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Oeconomics of Knowledge, Volume 6, Issue 4, 2014

Board Size and Board Independence: A Quantitative Study on Banking Industry in Pakistan

Kashif Rashid, Dr., Associate Professor COMSATS Institute of Information Technology Abbottabad, Pakistan E-mail: mkrashid[at]ciit[dot]net[dot]pk

Aqil Waqar Khan

Abstract:

This paper aims to investigate the relationship of board independence and board size with productivity and efficiency of the listed banks on the Karachi Stock Exchange, Pakistan. There is a lack of consensus regarding impact of corporate governance practices in correspondence to number of board members and board independence in banking sector. The derived results of the study show that there is a positive relationship between board independence and bank profitability and efficiency. Independent directors play a crucial role in providing genuine advice during executive decision making process which is an important source for improving overall corporate governance. Moreover, results regarding the role of control variables suggest a positive relationship of the total assets and deposits of the firm with the firm’s performance supporting stewardship theory in the market.

Keywords: Firm performance, banking and financial sector, Pakistan and Tobin’s Q. JEL:

G2, G21, G29.

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Introduction Corporate governance is a route through which companies are provided with direction and set boundary in terms of control. So far there is no single theory regarding board size and board independence contributing to the value of a firm. Andres and Vallelado (2008) found an inverted U shaped relationship among independent directors’ bank performance and profit efficiency. Furthermore, their study concluded the need for banks to have a balanced approach with respect to directors who are capable of decision making. Arosa et al. (2010) argued that independent directors have a positive relationship with the performance where the cost of obtaining information is low. According to normal perception, independent directors are believed to be effective monitors for the value addition and maintaining reputation, Fama and Jensen (1983). Independent board is a contributing source for lowering the cost associated with debt financing, Anderson and Reeb (2004). According to Jackling and Johl (2009) independent directors help to improve earning quality of banks and provide compensation benefits to managers. On the contrary, Jensen (1993) asserts that when board size exceeds from seven to eight it results in under-performance. Smaller boards are more effective than the large boards due to agency problems arising from increasing board size, Hermalin and Weisbach (1998). Directors in larger board face difficulties in expressing their views in limited time available during the board meetings.

According to Lipton and Lorsch (1992),

board size has a negative relationship with firm performance. Pathan and Skully (2010) did not find any significant relationship between board size and firm performance. Chiang and Lin (2011) developed a model for identifying the capability of banks board by taking into account a standardized evaluation

scheme

which

contributes

to

the

board

effectiveness.

According to their model, major drivers of bank board effectiveness are board size and proportion of independent directors.

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Adams and Ferreira (2007) analyzed the cross sectional variations in board independence by using the time series data. It was concluded that changes in board size are positively influenced in terms of changes in bank size but have a negative relationship with respect to alteration in performance. This paper examines the impact of corporate governance practices on board size and board independence in banking sector with respect to the profitability. The paper makes a novel contribution to the banking literature

by

providing

new

understanding

about

the

important

governance mechanisms and productivity in banks. Following the introduction, rest of the paper is comprised of the following sections. Section 2 presents the literature review. Section 3 discusses hypotheses development and section 4 presents methodology of the study. Section 5 explains results of the model along with the final section (6) which presents the conclusion.

Related Literature This section of study comprises of discussion regarding internal and external corporate governance instruments in developed and developing financial markets. The structure of a firm’s leadership and supervising mechanisms play a crucial role in affecting the shareholders’ value in financial markets. The board of directors being the most important internal corporate governance mechanism set strategic directions for the organization (Rashid and Islam, 2008). Research work for recognizing traits of victorious board of directors serving as obligatory constituent of corporate governance is inconclusive in developed and developing market. Chaganti et al. (1985) mentioned in their study that corporate governance falls within one of two major groups. First one is internal to the firm and other one is external to firm. Internal to firm management includes agents of shareholder which are responsible for decision making

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regarding investment, Jensen (1993). On the other hand, external to the firm management includes the need of using capital. Here, the major separation exists because of the differences between capital providers and capital manager. The results obtained were unable to reach on a single convincing point because of the divergence of views regarding optimal board size, Rashid and Islam (2010). The idea of corporate governance was started to be used and spoken more commonly from 1980’s, Pieper et al. (2008), but it was initially originated in nineteenth century, Yammeesri and Herath (2010). Because of enormous study in corporate governance, its definition varies from country to country. So it is not certain to have a single theory which could be universally accepted, Paul et al. (2011).

