Corporate Board Structures and Performance in the Banking...

Electronic copy available at: http://ssrn.com/abstract=1786200

Corporate Board Structures and Performance in the Banking Industry: Evidence from Japan∗

Hideaki Sakawa+ Naoki Watanabel⊥

March 2011

Abstract

The recent global financial crisis contributes for recognizing the importance of corporate governance mechanisms in the banking industry. Although mixed evidence is associated with the role of board of directors in non-financial industries, a few analyses have been made of the relation between board composition and firm performance of the banking industry in several OECD countries. This paper examines the relation between board size and composition and firm performance and its relations with financial systems and maintenance of foreign branches for a banking industry during 2006-2009. We find that banking firms with larger boards underperform their peers in terms of Tobin’s Q and that no significant relation between the proportion of outside directors on the board and Tobin’s Q. We also argue that banks with taxpayer money and foreign branches would make a larger board more desirable for these firms because they face the requirement of improving management. After accounting for these unique features of Japanese banks, we find that board structures of Japanese banking industry are well performed only in banks with taxpayer money. In addition, Tobin’s Q is negatively correlated with board size in banks with foreign branches. This finding suggests that the board structures of bank with foreign branches might be the causes of agency problem. Our findings imply that board structures of Japanese banking remains for the improvement and that a greater need for efforts on the part of the banking sector to change and improve their board structures. JEL classification: G34; G21; J41; L22 Keywords: Corporate governance, Banking industry, Board structure

∗ The authors are grateful to Reene Adams, Murya Habbash, Yoshiro Tsutsui, Ming Xu, Joao Vieito, and Rodrigo Zeidan and seminar participants at clusters seminar of Nagoya City University, Asian Finance

Association 2010 annual conference, Corporate Governance and Global Financial Crisis International

Conference, and Midwest Finance Association 2011 annual conference for their helpful comments and

suggestions. This research is financially aided by Joint Usage and Research Center, Institute of Economic

Research, Hitotsubashi University, and Japan Ministry of Education, Culture, Sports, Science and

Technology, Grants-in-Aid for Young Scientists (B). + Correspondence: Nagoya City University; Address: 1 Yamanohata, Mizuho-cho, Mizuho-ku, Nagoya, Nagoya, 467-8501, Japan; Tel: +81-52-872-5724; Email: [email protected] ⊥ Toyo University; Address: 5-28-20, Hakusan, Bunkyo-ku, Tokyo, 112-8606, Japan; Tel: +81-3-3945-7487; Fax: +81-3-3945-7477; Email: [email protected]


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1. INTRODUCTION

The importance of corporate governance mechanisms is recognized by both academics and

practitioners. In recent years, the debate has specifically focused upon the functioning of

board of directors, an important corporate internal control mechanism (Jensen, 1993). To date,

few analyses of the relation between board composition and firm performance of the banking

industry have been reported. Prior studies of the functioning of boards of directors have

mainly addressed non-financial industries. From the viewpoint of revealing board functions

under various corporate governance systems, it would be invaluable to analyze the relation

between board composition and firm performance in Japan, where corporate governance

mechanisms are expected to serve a “bank-centered system”, different from Western

“market-oriented systems” (Aoki, 1990). Regarding the board’s role in the banking sector, no

report in the relevant literature describes a study of the Japanese banking industry. This paper

therefore presents analysis of the board structure in the Japanese banking industry and its

relations with financial systems and maintenance of foreign branches.

Mixed evidence is associated with the role of board of directors in non-financial industries.

Many early studies imply that larger boards are not good monitors because of their higher

coordination cost problems (Lipton and Lorsch, 1992; Jensen, 1993). Previous empirical

studies such as those of Yermack (1996) and Eisenberg et al. (1998) found a negative relation

between board size and firm performance. These findings support the view that smaller

boards are better. However, some studies, such as those of Dalton et al. (1999) point out that


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larger boards offer better advice to CEOs. Hermalin and Weisbach (1998) showed

theoretically that “the CEO might choose an outside director who will give good advice and

counsel, who can bring valuable experience and expertise to the board.”

A few analyses have been made of the relation between board composition and firm

performance of the banking industry in several OECD countries. Their results show that the

bank board composition and size are positively related to performance, meaning that the

directors’ special ability is the monitoring and advising of managers, and that independent

boards might help to monitor and advise more efficiently and thereby create more value.

Andres and Valleano (2008) analyze the relation between board composition and firm

performance in the banking industry. Adams and Mehran (2008) also analyze the relation

between board composition and firm performance in the US bank holding companies (BHC).

They also find no negative relation between board size and firm performance.

After the lost decade of the 1990s, whether corporate governance mechanisms function

well in the Japanese banking industry or not remained an unresolved question. The Japanese

banking industry changed dramatically after the lost decade of the 1990s. After the late 1990s,

the rescue of the Japanese financial system through government bail-outs and loans was

funded with taxpayer-derived capital because Japanese banks suffered from continued bad

deficit problems. Many commercial banks intended to recover through merger activities in

the early 2000s, and attempted particularly to solve their bad deficit problems. During

restructuring, some major banks abolished their foreign branches because the Bank for

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International Settlements (BIS) required a sufficient capital asset ratio of banks that was

above minimum international standards.

Two empirical questions relate to the Japanese banking industry after 2006, when almost

all merger activity abated. The first is whether Japanese corporate governance mechanisms

such as board structure function properly in the banking industry after restructuring. Secondly,

we examine whether recent restrictive processes of Japanese banks––including measures

associated with rescues funded by taxpayer-derived public capital and with abolishment of

foreign branches––actually improve corporate governance mechanisms.

The first objective is to reveal whether or not boards of directors in the banking industry

are taking an effective monitoring role or advisory role in Japan in the recent period from the

late 2000s. Since 2003, the Japanese banking industry has been more stable than during the

lost decade of the 1990s. Hoshi and Kashyap (2006) describe that the total amount of “bad

deficits” in the Japanese banking industry declined dramatically during 2002–2005 and that

many commercial banks managed to solve “bad deficit” problems. We specifically examine

the recent period following the solution of “bad deficit” problems, and seek to reveal whether

or not boards of Japanese banks take roles of monitoring and advisory management.

