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

• DOI: https://doi.org/10.1108/CG-09-2015-0124
• Date: 01 August 2016
• Pages: 655-679
• Published date: 01 August 2016
• Author: Yulia Titova
• Subject Matter: Strategy,Corporate governance

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

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