Its dimensions are

distributed in several clusters ranging from broad to narrow and internal to firm along with external to firm. In narrow perspective, Mathiesen (2002)

argues

that

corporate

governance

secures

and

ensures

motivational environment within the organization. Maw et al. (1994) mentioned in their research that corporate governance is a fancy term in which directors and auditors need to play their effective roles. In broader context,

corporate

governance

refers

to

corresponding

group

of

economic, legal and social bodies that safeguard the interests of corporation owners, Javed and Iqbal (2007). Moreover, corporate governance refers to the legal system and key players that control the operations at the company and among these key players board size has a vital role, Pathan and Skully (2010). Banks with effective corporate governance will be more performance oriented

than

poorly

governed

banks.

Fadare

(2011)

scrutinize

connections between financial performances of banks by making an addition to existing literature after evaluating the influence of board on the performance of banking sector in Nigeria. The data in that study was extracted from the fact book of Nigerian Stock Exchange. After the application of regression analysis it was found that boards having less

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than 13 members are more productive. To sum up all, there exists a negative relationship between board size and financial performance of bank due to agency problems. Research work of Al-Hawary (2011) aimed to examine the impact of bank governance by considering dimensions of board size, non-executive directors and ownership concentration. The study was piloted in commercial banks of Jordan between 2002 and 2009. Results revealed that non-executive directors have a positive, while board size and blockholders have a negative effect on the firm productivity. Kiel and Nicholson (2003) investigated the link between board structure and bank performance after analyzing the panel data of European banks operating, during the time span of 2002 to 2008. Their findings showed a negative relationship between board size and bank performance on one hand and on the other hand supported the argument of non executive dominating system.

Hypothesis Development Agency theory argues that most of the time business operates under condition with lack of information and uncertainty and such environment leads to two main issues namely adverse selection and moral hazard. Separation of ownership from control communicates that firm is being managed by professionals on part of the firm’s owners, Kiel and Nicholson (2003).

Lack of consensus arises when firm owners observe

that professional managers are not working up to the mark in the best interest of the firm. Agency theory further states that classified information

access

to

professional

managers

provides

them

with

additional personal advantage of firm due to the fact that managers are more interested in their personal welfare as compared to shareholder’s interests. Loderer and Peyer (2002) in their studies argued that bigger board deteriorates the value of a firm in the financial market.

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Furthermore, they suggest that larger boards are ineffective due to coordination

issues along with the problems of free riding.

boards usually have the problem of socializing.

Bigger

To control this, firms

have to pay high co-ordination costs. In bigger board, it is not certain for board members to express their views completely in particular time available at the board meeting. Much of the literature of corporate governance discussed the advantages of smaller boards in the firm. The believers of the smaller board argue that these boards are strongly connected, more efficient and can look after the firm more effectively. The above discussion leads to the fact that board size has a negative relationship with bank profitability in developing economy of Pakistan. H1: Board size is negatively related to the firm’s profitability. The stewardship theory is also known as the stakeholder theory and suggests that managers are mostly reliable and are not involved in misappropriate corporate decision making, Pieper et al. (2008). The concept of this theory

originates from the theme that organizations

serve as broader social purpose apart from just maximizing the wealth of shareholders. Uzun et al. (2004) studied the impact of board size on firm risk and found that independent directors do not take excessive risk in order to improve their performance. Thus, the level of risk reduces which helps to raise firm’s value. Hermalin and Weisbach (1998) supported the positive relationship of board independence and firm performance because of the advisory role played by the larger board. The researchers also argue that when the number of states in which a bank has operations increases it will ultimately lead to an increase in board size and independence for accommodating representative of subsidiaries from different states. Zahra and Pearce (1989) argued that it is difficult to manipulate larger boards as compared to boards with fewer seats and lack of appropriate independence.