The second object of this paper is to examine whether or not the external Japanese rescued

system and banking organization have influence of some kinds on its corporate governance

system. Some Japanese banks suffered from bad deficit problems. Consequently, they were

rescued using taxpayer funds. They were rescued by the Japanese financial system which

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made regulatory demands to safeguard taxpayer funds. The Japanese government, especially

the Japanese Financial Service Agency (FSA), requires reduction of the labor cost and

executive compensation package in commercial banks. The board sizes of commercial banks

receiving taxpayer funds were also expected to be smaller than others undergoing

restructuring because they satisfy the limitation of executive compensation imposed by

regulation. In these restructured banks, the boards of directors are expected to remain as

effective management monitors or advisors. In addition, Japanese banks are separated into

two groups according to whether or not they have foreign branches. After the lost decade of

the 1990s, many banks closed their foreign branches because they did not maintain sufficient

capital determined by the capital requirement regulation of the BIS. Banks with foreign

branches have more complicated operations and regulations than those without. The board of

directors at a bank with foreign branches would be required to advise the management more

effectively.

This paper presents examination of the relation between board size and composition and

firm performance in the Japanese banking industry during 2006–2009. To analyze the

endogeneity of board structure and firm performance, we also adopt GMM estimation. Even

after controlling for the endogeneity problems, significant negative board size coefficients

imply coordination and decision-making problems for bank boards in Japan. We also analyze

the relation between firm performance and outside directors. Results show that their relation

is not significant.

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In addition, we examine the effect on board structures of rescues funded with taxpayer

capital and the abolishment of foreign branches. Our results show that Tobin’s Q is positively,

sometimes significantly, related with board size in banks supported with taxpayer funding.

This evidence supports that bank boards with taxpayer funding contribute to enhancement of

performance in Japanese banks recently. Additionally, it is apparent that the relation between

board size of banks with foreign branches is significant and negative, which implies that

board structures in banks with foreign branches have induced some agency problems during

the recent period.

The remainder of this paper is summarized into the following five sections. We introduce

the background of banking industry in Japan. Subsequently, we present a description of the

data and descriptive statistics analysis. We then analyze the relation between board structure

and firm performance. After presenting consideration of the recent Japanese banking features,

we summarize the conclusions based on the analyses explained in this paper.

2. BACKGROUND OF THE BANKING INDUSTRY IN JAPAN

The evolution of the Japanese banking industry accelerated quickly during the decade

following the late 1990s. A few previous reports (Hoshi and Kashyap, 2010) describe the

transition of Japanese banking, but most previous studies (Dow and McGuire, 2008; Hiraki

et.al, 2003; Morck and Nakamura, 1999; Morck et al., 2000) analyze the era preceding the

lost decade up to the 2000s. This section presents a brief summary of the transition or

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evolution of the Japanese banking industry.

According to Hoshi and Kashyap (2010), we can classify the changing phases of the

banking industry into three periods occurring within 1990–2003: Phase one (1990–1997), the

Actual phase (1997–1999), and Phase three (1999–2003). The first period, occurring before

the late 1990s, included few mergers and failures, with some changes in the corporate

governance of Japanese banks (Anderson and Campbell II, 2004). During the second period,

Big Bang deregulation was announced in late 1996 and implemented in fiscal year 1997. The

objective of the Big Bang deregulation was to remove barriers to competition within the

financial industry both for domestic and foreign participants, thereby producing a U.S.-style

competitive system (Patrikis, 1998). The rescue of the Japanese financial systems through

government bail-outs and loans was funded by taxpayers in later periods.

During the third period after the early 2000s, the corporate governance mechanisms of

Japanese banking industry also changed for several reasons. First, because of Big Bang

deregulation, formal limits on “mochiai” or cross-shareholding, were established by the

Banks’ Shareholding Restriction Law in September 2001. Such cross-shareholding was

regarded as playing an important role in Japanese corporate governance and bank-centered

systems (Aoki, 1990; Hoshi and Kashyap, 2001)1. The FSA asked banks that were funded by

taxpayers to change their corporate governance structures by measures such as cutting

executive compensation, altering the board size, and appointing outside directors to increase

1 According to Miyajima and Kuroki (2007), the sale of corporate shares by banks began after 1997.

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profitability. In this situation, many banks suffered from bad deficit problems and sought

recovery through M & A activities.

Some “recovery periods” are apparent during 2003–2006. Many commercial banks

reduced “bad deficits”. The real Gross Domestic Products (GDP) growth rate rose after 2002.

Through M&A activities, nine large city banks merged into three mega-banks from early

2000 through 2005: Mitsubishi-UFJ Financial Group, Sumitomo Mitsui Banking Corporation,

and Mizuho Financial Group. Hoshi and Kashyap (2006) explain that Japanese commercial

banks needed to propose a new strategy for the ensuing period.

After 2006, the Japanese banking industry stabilized in relation to other periods such as

the lost decade after the 1990s, leading up to the recent period. During that time (2006–2009),

regarded as a “stable period”, Japanese banking industry merging activities had largely

finished and restructuring of their corporate governance systems had become established.

Although the outcome remains in doubt, in latter 2009, this stable period might have ended as

a result of the U.S. financial crisis and the ensuing low-growth of the Japanese economy.

3. DATA AND DESCRIPTIVE STATISTICS

During the lost decade, the Japanese banking sector suffered from bad deficit problems and

repeated merger activities. For example, the number of Japanese city banks decreased from

nine to three during 2000–2005. After 2006, Japanese commercial banks experienced greater

stability than in other periods since the 1990s. In this section, we describe the data and

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variables and analyze descriptive statistics.

3.1 Data and Variables

We choose the sample period 2006–2009, when the Japanese banking industry performance

was stable. We examine this “stable period” specifically to avoid effects of merger activities.

The financial data were obtained from the Nikkei NEEDS database. Especially, data

related to characteristics and membership of boards were collected from the Nikkei NEEDS

Cges database, which is a subset of the Nikkei NEEDS database. The sample consists of 332

observations during 2006–2009 for 84 Japanese banks listed on the Tokyo Stock Exchange.

