04. MPRA_paper_78137

M PRA
Munich Personal RePEc Archive
How the corporate governance

mechanisms affect bank risk taking
Emmanuel Mamatzakis and Xiaoxiang Zhang and Chaoke

Wang
University of Sussex
4 April 2017
Online at https://mpra.ub.uni-muenchen.de/78137/
MPRA Paper No. 78137, posted 7 April 2017 10:13 UTC
How the corporate governance mechanisms affect bank risk taking
Emmanuel Mamatzakis*
e.mamatzakis@sussex.ac.uk
Xiaoxiang Zhang*
xiangxiang.zhang@sussex.ac.uk
Chaoke Wang*
cw322@sussex.ac.uk
Abstract
The effectiveness of the management team, ownership structure and other corporate
governance systems in determining appropriate risk taking is a critical issue in a modern
commercial bank. Appropriate risk management techniques and structures within
financial institutions play an important role to ensure the stability of economy. After
analyzing 43 Asian banks over the period from 2006 to 2014, I find that banks with
strong corporate governance are associated with higher risk taking. More specifically,
banks with intermediate size of board, separation of CEO and chairman of board, and
audited by Big Four audit firm, are likely higher risk taking. Overall, my findings
provide some new perspectives into the governance mechanisms that affect risk taking
on commercial banks.
Keywords: Banks, Risk taking, Corporate governance

JEL Classification: G21, G31, G39.
*Department of Business and Management, School of Business, Management and

Economics, Jubilee Building, University of Sussex, Falmer BN1 9SL, UK.
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1 Introduction
The reason of 2008 financial crisis is to a large extent attributable to excessive risk-
taking by financial institution (DeYoung et al., 2013; Minton et al., 2014). In turn,
international supervisory authorities propose an array of requirements to monitor and
control bank risk. Besides, the forces of technological change contributed to the
progressive process of financial integration and increased competition in the banking
industry over the last two decades. Therefore, the scope of banks’ operations and
activities has been completely reshaped, from traditional intermediation products to an
array of new businesses. As a result of this process, the intensive competition may lead
to greater risk-taking of bank, or possibly excessive risk.
Given that corporate governance is essentially a mechanism for controlling risk within
the bank, it is not surprising that the recent academic studies have emphasized the
importance of effective corporate governance practices in the banking industry
(Elyasiani and Zhang, 2015; Srivastav and Hagendorff, 2015). Some researches argue
that banks with better governance have lower risk taking (Ellul and Yerramilli, 2013;
De Andres and Vallelado, 2008). Yet, other studies claim that banks with more favorite
shareholders governance associate with higher risk taking (Erkens et al., 2012; Wang
and Hsu, 2013). Moreover, the same governance may have different effects on bank
risk taking depending on the bank’s ownership structure (Laeven and Levine, 2009;
Adams and Mehran, 2012), and board composition (Pathan, 2009). These mixed
empirical evidences motivate my investigation.
I empirically investigate the relationship between bank risk taking and corporate
governance using data from listed commercial banks on Great China banking industry
in 2006 to 2014 period. My results show that banks with strong corporate governance
are associated with higher risk taking. More specifically, banks with no relationship
among top 10 shareholders, a meaningful stake holding by managers and audited by
Big Four audit firm, are likely taking more risk. These findings are consistent with the
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importance of the monitoring role of bank governance in recent papers (Anginer et al.,
2016; Bolton et al., 2015).
My chapter complements the existing empirical research on banking governance in

several ways. First, my underlying idea is that several characteristics of the corporate
governance might reflect shareholders’ motivation to effectively monitor and advise
managers. Bank governance research on risk taking typically incorporates the
information on board compositions alone, such as the board size, the number of board
meetings and the percentage of independent board members. However, ownership
structure is an essential part of governance, which should be also a significant factor in
explaining risk difference for banking sector (Barry, et al., 2011). My research aims to
fill this gap by incorporate three characteristics to construct a governance score, which
represents the level of corporate governance. In addition, measurement of bank risk can
encompass a variety of dimensions; my chapter focus on loan quality and default risk
(Z score).
Second, my chapter increases the understanding of banking governance in an emerging

economy by involving China’s banking sector. This sector is dominated by large state-
owned banks that operate under strict government regulations and intervention.
Intensive government intervention may reduce the role of corporate governance on
effectively monitoring managers. However, my results show that the internal
governance is still an effective mechanism to monitor bank risk taking in Chinese
market, which consistent with the finding on European and US markets.
The reminder of the chapter is organized as follows. The next section discusses the
related literature and hypothesis development. Section 3 outlines the methodology used
in this chapter to construct measures of corporate governance and bank risk taking, as
well as describes the empirical model used. Section 4 describes my dataset, including
descriptive statistics about governance mechanisms and bank risk taking. In section 5 I
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discuss my main empirical results on the relation between governance and bank risk
taking. Section 6 presents results from additional robustness checks. Section 7 provides
concluding remarks.
2. Literature review and hypotheses development

Banking research has devoted tremendous effort to studying the roles of corporate
governance in recent years. Some studies emphasize that flaws in corporate governance
play a key role in bank risk taking (Srivastav and Hagendorff, 2015; Williams, 2014;
Minton et al., 2014). Srivastav and Hagendorff (2015) highlight the need for effective
bank governance to mitigate the behavior, harming the interest of different stakeholders
and exacerbating risk taking, which reflect the needs of shareholders, creditors and the
taxpayer. The idea is generally that strong corporate governance normally associates
with better risk management function, which would lead to correctly identify risks and
prevent such excessive risk taking. Therefore, my chapter is related to two strands of
literature: first, to the extensive literature on corporate governance in the banking sector;
and second, to the literature on the effects of bank risk taking.
Corporate governance is significantly related to bank risk taking because there are some
observed and unobserved bank characteristics. Such bank characteristics include the
functioning of the board, CEO duality, ownership structure, and external monitoring.
Follow Srivastav and Hagendorff (2015), I define bank risk-taking as policies that
increase risk through governance channels.
Academics have argued that the board is shareholders’ first line of defense in
governance (Adams and Mehran, 2012; De Andres and Vallelado, 2008). Indeed, the
role of the board of directors in overseeing and identifying risk in financial institutions
has come under scrutiny after financial crisis. Besides, establishing and implementing
risk control systems are also part of the responsibility of boards. Thus, the boards
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become one of key mechanisms to monitor managements’ behavior on risk taking of
the firm. Furthermore, having strong board governance structure is important to ensure
that bank managers focuse on the right issues. However, the evidence for a beneficial
effect of boards’ composition on bank risk taking has remained far from convincing.
Specifically, extant literatures on boards of directors concentrate on the determinants of
the size, board meeting and the fraction of independent board members are still mixed
and inconsistent.
The relationship between board size and bank risk taking remains ambiguous. Large
boards may add value due to the operational, geographic and financial complexity in
banking firms, which need a greater level of advising and monitoring, as well as less
easily captured by management. Adams and Mehran (2012) find that board size is
positively related to performance. However, free-rider problems may arise in large
boards which negatively affect the value of a bank. According to Jensen (1993),
increased group becomes less effective because the coordination and process problems.
Anginer et al. (2016) find that the form of boards of intermediate size is associated with
lower bank risk taking in terms of bank capitalization. Equally, De Andres and Vallelado
(2008) also suggest that an inverted U-shaped relation between board size and bank
performance. Pathan (2009) finds that a small bank board is associated with more bank
risk taking.
The presence of independent directors on bank board is mainly to mitigate the agency
cost of equity. More independent directors in a board are expected to better represent
the interest of shareholders and effectively monitor a bank’s managers. However, the
impact of more or less independent board on bank risk-taking is unclear given the mixed
nature of the empirical results. For instance, De Andres and Vallelado (2008) find that
larger and not excessively independent boards might prove more efficient in monitoring
and advising functions, and create more value. Erkens et al. (2012) find that banks with
more independent boards raised more equity capital during the crisis, which led to a
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wealth transfer from existing shareholders to debtholders. Nevertheless, both Anginer
et al. (2016) and Pathan (2009) report a higher fraction of independent directors pursue
less risky policies. Minton et al. (2014) find that independent directors with financial
expertise support increased risk taking prior to the financial crisis on US banks.
CEO power is also an important factor to affect board’s monitoring ability. CEO duality
restricts the information flow to other members of the board, which may give rise to
riskier bank strategies, and hence negatively affects the independence of board.
DeYoung et al. (2013) show that contractual risk taking incentives for CEO increased
when industry deregulation expanded banks’ growth opportunities. Thus effective
separation of the CEO and chairman roles may enable a board to promote the interests
of shareholders better (Anginer et al., 2016).
Despite with standard factors on board governance discussed above, Elyasiani and
Zhang (2015) examine the association between ‘‘busyness” of the board of directors
(serving on multiple boards) and bank holding company (BHC) risk. Berger et al. (2014)
demonstrate that banks take on more portfolio risk if they are managed by younger
executives and as higher proportion of female executives, while board changes increase
executives holding PhD degree would reduce portfolio risk.
In addition to the board function, standard agency theories suggest that ownership
structure has impact on corporate risk taking. Indeed, analysis without ownership
structure may provide an incomplete evidence of bank risk taking. Laeven and Levine
(2009) find that the relation between bank risk and capital regulations, deposit insurance
policies, and restrictions on bank activities depends on each bank’s ownership structure.
However, the evidence on the relationship between the ownership of banks and bank
risk-taking is still mixed. Lin and Zhang (2009) assess the effect of bank ownership on
performance in Chinese market, they find that banks with foreign ownership are more
profitable and have better asset quality than state-owned banks. As management of
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state-owned bank is not adequately monitored, and there is no private owner with
necessary incentives to engage in active monitoring. Iannotta et al. (2013) use cross-
country data on a sample of large European banks and find that government-owned
banks have lower default risk but higher operating risk than private banks, indicating
the presence of governmental protection induces higher risk taking. In addition,
institutional ownership of common share of bank has increased substantially over the
past two decades, which also implies changes in corporate governance and banks’
behavior in terms of risk taking. Both Erkens et al. (2012) and Barry et al. (2011) claim
that banks with higher institutional ownership took more risk prior to the crisis, which
resulted in larger shareholder losses during the crisis period. Moreover, Konishi and
Yasuda (2004) show that the relationship between the stable shareholders ownership
and bank risk is nonlinear after examining empirically the determinants of risk taking
at Japanese commercial banks.
Hypothesis development
H1: Strong corporate governance associated with lower bank risk taking.
My main hypothesis is motivated by Ellul and Yerramilli (2013), which suggest that
banks with strong internal control on governance should have lower tail risk, all else
equal. In opposite prospective, the poor governance banks likely engaged in excessive
risk taking, causing them to make larger losses. First, for risks to be successfully
managed, they must first be identified and measured correctly. A strong risk
management function is necessary to correctly identify risks and prevent such excessive
risk-taking. The main job of effective risk management at banks is to limit exposure to
risk, and hence to the possibility of negative outcomes (Chernobai et al., 2012).
DeAngelo and Stulz (2015) suggest that risk management is central to banks’ operating
policies. Keys et al. (2009) find that strong risk management is associated with less
risky subprime loan securitizations. Because only safe debt commands a liquidity
premium, banks use risk management to maximize their capacity to include such debt
into their operation. In addition, Minton et al. (2014), Ellul and Yerramilli (2013) and
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Aebi et al. (2012) all show that risk management governance can affect bank risk taking.
There are many tools used by bank to control their portfolio risk and maintain higher
level of safe debt, such as diversification, hedging, using derivatives. Ellul and
Yerramilli (2013) suggest that banks with better governance (lower G-Index), more
independent boards, and less entrenched CEOs have strong risk management function
in large US bank holding companies. Moreover, Aebi et al. (2012) document that banks
with its chief risk officer (CRO) directly reporting to the board of directors exhibit
significantly higher stock returns and return on equity during financial crisis in 2008.
Besides, from an asset quality management, better quality credit and reducing excessive
share of illiquid loans in asset portfolio will diminish bank risk-taking (Ghosh, 2015).
Second, the risk taking are affected not just by risk management, but also by the taking
of private benefits of larger shareholders. Larger shareholder may opt to risk averse
investment in order to protect their private benefit. Because there is less fear of
expropriation by insiders if the corporate governance improves (Burkart et al., 2003),
the dominant shareholders might reduce their holding or direct influencing the decision
making by managers. As from a shareholder’s perspective, assessing the risk of a bank
may be more difficult than other nonfinancial firms. Thereafter, managers would
implement conservative investment policies, which lead to reduce risk taking.
The third argument is the managerial incentives matter. Higher executive compensation
lead to excessive risk-taking by banks (Bai and Elyasiani, 2013; DeYound et al., 2013;
Cunat and Guadalupe, 2009; Bolton et al., 2015), which may improve performance in
the short run, but it also can cause significant impairment to the bank when such risk
materialize. Specifically, equity-based compensation (EBC) has increased recently for
embedded in bank executive compensation packages. The advantage of EBC for
executive is to share the benefits from risky investment with shareholders and reduce
agency cost. As senior managers’ personal wealth is undiversified, they would not
support the positive net present value but risky investment, which may lead to risk
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aversion. Indeed, it is difficult to directly monitor managers when firms have wide
range of investment opportunity sets. However, adopting EBC schemes align the
interest of management and shareholders, and also encourage managers to pass up risky
investment. A number of studies on financial firms provide evidence consistent with
this phenomenon. Specifically, Hagendorff and Vallascas (2011) find the evidence
which support for the view that increased EBC leads banks to make riskier choices in
their mergers and acquisition decisions. As Core et al. (1999) note, the executives earn
greater compensation when governance structures are less effective. Overall, the
presence of strong corporate governance may be necessary to control risk exposures of
financial institutions.
H2: Strong corporate governance associated with higher bank risk taking.
My second hypothesis is that banks with strong corporate governance attributes may
take more risk. Value-maximizing shareholders are likely to choose aggressive
strategies, especially for banks, and such risky strategies may lead to significant loss.
Thus, firm with better investor protection governance are likely to undertake riskier but
value enhancing investments (John et al., 2008). Anginer et al. (2016) find that
shareholder-friendly corporate governance associate with lower bank capitalization,
such relationship is especially strong for banks located in developed countries. Besides,
Fahlenbrach and Stulz (2011) find that CEOs whose incentives were better aligned with
the interests of shareholders performed worse and no evidence that they performed
better. Pathan (2009) finds that strong banks’ board positively affect bank risk taking.
Sullivan and Spong (2007) also find that stock ownership by hired managers can
increase total risk of a bank.
In addition, deposit insurance scheme is widely applied in many countries as part of a

