Committee Independence and Financial Institution Performance during the 2007–08 Credit Crunch: Evidence from a Multi‐country Study

• DOI: http://doi.org/10.1111/j.1467-8683.2011.00884.x
• Date: 01 September 2011
• Published date: 01 September 2011
• Author: Huimin Chung,Chih‐Liang Liu,Yin‐Hua Yeh

Committee Independence and Financial

Institution Performance during the 2007–08

Credit Crunch: Evidence from a

Multi-country Study

Yin-Hua Yeh, Huimin Chung, and Chih-Liang Liu*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Using the data of the 20 largest f‌inancial institutions from G8 countries, we explore whether the

performance is higher for f‌inancial institutions with more independent directors on different committees during the

2007–08 f‌inancial crisis. We also examine the moderating effect of a country-level civil law dummy and f‌irm-level excessive

risk-taking behaviors on the independence-performance relationships.

Research Findings/Insights: The empirical evidence shows that the performance during the crisis period is higher for

f‌inancial institutions with more independent directors on auditing and risk committees. The inf‌luence of committee

independence on the performance is particularly stronger for civil law countries. In addition, the independence-

performance relationships are more signif‌icant in f‌inancial institutions with excessive risk-taking behaviors.

Theoretical/Academic Implications: Our f‌indings complement existing works to partially resolve the independence-

performance relationship controversies by exploring the independence of different committees. The moderating effects of

civil law countries and excessive risk-takingf‌irms further address the governance environment’s role in the effectiveness of

director independence.

Practitioner/Policy Implications: Our results provide important policy implications for f‌inancial institutions. The regula-

tion authorities should enhance regulation compliance to improve director independence, particularly for auditingand risk

committees in banking industry. Independent directors in the banking industry are supposed to put more emphasis on

excessive risk-taking behaviors, as the f‌inancial institutions prof‌it from risk-bearing earnings.

Keywords: Corporate Governance, Committee Independence, Legal Origin, Excessive Risk-taking, Financial Crisis

INTRODUCTION

This study explores whether the performance during the

2007–08 f‌inancial crisis is higher for f‌inancial institu-

tions with more independent directors on their board

committees. Using hand-collected data of f‌inancial institu-

tions from the G8 countries, the empirical evidence shows

that independence in auditing and risk committees helps

improve crisis performance. We also f‌ind that such an effect

is particularly signif‌icant for civil law countries, which are

characterized as the legal origin with poor shareholder

protection practices. In addition, committee independence is

found to provide higher performance for those f‌inancial

institutions having more excessive risk-taking behaviors. We

suggest that the effect of committee independence on f‌inan-

cial institution performance is signif‌icant not only during

the crisis, but also particularly in civil law countries and

excessive risk-taking f‌inancial institutions.

Although the relationship between f‌inancial institution

performance and board of directors’ independence has been

extensively explored, the effect of the independence from

different board committees remains controversial. Since

independent director appointments are prevalent in many

countries, the recent global f‌inancial crisis presents a natural

laboratory to examine which committee independence helps

improve crisis-period performance. This study explores the

*Address for correspondence: National Yunlin University of Science and Technology,

no. 123, University Road, Sec. 3, Douliou, Yunlin 64002, Taiwan. Tel: 886-5-5342601;

Fax: 886-5-5312079; E-mail: chlliu@yuntech.edu.tw

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Corporate Governance: An International Review, 2011, 19(5): 437–458

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00884.x

effectiveness of independent directors on different board

committees, and our evidence shows that f‌inancial institu-

tion performance during the f‌inancial crisis is positively

related to the independence of auditingand risk committees.

The independence-performance relationships are affected

by country-level differences. Judge, Gaur, and Muller-Kahle

(2010) indicate that the effect of governance mechanisms

varies in different legal system environments. Aggarwal,

Erel, Stulz, and Williamson (2008) f‌ind that board indepen-

dence is positively related to f‌irm value only in countries

with poor investor protections. Since ownership structure

and the level of investor protection are quite different

between common-law and civil-law countries (La Porta,

Lopez-de-Silanes, Shleifer, & Vishny, 1997), we therefore

examine whether the relationship between committee inde-

pendence and f‌inancial institution performance is inf‌lu-

enced by their legal origins. The evidence on the positive

moderating effect of a civil-law environment on the

independence-performance relationships is consistent with

Durnev and Kim (2005) in that f‌irms operating under poor

legal environments still have high valuations if they adopt

high quality governance. Our results also conf‌irm La Porta,

Lopez-de-Silanes, Shleifer, and Vishny (1998), whereby

f‌irms seem to adapt to poor legal frameworks so as to estab-

lish better eff‌icient governance practices.