We measured firm performance using Tobin’s Q, which is the ratio of the firm’s market

value to its book value. The firm’s market value is calculated as the book value of assets

minus the book value of equity plus the market value of equity. This proxy of Tobin’s Q is

provided by the Nikkei NEEDS Cges database.

We use the following variables as financial data: return on assets (ROA), total assets

(Asset), the ratio of total capital to total assets (CAPITAL), and the volatility (VOLATILITY).

We control firm profitability for the return on assets (ROA). The return on assets (ROA) is the

ratio of ordinary profit to total assets. Firm size is controlled by the logarithm of the book

value of total assets (Asset). The ratio of total capital to total assets (CAPITAL) is calculated

as the ratio of the book value of capital to the book value of assets. It is controlled by

financial conditions. The firm risk is controlled by the volatility of the average daily stock

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return for the past three years (VOLATILITY), which is provided by the Nikkei NEEDS Cges

database.

We also adopt the following variables to represent Japanese governance mechanisms: the

number of directors on the board (BOARDSIZE), the percentage of directors from outside the

firm (OUTSIDE), the percentage of managerial ownership (Managerial Own), the percentage

of CEO ownership (CEO Own), a dummy to indicate banks rescued using taxpayer-derived

funds (Tax), and a dummy to indicate banks with foreign branches (Foreign Branches). The

former three variables were collected from the Nikkei NEEDS Cges database. We defined the

dummy of the bank rescued by taxpayer funds (Tax) as one if the FSA reported a commercial

bank as receiving tax-payer’s money. A dummy of the bank with foreign branches (Foreign

Branches) equals one if a commercial bank had at least one foreign branch. This information

was provided by “Zenkoku-Ginko-Kyokai” or the Japanese Bankers Association.

We explain other variables such as the bank category dummy (BCD) and ownership

variables. Japanese banks in our samples are mainly classified as City Banks and Regional

Banks by the Japanese Bankers Association. Generally, the size and business area of Regional

Banks are smaller than those of City Banks. We defined BCD as one if a bank is not a

"Regional Bank". The ratio of president’s shares to total shares is designated as CEO

ownership. The board director’s ownership signifies the ratio of the total board of director’s

share to total shares.

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3.2 Descriptive Statistics Analysis

We provide descriptive statistics in Table 1. There, Panel A, Panel B, and Panel C of Table 1

respectively present summary statistics of financial variables, corporate governance variables,

and the other variables related to Japanese banks during 2006–2009.

------------------------------------

Insert Table 1 about here

------------------------------------

Panel A of Table 1 presents that the average of Tobin’s Q is 1.000 and the average ROA is

0.306%. An average bank in Japan has 0.9 billion yen in assets and about a 6.9% capital ratio.

The average ratio of stock volatility during three years is about 2.08. Therefore, the Japanese

banking industry can be characterized as being huge, but with small capital during this period,

implying the Japanese banks’ bad deficit problems and subsequent M & A activities during

last 1990 and early 2000s. The average of the banks with taxpayer funds dummy is 10.8%.

The average of the banks with foreign branches dummy is 13.6%: inadequate capital

problems were severe for Japanese banks after 2006.

Panel B of Table 1 presents summary statistics of corporate governance variables of

Japanese banks during 2006–2009. We report governance variables such as the board size, the

number of outside directors, managerial ownership, and cross-shareholding ratios.

The average board size was about 10.5 members during this period. According to Adams

and Mehran (2008) and Andres and Vallelano (2008), the board size of BHC in the U.S. was

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about 18.0 and that in several OECD countries is about 15.8. These differences illustrate that

Japanese board sizes in banking industry are smaller than those in other developed countries,

implying that corporate governance regulation might have recommended smaller boards. The

ratio of outside directors to board size and the average of outside directors are, respectively,

about 0.077 and 0.789. Therefore, the board composition of Japanese banks is mainly

occupied by inside directors. The ratio of outside directors is smaller than that of US or

economically developed countries.

Panel C of Table 1 shows descriptive statistics of BCD and ownership variables. The BCD

is about 0.1 or 10%, which means that our sample is mainly occupied by regional banks. The

average CEO ownership and managerial ownership respectively have 0.056% and 0.241%.

4. RELATION BETWEEN BOARD STRUCTURE AND FIRM

PERFORMANCE

Immediately hereinafter, we present our empirical specifications about the relation between

Tobin’s Q and board size and composition. Furthermore, our empirical specifications are

explained. Thereafter, our empirical results are interpreted.

4.1 Empirical Specifications

The relation between board size and bank value might not be uniquely determined. Dalton et

al. (1999), for example, reported that larger boards might be profitable because they increase

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the expertise that is available for the organization. Large banks have diversified

geographically, setting up branches in foreign countries and operating under different

regulatory systems. Therefore, one should expect bank boards to emphasize strategic

decisions to address a competitive environment while ensuring that their bank complies with

regulatory requirements in each country. Larger boards might facilitate manager supervision

and might advise managers.

Nevertheless, many previous studies such as those of Yermack (1996) and Eisenberg et al.

(1998) point out that larger boards yield excessive control to the CEO and hinder the efficacy

of decision making. Jensen (1993) also argues that larger boards become less effective at

monitoring because of free-riding problems among directors. Considering results of these

studies, the effect of board size on bank value is a tradeoff between monitoring and advisory

roles and coordination and decision-making problems.

Previous reports of the literature do not offer conclusive evidence of the effect of

appointing outside directors (Bhagat and Black, 2002; Hermalin and Weisbach, 1991; John

and Senbet, 1998). An independent director has fewer conflicts of interest in monitoring

managers. Consequently, if the monitoring of independent directors is prevalent, then we

could expect a positive relation between the presence of outsiders and bank value. On the

other hand, an excessive ratio of non-executive directors might damage the advisory role of

boards. The possibility exists that inside directors contribute information to the board that

outside directors would find it difficult to gather.