financial system safety net to promote banking stability. However, the scheme may
contribute to bank shareholders moral hazard problem by stimulating higher bank risk
taking as they enjoy a ‘subsidy’ which increases in value of leverage. For instance,
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Laeven and Levine (2009) find that that deposit insurance is associated with an increase
in risk when the bank has a large equity holder with sufficient power to act on the
additional risk-taking incentives created by deposit insurance. The scheme also
discourages most bank creditors from limiting managers’ risk taking. Anginer et al.,
(2014) find that deposit insurance scheme increases bank risk and systemic fragility in
the years leading up to the global financial crisis. Since shareholders have incentives to
take higher risk, thus strong corporate governance can be expected to associate with
bank risk taking positively.
H3: Corporate governance has no impact on bank risk taking.

My third hypothesis is that the corporate governance does not have any impact on bank
risk taking. Several arguments support this hypothesis. First, because risk managers of
bank are without any real power, it is merely to satisfy regulatory requirement to appoint
them by bank. Beltratti and Stulz (2012) find no relationship between better governance
and bank risk taking because the fragility of banks financed with short-term capital
market funding. Vazquez and Federico (2015) also find that banks with weaker
structural liquidity and higher leverage were more likely to fail afterward.
Second argument relates to regulatory. Stability of the banking sector is a major concern
of relevant economic authorities. Indeed, the authorities use several tools to monitor
and control bank risk taking, which includes capital requirements, restrictions on bank
activities and official supervisory power. As the failure of banking sector would
increase systemic risk and cause possible consequent meltdown of whole financial
system. Fratzscher et al. (2016) suggest that bank supervision/regulation and
institutions tend to be substitutes rather than complements. There is an obvious example
showing that many governments’ bail-out to stabilize financial institution in the
financial crisis of 2008-2009. However, Hakenes and Schnabel (2010) find that
government’s bail-outs lead to higher risk taking among the protected bank’s
competitors. Acharya et al. (2014) documents that bailouts triggered the rise of
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sovereign credit risk in 2008. Banks’ shareholders benefit from ‘too big to fail’
supported by regulators and gain most from shifting risk to other stakeholders
(Hagendorff and Vallascas, 2011). Williams (2014) find the evidence of risk seeking
due to ‘too big to fail’ effects in Asian region.
Third, market discipline is another mechanism in influencing bank risk taking (Bennett
et al., 2015; Hilscher and Raviv, 2014; Barry et al., 2011), because the market
participants have the incentives to monitor the bank and the ability to process accurately
the disclosed information. In addition, The Basel Accord III has highlighted the
importance of market discipline and it is one of the three pillars in Basel Accord II.
However, empirical evidence on the market discipline is remaining mixed in banking
sector. Hilscher and Raviv (2014) conclude that market discipline is an effective tool
for stabilizing financial institutions after investigating the effects of issuing contingent
capital. Hou et al. (2016) investigates whether the depositor discipline of banking works
in the context of an emerging economy under financial repression and implicit
government guarantee, and they find that bank risk is negatively associated with the
growth of deposit volumes.
Finally, several studies conclude that the managerial incentive on governance does not
connect with the risk taking in banking industry. One plausible interpretation is that the
board provides their executives the incentives necessary to exploit the growth
opportunities in new products, such as insurance underwriting, securities brokerage,
and investment banking. But the investment opportunities were limited by regulatory
restriction in banking industry. Therefore, EBC are expected to be lower under strict
regulation, leading to weaker incentives to take risk.
H4: Corporate governance has positively impact bank risk taking while bank
performance increasing.
H5: Corporate governance has negatively impact bank risk taking while bank
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performance increasing.
Banking theory suggests that corporate governance affect the risk taking in different
economic environment. Better governed bank can identify risks that are more beneficial
to shareholder and encourage managers to take on higher risks in normal time. Strong
risk management function can curtail tail risk exposures at banks (Ellul and Yerramilli,
2013). Minton et al. (2014) claim that financial expertise among the boards is associated
with more risk taking prior to the financial crisis. However, it is commonly believed
that the better governed banks would have limited the excessive risks taken by banks’
management and mitigated their fall during the financial crisis. Poor bank governance
might be a major cause of financial crisis because banks with more shareholder-friendly
boards performed worse during the crisis (Beltratti and Stulz, 2012). Thus, it is an
empirical question as to whether the corporate governance is associated with more or
less risk taking while bank performance increasing.
3 Methodology
3.1 Measures of corporate governance
Following Hass et al. (2014), I construct a parsimonious index to measure the strength
of bank corporate governance. The index contains three aspects of corporate
governance, which are the board governance, ownership structure and quality of
external auditor.
First, bank board should able to effectively monitor and control bank risk (Minton et
al., 2014; Berger et al., 2014). Therefore, banks with boards that are more effective in
monitoring and advisory management terms are better governed. A vast of literatures
discusses the composition of the board of directors. I argue that three crucial aspects on
boards of directors need to emphasis relating to bank risk taking, which are the fraction
of independence directors, board size and CEO duality. Adams and Mehran (2012) find
that banks have larger and more independent boards than other non-financial firms.
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More independent board members would improves the supervision of management and
reduce the conflict of interest between shareholders and managers. The skilled
independent directors help to improve the strategic decision and risk management
control. As a bank grows and diversifies, it faces an increasing demand for specialized
outsides board members who can perform tasks such as identifying and monitoring risk.
Liang et al. (2013) find that the proportion of independent directors has positively
impacts on bank asset quality in Chinese banks. In addition, the advantage of large
boards is able to assign more people to supervise and advice on managers’ decisions.
Both Pathan (2009) and Wang and Hsu (2013) find that small boards lead to additional
bank risk as reflected in market measure of risk. In contrast, large boards may encounter
problems of coordination, control, and decision-making, as well as the concern of free
rider. But the small boards may not have enough ability to monitor such complexity of
the banking business. De Andres and Vallelado (2008) confirm that a hypothesized
inverted U-shaped relation between board size and bank performance. Furthermore,
Anginer et al. (2016) show that separation of the CEO and chairman roles associated
with higher bank risk in terms of bank capitalization due to a board independence from
management. In contrast, Pathan (2009) find that CEO power (CEO’s ability to control
board decision) negatively affects bank risk taking.
Apart from the board governance, the incentives of managers or directors to take risk
should also be considered on banking sector. The managers or directors may have
incentive to take less risk when they hold a small share of the banks’ ownership. As
managers’ human capital investment and reputation are non-diversifiable, thus they
have incentive to lead a bank better performance. Fahlenbrach and Stulz (2011) find
that the banks with managers whose incentives were better aligned with shareholders
affects performance. However, Saunders et al. (1990) shows that stockholder controlled
banks exhibit significantly higher risk taking behavior than managerially controlled
banks during deregulation period. In addition, given the growing significance of
financing across countries, foreign ownership is one of the factors that draw
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considerable attention from corporate governance. Foreign investors are in the position
with informational disadvantage compare to domestic investors (Choe et al., 2005).
Besides, foreign investors avoid invest to poorly governed corporation because they
suffer from asymmetrical information problems (Leuz et al., 2010; Ferreira and Matos,
2008). Therefore, they are normally acting more risk adverse.
Large controlling shareholders are suggested by concentrated their stakes to monitor

managers and directly intervene in investment decisions (Porta et al., 1999), which may
help to mitigate the agency costs. However, ownership concentration stimulates
shareholders’ incentives to seek private benefit of control (Faccio et al., 2001; Peng et
al., 2011), which could negatively affect firms’ corporate governance. The first reason
is that relational large shareholders have incentive and opportunity to gain access to
critical information which benefit for them. Second, the relational of shareholders
provides facility for expropriating benefit from dispensed small shareholders. Thus, the
presence of the relation between larger shareholders is likely affect firms’ corporate
governance.
The regulatory environment can constrain the excessive bank risk taking. More
specifically, a high quality audit is expected to affect firms’ governance. The level of
monitoring and control imposed by external audits and supervisory actions can improve
the governance and constrain opportunistic of excessive risk-taking (Bouvatier et al.,
2014).
Based on above discussion and consistent with Hass et al. (2014), I filter seven relevant
characteristics, which are the percentage of total directors who are independent
(1INDIV); the number of directors serving on the bank's board (2BS); CEO power is
whether or not the CEO also chairs the board (3DUAL); whether there are any relational
of the largest ten shareholders (4TOP10); the percentage of shares owned by directors,
supervisors, and executives (5MH); the percentage of shares owned by foreign
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shareholders (6FOREIGN); and who is their external auditor (7AUDIT). Thereafter, in
light of the findings previous studies (e.g. Bouvatier et al., 2014; Adams and Mehran,
2012; Anginer et al., 2016; DeYoung et al., 2013), I apply specific criteria for each
characteristic. According to Hass et al. (2014), a dummy variable is being constructed
for each characteristic that meets certain criteria. Seven criteria are specifying as
following: whether the board consist 50% of independent board members; whether the
board size greater than 6 but less than 13; whether separation of the role of CEO and
board chairman; whether there is no relation among the top 10 largest shareholders;
whether there is any holding of executive greater than 1% but less than 30%; whether
there have any foreign ownership; whether the bank audited by the joint ventures of the
Big Four1 internal audit firms and domestic audit firms. Finally, I add the seven criteria
into a total score that represent the overall governance quality, donated as CG. Higher
score indicates strong corporate governance for individual bank in a particular year.
3.2 Measures of bank risk taking

