Are board characteristics relevant for banking efficiency? Evidence from the US

Author:Yulia Titova
DOI:https://doi.org/10.1108/CG-09-2015-0124
Pages:655-679
Publication Date:01 Aug 2016
Are board characteristics relevant for
banking efficiency? Evidence from
the US
Yulia Titova
Yulia Titova is based at
IESEG School of
Management, Paris,
France.
Abstract
Purpose This paper aims to examine whether board-related characteristics matter for cost efficiency
in banking sector.
Design/methodology/approach This study uses a sample of publicly traded US commercial banks
and savings institutions to estimate a relationship between cost efficiency measured by stochastic
frontier analysis and a set of board-related characteristics for the period 2007-2013.
Findings An inverted U-shape relation is found between board size and efficiency. Thus, there is a
trade-off between costs and benefits of larger boards. Optimal board size is higher for banks with more
complex operations. This study also observed an inverted U-shape relation between board
independence and cost efficiency. The banks where the Chairman also executes the CEO responsibility
show lower efficiency. However, a higher proportion of independent board members in banks with
unitary leadership structure may mitigate the conflict of interest and lower efficiency stemming from
CEO duality.
Research limitations/implications This study’s evidence supports the Basel Committee on Banking
Supervision emphasis on advising a board composition that provides for a sufficient degree of director
independence.
Practical Implications The results are relevant for banks and their external and internal
stakeholders. Banks may adjust their current board characteristics to increase the board effectiveness.
Externally, potential investors can evaluate the quality of corporate governance of banks before making
investment decisions. The empirical findings can also be useful for regulators imposing corporate
governance codes in banking.
Originality/value To the best of the authors’ knowledge, this is the first paper to provide empirical
evidence on the impact of board characteristics on bank efficiency for a wide panel of US banks.
Additionally, a comprehensive set of board-related variables is used.
Keywords Corporate governance, Board of directors, Banking efficiency,
Stochastic frontier analysis
Paper type Research paper
1. Introduction
The recent decade has witnessed increased attention of stakeholders and regulatory
bodies to the corporate governance practices, fostered by the publication of Organisation
for Economic Co-operation and Development (OECD) corporate governance principles
(2004) and Sarbanes–Oxley Act (2002), which were in turn triggered by scandals in Enron,
Worldcom and Parmalat. These events undermined investor confidence and thus created
obstacles to transferring capital to its best use. One of the solutions to this issue is
corporate governance. As mentioned by Tanna et al. (2011), OECD considers governance
as an important element of the economic efficiency. Basel Committee on Banking
Supervision (BCBS, 2006;BCBS, 2014) echoes this statement:
Enhancements to the framework and mechanisms for corporate governance should be driven
by such benefits as improved operational efficiency, greater access to funding at a lower cost,
and an improved reputation (p. 21).
JEL classification – G21, G32
Received 17 September 2015
Revised 4 March 2016
Accepted 11 April 2016
DOI 10.1108/CG-09-2015-0124 VOL. 16 NO. 4 2016, pp. 655-679, © Emerald Group Publishing Limited, ISSN 1472-0701 CORPORATE GOVERNANCE PAGE 655
Meanwhile, despite a significant body of research in non-financial sectors, very few papers
address governance issues in financial industry in general and in banking in particular,
although the key aspects of corporate governance apply to banking industry (de Andrés
and Vallelado, 2008). Furthermore, the topic remains relevant and sparks continuous
interest from regulators, as evidenced by regular updates published by the Basel
Committee, including the most recent consultative document (BCBS, 2014).
There is even scarcer evidence on the link between performance and corporate
governance in banking, although the BCBS document emphasizes that sound corporate
governance should contribute to it: “a bank’s board of directors and senior management
are primarily responsible and accountable for the performance of the bank” (BCBS, 2006,
p. 19, par. 57). Moreover, the performance is typically measured by financial ratios (return
on equity [ROE] and cost-to-income ratio are quite common) which are restrictive because
they combine both output and input efficiencies (Pi and Timme, 1993). Financial ratios do
not control for input prices and output mix (Halkos and Salamouris, 2004). Moreover, the
efficiency of banks measured by accounting ratios, such as ROE or return on assets (ROA),
is unstable and is, therefore, challenged as being suitable to determine productive
efficiency of banks (Maudos et al., 2002). Efficiency derived from production frontier
techniques helps overcome this drawback because “frontier analysis provides an overall,
objectively determined, numerical efficiency value and ranking of firms” (Berger and
Humphrey, 1997). Consequently, this property makes the scores estimated by frontier
techniques particularly useful for policy recommendations (Berger and Humphrey, 1997).
Such an approach is therefore relevant for our study because one of the motivations is to
verify the guidelines set out in BCBS (2014) with respect to board attributes. Nevertheless,
frontier estimation procedures are employed in very rare studies on corporate governance
in banking.
The recent bibliometric analysis (Lampe and Hilgers, 2015) has put in evidence that the two
most important and widely adopted and diffused methods of efficiency and performance
measurement are stochastic frontier analysis (SFA) and data envelopment analysis (DEA).
Both methods allow for benchmarking because they estimate the efficiency of each
organization relative to a best-performing peer. Whereas Berger and Humphrey (1997)
point out that it is impossible to identify a dominant approach between the two because of
the uncertainty regarding the true efficiency; Lampe and Hilgers (2015) identify that one of
the most influential application areas in banking is SFA.
SFA is a stochastic model in which inefficiency can be distinguished from noise, as
opposed to the deterministic DEA, where all deviations from the frontier are considered as
inefficiency, thus making it quite sensitive to outliers and measurement errors. The first
advantage of the SFA can therefore be considered in its ability to disentangle a random
error term and controllable inefficiency. This assumption seems to be more consistent with
empirical data (Pi and Timme, 1993).
The second advantage of SFA, in its Battese and Coelli (1995) specification, is that it allows
a simultaneous estimation of the parameters of the efficiency frontier and the coefficients of
inefficiency model. This procedure is assumed to be superior to a two-step approach due
to a higher reliability of estimated efficiency (Lozano-Vivas and Pasiouras, 2010;Battese
and Coelli, 1995;Greene, 1993;Lensink and Meesters, 2014;Wang and Schmidt, 2002)[1].
Several factors are likely responsible for a relative lack of empirical evidence on corporate
governance practices in banks. First, the banking sector is more heavily regulated
compared to others, with government authorities reducing the flexibility of managerial
decisions. Therefore, the role of corporate governance has been consistently downplayed
as regulation has been considered a substitute, at least a partial one, of internal monitoring
mechanisms (Booth et al., 2002). The interaction between corporate governance,
regulation and bank risk taking is thoroughly discussed by Laeven and Levine (2009).
Second, peculiar features of the banking business model, in particular high leverage, make
PAGE 656 CORPORATE GOVERNANCE VOL. 16 NO. 4 2016

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