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Anderson and Reeb (2004) argue that investors of firm with greater board independence believe that financial accounting structures are poorly

monitored

compared

to

the

firms

with

smaller

independence. Abidin et al. (2009) investigated the

board

structure

of

supervisory board of German banks and found that presence of independent directors depicts inside control. Hence, from the literature we conclude that greater board independence enables its members to take moderate decisions and also compensates management according to their performance. H2: Higher proportion of independent directors is positively related to firm’s profitability.

Conceptual Framework

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Methodology Secondary data is obtained from the annual reports of banks operating in Pakistan, which covers period from 2006-2010. 23 banks are selected and Ordinary Least Square (OLS) Regression Analysis and Generalized Method of Moment (GMM) are used to examine the relationship between board independence and profitability and to take care for endogeneity and data scattering factor. Two control variables including the size of a firm and funds available for lending are used in this study. Bank performance is measured by taking into account the basic measure comprising of cost to income ratio. Cost to income ratio is rapid test of efficiency and reflects banks non-interest cost as a share of net income (Coles et al., 2008). Board size is measured by using natural logarithm of total number of member directors working in the board, Adusei (2011). Board independence is measured as non-executive ratio to the total number of directors and can be defined as the board member that could get seat without controlling shareholders vote. Uzun et al. (2004) developed models for identifying the capability of banks board by taking into account a standardized evaluation scheme which contributes to board effectiveness. According to these models, major drivers of bank board effectiveness are board size and proportion of independent directors. Other explanatory variables used in this study are size of the bank and funds available for lending. The size of bank is calculated as natural logarithm of total assets. Funds available for lending are calculated as natural logarithm of total deposits by customers, Adusei (2011).

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Variables Description Measure of bank performance (Dependent variable) Cost-Income Ratio Operating expenses + other cost/ Net income Measure of Board Structure Board Size Natural logarithm of the total number of board of directors

Symbol (CIRATIO)

(Log Size)

Board Composition

Proportion of outside directors on the board (BINDEPEND)

Board independence Control Variables Size of Banks Funds for Lending

Natural logarithm of total Assets Natural logarithm of total Deposits

(SIZE) (FUNDS)

(Carter and Lorsch, 2004)

Results and Discussion The model specified above is estimated by applying the OLS regression based framework as previously used by Adusei (2011) and is explained in Table 1. The finding represents that the value for the R squared of the model is 0.39. This value shows that only 39% variation is described by the explanatory variables of the model. The rest of the variation remains unexplained by these independent variables. In this study board independence has the coefficient value of 2.81 with the p value of 0.02 which shows that the variable is significant at a 5% significance level. The result implies that greater board independence leads to the improved firm performance accepting the hypothesis H2 for the study. Moreover the result suggests that independent directors depict inside control which helps to raise firm’s value. Log of funds has the coefficient value as 0.27 with the p value of 0.01 which shows that the variable is

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significant at the 1% significance level. The result represents the fact that level of risk reduces due to increase in funds available for lending which contributes to the enhanced value of the firm. Table 01. Method: Ordinary Least Squares Dependent Variable: I/C Variable Coefficient Std. Error t-Statistic C -4.309221 0.932847 -4.619428 BS -0.032134 0.065496 -0.490630 LOG(FUNDS) 0.275590 0.109524 2.516256 BI 2.819356 1.197630 2.354113 LOG(SIZE) 0.236368 0.099215 2.382378 R-squared 0.396416 Mean dependent var Adjusted R-squared 0.374468 S.D. dependent var Log likelihood -167.6250 Hannan-Quinn criter. F-statistic 18.06119 Durbin-Watson stat Prob(F-statistic) 0.000000