A traditional measure of banks’ risk is the standard deviation of either return on equity
or return on assets. However, this type measure has been criticized imprecision as based
upon small samples. Two proxies of bank risk are selected to show whether strong
corporate governance have any impact on the bank risk taking. I primarily measure
bank risk using the Z-score, which is widely used in the bank literature as a bank risk-
taking indicator (see, for instance, Beltratti and Stulz, 2012; Fu et al., 2014; Williams,
2014; Minton et al., 2014; Laeven and Levine, 2009). Z-score calculated as follows:
𝑅𝑂𝐴𝑖𝑡 + 𝐸𝑖𝑡 /𝑇𝐴𝑖𝑡
𝑍𝑖𝑡 =
𝜎𝑅𝑂𝐴𝑖𝑡
(Equation 1)
where ROA is the return on assets, E/TA is the ratio of equity to total assets, and 𝜎𝑅𝑂𝐴
is the standard deviation of return on assets. As the Z-score is highly skewed, following
Laeven and Levine (2009) and Fu et al. (2014), I use natural logarithm of the Z-score,
which is normally distributed.
1 The Big Four audit firms are Deloitte, Ernst & Young, KPMG and PwC.
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The Z-score measures the distance from insolvency because a bank becomes insolvent
when its assets value less than its debts. As it shows the number of standard deviations
below the average a bank’s return on assets has to fall in order for that bank’s capital
reserves to be depleted. So the larger Z-score indicates that the bank is more stable as
away from bankruptcy. Elyasiani and Zhang (2015) use Z-score as insolvency risk and
find that banks with a greater number of busy directors exhibit lower insolvency risks.
and Beltratti and Stulz (2012) find that Z-score are positively associated with
shareholder-friendly boards. Minton et al. (2014) suggest that boards consisting of
higher amount of financial experts were positively associate with bank risk, which
measured by Z-score. Fu et al., (2014) investigate the influence of bank competition,
concentration, regulation and national institutions on individual bank fragility as
measured the bank’s Z-score.
My second measure of risk is the reserve of impairment loans, which reflects credit
quality of banks and the overall attitude of the banking system. Bank with poor credit
quality would associate with the risky loan portfolio, which in turn results in higher
risk-taking. This risk measure is commonly applied in recent banking study. For
instance, Haq and Heaney (2012) use loan loss provision as a measure to examine the
determinants of bank risk.
3.3 Other explanatory variables

Following Elyasiani and Zhang (2015), Fu et al. (2014), Laeven and Levine (2009) and
Williams (2014), I include a range of bank specific variables to explain bank risk taking
and obtain consistence parameters. These measures are common and well accepted in
recent banking literature.
One of the most debatable questions is whether size affects bank risk taking. Large
banks are benefit from diversification and economies of scales, which would be more
stable than smaller banks. Pathan (2009) shows that bank size lower insolvency risk.
Haq and Heaney (2012) also find that large banks reflect lower credit risk. Besides,
smaller banks are easier to be liquidated or the target of unfavorable takeovers when
16
they are in financial distress. However, banks are becoming larger and arguably more
complex, which may increase difficulty to monitor their risk effectively. Fu et al., (2014)
find that smaller banks tend to be less risky in a recent study of Asian banks. In addition,
the concept of ‘too big to fail’ is important to the national banking system as the
government are likely seek to prevent bank failure (Williams, 2014). Given the
skewness of the size distribution, the logarithm of its total assets (LNTA) is being
employed as proxy for a bank’s size, which consistent as Fu et al. (2014), Pathan (2009)
and Laeven and Levine (2009).
Diversification provides a credible signal of bank’s ability to minimize risk. In contrast,

increased non-interest income also generates agency conflicts and increased complexity.
Broad activities may lead to the bank extremely large and complex that are
extraordinarily difficult to monitor and ‘‘too big to discipline’’ (Laeven and Levine,
2007). In addition, diversification might intensify moral hazard problem and present
more opportunities for banks to take higher risk. As diversification relates to both bank
risk taking and corporate governance, I additionally control for the banks’
diversification activities. Following Fu et al. (2014), I employed the return on average
asset (ROAA) to track the profitability of a bank’s operating activities.
Theory suggests an important role for capital in mitigating agency problems and the
attendant uncertainty for outsider stakeholders, especially depositor in particular on
banking sector. Bank capital is the main source to act as buffer to against unexpected
default, but the effect of bank capital on risk is ambiguous. Greater equity capital
encourages prudent behavior and improves the survival probability of bank (Beltratti
and Stulz, 2012; Fratzscher et al., 2016). Both Fratzscher et al. (2016) and Haq and
Heaney (2012) find that the higher capital buffer the lower the bank risk, which
consistent with the argument that facilitate stability the banking system. Besides, Lee
and Hsieh (2013) also find that a negative relation between capital and bank risk.
Konishi and Yasuda (2004) find that the implementation of the capital adequacy
17
requirement reduced risk taking at commercial banks. Yet, moral hazard hypothesis
suggest that banks’ manager have incentive to increase risk taking. Highly capitalized
bank may take more risk as the deposit being guaranteed. Ghosh (2015) find a positive
relationship between the level of capital and bank risk. Moreover, Williams (2014) find
a U-shaped relationship between bank risk and capital. I use the ratio of total equity to
total asset to measure capitalization, muck like Ghosh (2015) and Beltratti and Stulz
(2012).
In additional to bank-specific variables, the impact of state-level economic conditions

on bank risk also needs to take into account (Ghosh, 2015). Banks may fail to
internalized risks stemming from overheated macroeconomic and loose monetary
conditions (Vazquez and Federico, 2015). Thus, I include three measures of economic
performance to control for different macroeconomic conditions.
First, the rate of real GDP growth (RGDP), the most natural indicator of the business
cycle of an economy, is used as a proxy for the fluctuations in economic activity. Ghosh
(2015) shows that higher state real GDP reduce nonperforming loans. The GDP growth
is expected to have a negative effect on bank risk because the demand for revenue
increases during cyclical upswings. Alternatively, positive relationship is expected if
the level of bank risk is lower in business upturns given a countercyclical
materialization. Both Williams (2014) and DeYoung et al. (2013) find that banks in
better economic environments are more likely to implement risk-increasing investment
strategies.
Second, inflation rate also has an ambiguous role in determinant on bank risk taking.
Inflation variability causes lenders to estimate incorrectly the value of loan collateral
and borrowers’ loan repayment. Thus, stable and constant inflation rate would reduce
the real value of debt, in turn lower bank risk. However, excessive inflation rate may
deplete borrowers’ real income and booming bank risk, especially when the income
18
does not raises compare with inflation. Ghosh (2015) find a positive relationship
between inflation rate and bank risk taking.
Third, lending interest rate is being employed as proxy for the term structure of
borrowing. Banks normally use short-term deposits to finance long-term lending.
Rising in interest rate may increases the real value of borrowers’ debt, stimulates debt
servicing more expensive, as well as increase loan defaults. Thus, bank risk may be
positively impacted by the lending interest rate. However, Ghosh (2015) show that
interest rate has no effect on bank risk, in terms of nonperforming loans.
3.4 Empirical models

Panel data analysis is the most efficient instrument to use when the sample is a mixture
of time series and cross-sectional data. So the following regression equation is
formulated to test empirically the hypotheses 1 to 3,
𝑅𝐼𝑆𝐾𝑖𝑡 = 𝛼 + 𝛽1 𝐶𝐺𝑖𝑡 + 𝛽2 𝐿𝑁𝑇𝐴𝑖𝑡 + 𝛽3 𝐸𝑇𝐴𝑖𝑡 + 𝛽4 𝑃𝐸𝑖𝑡 + 𝛽5 𝑅𝑂𝐴𝐴𝑖𝑡 + 𝛽6 𝐷𝐸𝑃𝑖𝑡
+ 𝛽7 𝐺𝐷𝑃𝑖𝑡 + 𝛽8 𝐼𝑁𝐹𝑖𝑡 + 𝛽9 𝐼𝑁𝑇𝑖𝑡 + 𝜀𝑖𝑡
(Equation 2)
where t and i denote time period and banks, respectively. 𝜀𝑖𝑡 is the error term with a
mean of zero. RISK refers to the i th bank’s risk-taking in year t, proxied by two risk
variables: Z-score (ZS) and loan loss provision (LLP). CG is the score of corporate
governance. In addition, four internal control variables are set as the bank specific
characteristics: the logarithm of total assets (LNTA), equity to assets ratio (ETA), price
to earnings ratio (PE), return on average asset (ROAA), and the logarithm of total
deposit (DEP). Furthermore, three macro control variables are set as the related external
control variables: GDP growth rate (GDP), inflation rate (INF), and lending interest
rate (INT).
To test the hypotheses 4 and 5, the interaction term of GG and ROAA is being included
19
in the equation 3,
𝑅𝐼𝑆𝐾𝑖𝑡 = 𝛼 + 𝛽1 𝐶𝐺𝑖𝑡 + 𝛽2 𝐿𝑁𝑇𝐴𝑖𝑡 + 𝛽3 𝐸𝑇𝐴𝑖𝑡 + 𝛽4 𝑃𝐸𝑖𝑡 + 𝛽5 𝑅𝑂𝐴𝐴𝑖𝑡 + 𝛽6 𝐷𝐸𝑃𝑖𝑡

+ 𝛽7 𝐶𝐺 ∗ 𝑅𝑂𝐴𝐴𝑖𝑡 + 𝛽8 𝐺𝐷𝑃𝑖𝑡 + 𝛽9 𝐼𝑁𝐹𝑖𝑡 + 𝛽10 𝐼𝑁𝑇𝑖𝑡 + 𝜀𝑖𝑡
(Equation 3)
The definition of the above bank risk proxies and explanatory variables are summarized
in Table (1).
Table 1: Definition of variables

Variables Symbol Description Sources
Corporate governance
Independent members 1NDIV Whether board is controlled by more Manual collection
than 50% independent directors
Board size 2BS Whether board size is greater than 6 Manual collection
but fewer than 13
CEO chairman duality 3DUAL The chairman and CEO are not the Manual collection
same person
Relationship 4TOP10 There are no relationships among the Manual collection
top ten shareholders
Managerial holding 5MH Management ownership (directors, Manual collection
supervisors, and executives) is greater
than 1% but less than 30%
Foreign ownership 6FORE Foreign investor ownership is greater Manual collection
than zero
Bi4 4 Audit firm 7AUDIT Audited by one of the Big 4 audit Manual collection
firm or their joint ventures
Internal corporate CG Internal corporate governance score Aggregate above
governance seven attributes
Bank risk-taking
Z-score ZS [Average (Returns) + Average Use original
(Equity/Total assets)] / Standard Bankscope data to
deviation (Equity/Total assets) calculate
Loan loss provision LLP The natural logarithm of the amount Bankscope
of loan loss reserve
Bank specific characteristics
Bank size LNTA The natural logarithm of total assets Bankscope
in thousands of USD.
Capitalization ETA The ratio of equity to assets. Bankscope
20
PE ratio PE The ratio of market price to earnings Bankscope
per share.
Return on assets ROAA The ratio of profit to average assets. Bankscope
Depositor LNDEP The natural logarithm of the amount Bankscope
of deposit in thousands of USD.
Macroeconomics
GDP growth rate GDP Yearly real GDP growth (%) International
Monetary Fund
Inflation rate INF Inflation rate International
Monetary Fund
Lending interest INT Lending interest rate International
Monetary Fund
3.5 Endogeneity and Generalized Method of Moments (GMM)