Previous reports of studies such as those of Adams and Ferreira (2007), Harris and Raviv

(2008), and Coles et al. (2008) point out that executive directors help to facilitate the transfer

of information between board of directors and management. However, a negative relation is

expected between the proportion of outsiders and bank value. A tradeoff relation exists

between the advantages and disadvantages in the proportion of non-executive directors.

Adams and Mehran (2008) found no significant relation between Tobin’s Q and board

composition on the U.S. banking holding companies. Therefore, we cannot predict the

relation on the Japanese banking industry.

We investigate the relation between performance and board composition and size. Our

dependent variable is Q, which is our proxy for bank performance. The independent variables

are board size (BOARDSIZE), board composition (OUTSIDE), and several control variables

(asset, capital, bank category dummy, and Year dummy). Japanese banks of our samples are

classified mainly into the following two categories: City Banks and Regional Banks. The

performance of banks depends on the differences of these categories. We control for these

categories for each of equations using BCD. Analytically, the regression model with the

relation of board size is shown below.

ti,t76ti,5

ti,4ti,3ti,2ti,10ti, )(Q Tobinsεβββ

βββββ++++

++++=

YearBCDVolatilityCapitalAssetLnOutsideBoardSize

i

(1)

Potential endogeneity exists for board characteristics and individual effects of each bank.

Hermalin and Weisbach (2003), for example, argue that the board structure is determined

13

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endogenously. When the unobserved effect is correlated with independent variables, the

estimated coefficient of pooled OLS is inconsistent and biased. We use the GMM estimation

to address endogeneity problems. The instrument variables for GMM estimation are lagged

variables of the logarithm of board size and the number of outside directors.

4.2 Empirical Results

Table 2 presents OLS regression estimates of the relation between Tobin’s Q and board size

and composition using our sample of banks during 2006–2009. In columns I and II of Table 2,

we present the basic regression. In columns II and IV we add the bank characteristic variables

(capital ratio and volatility) sequentially to the regression.

------------------------------------


------------------------------------

In column I, the natural logarithm of board size, Ln (board size), is shown to have a

negative and statistically significant (at greater than the 1% level) correlation with Tobin’s Q

in three of the specifications. The outside director ratio on the other hand, shows no

significant relation with Tobin’s Q.

The latter finding related to the outside director ratio is consistent with previous studies of

board composition. Our finding of a negative relation between the logarithm of board size

and Tobin’s Q is consistent with previous studies of non-financial firms. However, it is

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inconsistent with the conclusion drawn in previous studies of banking firms of Adams and

Mehran (2008). For example, Hermalin and Weisbach (2003) point out that board size is

negatively related to performance. Our results are interpreted as showing the existence of

coordination and decision-making problems for the Japanese bank boards.

The coefficients related to financial control variables are summarized as follows. The firm

size is positive and significant. The coefficients on volatility of stock return and capital ratio

are not significant. The bank classification dummy is also not significant. These results imply

that only firm size is related to firm performance in the Japanese banking industry, which is

inconsistent with U.S. data presented by Adams and Mehran (2008).

------------------------------------


------------------------------------

Table 3 shows estimated results of GMM estimation. In all four columns I–IV, the natural

logarithm of board size has a negative and statistically significant correlation with Tobin’s Q.

This result is consistent with the OLS estimation. The outside director ratio is not significant

for any of the four models. Regarding the coefficient related to financial control variables,

only the firm size is significant and positive; the other variables are not significant.

Both OLS and GMM estimation results show the following two points. First, we can find

significant negative board size coefficients, implying coordination and decision-making

problems for the Japanese bank boards. Second, the relation between firm performance and

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outside directors is not significant.

5. FINANCIAL SYSTEM AND ORGANIZATION STRUCTURE

Although the importance of studying the board structure has been clarified, few studies have

analyzed banking industry features. Previous corporate governance studies of banks such as

those of Ciancanelli and Reyes (2001), Levine (2004), Macey and O’Hara (2003), and

Prowse (1997) point out that banking institutions have opacity or complexity in their

corporate governance mechanisms. For stability of the financial systems, commercial banks

are rescued by taxpayer funding from their countries’ governments in cases where they

experience financial distress. In addition, the BIS requires sufficient capital/asset ratios of

commercial banks to satisfy minimum international standards if they intend to have foreign

subsidiaries. This section presents analysis of a relation between board structures and features

of the banking industry such as financial systems and regulations of the BIS.

Financial regulation plays a special role for banks because both credit and payment

systems depend on the banks’ financial health. Diamond (1984) points out that regulators are

main stakeholders; their objectives might conflict with those of the other stakeholders in the

banking industry. When regulators intervene directly in the shareholding of banks, this

conflict of interest is compounded. Such a conflict might damage the efficacy of supervision

and give other stakeholders an incentive to control managers (La Porta et al., 2002).

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The BIS sets requirements on capital of two categories: Tier 1 capital and Total capital2.

Tier 1 capital must be at least 4% of total risk-weighted assets. Total capital must be at least

8% of total risk-weighted assets. Every bank with foreign branches must satisfy these capital

requirements. They are expected to maintain higher performance while maintaining a

sufficient capital level. For example, a bank with foreign branches might expect their board

members to take an advisory role more than a bank without foreign branches would.

In Japan, regulators intervened several times after the lost decade. The FSA set guidelines

related to classification of bad loans at banks. When the amount of a bad loan exceeds a

certain threshold, the Japanese government rescued the bank using taxpayer funds. The

regulations of the FSA asked firms to obey a management improvement plan. This regulation

of banks that had been rescued using taxpayer funds might compel drastic changes of the

bank board. In addition, Japanese banks must satisfy capital ratio requirements of the BIS.

This regulation might also affect the corporate governance structure in banking industries.

Therefore, we analyze the differences of bank boards’ monitoring activities between banks

with and without taxpayer funding or foreign branches.

In the following discussion, we examine other possibilities that bank board structures are

affected by the rescue using taxpayer funds and the existence of foreign branches. We

particularly note the differences of Japanese banks among them. We also construct

specifications about the relation between board structure and foreign branches among them.

