 2000) suggested that block shareholders cause equity agency problem and ownership concentration will reduce corporate value. We expect La Porta et al. (1999) and Claessens et al. (1999, 2000) investigated the East Asia may more identical to our case but look over the change on block shareholders’ holding.
We state it in null from as follows:
H1a: Director shareholders’ holding is positively associated with risk
H1b: Director shareholders’ holding is negatively associated with performance
As discussed above, such as Chinatrust Bank Holding Company’s case, the family block shareholder could use little money to own shares with management controlship through personal leverage approach such as the share collateralized. It causes equity agency problem because of the deviation between the controlship and the ownership. Hsiung (2000) and Chiou et al. (2002) found that the higher the proportion of collateralized shares, the poorer the operating performance and thus the higher the possibility of financial crises. Kao and Chiou (2002) also suggested that the higher the proportion of collateralized shares, the lower the prediction power of current earnings on future earnings because managers would mitigate the relation between accounting earnings and stock returns through earning management.
However, there are still few researches to explore collateralized shares in corporate finance. Since banks are regarded as corporate with enforced regulations, the relationship between collateralized shares and corporate is examined in our study. We state it in null from as follows:
H2a: Collateralized shares are positively associated with credit risk H2b: Collateralized shares are negatively associated with performance
2.5 The Contribution of the Study
As we described earlier, although collateralized shares give rise to discuss in recent years, it is rare to explore the relationship between collateralized shares, credit risk and performance. Hence, the purpose of this paper is to examine this relationship
and give it a feasible explanation. Under the hypothesis of the higher the risk, the higher the return, it shows that collateralized shares influence bankers’ intention to credit risk management if there were significantly relationship between them. We also detect the relationship between collateralized shares and risk-adjusted rates of return, if there were no significantly relationship among them when banks are profitable, it shows that those banks “Take risk too much.” Overall, this study will be expected to lead to better understanding of the relationship between the collateralized shares, credit risk management and performance in the banking industry. It might be critically important in laying the groundwork for realizing is the collateralized shares worth monitoring. The results may provide policy implications for the regulators in the later monitoring requirement.