Base on the discussions of the dependent and explanatory variables, I employ
Generalized Method of Moments (GMM) estimator as robustness to test my hypotheses
and estimate the model parameters. The GMM estimator is proposed by Blundell and
Bond (1998) and being applied by several recent banking literatures, such as Hou et al.
(2016) Ghosh (2015), and Bouvatier et al. (2014). As most empirical corporate finance
research, the analysis of the relationship between corporate governance and bank risk-
taking faces the challenge of endogeneity, which can arise from unobserved
heterogeneity, simultaneity, and reverse causality. The GMM estimator enables us to
tackle these particular econometric problems: (i) the autoregressive process in the data
relating dependent variables; (ii) the presence of unobserved firm-specific effects; and
(iii) and the likely endogeneity of the independent variables.
I employ the AR (1) and AR (2), and Hansen test to check the validity of my estimates.
AR (1) and AR (2) are the Arellano–Bond tests for first and second order
autocorrelation of the residuals. AR (1) test should reject the null hypothesis of no first
order serial correlation, while AR (2) test should not reject the null hypothesis of no
second order serial correlation of the residuals. Hansen test is the checking the validity
of the entire set of instruments as a group.
21
4 Data
4.1 Data sources
The sample examined in my chapter includes the largest commercial listed banks in
three markets, Mainland China, Hongkong and Taiwan, cover 9 years from 2006 to
2014. The requirement of my observation is that the bank must be publicly traded made
it possible to collect data on board governance as well as other internal governance
characteristics of the firms from published statements. My sample period 2006-2014 is
carefully chosen to avoid the impact of the 2005 reform in Mainland China2. In addition,
most of the banks in Mainland are starting listing in the Shanghai Stock Exchange and
the Shenzhen Stock Exchange from 2006. These banks pillar contains large nationwide
banks and regional banks. Moreover, aggregate data for cross-market are considered
preferable as the risk of non-representativeness of the sample is reduced. Meanwhile,
studies based on bank-by-bank are useful in a micro-prudential context. Therefore,
exploiting cross-market variation in risk-taking trends is likely to produce more robust
results than the analysis of individual market.
The data used in my chapter comes from three sources. My first source is the Bankscope,
which is a leading information source for global financial institutional. All variables
sourced from Bankscope are in US dollars, using year ended date exchange rate. Second,
information on bank governance is particularly difficult to construct. I hand-collect
information on various aspects of the institution structure of the corporate governance
function at each bank each year, and use this information to construct a score to measure
the strength of governance. These governance data are measured on the date of the
proxy at the ending of the corresponding fiscal year3. Third, macroeconomic data are
obtained from the International Monetary Fund’s International Financial Statistics with
2 The authority of China initiated a reform to make non-tradable shares becoming tradable in 2005. The non-tradable
shares originally held by the State or by politically connected investors that were issued at the early stage of financial
market development.
3 Following Adams and Mehran (2012), we also adjust our data collection procedures to account for the fact that
statements disclose some governance characteristics for the previous fiscal year and others for the following fiscal
year.
22
the exception of Taiwan4.
As discuss on Section 3, I obtain the score of corporate governance by taking the

principle component of the following seven governance variables: independent
directors, the board size, CEO duality, relationship of top 10 shareholders, managerial
shareholding, foreign ownership and external audit firm. These components analysis
effectively performs a singular value decomposition of the strength of bank governance.
The main advantage of using the sum of all components analysis is that I do not have
to subjectively eliminate any characteristics of governance, or make subjective
judgements regarding the relative importance of these characteristics (Tetlock, 2007).
Table (2) reports the number of banks and the number of bank-year observations for
each market. Banks from Mainland China account for 36% of the total observations,
while banks of Hongkong and Taiwan represent 15% and 49% respectively. The dataset
thus comprises countries with different levels of development as well as different legal,
political, and institutional environments. However, my data set is comparable with Sun
and Chang (2011) database, they investigate the role of risk in eight emerging Asian
countries. There are several advantages associated with my data set. The first advantage
is that the sample includes different prospective over corporate governance, and thus
providing potentially more complete tests of the importance of governance structures.
Second, the managers of these banks have similar culture background in these markets,
thus it offers a unique regional set of data for each year over the 2006-2014 period.
Third, using panel data allows us to capture the market-specific effects and the
unobservable differences between markets. While it is true that I examine corporate
governance at only the very largest banks in these markets and those banks hold the
vast majority of industry assets. Consequently, these banks command great interest
among investors, regulators and other stakeholders.
4 Taiwanese data is sourced from either the website of the Central Bank of the Republic of China (interest rates) or
the website of the National Statistics of the Republic of China (all other data).
23
Table 2: Number of banks in samples used for estimating risk
2006 2007 2008 2009 2010 2011 2012 2013 2014 Total
Mainland 7 14 14 14 16 16 16 16 16 129
Hongkong 6 6 6 6 6 6 6 6 6 54
Taiwan 21 21 21 21 21 21 21 21 21 189
34 41 41 41 43 43 43 43 43 372
I present summary statistics for the risk measures, governance score, bank financial
characteristics and macroeconomic variables in Table (3). The mean Z-score of 3.13 is
close to that mean Z-score (3.25) reported by Beltratti and Stulz (2012). The mean of
loan loss provision is 13.113. The mean score of governance is 3.429, and the minimum
and maximum value ranges between 1 and 6. My governance score is higher than 2.01
from Hass et al. (2014). As the sample of Hass et al. (2014) excludes the financial sector,
it is reasonable to believe that the governance of financial sector is stronger than other
industries. Regarding the bank characteristics variables, bank capital ranges from 2.53%
to 38.97% with an average 7.38%. Bank size, the logarithm of total assets ranges from
15.42 to 21.72 with an average 18.12.
Table 3: Descriptive statistics for main model variables

Variable N Mean Std. Dev. Min. Max.
Panel A: Corporate governance attributes
1NDIV 372 0.074 0.263 0 1
2BS 372 0.483 0.500 0 1
3DUAL 372 0.925 0.263 0 1
4TOP10 372 0.302 0.459 0 1
5MH 372 0.147 0.354 0 1
6FORE 372 0.622 0.485 0 1
7AUDIT 372 0.868 0.338 0 1
CG 372 3.429 0.939 1.000 6.000
Panel B: Main model variables

ZS 372 3.138 0.771 -1.442 5.308
LLP 372 13.113 1.948 9.603 18.466
ETA 372 7.384 5.038 2.530 38.970
LNTA 372 18.128 1.572 15.429 21.729
PE 372 5.227 0.739 2.838 6.602
ROAA 372 0.761 0.665 -2.020 2.630
24
LNDEP 372 17.888 1.630 14.624 21.781
GDP 372 5.918 4.195 -2.459 14.16
INF 372 2.205 1.784 -0.860 5.864
INT 372 4.625 1.526 2.560 7.900
Note: This table contains means, standard deviations, minimum and maximum values on the variables included in the main model. ZS is the
Z-score, calculate as [Average (Returns) + Average (Equity/Total assets)] / Standard deviation (Equity/Total assets). LLP is loan loss provision
in natural logarithem. LNTA is total assets in natural logarithem. ETA is the ratio of equity to asset. PE is the ratio of market price to earnings
per share. ROAA is the ratio of profit to average assets. LNDEP is natural logarithm of the amount of deposit. GDPG is GDP growth rate.
INF is the inflation rate. INT is the lending interest rate. 1NDIV is 1 if board controlled by more than 50% independent directors and 0
otherwise. 2BS is 1 if the board size greater than 6 but less than 13 and o otherwise. 3DUAL is 1 if the chairman and CEO are not the same
person and 0 otherwise. 4TOP10 is 1 if there are no relationships among the top ten shareholders and 0 otherwise. 5MH is 1 if management
ownership is greater than 1% but less than 30% and 0 otherwise. 6FORE is 1 if foreign investor ownership is greater than zero and 0 otherwise.
7AUDIT is 1 if external audited by one of the Big 4 audit firm or their joint ventures and 0 otherwise. CG is the score of internal corporate
governance by aggregate seven attributes.
Pearson pairwise correlation coefficients are also calculated and reported in Table (4).
The correlation coefficients are usually small (less than 0.4), suggesting that the
correlation between variables has weak association. Pointedly, governance score
exhibits a negative correlation with Z-score and loan loss reserve. The Pearson pairwise
correlation analysis can only provide some preliminary information to the following
regression analysis because of the ambiguous causality of the correlation coefficients
and the omission of key control independent variables.
Table 4: The matrix of Pearson correlation coefficients

ZS LLP CG LNTA ETA PE ROAA LNDEP
ZS 1.0000
LLP 0.3908* 1.0000
CG -0.1656* -0.3809* 1.0000
LNTA 0.0123 -0.2776* 0.0016 1.0000
ETA 0.4027* 0.9400* -0.3659* -0.2499* 1.0000
PE 0.4313* 0.7247* -0.4085* -0.0754 0.7577* 1.0000
ROAA 0.3122* 0.3146* -0.1604* 0.2676* 0.4007* 0.4143* 1.0000
LNDEP 0.4149* 0.9497* -0.3578* -0.3116* 0.9814* 0.7469* 0.4001* 1.0000
GDP 0.2462* 0.5207* -0.3951* -0.1803* 0.4423* 0.4138* 0.2551* 0.4718*
INF 0.1727* 0.2438* -0.1875* -0.0467 0.2771* 0.2436* 0.2182* 0.3008*
INT 0.3052* 0.4709* -0.4020* -0.1470* 0.4871* 0.4384* 0.3546* 0.5303*
GDP INF INT

GDP 1.0000
INF 0.3198* 1.0000
INT 0.6077* 0.5529* 1.0000
Note: ZS is the Z-score, calculate as [Average (Returns) + Average (Equity/Total assets)] / Standard deviation (Equity/Total assets). LLP
25
is loan loss provision in natural logarithem. LNTA is total assets in natural logarithem. ETA is the ratio of equity to asset. PE is the ratio
of market price to earnings per share. ROAA is the ratio of profit to average assets. LNDEP is natural logarithm of the amount of deposit.
GDPG is GDP growth rate. INF is the inflation rate. INT is the lending interest rate. 1NDIV is 1 if board controlled by more than 50%
independent directors and 0 otherwise. 2BS is 1 if the board size greater than 6 but less than 13 and o otherwise. 3DUAL is 1 if the
chairman and CEO are not the same person and 0 otherwise. 4TOP10 is 1 if there are no relationships among the top ten shareholders
and 0 otherwise. 5MH is 1 if management ownership is greater than 1% but less than 30% and 0 otherwise. 6FORE is 1 if foreign
investor ownership is greater than zero and 0 otherwise. 7AUDIT is 1 if external audited by one of the Big 4 audit firm or their joint
ventures and 0 otherwise. CG is the score of internal corporate governance by aggregate seven attributes.
5 Empirical results
5.1 Governance and risk taking - OLS estimation
The empirical evidence of the relationship between bank performance and governance
are presented in this section. Table (5) reports the estimation results of Equation (2) to
test the relationship between the corporate governance (CG) and bank risk taking (Z-
score) by OLS estimation. In specifications (1) and (2) of Table (5), macroeconomic
control variables are excluded from the estimations because it is statistically
insignificant in most specifications. The regression results are reported in columns (3)
and (4) of Table (5) are consistent with those in columns (1) and (2) of Table (5).
Table 5: The relationship between bank corporate governance and risk taking (Z-score) -
OLS
(1) (2) (3) (4)
Dependent
ZS ZS ZS ZS
variable
CG -1.244** -1.355** -1.337** -1.360**
(-2.53) (-2.42) (-2.55) (-2.43)
ETA 2.006*** 1.926*** 1.976*** 1.936***
(15.76) (13.21) (14.45) (13.30)
LNTA -8.188*** -9.708*** -8.053*** -9.541***
(-2.77) (-2.94) (-2.58) (-2.92)
PE -0.564 0.223 -0.291 0.455
(-1.10) (0.36) (-0.51) (0.72)
ROAA 1.091*** 1.010** 1.180*** 0.979**
(2.90) (2.20) (2.84) (2.12)
LNDEP 9.716*** 10.86*** 10.02*** 11.09***
(3.28) (3.31) (3.21) (3.4)
GDP 0.027 0.104
(0.42) (0.73)
INF 0.167 0.575*
(1.29) (1.96)
INT 0.322 -0.171
26
(1.15) (-0.33)
Constant -1.004 3.668 -11.79 -5.061
(-0.10) (0.24) (-1.07) (-0.30)
Year effect No Yes No Yes