2Tier 1 capital is the book value of its stock plus retained earnings. Tier 2 capital is loan-loss reserves plus subordinated debt. The total capital is the sum of Tier 1 and Tier 2 capital.

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Then we discuss the estimated results between bank performance and board structure.

5.1 Empirical Specifications

Unique corporate governance mechanisms remain in banks and might reflect differences of

bank board structures between those of banks with foreign branches and those of banks

without because of the peculiar regulations affecting the banking industry. This subsection

presents analyses of whether or not these board size differences among banks are expected to

engender a stronger advisory role of bank boards. We also investigate the board functioning

of banks with foreign branches.

We investigate the board functioning of banks using taxpayer funds. In other words, we

examine whether the board sizes and the ratio of outside directors with the banks are larger

and higher than the others or not. Regulation of the FSA requiring a smaller board is effective.

The FSA demanded reduction of the executive compensation of banks using taxpayer funding.

Therefore, their board size was decreased to satisfy the FSA request. In addition to the board

size, banks accepting taxpayer funding face difficulties of management. Outside directors are

appointed more often than in other banks.

To examine this hypothesis, we analyze the differences of bank boards’ structure between

banks funded with and without taxpayer-derived capital. Moreover, we regress additional

estimated equations to add the cross terms: Boardsize*Tax and Outside*Tax into equation (1),

considering the role of bank boards with taxpayer funding. The estimated equations are

expressed as shown below (2):

ti,ti,9ti,8ti,7ti,6ti,5

ti,4ti,3ti,ti,2ti,10ti,

)(**Q Tobins

εββββββββββ

++++++

++++=

YearSDVolatilityCapitalAssetLnTaxOutsideOutsideTaxBoardSizeBoardSize

(2)

Coefficient 1β captures the effect of board size on Q for ordinary banks. The

coefficient 2β signifies the incremental effect of board size on Q for banks with taxpayer

funds, whereas 21 ββ + represents the total effect of board size on Q for banks with

taxpayer funds. Both 2β and 21 ββ + become positive if the boards in banks with taxpayer

funds take a role of advisor or have lower coordination costs than the others.

We also investigate the board functioning of banks with foreign branches, leading to the

two following predictions. The first prediction is that banks with foreign branches might

expect their board members to take an advisory role more than banks without foreign

branches would. Coles et al. (2008), for instance, reports an advisory role of managers on

nonfinancial complicated firms in the U.S because complicated firms require more specific

knowledge of the board. Therefore, we predict that the board sizes of banks with foreign

branches are larger because such banks are more complicated than banks without foreign

branches, and outside directors of the banks with them are likely to be appointed more.

On the other hand, banks with foreign branches might face severe agency problems. These

banks, which have a larger amount of capital to satisfy the BIS requirements, would not

immediately face a shortage of capital in a financial distress. In contrast, other banks without

foreign branches might immediately show a shortage of capital during difficult financial

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periods because the capital requirements of BIS for them are lower. Regarding industrial

firms, Berger et al. (1997), for example, find that managerial entrenchment is a stronger

possibility for less-leveraged firms. These results imply that banks with lower capital ratios

tend to be the cause of the managerial entrenchment. In this case, the board sizes of banks

with foreign branches are predicted to be larger than the others. The appointment of outside

directors is predicted not to be more, and predicted as sometimes less appointed than others.

To examine whether banks with foreign branches need to take an advisory role or face

severe agency problems, we also analyze the differences of bank board structures between

those of banks with and without foreign branches. We regress the following equations:

ti,ti,9ti,8ti,7ti,6ti,5

ti,4ti,3ti,ti,2ti,10ti,

)(**Q Tobins

εββββββββββ

++++++

++++=

YearSDVolatilityCapitalAssetLnForeignOutsideOutsideForeignBoardSizeBoardSize

(3)

The estimated equation (3) is established to add the cross term: Boardsize*Foreign and

outside*Foreign into equation (1). When the advisory role of board in banks with foreign

branches is satisfied, both 2β and 21 ββ + become positive as do banks using taxpayer

funds.

Finally, we regress an additional estimated equation to add the cross term: Boardsize*Tax,

Outside*Tax, Boardsize*Foreign and outside*Foreign into following equation (1).

ti,ti,11ti,10

ti,9ti,8ti,7,6

ti,5ti,4,ti,3

ti,ti,2ti,10ti,

)(***

*Q Tobins

εββββββ

ββββββ

+++

++++

+++

++=

YearSDVolatilityCapitalAssetLnForeiginOutside

TaxOutsideOutsideForeiginBoardSizeTaxBoardSizeBoardSize

ti

ti

(4)

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The coefficients on 21 ββ + and 31 ββ + respectively signify the total effect of board size

on Q for banks with taxpayer funding and with foreign subsides. In other words, we

simultaneously examine the total effect of board size on Q with them.

5.2 Mean Difference Test

To provide an initial assessment of our sample banks, we compare board structures across

various subsamples of banks and discuss their mutual differences to investigate the mean

differences of banks with and without taxpayer funding and foreign branches.

------------------------------------


------------------------------------

In Table 4, we report the mean difference test results between banks with and without

taxpayer funding. Panel A of it describes that the mean differences of performance variables:

Tobin’s Q and ROA are not significant, which implies that the restructuring of Japanese

banks with taxpayer funding succeeds and the difference of performance to the ordinary

banks becomes small. The average of firm size and capital ratio with taxpayer funding is

significantly higher. The average volatility of banks with taxpayer funding is significantly

higher, implying that banks with taxpayer funding tended to lend to risky projects and

increase the amounts of bad loans.

Regarding governance variables, Panels B and C of Table 4 show mean difference test

21

22

results between banks with and without taxpayer funding. In Panel B, The average of board

size in commercial banks with taxpayer funding is significantly smaller by about one member,

which is consistent with the regulation of the FSA to decrease the board size for banks that

use taxpayer funding. The average ratio of outside directors to board directors and the number

of outside directors in banks with taxpayer funding are, respectively, significantly larger than

those of outside directors without taxpayer funding and are about 25% and three directors.

Panel C describes that CEO ownership is significantly smaller in firms with taxpayer funding.

