Impact of Corporate Governance on Banking
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Corporate Governance refers to the way an organization is directed, administrated or controlled. It includes the set of rules and regulations that affect the manager's decision and contribute to the way company is perceived by the current and potential stakeholders. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation such as; boards, managers, shareholders and other stakeholders and spells out the rules and procedures and also decision making assistance on corporate affairs. By doing this, it also provides the structure through which the company's objectives are set and the means of obtaining those objectives and monitoring performance. Corporate governance may be the ways of bringing the interests of investors and managers into line and ensuring that firms are run for the benefit of investors.
Given the state of the economy of Pakistan in 2010, troubled as it is; ideally it would be more desirable to look at the governance issues at macro level for Pakistan. As a famous economist, Dr Shahid Javaid Burki- a long observer of Pakistan's economy has recently stated “Pakistan can generate a greater bounce in its economy than India by creating better governance. It has occurred before in the country's difficult economic history and could happen again.” (Improved Governance: Dawn, 12th, October 2010).
However, as a starting point, in this paper we look at closely the governance issues for the banking, a sector which has played a significant role till recent years in economic activity of Pakistan. Rehman et al (2010) have looked at the issue of corporate governance in Chemical and Pharmaceutical sectors of Pakistan and found that there is a significant impact of corporate governance on the shareholder's returns in pharmaceutical sector of Pakistan. Corporate governance has become an issue of global significance. The improvement of corporate governance practices is widely recognized as one of the essential elements in strengthening the foundation for the long-term economic performance of countries and corporations. In Pakistan, the first Code of Corporate Governance for Pakistan was finalized and issued by SECP in March 2002. Then it was subsequently incorporated in all the listed companies of three stock exchanges in Pakistan. In 2004, SECP took the first step to establish the Pakistan Institute of Corporate Governance in public private partnership.
According to” A Survey of Corporate Governance Practices in Pakistan, 2007”, conducted by: International Finance Corporation and SECP, 92% respondents prepare annual “statement of Ethics and Business Policy”, 48% had “vision and Mission Statement”, and none of the respondents have Code of Corporate Governance. On the other hand, it was also found that 50% of the corporations in Pakistan did not include non-executive directors in their board of directors, 54% have not introduced transaction administration procedure, 53% have not implement a formal remuneration system, and 55% did not have corporate governance improvement plan. Whereas, 31% respondents did not identify the barriers to improve the corporate governance, 69% identified the barriers, 42% had non availability of qualified staff to implement and 21% did have the claim that corporate governance produces sensitive information that cannot be shared with the competitors.
According to Maria Mahar and Thomas Anderson (2008) there are some weaknesses, strengths and economic implications associated with corporate governance systems. It is widely believed that good corporate governance is an important factor in improving the value of a firm in both developing and developed financial markets. However, the relationship between corporate governance and the value of a firm differs in emerging and mature financial markets due to disparate corporate governance structures in these markets resulting from dissimilar social, economic and regulatory conditions in these countries. There is a need to understand the differences which affect the value of a firm for academic investigations, financial and management practices and public regulation of corporations and markets. The variables used by Kashif Rashid (2008): price to book value ratio, market capitalization, gearing ratio, return on total assets, shareholder's concentration (agency cost), CEO duality, board size, and judicial and regulatory authority efficiency.
Burki and Ahmad (2007) explored the changes of corporate governance in Pakistan's banking sector and its impact on their efficiencies. They introduced dummy variables as a proxy of corporate governance changes in the banking sector of Pakistan. The result suggested that there was an impact of corporate governance changes on the banking efficiencies. Driffield et al., (2007) examined a positive impact of higher ownership concentration on the firm value and its capital structure. When ownership concentration is low then the change of capital structure is depend upon the strict managerial approach. Friend and Lang (1998) found that ownership concentration play an important role in the firm performance. The strong control of owners can control and direct the managers in achieving the organization goals.
Baysinger et al (1985) explored that there is a positive correlation between independent directors and the accounting performance of the firm. Hambrick et al (2000) also agreed with these results. Agrawal et al (1996) found a negative correlation between independent board of directors and the performance of the firm. On the other hand, studies by Klein (1998), Bhagat et al (1997), and Hermalin et al (1991) contradicted the abovementioned results and found no significant relationship between independent directors and the accounting performance of the firm. Similarly, Jeffrey et al (1990) determined no relationship between the outside directors and the firm performance.
This study will explore the practices of corporate governance in banks in Pakistan and measure its impact on their efficiency.
The secondary data of corporate governance and banking performance variables of thirty banks will be used for the analysis purpose over the period of 2001-2009. The chosen study period experienced huge structural changes in the banking sector of Pakistan. Many foreign banks are acquired by the private banks. Small banks are merged with large banks. Due to this reason, this study included only those banks which are performing their operations consistently over the period of last one decade. The selected thirty banks include all types of banks such as private, public, foreign and Islamic. But the number of private banks is more than public, foreign due the liberalization reforms of the banking sectors.