Observation 372 372 372 372
F test 0.000 0.000 0.000 0.000
R 0.547 0.588 0.550 0.590
With regard to the determinant of Z-score as dependent variable, I find relatively strong
evidence that the coefficient estimates on corporate governance are negative and
significant on all specifications in Table (5). This finding confirms the Hypothesis (2).
This illustrates that, after controlling for other bank characteristics and macro-economic
factors, a bank with strong governance is associated with a higher risk taking. More
specification, a 1-standarad deviation increase in CG is associated with around 1.22 to
1.36 increase in the bank risk taking. This result is consistent with the evidence by
Pathan (2009) and Elyasiani and Zhang (2015).
The board of directors is widely recognized as the cornerstone of an effective

governance framework. The board could evaluate whether the current and future risk-
exposure is consistent with risk appetite by monitoring and advising bank operation.
Most banks can be viewed as complexity and opacity based on revenue diversification
and debt intensity. Thus, banks are likely to require more advising from their boards.
My result confirms that an intermediate board with a greater number of independent
directors is more effectively monitor and advise bank’s management team (Liang et al.,
2013), in turn leads bank to undertake riskier but value-enhancing investment. From an
opposite direction, my results support the claim of both Pathan (2009) and Wang and
27
Hsu (2013), who finds that a small board associated with higher risk of bank. Besides,
larger boards are also less effective more susceptible by influencing from CEO. In
addition, as independent directors pay more attention to the regulatory and statutory
issue, therefore, managers would act more conservatively to avoid any lawsuits (Pathan,
2009). Bank directors are likely exposed to high penalties imposed by regulators for
violating fiduciary duties. Besides, recent discussion suggests that independent board
may become less effective as they attend ‘too many’ boards. However, Elyasiani and
Zhang (2015) suggest that many directors serve on too many boards to fulfill their
duties adequately and the relation between bank risk and busyness board is negative.
Besides, Wang and Hsu (2013) also suggest that banks with a higher proportion of
independent directors are less likely to suffer from fraud or failure to comply with
professional obligations to clients. Thus, my result is consistent with the finding of
Elyasiani and Zhang (2015) and Wang and Hsu (2013), which are the board with more
outside member lead to higher risk taking. Moreover, separated CEO and chair could
be one of explanation for the strong governance and lower bank risk-taking. As
individual has a more complex job and merits a higher equilibrium wage if CEO and
chair duality, I might expect increases in the level of job complexity and monitoring
quality falls. Thus, these CEOs may slack to monitor and advise on bank risk taking.
Second, another possible explanation might be that banks with managerial shareholding
and foreign ownership can serve as catalyst to control bank risk taking. Agency
problems and risk preference behavior are different depending on the nature and
incentive of the shareholder (Barry et al., 2011; Saunders et al., 1990). If a bank is
managed to maximize investor return, it will choose a level of risk that is consistent
with that objective. This because managers seeking to improve the profitability might
implement certain strategies that raise the uncertainty of the firms' income, such as
introducing new production technologies, cutting expenses and tightening controls on
production. Besides, shareholders may not be able to commit to monitor such complex
contracts and projects (Bolton et al., 2015). Sullivan and Spong (2007) find that
28
managerial shareholding is positively linked with bank risk, meaning that under certain
conditions, hired managers operate their bank more closely in line with stockholder
interests. The limited liability shareholders have great incentive to increase the risk
taking of the bank by increasing leverage to maximize their wealth. In contrast,
managers may act in a risk-averse rather than chasing risk due to non-diversifiable
human capital. Therefore, bank with part managerially shareholding exhibit higher risk
taking behavior than stockholder controlled banks (Saunders et al., 1990). My result is
consistent with the finding of Saunders et al. (1990). In addition, foreigners have
ownership structures that are conductive to governance problems (Leuz et al., 2010).
Given the financial resources and managerial know-how, foreign investors are more
likely to improve the level of corporate governance through monitoring managers
effectively. As the consequence, bank with foreign shareholders would be more
efficient due to the strength of governance, while operating in higher risk.
Third, DeAngelo and Stulz (2015) claim that risk management is central to banks’
operating policies as banks with risky assets use risk management to maximize their
capacity. The risk management function is performed by the asset and liability
management committee of the board of directors. The main function of risk
management at banks is to limit exposure to risk, and hence to reduce the possibility of
significant losses. Most operational losses in bank can be characterized as consequences
of a weak internal control environment (Chernobai et al., 2012). Thus, risk management
system can ensure that the bank has the appropriate risk level, for example, ceiling
increases risk or eliminating uncover risk. Indeed, risk management system would
strike the balance between helping bank take risks efficiently and ensuring not take
excessive risks that destroy value. For instance, bank with a greater percentage of
financial experts among management team can engage in higher risk-taking activities
because they have better understanding of more complex investments (Minton et al.,
2014). Besides, the presence of a chief risk officer in a bank’s executive board and
whether the CRO reports to the CEO or directly to the board of directors, are associated
29
with a better bank performance (Aebi et al., 2012). Therefore, consistent with my
finding, banks with strong corporate governance normally associated with better risk
management system, in turn raising risk-taking (Ellul and Yerramilli, 2013).
Fourth, depositors discipline could also be one of the reasons to explain the positive
relationship between corporate governance and bank risk taking. Deposit insurance
protects the interests of unsophisticated depositors and helps prevent bank failure. The
banking sector is dominated by large state-owned banks in those emerging economy,
especially in China. Those commercials banks are under strict government regulations
and guaranteed by government safety net. However, Demirguç-Kunt and Detragiache
(2002) finds that explicit deposit insurance tends to increase the likelihood of banking
crises. Anginer et al. (2014) suggest that the moral hazard effect of deposit insurance
dominates in good times, while the stabilization effect of deposit insurance dominates
in turbulent times. Thus, strong governance bank may focus on maximize shareholders’
wealth mainly and neglect the interest of depositor, which would to take on excessive
risk in normal time.
Summing up, as my sample represent all major banks in the three markets, my result is
consistent with the conjectural on corporate, which in turn allow these banks to monitor
and control their risk taking in an appropriate level. My result is in line with corporate
firm evidence by Core et al. (1999), who suggest that board and ownership structure
are associated with the level of firm risk in term of managerial compensation. Besides,
my result also consistent with the finding of John et al. (2008), they conclude that
corporate risk-taking is positively related to the quality of investor protection. The
results support the hypothesis (2), better corporate governance increased bank risk
taking. This finding is in line with other published papers using data from other markets
(e.g. Pathan, 2009 and Elyasiani and Zhang, 2015).
Concerning the control variables, not surprisingly, size is an important determinant of
30
bank risk-taking. From table (5), I find that the coefficients of bank size are positively
and statistically significant. This indicates that larger banks have lower risk than smaller
banks, which consistent with the finding of Pathan (2009). The results do not support
the argument for ‘too big to fail’, where large banks have greater incentive to take
higher risk (Haq and Heaney, 2012; Elyasiani and Zhang, 2015; Bai and Elyasiani,
2013). A possible explanation for this relation is that the larger banks likely to have
strong risk management function (Ellul and Yerramilli, 2013).
The coefficients on the ratio of equity to asset are negative and statistically significant
for all specifications. More specifically, a 1% rise in equity to assets, capturing the
extent of capitalization, decreases Z-score by 1–15%. These findings suggest that an
increase in bank capital associated with rise in bank risk taking, which consistent with
the argument that careful management of bank capital can control bank risk taking. My
result is in accordance with some of the prior studies such as Haq and Heaney, (2012).
However, my results are contrary to the results obtained in Konishi and Yasuda (2004),
who found a positive correlation between the capital equity and the level of bank risk.
Some-what surprisingly, greater price to earning ratio negatively influences Z-score,

suggesting a higher share price increases bank risk taking. This implies that banks in
favorite stock market engaged in less prudent lending and not carefully originate their
loans, in turn increasing risk. The possible explanation is that excess bank risk taking
is induced by management compensation base on the stock price performance (Bolton
et al., 2015).
Turning to the regional economic determinants, the coefficients on the GDP growth are
negative and statistically significant for two specifications. This suggests that increased
economic growth is found to be associated with increased bank risk.
Overall, my economic model has strong predictive power: R-square of the regression
31
implies that the variables explain between 11.1% and 17.3% of the variation in risk
taking, net of any effect they may have through the other independent variables. In
addition, the F-test rejects the null hypothesis that the coefficients on both instruments
are jointly zero. However, the joint determination of corporate governance and risk
taking raise concern that the result could bias. For instance, high risk banks might from
better governance structure if disperse shareholders have difficulty monitoring risky
investment. In the estimation equation R = b * C + u, R represent bank risk taking
variable, C the matrix of all independent variables, u the error term, and b the vector of
estimated coefficients. OLS is consistent only if no unobservable factors affect both
governance and risk. I attempt this concern using a variety of strategies in following
sections.
5.2 Governance and risk taking - Fixed-effect within estimation

The OLS estimation may not consistent due to it does not consider the unobservable
and constant heterogeneity of the bank. Therefore, in the presence of unobserved bank
fixed-effect, panel‘Fixed-effect’ (FE) estimation is commonly suggested (Wooldridge,
2002, pp. 265–291, for details on FE estimation). By including bank fixed effects, I
limit both omitted variables bias and the effect of potential outliers caused by the fact
that the number of cross-sectional units in my sample is small. FE estimation is
consistent only if the independent variables are exogenous, which is not the case in the
analysis of corporate governance and bank risk taking. Many other previous papers use
either this estimation in research on corporate governance or risk (Adams and Mehran,
2012; Pathan, 2009; De Andres and Vallelado, 2008; Laeven and Levine, 2009). Finally,
Hausman test is used to identify the optimal model compare with random effect. The
result shown in Tables (6) suggest that the fixed effects model is the optimal one.
Table 6: The relationship between bank corporate governance and risk taking (Z-score) - FE
(1) (2) (3) (4)
Dependent
ZS ZS ZS ZS
variable
CG -1.155** -0.970** -1.173** -1.054**
32
(-2.36) (-2.06) (-2.40) (-2.22)
ETA 2.027*** 1.971*** 2.017*** 1.962***
(16.01) (16.02) (15.79) (15.77)
LNTA -7.998*** -9.854*** -7.799*** -9.697***
(-2.69) (-3.41) (-2.62) (-3.35)
PE -0.622 -0.0683 -0.479 0.0443
(-1.22) (-0.14) (-0.92) -0.08
ROAA 1.087*** 0.812** 1.151*** 0.885**
(2.93) (2.16) (3.02) (2.31)
LNDEP 9.358*** 9.225*** 9.335*** 9.426***
(3.14) (3.21) (3.13) (3.26)
GDP 0.017 -0.075
(0.29) (-0.61)
INF 0.164 0.279
(1.38) (1.12)
INT 0.171 -0.526
(0.65) (-1.20)
Constant -1.168 31.68** -6.207 28.33*
(-0.13) (2.23) (-0.62) -1.77

F test 0.000 0.000 0.000 0.000
R 0.548 0.598 0.552 0.602
Note: ZS is the Z-score, calculate as [Average (Returns) + Average (Equity/Total assets)] / Standard deviation (Equity/Total assets). LLP is
loan loss provision in natural logarithem. LNTA is total assets in natural logarithem. ETA is the ratio of equity to asset. PE is the ratio of
market price to earnings per share. ROAA is the ratio of profit to average assets. LNDEP is natural logarithm of the amount of deposit.
independent directors and 0 otherwise. 2BS is 1 if the board size greater than 6 but less than 13 and o otherwise. 3DUAL is 1 if the chairman
and CEO are not the same person and 0 otherwise. 4TOP10 is 1 if there are no relationships among the top ten shareholders and 0 otherwise.
5MH is 1 if management ownership is greater than 1% but less than 30% and 0 otherwise. 6FORE is 1 if foreign investor ownership is
greater than zero and 0 otherwise. 7AUDIT is 1 if external audited by one of the Big 4 audit firm or their joint ventures and 0 otherwise.
CG is the score of internal corporate governance by aggregate seven attributes.
Table (6) reports the estimation results of Equation (3) to test the relationship between
CG and Z-score using the FE estimation. As before, the coefficients on the CG is not
significantly different from zero. I still find relatively strong evidence that the
coefficients on CG are negative and significant on all specifications in Table (6). This
illustrates that, after controlling for unobserved bank fixed effect, a bank with strong
governance is associated with a higher risk taking. Thus, the second Hypothesis (H2)
is also supported. A 1-standarad deviation increase in CG is associated with around 0.97
to 1.16 increase in the bank risk taking, which is little smaller than OLS estimation.
33
Corporate governance plays a proactive role through directors’ meetings to discuss and
exchange ideas on how to monitor and advise managers, which could subsequently
influence bank risk taking.
5.3 Governance and risk taking - GMM estimation