On the other hand, managerial ownership is significantly higher by about 0.47% in firms with

taxpayer funding, suggesting manager entrenchment. The results of mean difference tests

imply that corporate governance differences, especially those of board structures, are

significant.

------------------------------------


------------------------------------

Table 5 presents mean differences of banks with and without foreign branches. In Panel A,

the average of Tobin’s Q and ROA with foreign branches is shown to be significantly higher,

suggesting that banks with higher performance retain foreign branches. The averages of firm

size and the capital ratio are also significantly higher for banks with foreign branches, which

implies that banks with foreign branches must have healthier management to obey BIS

regulations. The averages of volatility are not significantly different.

23

We also analyze some differences of corporate governance mechanisms and other

variables between those of banks with and without foreign branches. Results are shown in

Panels B and C of Table 5. Panel B shows that the mean of board size with foreign branches

is significantly higher by about 1.8, which is consistent with the monitoring and advisory role

for complicated work of the board. The average number of outside directors is not

significantly different. In Panel C of Table 5, managerial ownership is significantly lower by

about 2.0%.

Differences were found between Japanese banks with and without taxpayers’ money and

foreign branches. The mean difference test results portrayed in Table 4 indicate that board

size is significantly smaller for the banks with taxpayer funding. The results also show that

the board composition represented as outside directors numbers are significantly higher for

banks with taxpayer funding. In Table 5, the mean difference test shows that board size is

significantly smaller for the banks without foreign branches, although the difference of the

outside director rate is not significant. These findings imply that a bank with foreign branches

might have the board serve in an advisory role because foreign business operations are more

complicated than those for domestic business.

5.3 Estimated Results

In this section, we report estimation results of regression (2), (3), and (4). We also investigate

the board functioning of banks with taxpayers’ money and foreign branches.

------------------------------------


------------------------------------

Table 6 presents estimated results for equation (2). The respective coefficients of board

size ( 1β ) in columns A and B are –0.019 and –0.015, which are significant and negative. The

coefficients of Boardsize*Tax ( 2β ) presented in columns I and II show values of 0.027 and

0.029 and are significant and positive. The results suggest that the negative effect of board

size on Tobin’s Q for banks with taxpayer funding is smaller. For banks with taxpayer

funding, the total effect of board size ( 21 ββ + ) is significant and positive (0.008 and 0.014).

These results mean that Tobin’s Q is increasing in board size and that the banks with taxpayer

funding require a strong advisory role of bank boards and mitigate agency problems. We also

consider that the management of banks with taxpayer funding would have a greater need for

advice and expertise. Table 6 shows that neither coefficient 3β nor 4β is not significant.

Consequently, the outside directors of the banks with taxpayer funding do not contribute to

the needs for advice and expertise.

------------------------------------


------------------------------------

In Table 7, we present the estimated results for equation (3). Table 7 shows that the

coefficient on the dummy of Foreign Branches is significant and positive. The coefficients on

24

1β in columns I and II are not significant, but 2β in them are significant and negative.

Moreover, the total effect of board size ( 21 ββ + ) in Table 7 is significant and negative. These

results reflect that bank boards with foreign branches might face severe agency problems.

Furthermore, the coefficients on outside director ratio ( 3β ) are not significant in columns I

and II. The interaction terms of a dummy of Foreign Branches ( 4β ) are significant and

negative. In addition, the total effect of the outside director ratio ( 43 ββ + ) is significant and

negative (-0.092 and -0.102) in columns I and II. When outside directors take an advisory

role, we expect the positive relation between board size and Q to be driven by the number of

outsiders on the board. These negative results such as those of 4β and 43 ββ + imply that

the outside directors of banks with foreign branches at least take no advisory role.

------------------------------------


------------------------------------

Table 8 presents the estimated results for equation (4). For the coefficients of board size,

the coefficient of Boardsize*Tax ( 2β ) and Boardsize*Foreign Branches ( 3β ) are,

respectively, positive and negative, which is consistent with estimated results of both

equations (2) and (3). Both interaction terms of the outside director ratio and Foreign

Branches ( 6β ) and the total effect of outside director ratio ( 64 ββ + ) are significant and

negative.

Our empirical results related to the relation between these unique features of the Japanese

25

26

banking industry and board size and composition can be summarized as the following two

points. First, Tobin’s Q is increasing in board size in banks with taxpayer funding and

requires a strong advisory role of bank boards or mitigates agency problems. Second, Tobin’s

Q is negatively correlated with board size in banks with foreign branches.

6. CONCLUSIONS

We examined the relation between firm performance and board size and board composition in

the Japanese banking industry. After merger activities of Japanese banks had almost ended,

the Japanese banking industry sought to resolve bad deficit problems.

Consistent with prior findings for nonfinancial firms, we find no significant relation

between the proportion of outside directors on the board and Tobin’s Q. A significant

negative relation exists between the board size and Tobin’s Q, inconsistent with the US

banking industry’s evidence reported by Adams and Mehran (2008). After controlling for

endogeneity problems, our results for the Japanese banking industry show no change.

As described in this paper, we specifically examine two unique characteristics of the

Japanese banking industry during this sample period: 2006–2009. First, Japanese banks

funded with taxpayer-derived capital have been obligated to improve their corporate

governance mechanisms, obeying the FSA guidelines. Tobin’s Q is positively associated with

board size in banks with taxpayer funds. Our results support that the bank board with

taxpayer funding contributes to enhancement of performance and mitigates severe agency

27

problems such as board size problems in Japanese banks recently.

Second, Tobin’s Q is negatively correlated with board size in banks with foreign branches.

This result demonstrates that larger bank boards decrease firm performance and give rise to

agency problems. Moreover, the outside directors of banks with foreign branches do not

improve firm performance, which is inconsistent with the advisory roles of bank boards.

Japanese banks with foreign branches must satisfy the Tier 1 capital amount requirement.

They therefore need to improve their corporate governance mechanisms to achieve higher

performance.