Firm-level differences such as the level of risk-taking

in the banking industry also affect the independence-

performance relationship. Since f‌inancial institutions make

prof‌its by bearing a certain level of risk, depositors and

stakeholders are burdened with (un)discernible costs from

the credit crunch, and exploring the failure of f‌inancial insti-

tution governance is therefore of crucial importance (Macey

& O’hara, 2003). Adams, Hermalin, and Weisbach (2010)

indicate that one future topic that needs to be explored on

the issue of the f‌inancial crisis is how boardmembers matter.

A board’s incapability to monitor its f‌irm’s risk-taking level

is the major cause for economic crises (Greenspan, 1999;

Mitton, 2002; Stiglitz, 1998). One of the problems causing the

2007–09 credit crunch was excessive risk-taking behaviors.1

To understand the role of independent directors in f‌inancial

institutions, we explore the moderating effect of excessive

risk-taking behaviors in the independence-performance

relationship. Our evidence shows that excessive risk-taking

behaviors provide higher performance during the normal

period of 2005–06, while the effects are inverse during the

2007–08 crisis. In addition, the independence-performance

relationship is particularly signif‌icant for f‌inancial institu-

tions with more excessive risk-taking behaviors. We provide

potential contributions as follows.

First, the f‌indings that f‌inancial institution performance

is higher only for auditing and risk committees partially

resolve the anomalies of the independence-performance

relationship. Although previous crisis-related studies have

shown that performance is lower for f‌irms with poor gover-

nance (Baek, Kang, & Park, 2004; Joh, 2003; Lemmon & Lins,

2003; Mitton, 2002), these examinations are limited by the

“board independence in non-f‌inancial institution” frame-

work, and several studies f‌ind inconsistent results with dif-

ferent data settings. Instead of focusing on the board of

directors’ independence, we focus on the role of indepen-

dent directors on different board sub-committees, including

the auditing, nominating, compensation, and risk commit-

tees. Since each committee functions well only for specif‌ic

criteria and the expertise and professions of the independent

directors on different committees are varied, they can con-

tribute to the performance from different dimensions. The

independence-performance relationship therefore depends

on the problems faced by the f‌irm and the capability of the

independent directors responsible for resolving it. Our

results suggest that only the independence of auditing and

risk committees in f‌inancial institutions helps improve their

crisis-period performance.

Second, this research examines the independence-

performance relationship with multi-country settings for

2005–06 (ordinary time) and 2007–08 (f‌inancial crisis). One

of the problems of governance-related studies is that the

literature focuses on the relationship between performance,

governance, or f‌inancial crisis under a single country

only (Hagendorff, Collins, & Keasey, 2007). In contrast, our

research encompasses committee independence with multi-

national settings, instead of one single country.

Aside from examining the independence-performance

relationship with multi-country settings, with committee

independence data, and with a f‌inancial institution sample,

we also partially resolve the relationship controversies

by exploring the moderating effect of country- and f‌irm-

level differences. Since governance practices vary between

common-law and civil-law systems, the effectiveness

of independent directors on each committee is different.

We therefore examine the moderating effect of a civil-law

dummy on the independence-performance relationship. The

excessive risk-taking behaviors in f‌inancial institutions

are also taken as the f‌irm-level moderator. We f‌ind that the

inf‌luence of committee independence on f‌inancial institu-

tion performance is particularly signif‌icant in excessive risk-

taking f‌inancial institutions and countries with a civil-law

environment. Such evidence explains that the effects of

board independence are largely different after considering

various governance environments.

There are several motivations for independent directors to

improve f‌inancial institution performance. First, indepen-

dent directors provide not onlymonitoring and disciplining,

but also have expertise in the decision making process.

Anderson and Fraser (2000) suggest that a board’s effective-

ness in its monitoring function is determined by its indepen-

dence. Since independent directors are in a better position

to discipline management, they are expected to be more

effective in prohibiting opportunistic behaviors, thereby

reducing potential agency conf‌licts (Altunbas, Evans, &

Molyneux, 2001; Hermalin & Weisbach, 1998; Kren & Kerr,

1997; Ryan Jr & Wiggins, 2004; Bebchuk, Grinstein, & Peyer,

2010; Choi, Park,& Yoo, 2007; Pathan, 2009). Hossain, Cahan,

and Adams (2000) indicate that the value of independent

directors is related to their capability of making objective

decisions. We therefore suggest that independent directors

can help a f‌irm by actively providing their expert prestige

and monitoring power.

The competitive directorship market in the banking

industry causes independent directors to be actively con-

cerned more about their own reputations (Pathan, 2009).

Gilson (1990) f‌inds that directors who leave distressed f‌irms

hold fewer directorships in the future. The need to maintain

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