The OLS and fixed effect estimators are neither econometrically consistent nor related
with the theoretical postulates of corporate governance literature. Besides, those
estimators could be problematic because risk-taking can be endogenous. The
endogeneity concern arises because greater risk-taking may be likely in banks operating
in markets with higher growth rates, that is, risk-taking and growth could be driven by
a potential variable. Thus, I need other econometric technique able take account at the
same time the individual characteristics of each bank together with the potential
endogeneity of governance characteristics.
The two step system GMM estimator with adjusted standard errors considers the
unobservable heterogeneity transforming the original variables into first differences and
the endogeneity of independent variables using instruments. Table (7) present the two
step system GMM results of bank risk measure as Z-score. I present estimated
coefficients whether they are statistically different from zero (p-value). Besides, the
diagnostics tests in Table (7) show that the model is well fitted with statistically
insignificant test statistics for both second-order autocorrelation in second differences
(AR 2) and Hansen J-statistics of over-identifying restrictions. Besides, the residuals in
the first difference (AR 1) are statistically significant, which is serially correlated by
way of construction.
Table 7: The relationship between bank corporate governance and risk taking (Z-score) -
GMM
(1) (2) (3) (4)
DIFF SYS DIFF SYS
Dependent
ZS ZS ZS ZS
variable
34
Lag.ZS 0.045*** 0.737*** 0.143*** 0.966***
(4.22) (21.76) (6.16) (42.46)
CG -0.400** -0.652 -1.002** -0.159*
(-2.04) (-1.46) (-2.18) (-1.82)
ETA 2.323*** 0.177*** 1.476*** -0.118*
(11.10) (3.37) (12.25) (-2.00)
LNTA -5.010*** 0.31 -4.330** -0.479
(-3.63) (0.29) (-2.68) (-1.58)
PE -0.526*** -5.251*** 0.905 -0.941**
(-5.62) (-6.12) (0.98) (-2.68)
ROAA 2.258*** 0.471 1.144*** 0.092
(16.13) (0.68) (9.18) (0.23)
LNDEP 6.402*** 2.896** 4.274*** 1.516***
(4.56) (2.40) (3.42) (4.26)
GDP -0.275*** -0.416***
(-4.98) (-13.15)
INF 0.507*** 1.199***
(5.60) (9.49)
INT -1.180*** -0.643***
(-4.93) (-3.84)
Constant -21.73*** -7.331***
(-5.20) (-2.75)

F test 0.000 0.000 0.000 0.000
AR1 0.001 0.000 0.001 0.000
AR2 0.294 0.946 0.805 0.371
Hansan 0.998 0.828 1.000 0.682
With regard to the determinant of Z-score as dependent variable, I find relatively strong
evidence that the coefficient estimates on corporate governance are negative and
significant on all columns. This illustrates that, after controlling for other bank
characteristics and macro-economic factors, a bank with strong governance is
associated with higher risk taking. This result supports the hypothesis (2) that bank
35
governance play a role that is more proactive than reactive. In addition, the results in
Table (7) provide at least some assurance that the negative association between bank
governance and risk taking is not being induced by obvious model misspecification.
5.4 Governance components and risk taking - OLS estimation

As corporate governance components tend to be highly correlated, correlated omitted
variables remain a concern in this chapter. I attempt to mitigate this concern by focusing
on how the individual components affect risk taking. In Table (8), I replace the
aggregate governance score with individual components to test the relationship between
bank governance and risk taking. The coefficients on these bank attributes variables
offer some important insights. Among seven attributes of corporate governance, board
size (2BS) has a negative coefficient across different specifications, which supports that
intermediate board bank boards (greater than 6 but fewer than 13) involve with more
risk-taking. This result is consistent with the evidence by Pathan (2009) and De Andres
and Vallelado (2008) in banking sector.
The governance literature argues that the optimal board size should balance advisory
needs with the costs of decision-making. More directors in boards are able to assign
more people to supervise and monitor on management decisions. Especially for
independent directors, they should be endowed with the knowledge, incentive and
abilities to discipline and advise managers, thus enabling to reduce the conflicts of
interest between insiders and shareholders. Large banks have many subsidiary boards
makes the role of the parent board in dealing with complexity less clear. Adams and
Mehran (2012) argue that large boards may be beneficial due to additions of directors
with subsidiary directorships may add value as complexity increases. Small board may
not able to monitor the complexity organization. Nevertheless, larger boards are not
more valuable over time. Complexity can explain the positive relation between board
size and risk taking due to banks engage diversify activities while increase risk exposure
over time. In addition, negative relation between bank performance and board size is
36
commonly finding in previous literatures due to less communication and coordination.
Elyasiani and Zhang (2015) find a negative relationship between BHC market based
risk measures and busy boards, indicating that BHCs with more busy directors have
lower total, market, and idiosyncratic risk. Therefore, since shareholders have
incentives to take more risk, strong bank boards (measured by board size) can be
expected to associated with bank risk taking positively.
37
Table 8: The relationship between the composition of corporate governance and risk taking (Z-score) - OLS
(1) (2) (3) (4) (5) (6) (7) (8)
Dependent variable ZS ZS ZS ZS ZS ZS ZS ZS
varivariable
1INDIV -0.017 0.628
(-0.01) (0.45)
2BS -1.996*** -1.390**
(-2.77) (-1.99)
3DUAL 6.619*** 6.821***
(3.61) (3.73)
4TOP10 18.61*** 19.50***
(2.95) (2.74)
5 MH -5.644 1.996
(-0.73) (0.24)
6FORE 0.086 0.659
(0.07) (0.53)
7AUDIT -2.474 -3.378**
(-1.58) (-2.22)
ETA 1.881*** 1.844*** 1.825*** 1.889*** 1.881*** 1.884*** 1.896*** 1.832***
(13.09) (13.04) (13.07) (13.28) (13.22) (13.19) (13.35) (13.44)
LNTA -9.277*** -8.572*** -9.662*** -10.41*** -9.544*** -9.292*** -9.138*** -9.864***
(-2.90) (-2.71) (-3.11) (-3.25) (-2.98) (-2.91) (-2.88) (-3.23)
PE 0.190 0.209 0.227 0.155 0.176 0.190 0.168 0.215
(0.30) (0.34) (0.38) (0.25) (0.28) (0.31) (0.27) (0.37)
ROAA 0.961** 1.004** 0.933** 0.915** 0.956** 0.959** 0.931** 0.889**
(2.11) (2.26) (2.13) (2.03) (2.13) (2.13) (2.07) (2.09)
LNDEP 8.704*** 8.091** 8.224*** 9.366*** 8.882*** 8.722*** 9.150*** 8.897***
38
(2.69) (2.54) (2.62) (2.91) (2.76) (2.71) (2.85) (2.90)
GDP -0.0604 -0.0971 -0.133 -0.0776 -0.0638 -0.0593 -0.0704 -0.183
(-0.42) (-0.68) (-0.94) (-0.54) (-0.44) (-0.41) (-0.49) (-1.32)
INF 0.243 0.290 0.0610 0.205 0.236 0.245 0.247 0.0652
(0.82) (1.00) (0.21) (0.70) (0.81) (0.83) (0.85) (0.23)
INT -0.519 -0.536 -0.757 -0.458 -0.508 -0.520 -0.477 -0.658
(-0.99) (-1.05) (-1.50) (-0.89) (-0.99) (-1.01) (-0.93) (-1.34)
Constant 20.95 21.13 31.07* 19.28 23.90 20.84 13.16 15.84
(1.23) (1.26) (1.85) (1.14) (1.37) (1.21) (0.75) (0.89)
Year effect Yes Yes Yes Yes Yes Yes Yes Yes
Observations 372 372 372 372 372 372 372 372
F test 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
R 0.594 0.605 0.616 0.594 0.594 0.594 0.601 0.634
Note: ZS is the Z-score, calculate as [Average (Returns) + Average (Equity/Total assets)] / Standard deviation (Equity/Total assets). LLP is loan loss provision in natural logarithem. LNTA is total assets in natural logarithem. ETA is the ratio of
equity to asset. PE is the ratio of market price to earnings per share. ROAA is the ratio of profit to average assets. LNDEP is natural logarithm of the amount of deposit. GDPG is GDP growth rate. INF is the inflation rate. INT is the lending
interest rate. 1NDIV is 1 if board controlled by more than 50% independent directors and 0 otherwise. 2BS is 1 if the board size greater than 6 but less than 13 and o otherwise. 3DUAL is 1 if the chairman and CEO are not the same person and
0 otherwise. 4TOP10 is 1 if there are no relationships among the top ten shareholders and 0 otherwise. 5MH is 1 if management ownership is greater than 1% but less than 30% and 0 otherwise. 6FORE is 1 if foreign investor ownership is greater
than zero and 0 otherwise. 7AUDIT is 1 if external audited by one of the Big 4 audit firm or their joint ventures and 0 otherwise. CG is the score of internal corporate governance by aggregate seven attributes.
39
An alternative explanation for why banks with more board members experienced high
risk taking is that board members encouraged managers to raise equity capital during
the crisis period to avoid regulatory intervention. However, raising equity capital is
costly during the crisis period and may cause a wealth transfer from shareholders to
debtholders. Erkens et al. (2012) find that the wealth transfer from existing shareholders
to debtholders due to equity capital raisings was substantial. Non-equity stakeholders
such as debtholders and regulators, which often prefer conservative investment, may
influence investment policy for their own benefit. The conflicts between bank manager
and shareholders would lead to risk taking varies within different corporate governance
structure (Laeven and Levine, 2009). Strong governance dampens the magnitude and
the importance of private benefit to those stakeholders, resulting in less forgoing of
positive net present value risky investment.
The coefficient on board independence is insignificant, which is consistent with the

finding of Erkens et al., (2012). If a bank with more independent board members,
strategic decisions should improve due to the counseling skills of the members
complement those of the CEO. Adams and Mehran (2012) also find that board
independence is not related to bank performance. My result is in contrast to the work
of Minton et al. (2014), they find that the fraction of independent financial experts is
positively related to several measures of risk for U.S. commercial bank. Besides, Liang
et al. (2013) also suggest that the proportion of independent direct has significantly
positive impacts on bank asset quality. However, I focus exclusively on the markets
where data about insolvency risk is widely available.
In addition, the Big 4 Audit firm (7AUDIT) also has a negative coefficient across
different specifications, which supports that banks with audited by Big 4 audit firm
involve with more risk-taking. Agency theory suggests that managers have incentives
to avoid risk, while shareholders prefer excessive risk. Firms with weaker governance
40
structures have greater agency problems, as a result perform worse (Core et al., 1999).
If a bank is audited by an industry specialist for the controlling accounting quality,
which may encourage shareholder-focused corporate risk-taking. Shareholders are
reluctant to monitor the complex accounting information due to a commitment problem
that may be exacerbated by unobservable tail risk (Bolton et al., 2015). Banks audited
by a Big 4 audit firm display a high financial stability than banks audited by non-Big 4
audit firm. My result thus in line with Bouvatier et al. (2014), they find that Big 4 firms
do not contribute to improving the quality of banks’ financial statement. Thus, high
quality auditing could enhance bank governance and thus act as one of mechanisms to
associated with higher bank risk-taking.
Furthermore, the relationship between top 10 shareholders (4TOP10) has a positive

coefficient across different specifications. These findings suggest that banks with no
relationship among top 10 shareholders associated with lower risk taking. The results
largely consistent with the findings in Laeven and Levine (2009), who find that bank
risk is generally higher in banks that have large owners with substantial cash flow rights.
Larger shareholders have power and incentives to reduce the discretions enjoyed by
managers. Besides, other stakeholders have less incentive in monitoring bank risk
taking for their self-interest (Bolton et al., 2015). Better corporate governance mitigates
the risk of taking of private benefits from larger shareholder (Morck et al., 2000).
Furthermore, the dominant shareholders may instruct lower-layer departments to take
less risks and tunnel gains to upper-layer departments in a pyramid of banks. Therefore,
bank with strength of corporate governance, represent as no relationship among top 10
shareholders, associated with lower risk taking.
5.5 Governance components and risk taking - GMM estimation