Our findings described in this paper are interpreted as showing that the corporate board

structures of the Japanese banking industry are well reformed only in banks that have

accepted taxpayer funds. Even bank boards with foreign branches do not contribute to

improvement of their performance but rather fail to solve the severe agency problem, which

implies a greater need for efforts on the part of the banking sector to change and improve

their board structures.

28

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32

Table 1 Descriptive Statistics Table 1 shows descriptive statistics for select financial variables, board size and board composition and control variables for our sample. Our sample consists of 332 observations from 2006-2009. We check Zenginkyo to identify whether or not each bank belongs to "regional bank ". The other variables are collected from Nikkei Needs Cges. Our Tobin’s Q is defined as followed: Tobin’s Q = (book value of debt + market value of equity) / (book value of assets). Return on assets (ROA) is calculated as the ratio of ordinary profit to book value of assets. Our Capital ratio is defined as followed: Capital ratio = Book value equity/Book value assets. Volatility of stock price is measured as the standard deviation of the dairy returns on the stock price for three years. Board size means the number of board directors. Outside directors are defined by Japanese Commercial Law (Kaisha-shikiHo). Variable Observations Mean Std.Dev. Min Max Panel A:Financial Variables Tobin’s Q 330 1.000 0.024 0.942 1.232 Return on assets 328 0.306 0.725 -3.450 7.139 Total assets (in trillion of Yen)

328 9.091 26.788 0.112 190.732

Ln (Total assets) 328 14.980 1.112 11.625 19.066 Capital ratio 331 0.054 0.015 0.007 0.121 Volatility 312 2.083 0.494 1.184 3.600 Panel B: Board Size and Composition Board size 332 10.533 3.130 4.000 18.000 Ln(Board size) 332 2.307 0.319 1.386 2.890 Ratio of outside directors to board size

332 0.077 0.154 0.000 0.857

The number of outside directors

332 0.789 1.775 0.000 12.000

Panel C: Other Variables BCD 332 0.105 0.308 0.000 1.000 % CEO ownership 330 0.056 0.117 0.000 0.982 % board director's ownership

330 0.241 0.635 0.000 6.640

33

Table 2 Regressions Results of Equation (1) Table 2 shows Tobin’s Q regressions in columns II and IV after controlling by BCD. Tobin’s Q = (book value of debt + market value of equity) / (book value of assets). The definitions of control variables are same as in Tables 1. All specifications include year dummies such as Year06, Year07, and Year08. Robust t-statistics are in parentheses. Significance levels: (***)-1% (**)-5% (*)-10%. Dependent Variable: Tobin’s Q Independent Variables I II III IV Ln(Board size) -0.018 *** -0.014 *** -0.011 *** -0.007 **

-3.72 -4.16 -2.60 -2.08 Ratio of outside directors -0.007 -0.023 -0.007 -0.017 -0.80 -1.35 -0.60 -1.09 Ln (Total assets) 0.008 *** 0.004 ** 0.007 *** 0.003 6.69 2.09 6.41 1.15 Capital ratio -0.198 -0.210 *

-1.42 -1.68 Volatility 0.011 0.008 1.62 1.66 *

BCD 0.022 0.022 1.42 1.51 Constant 0.908 *** 0.956 *** 0.887 *** 0.944 ***

77.49 31.21 49.87 32.73 Year Dummy Yes Yes Yes YesObservations 327 327 312 312R2 0.333 0.361 0.372 0.398 F-statistic 18.79 *** 22.87 *** 28.110 *** 24.060 ***

34

Table 3 Regression results of Equation (1) using GMM We estimate the model using GMM methods. The instrument variables are the lagged variables of logarithm of board size and the rate of outside directors. All four specifications include year dummies such as Year06, Year07, and Year08. Robust t-statistics are in parentheses. Significance levels: (***)-1% (**)-5% (*)-10%. Dependent Variable: Tobin’s Q Independent Variables I II III IV Ln(Board size) -0.019 *** -0.014 *** -0.011 *** -0.008 **

-3.83 -3.95 -2.75 -2.03Ratio of outside directors -0.012 -0.030 -0.011 -0.024 -1.12 -1.63 -0.94 -1.41Ln (Total assets) 0.008 *** 0.004 * 0.008 *** 0.003 6.84 1.91 6.53 1.17Capital Ratio -0.198 -0.213 *

-1.43 -1.73Volatility 0.010 0.008 1.60 1.62BCD 0.025 0.023 1.59 1.57Constant 0.906 *** 0.960 *** 0.885 *** 0.944 ***

77.23 31.05 49.54 32.95Year Dummy Yes Yes Yes YesObservations 325 325 312 312AdjR2 0.319 0.346 0.355 0.379 F-statistic 18.44 *** 22.66 *** 27.69 *** 23.64 ***

35

Table 4 The mean difference test between banks with or without Taxpayer Money The t-statistics are in parentheses. Significance levels: (***)-1% (**)-5% (*)-10%. Mean Difference Test

Variable Observations Tax = 0 Tax= 1 Differences Mean Mean t-value Panel A: Financial Variables Tobin’s Q 330 1.000 0.998 0.515 Return on assets 328 0.298 0.371 -0.570 Total assets (in trillions of Yen)

328 8.509 13.813 -1.121

Ln (Total assets) 328 14.899 15.636 -3.829 ***

Capital ratio 331 0.053 0.062 -3.313 ***

Volatility 312 2.021 2.649 -7.261 ***

Panel B: Board Size and Composition Board size 332 10.642 9.639 1.822 **

Ln(Board size) 332 2.321 2.189 2.364 ***

Ratio of outside directors 332 0.055 0.252 -7.900 ***

The number of outside directors

332 0.520 3.000 -8.775 ***

Panel C: Control Variables BCD 332 0.064 0.444 -7.578 ***

% CEO ownership 330 0.062 0.009 2.559 ***

% board ownership 330 0.190 0.660 -4.306 ***

36

Table 5 The mean difference test divided by banks with or without foreign branches The t-statistics are in parentheses. Significance levels: (***)-1% (**)-5% (*)-10%.