Prob. 0.0000 0.6247 0.0133 0.0203 0.0189 2.109304 1.343761 3.050616 1.781003

Log of size has the coefficient value of 0.23 with the p value of 0.01. The result implies that increase in assets also contribute positively in productivity because of the fact that financial accounting structures are monitored in a better manner resulting in enhanced firm size. Board size has the coefficient value of -0.03 with the p value of 0.6 which shows the lack of relationship between board size and the value of a firm in Pakistan. The result leads to the rejection of hypothesis H1 for the study. The GMM approach is suited to deal with the important dynamic effects and accounts for endogeneity in the explanatory variables and has been explained in the second model reported in Table 2. The J-statistic reported at the bottom of the table is the minimized value of the objective function. A simple application of the J-statistic is to test the validity of over identifying restrictions. Over-identification makes possible for us to verify whether the model moment conditions match the data well or not. To pursue with the test we compute the J value from the data. It is a positive number with the 5% confidence interval having the

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Oeconomics of Knowledge, Volume 6, Issue 4, 2014

p value of 0.05. Here the value of J-statistic is 0.01 which depicts that there is a lack of endogeneity in the model. Table 02. Generalized Method of Moments Dependent Variable: I/C Instrument list: C PL BS(-1) BI(-1) LOG(SIZE) LOG(FUNDS)s Variable C LOG(SIZE) LOG(FUNDS) BI BS R-squared Adjusted R-squared S.E. of regression Durbin-Watson stat

Coefficient -4.950607 0.186710 0.241312 4.211518 0.127479 0.340296 0.316087 1.115766 1.749291

Std. Error t-Statistic 1.318944 -3.753462 0.070269 2.657090 0.083655 2.884619 2.342503 1.797871 0.109617 1.162951 Mean dependent var S.D. dependent var Sum squared resid J-statistic

Table 03 Dependent Variable: ROE Variable

Std. Error

t-Statistic

Prob.

C

Coefficient -0.628259

0.471016

-1.333838

0.1850

LOG(BS)

0.154690

0.180623

-0.856424

0.3936

LOG(SIZE)

-0.018963

0.032288

-0.587311

0.5582

LOG(FUNDS)

0.018143

0.036031

0.503547

0.6156

PL

1.67E-05

7.55E-06

2.210731

0.0291

BI

0.937519

0.441944

2.121351

0.0362

R-squared

0.245851

Mean dependent var

0.018435

Adjusted R-squared

0.211257

S.D. dependent var

0.384147

Prob. 0.0003 0.0091 0.0047 0.0750 0.2474 2.105877 1.349189 135.6979 0.019461

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The R squared for the next estimated model in which return on equity is used as a dependent variable is 0.24. The result endorses that only 24% variation is explained by the explanatory variables of the model and 76% variation remains unexplained by these independent variables. According to t-statistic, board independence has the value of 2.12 with the p value of 0.03 which shows that it is significant at 3% level of significance. The result as reported in Table 3 supports the argument that increasing board independence favours unbiased and genuine decision making. Moreover results obtained are consistent with Coles et al. (2008) and Adusei (2011).

Conclusions The current study makes an original contribution to the literature related to the board diversity and firm performance in banking sector of Pakistan. The results suggest that there exists a positive relationship between board independence and bank profitability along with the efficiency. This means that non-executive directors play a vital role in improving economic value of banks. According to this research work, independent directors perform a dynamic and important role in providing independent statements and recommendations during corporate decision making process, while such recommendations positively enhance overall corporate governance. GMM technique has been used as the robustness test and takes care for endogeneity problem in the data. The findings of this empirical study regarding the control variables suggest that higher deposits in the firm build the confidence of investors and improve the firm performance. Finally, the higher tangible assets improve the value of a firm as the managers work as stewards and use them in the benefits of the shareholders in the developing market.

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