Following De Andres and Vallelado (2008) and Liang et al. (2013), the generalized
method of moments (GMMs) is being used to control for the potential endogeneity
problem for each governance components and risk taking. Table (9) reports the result
41
from two-step system estimator with adjusted standard error for potential
heteroskedasticity proposed by Blundell and Bond (1998).
It is well recognizing that the GMM estimation can take accounts for the unobserved
heterogeneity and the dynamic nature of panel data. I use lagged governance component
variables and lagged other control variables as instruments. The intuition is that
governance variables in earlier years could not have resulted from bank risk taking in
subsequent years. Therefore, endogeneity concern is unlikely. Since out sample size is
not large, I use the adjustment for small sample as in Windmeijer (2005).
The column (2) of Table (9) shows that board size (2BS) has a significantly negative
relationship with Z-score at the 1% level across different specifications, which is
consistent with above OLS finding and a number of empirical studies (e.g. Anginer et
al., 2016; Pathan, 2009; and De Andres and Vallelado, 2008). The strong negative
relationships suggest that intermediate boards represent efficient governance and align
with the shareholder’s preference on bank risk taking.
42
Table 9: The relationship between the composition of corporate governance and bank risk (Z-score) - GMM
(1) (2) (3) (4) (5) (6) (7) (8)
Dependent ZS ZS ZS ZS ZS ZS ZS ZS
Lag.ZS
variable 0.950*** 0.943*** 0.955*** 0.949*** 0.952*** 0.952*** 0.949*** 0.895***
(200.32) (81.87) (237.00) (196.44) (158.54) (167.11) (163.89) (24.30)
1INDIV -0.139 -0.394
(-0.28) (-0.23)
2BS -0.463* -2.243*
(-1.76) (-1.89)
3DUAL -2.003*** -2.221
(-4.38) (-0.75)
4TOP10 0.166 2.683
(0.77) (1.65)
5MH -0.461 -2.244
(-1.17) (-1.51)
6FORE 0.295 4.302*
(1.00) (1.71)
7AUDIT 0.167 1.705
(0.66) (1.21)
ETA -0.099*** -0.129*** -0.104*** -0.096*** -0.100*** -0.113** -0.076*** 0.131***
(-4.76) (-3.47) (-2.90) (-3.82) (-4.95) (-2.67) (-3.37) (5.48)
LNTA 0.635*** 0.144 0.702*** 0.537* 0.544* 0.813** 0.655** -1.548
(2.78) (0.66) (2.88) (1.99) (2.00) (2.69) (2.50) (-1.56)
PE -4.045*** -3.009*** -4.128*** -3.954*** -4.101*** -3.974*** -3.825*** -2.042***
(-15.50) (-4.79) (-23.03) (-13.99) (-16.44) (-16.91) (-13.97) (-3.19)
ROAA 1.946*** 1.833*** 1.783*** 1.923*** 1.869*** 1.816*** 1.592*** 1.139***
(8.26) (5.16) (10.00) (7.84) (8.46) (6.87) (6.29) (3.97)
43
LNDEP 1.089*** 1.165*** 1.017*** 1.130*** 1.148*** 0.896*** 1.028*** 2.558**
(4.87) (5.42) (4.24) (4.36) (4.46) (2.99) (4.56) (2.52)
GDP 0.006 0.046** 0.016 0.004 0.006 0.007 0.007 0.017
(0.40) (2.39) (0.96) (0.28) (0.40) (0.50) (0.39) (0.81)
INF 0.079*** 0.141** 0.064*** 0.072*** 0.066*** 0.069*** 0.054** 0.248***
(5.12) (2.70) (4.30) (4.35) (3.52) (2.84) (2.70) (2.75)
INT -0.179** -0.429*** -0.194** -0.164** -0.174** -0.167* -0.0957 -0.493***
(-2.53) (-3.13) (-2.28) (-2.14) (-2.06) (-1.94) (-0.86) (-5.34)
Constant -8.068*** -4.483 -5.549*** -7.585*** -7.120*** -8.345*** -8.817*** -5.304
(-6.87) (-1.31) (-3.95) (-5.94) (-5.37) (-6.73) (-6.59) (-1.09)
Observations 321 321 321 321 321 321 321 321

F test 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Ar1 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Ar2 0.564 0.382 0.565 0.559 0.573 0.539 0.505 0.319
Hansen 0.746 1.000 0.764 0.738 0.760 0.752 0.732 1.000
44
The column (3) of Table (9) illustrates the effects of CEO chairman duality (3DUAL) on
bank risk taking. The result shows that the CEO chairman duality has a significantly
negative effect on the bank risk taking, meaning that banks operating in non CEO
chairman duality are more risk taking than those operating in CEO chairman duality
structure. The result is consistent with the evidence of Pathan (2009), which find that
CEO power (CEO’s ability to control board decision) negatively affects bank risk
taking. The presence of CEO chairman duality may result in greater managerial
discretion to implement conservative investment strategy. This can give rise to a
negative relation between governance and risk taking. In addition, Anginer et al. (2016)
also find that banks with shareholder-friendly corporate governance, in terms of
separation of the CEO and chairman roles, is associated with higher risk taking, and the
relationship is especially strong for banks located in developed countries. A board not
chaired by the CEO is less easily captured by management, and expected to choose
riskier investment as the risk taking incentives of shareholders. More risky investments
may increase the expected value of shareholders’ wealth, analogously to the positive
effect on stock market valuation.
5.6 Interactive effects: corporate governance and bank performance

So far, I have investigated the effect of corporate governance on bank risk taking
controlling for other control variables. I follow up with additional investigation with
possible interaction effects of corporate governance and bank performance on risk
taking. To do this analysis, I have defined variables to measure the interaction effects.
I construct one main variables CG*ROAA, which is constructed by the interaction
between the score of governance and the return on average asset. Table (10) reports the
estimation results of Equation (3) to test the relationship between the interaction term
(CG*ROAA) and bank risk taking by OLS estimation.
45
Table 10: The relationship between the interaction term and risk taking (Z-score) - OLS
(1) (2) (3) (4)
Dependent
ZS ZS ZS ZS
variable
CG -0.257 -0.415 -0.392 -0.473
(-0.42) (-0.59) (-0.60) (-0.67)
ETA 2.010*** 1.921*** 1.978*** 1.933***
(15.98) (13.30) (14.63) (13.41)
LNTA -8.617*** -10.21*** -8.479*** -10.02***
(-2.94) (-3.11) (-2.74) (-3.08)
PE -0.392 0.344 -0.164 0.53
(-0.77) (0.56) (-0.29) (0.85)
ROAA 4.734*** 4.467*** 4.666*** 4.187**
(3.31) (2.66) (3.02) (2.51)
LNDEP 10.08*** 11.03*** 10.32*** 11.23***
(3.43) (3.39) (3.34) (3.47)
CG*ROAA -0.962*** -0.921** -0.923** -0.857**
(-2.64) (-2.14) (-2.34) (-2.00)
GDP 0.025 0.108
(0.38) (0.76)
INF 0.179 0.508*
(1.40) (1.74)
INT 0.238 -0.15
(0.85) (-0.29)
Constant -4.400 5.235 -13.42 -2.88
(-0.45) (0.34) (-1.22) (-0.17)

F test 0.000 0.000 0.000 0.000
R 0.557 0.599 0.560 0.600
The coefficients of CG*ROAA variable in Table (10) regressions were negative and
significant at least at the 5% level. These results indicate that the increase in bank
governance level while having a better performance enhanced bank risk taking
46
significantly, and the results remain significant even after controlling for the size and
other bank characteristics. This finding confirms hypothesis (4). Results were
consistent in the risk estimates i.e., in the Table (5), (6) and (7) regressions with the
expected sign and significant statistical significance.
In Table (11), I present the firm fixed effects estimates (with t-statistics adjusted for
firm level clustering). The fixed effects estimations go a long way toward dismissing
omitted variables explanations as sources of endogeneity. As the result, there is still
evidence of a negative relation between the interaction term (CG*ROAA) and bank risk
taking.
Table 11: The relationship between the interaction term and risk taking (Z-score) - FE
(1) (2) (3) (4)
Dependent
ZS ZS ZS ZS
variable
CG -0.172 0.114 -0.201 -0.002
(-0.28) (0.19) (-0.33) (-0.00)
ETA 2.030*** 1.963*** 2.017*** 1.956***
(16.20) (16.16) (15.94) (15.89)
LNTA -8.454*** -10.53*** -8.280*** -10.35***
(-2.87) (-3.68) (-2.80) (-3.61)
PE -0.447 0.0709 -0.342 0.132
(-0.88) (0.14) (-0.66) (0.25)
ROAA 4.725*** 4.735*** 4.734*** 4.617***
(3.34) (3.44) (3.32) (3.33)
LNDEP 9.754*** 9.471*** 9.699*** 9.605***
(3.30) (3.33) (3.28) (3.36)
CG*ROAA -0.961*** -1.046*** -0.949*** -0.998***
(-2.66) (-2.96) (-2.61) (-2.80)
GDP 0.0154 -0.073
(0.25) (-0.60)
INF 0.177 0.194
(1.50) (0.78)
INT 0.088 -0.495
(0.34) (-1.14)
Constant -4.67 34.36** -8.071 32.22**
(-0.54) (2.44) (-0.81) -2.02
47
F test 0.000 0.000 0.000 0.000
R 0.558 0.609 0.562 0.612
In Table (12), I present the GMM estimates (with difference and system GMM). Again,
there is evidence of a negative relation between the interaction term (CG*ROAA) and
bank risk taking. The investigations of the combined impact of corporate governance
and performance on bank risk taking strengthened my previous findings of individual
effects of corporate governance on bank risk. Most of the other bank-level
characteristics enter with their expected signs and are usually consistent with the
literature on bank risk determinants.
Table 12: The relationship between the interaction term and risk taking (Z-score) - GMM
(1) (2) (3) (4)
DIFF SYS DIFF SYS
Dependent
ZS ZS ZS ZS
variable
Lag.ZS -0.100*** 0.907*** 0.084*** 0.915***
(-5.84) (181.90) (3.76) (18.51)
CG -1.415* 0.123 2.790*** 0.631
(-1.74) (0.47) (7.71) (1.12)
ETA 3.942*** -0.189*** 1.630*** -0.192**
(22.49) (-7.26) (8.04) (-2.68)
LNTA 5.650*** -0.231 -12.53*** -1.489*
(3.18) (-0.74) (-4.35) (-1.85)
PE 0.069 -1.474*** 1.138 1.477
(0.62) (-17.99) (1.61) (1.02)
ROAA 6.605*** 6.575*** 10.26*** 5.574**
(3.95) (12.12) (7.06) (2.11)
LNDEP -2.877** 1.457*** 10.99*** 1.844**
(-2.03) (4.41) (3.81) (2.15)
CG*ROAA -1.634*** -1.261*** -2.218*** -1.107*
48
(-3.48) (-6.82) (-5.39) (-1.87)
GDP -0.065 -0.461***
(-1.58) (-3.09)
INF 0.430*** 1.083***
(3.28) (5.25)
INT -1.594*** -0.791**
(-5.92) (-2.29)
Constant -11.33*** -8.409
(-8.24) (-0.77)

F test 0.000 0.000 0.000 0.000
Ar1 0.033 0.003 0.027 0.000
Ar2 0.552 0.631 0.581 0.474
Hansen 0.732 0.562 1.000 1.000
Overall, the estimations presented above were relatively robust under different
specifications. I concern the fact that the endogeneity problem associated with
governance variable in the regression may be a potential limitation to make any
conclusive comments. I attempt to correct this problem by using the GMM estimation
and the result is very close of the OLS and FE estimation. Also the chapter may suffer
from self-selectivity bias and again lack of data did not give us the opportunity to
provide further detailed robustness test. I mitigate this selection bias problem by using
the alternative risk taking variable and the results were similar to those of the Z-score
regressions.
6 Robustness test
I have conducted several additional tests to check the robustness of my results. First, I
49
re-estimate equation (2) using pooled-OLS with clustered standard errors on an
alternative risk taking measure, loan loss provision (LLP), while controlling for the
effect bank characteristics and other macroeconomic factors. In addition, the F-test
rejects the null hypothesis that the coefficients on both variables are jointly zero. The
results of Table (13) shows that governance still has a significant effect on bank risk
taking.
Table 13: The relationship between bank corporate governance and risk taking (Loan loss
provision) - OLS
(1) (2) (3) (4)
Dependent
LLP LLP LLP LLP
variable
CG -0.106*** -0.041 -0.102*** -0.046*
(-3.08) (-1.42) (-2.87) (-1.69)
ETA 0.015* 0.018*** 0.017** 0.017***
(1.83) (2.84) (2.06) (2.62)
LNTA 0.656*** 0.347*** 0.388*** 0.358***
(3.62) (2.95) (2.59) (3.03)
PE -0.029 -0.015 -0.007 -0.025
(-0.75) (-0.42) (-0.17) (-0.68)
ROAA -0.087*** -0.064** -0.111*** -0.054*
(-3.02) (-2.26) (-3.25) (-1.89)
LNDEP 0.376** 0.637*** 0.707*** 0.614***
(2.08) (5.22) (4.72) (4.99)
GDP -0.001 -0.018**
(-0.23) (-2.03)
INF -0.007 -0.027
(-0.68) (-1.47)
INT 0.029 -0.026
(1.41) (-0.79)
Constant -5.070*** -4.424*** -6.365*** -3.927***
(-8.75) (-7.89) (-11.61) (-6.54)