Variable Observations

Foreign Branch= 0

Foreign Branch = 1

Differences

Mean Mean t-value Panel A: Financial Variables Tobin’s Q 330 0.997 1.017 -5.231 ***

Return on assets 328 0.269 0.544 -2.385 ***

Total assets (in trillions of Yen)

328 5.670 30.607 -6.115 ***

Ln (Total assets) 328 14.777 16.256 -9.307 ***

Capital ratio 331 0.052 0.064 -4.976 ***

Volatility 312 2.075 2.135 -0.762 Panel B: Board Size and Composition Board size 332 10.296 12.044 -3.544 ***

Ln(Board size) 332 2.286 2.443 -3.116 ***

Ratio of outside directors 332 0.079 0.060 0.780 The number of outside directors

332 0.808 0.667 0.497

Panel C: Control Variables BCD 332 0.066 0.356 -6.190 ***

% CEO ownership 330 0.063 0.012 2.722 ***

% Board ownership 330 0.269 0.063 2.036 **

Table 6 Regressions Results of Equation (2) Table 6 shows Tobin’s Q regressions in columns II after controlling by BCD. Tobin’s Q = (book value of debt + market value of equity) / (book value of assets). All specifications include year dummies such as Year06, Year07, and Year08. Robust t-statistics are in parentheses. Significance levels: (***)-1% (**)-5% (*)-10%. Dependent Variable: Tobin’s Q Independent Variables I II Tax -0.079 *** -0.082 ***

-3.61 -3.76 Ln(Board size) 1β -0.019 *** -0.015 ***

-3.59 -3.94 Ln(Board size)*Tax 2β 0.027 *** 0.029 ***

3.49 3.61

Ratio of outside directors 3β -0.016 -0.020

-0.99 -1.14 Ratio of outside directors *Tax 4β 0.016 0.001 0.83 0.07 Ln (Total assets) 0.008 *** 0.004 6.68 1.35 Capital ratio -0.101 -0.099 -0.64 -0.67 Volatility 0.015 ** 0.013 **

1.97 2.10 BCD 0.023 *

1.69 Constant 0.883 *** 0.941 ***

46.17 35.63 Year Dummy Yes YesObservations 312 312R2 0.428 0.456 F-statistic 23.490 *** 19.560 ***

lnbsn+lnbsn*Tax =0 0.008 * 0.014 **

( 021 =+ ββ ) 3.23 4.99outsideratio+outsideratio*Tax =0 0.000 -0.018

( 043 =+ ββ ) 0.00 0.89

37

Table 7 Regressions Results of Equation (3) Table 7 shows Tobin’s Q regressions in columns II after controlling by BCD. Tobin’s Q = (book value of debt + market value of equity) / (book value of assets). All specifications include year dummies such as Year06, Year07, and Year08. Robust t-statistics are in parentheses. Significance levels: (***)-1% (**)-5% (*)-10%. Dependent Variable: Tobin’s Q Independent Variables I II Foreign Branches 0.147 ** 0.140 **

2.29 2.46 Ln(Board size) 1β -0.003 -0.001 -0.85 -0.22 Ln(Board size)*Foreign Branches 2β -0.051 ** -0.049 **

-2.15 -2.29

Ratio of outside directors 3β 0.007 -0.001

0.78 -0.11 Ratio of outside directors* Foreign Branches 4β -0.099 *** -0.101 ***

-2.63 -2.81 Ln (Total assets) 0.006 *** 0.003 3.54 1.04 Capital ratio -0.428 *** -0.429 ***

-5.47 -5.37 Volatility 0.009 * 0.008 *

1.79 1.80 BCD 0.017 1.52 Constant 0.906 *** 0.946 ***

51.39 36.88 Year Dummy Yes YesObservations 312 312 R2 0.476 0.490 F-statistic 20.37 *** 19.49 ***

lnbsn+lnbsn*Foreign Branches =0 -0.055 ** -0.050 ***

( 021 =+ ββ ) 5.88 6.85 Outsideratio+outsideratio*Foreign Branches =0 -0.092 ** -0.102 **

( 043 =+ ββ ) 5.74 6.54

38

Table 8 Regressions Results of Equation (4) Table 8 shows Tobin’s Q regressions in columns II after controlling by BCD. Tobin’s Q = (book value of debt + market value of equity) / (book value of assets). All specifications include year dummies such as Year06, Year07, and Year08. Robust t-statistics are in parentheses. Significance levels: (***)-1% (**)-5% (*)-10%. Dependent Variable: Tobin’s Q Independent Variables I II Tax -0.047 *** -0.053 ***

-3.49 -3.88 Foreign Branches 0.127 ** 0.117 **

2.08 2.24 Ln(Board size) 1β -0.009 ** -0.007 -2.31 -1.44 Ln(Board size)*Tax 2β 0.015 *** 0.018 ***

2.70 3.34

Ln(Board size)*Foreign Branches 3β -0.044 * -0.041 **

-1.94 -2.08 Ratio of outside directors 4β 0.006 0.003 0.35 0.19

Ratio of outside directors*Tax 5β 0.002 -0.013

0.10 -0.58

Ratio of outside directors*Foreign Branches 6β -0.101 ** -0.112 ***

-2.46 -2.60 Ln (Total assets) 0.007 *** 0.003 4.20 1.30 Capital ratio -0.329 *** -0.313 ***

-3.59 -3.24 Volatility 0.013 ** 0.011 **

2.09 2.16 BCD 0.020 *

1.76 Constant 0.893 *** 0.937 ***

41.87 37.91 Year Dummy Yes YesObservations 312 312

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R2 0.4982 0.518 F-statistic 18.29 *** 17.72 ***

lnbsn+lnbsn*Tax =0 0.006 0.012 **

( 021 =+ ββ ) 2.08 5.09 lnbsn+lnbsn*Foreign Branches =0 -0.054 ** -0.048 ***

( 031 =+ ββ ) 6.10 7.30

outsideratio+outsideratio*Tax =0 0.008 -0.010

( 054 =+ ββ ) 0.36 0.36

outsideratio+outsideratio*Foreign Branches =0 -0.095 ** -0.108 ***

( 064 =+ ββ ) 6.37 7.29

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