The efficiencies of all the banks are estimated by applying Data Envelopment Analysis (DEA) a non parametric approach. As there are two approaches used by the researchers in past, one is parametric approach i.e., Stochastic Frontier Approach (SFA) and other is non parametric approach Data Envelopment Analysis (DEA). Both approaches have been criticized by the researcher due their limitations. In spite of that DEA was used more frequently than Stochastic Frontier approach due to its simplicity of assumptions. For this purpose, net capital and deposits are taken as input variables and loans and advances and net investments as output variables. The data envelopment analysis is applied under the variable return to scale model. The total efficiencies are then categorized as Technical Efficiency, Allocative Efficiency and Cost Efficiency. The data is collected from State Bank of Pakistan.
The corporate governance variables such as ownership concentration (OC), board size (BS), independent Audit Committee (IAC) and tier shari's compliance structure (TSC) in case of Islamic banks is used. These variables are chosen on the basis of previous literature. The ownership concentration is defined as the majority of the shares are held by a small group of investors. For this ownership concentration value is determined by the following assumption
Ownership Concentration = % of shares held by top five shareholder
Board size (BS) is consisted on number of total directors in the banks. It includes both executive and non-execute members of the bank. Independent Audit Committee (IAC) is defined as the number of non-executive audit committee in the audit team of the bank.
The data of above mentioned variables are combined in two of the following econometric models. The following models are multiple linear regression models in which financial performance variables are independent whereas corporate governance variables are dependent. The significance of these models is test with ANOVA.
In the above mentioned models the coefficients of board size are, > 0, whereas, > 0 are the coefficients of ownership concentration. The independent audit committee coefficients are, >0.
RESULT AND ANALYSIS:
In the first part of the analysis, banking efficiencies are computed by applying Data Envelopment Analysis over the period of 2001-2009. The banking sector is divided into three categories, State Owned Banks, Private and Foreign Banks. The results show that the overall average technical efficiency of Pakistan banking sector is 0.84, in which state owned banks is having 0.84, private banks 0.83 and foreign banks 0.81. Similarly, the average allocative efficiency of overall banking sector is 0.76. Whereas, the allocative efficiency of state owned, private and foreign is attributing 0.80, .80 and 0.74 respectively. At the same point of time, cost efficiency of overall Pakistan banking sector is 0.64, in which state owned, private and foreign banks are attributing 0.68, 0.67 and 0.60 respectively. There is no significant difference among the average technical, allocative and cost efficiencies of all segments of Pakistan banking sector.
The second part of the analysis shows the results of multiple regression analysis. In which two efficiencies (technical and allocative) of different segments of banking sectors (State Owned, Private and Foreign banks) are regressed over corporate governance variables, such as board size, ownership concentration and independent audit committee. The results show that the model 1 and 2 for overall banking sector are significant at 1%, 5% and 10% level of Significance. Further, the coefficients of board size, ownership concentration and independent audit committee, 0.104, -.561 and .27 for model-1,.14, -0.648 and 0.32 for model- 2 are also significant at 1%, 5%, and 10% significance levels respectively. Same analysis is performed for all three segments of banking sectors.
For state owned banks, the model 1, 2 and 3 are highly significant at 1, 5 and 10% level of significance. Whereas the coefficients of board size, ownership concentration and independent audit committee for both models are highly significant at 1, 5 and 10% level of significance.
In case of private banks all models are highly significant at 1, 5 and 10% level of significance. The coefficients of board size and ownership concentration for private banks against all models are insignificant. But the independent audit committee coefficients for private bank, .11 and .37 are highly significant.
The results show that both models are highly significant in case of foreign banks at 1, 5 and 10% level of significance. The coefficients of board size and ownership concentration in case of foreign banks are insignificant for model 1 and 2. The independent audit committee coefficients for foreign banks, 0.43 and 0.36 are highly significant. (See Table 1-1)
State Owned Banks
** Significant at 5% & 10% level of Significance
*** Significant at 1%,5% & 10% level of Significance
This paper explores some important connections between banking efficiencies and corporate governance practice of Pakistan. This is the first effort in this regard. Previously, there are so many studies conducted on the subject of measuring efficiencies of Pakistan banking sector, but no one yet examines the impact of corporate governance on banking efficiencies. The mean technical efficiency of overall banking sector is 0.84, which is very close to world average banking efficiency 0.86 as estimated by the World Bank.
The role of corporate governance is becoming very critical now days while determining the performance of a corporate. The results of this study also are an evident of this comment and find a significant impact of corporate governance practice in the banking sector on their efficiencies. The board size, ownership concentration and independent audit committee has a very significant role in changing the technical and allocative efficiencies of public limited banks. The ownership concentration has negative relationship with technical and allocative efficiencies of public banks. On the other hand board has size positive impact on public banks efficiencies. In case of foreign and private banks, their efficiencies are only affected by independent audit committee. The role of independent audit committee in public, private and foreign banks are very important i.e., the efficiency of banking sector increases if it poses an independent audit committee in their governance structure.
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