F test 0.000 0.000 0.000 0.000
R 0.692 0.718 0.685 0.725
50
Second, I re-estimate equation (2) using fixed effect estimation on the loan loss
provision in Table (14) as the pooled-OLS specification could be problematic because
risk taking can be endogenous. The results are unchanged after the inclusion of firm
fixed effects, suggesting that time invariant unobserved firm characteristics cannot
explain my empirical findings. My results are robust to the alternative risk taking
measure in terms of economic and statistical significance. Results show that a negative
correlation between corporate governance and bank risk taking remains strong after
controlling for a long list of possible covariates.
Table 14: The relationship between bank corporate governance and risk taking (Loan loss
provision) - FE
(1) (2) (3) (4)
Dependent
LLP LLP LLP LLP
variable
CG -0.078** -0.065* -0.083** -0.066*
(-2.13) (-1.85) (-2.32) (-1.90)
ETA 0.012 0.011 0.010 0.008
(1.34) (1.26) (1.10) (0.87)
LNTA 1.065*** 0.944*** 1.051*** 0.925***
(4.75) (4.33) (4.75) (4.29)
PE -0.041 -0.009 -0.027 -0.023
(-1.08) (-0.24) (-0.72) (-0.59)
ROAA -0.070** -0.060** -0.052* -0.050*
(-2.51) (-2.13) (-1.83) (-1.77)
LNDEP -0.112 -0.060 -0.116 -0.122
(-0.50) (-0.28) (-0.52) (-0.57)
GDP -0.015*** -0.025***
(-3.31) (-2.80)
INF -0.001 -0.040**
(-0.12) (-2.19)
INT 0.032 -0.003
(1.65) (-0.11)
Constant -3.800*** -2.699** -3.578*** -0.92
(-5.82) (-2.52) (-4.80) (-0.77)
51
F test 0.000 0.000 0.000 0.000
R 0.698 0.730 0.709 0.739
Third, to further control for path dependence in the series of the loan loss provision,
remove the strict exogeneity assumption for independent variables, and eliminate the
unobserved bank-specific effects, I employ the GMM estimator for hypothesis testing.
Table (15) presents the dynamic panel regression results of corporate governance and
alternative risk taking, LLP. All specifications can pass, at the 5% significance level,
the Arellano-Bond test for zero autocorrelation in the first-differenced errors and the
Hansen test of over-identifying restrictions. The evidence in Table (15) suggests that
the strong corporate governance is still associated with higher bank risk taking.
Table 15: The relationship between the interaction term and risk taking (Loan loss
provision) - GMM
(1) (2) (3) (4)
DIFF SYS DIFF SYS
Dependent
LLP LLP LLP LLP
variable
Lag.LLP 0.270*** 0.622*** 0.354*** 0.862***
(4.34) (13.23) (4.95) (11.13)
CG -0.138*** -0.016* -0.060** -0.096**
(-7.70) (-1.81) (-2.21) (-2.39)
ETA -0.032** 0.009*** -0.021 -0.009**
(-2.16) (2.96) (-1.31) (-2.32)
LNTA 2.201*** 0.042 1.796*** -0.059
(7.10) (0.86) (3.53) (-1.58)
PE -0.128*** -0.094 0.0845** 0.026
(-2.80) (-1.54) (2.58) (0.56)
ROAA -0.062** -0.082** -0.026 0.001
(-2.57) (-2.51) (-0.54) (0.02)
52
LNDEP -1.375*** 0.394*** -1.309** 0.147
(-5.40) (10.14) (-2.69) (1.47)
GDP -0.013*** 0.010**
(-3.33) (2.04)
INF -0.013* -0.018*
(-1.94) (-1.71)
INT 0.022 0.010
(0.84) (0.59)
Constant -2.249*** 0.673
(-9.64) (0.76)

F test 0.000 0.000 0.000 0.000
Ar1 0.002 0.001 0.002 0.001
Ar2 0.051 0.235 0.224 0.375
Hansen 0.603 0.718 1.000 1.000
Fourth, I turn to empirically assess the relationship between governance individual

components and loan loss provision (LLP) in Table (16), while controlling for the effect
bank characteristics and other macroeconomic factors. Consistent with above, I find
that my results continue to be qualitatively similar to those reported in previous. Thus,
my conclusion on the relation between risk taking and governance is not sensitive to an
alternative measure of risk.
53
Table 16: The relationship between the composition of corporate governance and risk taking (Loan loss provision) - OLS
(1) (2) (3) (4) (5) (6) (7) (8)
Dependent variable LLP LLP LLP LLP LLP LLP LLP LLP
varivariable
1INDIV -0.247*** -0.260***
(-2.82) (-2.94)
2BS 0.005 -0.006
(0.13) (-0.15)
3DUAL -0.217** -0.238**
(-1.99) (-2.16)
4TOP10 -0.123 -0.107
(-1.22) (-0.96)
5 MH 0.078 0.092
(0.66) (0.71)
6FORE 0.033 -0.033
(0.53) (-0.49)
7AUDIT -0.077 -0.039
(-0.94) (-0.46)
ETA 0.0192*** 0.0180*** 0.0188*** 0.0171*** 0.0183*** 0.0178*** 0.0172*** 0.0198***
(2.99) (2.76) (2.87) (2.63) (2.78) (2.73) (2.62) (2.98)
LNTA 0.363*** 0.362*** 0.369*** 0.397*** 0.385*** 0.377*** 0.368*** 0.414***
(3.13) (3.08) (3.13) (3.29) (3.17) (3.14) (3.11) (3.36)
PE -0.028 -0.021 -0.027 -0.018 -0.019 -0.021 -0.023 -0.032
(-0.77) (-0.57) (-0.72) (-0.49) (-0.52) (-0.56) (-0.62) (-0.85)
ROAA -0.062** -0.054* -0.053* -0.051* -0.054* -0.054* -0.055* -0.058**
(-2.16) (-1.89) (-1.86) (-1.77) (-1.89) (-1.90) (-1.92) (-2.03)
LNDEP 0.620*** 0.611*** 0.610*** 0.591*** 0.592*** 0.598*** 0.612*** 0.596***
54
(5.15) (5.01) (4.98) (4.82) (4.76) (4.83) (4.98) (4.77)
GDP -0.016* -0.016* -0.015* -0.016* -0.016* -0.016* -0.017* -0.014
(-1.79) (-1.83) (-1.70) (-1.80) (-1.83) (-1.81) (-1.93) (-1.61)
INF -0.022 -0.02 -0.024 -0.026 -0.027 -0.027 -0.028 -0.016
(-1.20) (-1.51) (-1.30) (-1.42) (-1.49) (-1.46) (-1.54) (-0.90)
INT -0.039 -0.027 -0.017 -0.029 -0.028 -0.028 -0.025 -0.028
(-1.18) (-0.84) (-0.52) (-0.90) (-0.85) (-0.86) (-0.76) (-0.85)
Constant -4.238*** -4.145*** -4.085*** -4.338*** -4.242*** -4.195*** -4.186*** -4.454***
(-7.32) (-6.99) (-6.94) (-7.21) (-6.80) (-6.93) (-7.04) (-6.94)
Year effect Yes Yes Yes Yes Yes Yes Yes Yes
Observations 372 372 372 372 372 372 372 372
F test 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
R 0.727 0.722 0.726 0.721 0.722 0.722 0.723 0.732
55
7 Conclusions
Banking crises are crucial not just because of the destruction on a particular sector, but
also typically the shock waves strike the entire economy. Thus, the substantial portions
of banks’ wealth should be operated in a safe and sound manner. However, the relative
opacity of banks provides some justification for regulator and investor suspicion.
Therefore, the effectiveness of the top management team and ownership structure, and
its corporate governance systems in determining appropriate risk-taking is a critical
issue in a modern commercial bank.
This chapter examines the relationship between bank corporate governance and risk
taking, using 43 Asian banks with the latest and a wider range of panel data that cover
372 bank observations over the period from 2006 to 2014. The empirical results indicate
that the effect of strong corporate governance on bank risk is significantly negative,
which suggest that corporate governance that favors the interests of their shareholders,
is associated with higher levels of bank risk taking. Despite with OLS and fixed effect
estimations, my chapter also applies recent two-step system GMM dynamic panel data
techniques as the robustness test.
While my sample is unique in terms of the prudential regulation and similar cultural
background, so the financial incentives analyze may also play a role in explaining risk
in other businesses and stock markets. Other businesses are likely to face many of the
same governance issues, such as board composition, designing appropriate incentive to
top managers and ownership structure. All of these issues are need to take account when
establish the appropriate governance structure of other banks and businesses. In
addition, given the differences in institutions and business environment, it is certainly
possible that the governance provisions may work differently in nonfinancial firms.
Further exploration of nonfinancial firms’ specific governance attributes and criteria
may be useful.
56
In response to the financial crisis, global authorities were tightened to strengthen
corporate governance and resilience of the banking industry. Thus, improved
understanding of bank risk is essential for a range of financial market participants. My
findings highlight several important issues for policymakers in relevant economic
authorities. First, to prevent excessive risk taking, regulators should adopt a more
cautious approach to evaluate and approve bank engaged activities at the national level.
If banking regulators are committed to safeguarding banks’ asset quality, elimination of
explicit protection might be a sufficient condition. Second, to promote the stability of
economy, regulators should encourage banks building a high standard of risk
management system. Third, regulator should consider using a recent innovation in
financial markets to reduce risk taking of banks’ executive (Bolton et al., 2015). The
push for increased market discipline of banks may shed light on limiting risk taking.
Indeed, market forces rather than regulation may have been more effective in mitigating
moral hazard problem (Keys et al., 2009).
57
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How the corporate governance

Emmanuel Mamatzakis and Xiaoxiang Zhang and Chaoke

Keywords: Banks, Risk taking, Corporate governance

*Department of Business and Management, School of Business, Management and

My chapter complements the existing empirical research on banking governance in

Second, my chapter increases the understanding of banking governance in an emerging

2. Literature review and hypotheses development

In addition, deposit insurance scheme is widely applied in many countries as part of a

H3: Corporate governance has no impact on bank risk taking.

Large controlling shareholders are suggested by concentrated their stakes to monitor

3.2 Measures of bank risk taking

3.3 Other explanatory variables

Diversification provides a credible signal of bank’s ability to minimize risk. In contrast,

In additional to bank-specific variables, the impact of state-level economic conditions

3.4 Empirical models

𝑅𝐼𝑆𝐾𝑖𝑡 = 𝛼 + 𝛽1 𝐶𝐺𝑖𝑡 + 𝛽2 𝐿𝑁𝑇𝐴𝑖𝑡 + 𝛽3 𝐸𝑇𝐴𝑖𝑡 + 𝛽4 𝑃𝐸𝑖𝑡 + 𝛽5 𝑅𝑂𝐴𝐴𝑖𝑡 + 𝛽6 𝐷𝐸𝑃𝑖𝑡

Table 1: Definition of variables

3.5 Endogeneity and Generalized Method of Moments (GMM)

As discuss on Section 3, I obtain the score of corporate governance by taking the

Table 3: Descriptive statistics for main model variables

Panel B: Main model variables

Table 4: The matrix of Pearson correlation coefficients

GDP INF INT

Year effect No Yes No Yes

The board of directors is widely recognized as the cornerstone of an effective

Concerning the control variables, not surprisingly, size is an important determinant of

Some-what surprisingly, greater price to earning ratio negatively influences Z-score,

5.2 Governance and risk taking - Fixed-effect within estimation

Year effect No Yes No Yes

5.3 Governance and risk taking - GMM estimation

Observation 279 321 279 321

5.4 Governance components and risk taking - OLS estimation

The coefficient on board independence is insignificant, which is consistent with the

Furthermore, the relationship between top 10 shareholders (4TOP10) has a positive

5.5 Governance components and risk taking - GMM estimation

Observations 321 321 321 321 321 321 321 321

5.6 Interactive effects: corporate governance and bank performance

Year effect No Yes No Yes

Observation 279 321 279 321

Year effect No Yes No Yes

Observation 279 321 279 321

Fourth, I turn to empirically assess the relationship between governance individual

Ghosh, A., 2015. Banking-industry specific and regional economic determinants of

Laeven, L., Levine, R., 2007. Is there a diversification discount in financial

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