Corporate Governance Impact on Banking Efficiency

Corporate Governance means to give direction, taking control or doing administration in an organization. It sets rules and regulations for a manager of an organization who works ultimately for the rights of the current and the potential stakeholders. The structure of a corporate governance designate the powers, rights and responsibilities among the different groups in a firm for example, board of governance, managers, and other stakeholders and give them policies and procedures which give them assistance while making decision on corporate affairs. It also gives a guideline to the corporate managers by setting up these rules and procedures that how to approach for getting the goals and objectives of an organizations and monitor their performance. In the light of above mentioned description of corporate governance and its importance, one cannot ignore its significance while measuring the efficiency or a performance of a firm.

In current state of the economy of Pakistan, which troubled for the last one year; ideally it would be more desirable that one should look at the governance issues at macro level for Pakistan. As a famous economist, Dr Shahid Javaid Burki- a long observer of Pakistan’s economy has recently stated “Pakistan can generate a greater bounce in its economy than India by creating better governance. It has occurred before in the country’s difficult economic history and could happen again.” (Improved Governance: Dawn, 12th, October 2010).

In this paper, initially we look at closely the efficiencies of banking sector in Pakistan in the light of corporate governance and measure the impact of corporate governance practices on the overall banking sector efficiencies. Rehman et al (2010) studied the impact of corporate governance on the performance of Chemical and Pharmaceutical sectors of Pakistan. The results of their study showed that there is a significant impact of corporate governance only on return on equity of pharmaceutical sector of Pakistan. Corporate governance has become an issue of global significance. The corporate governance and its practices are getting popularity in all over the globe. Several entities are established over the last one decade in world, which are establishing the code and practices of corporate governance for the organizations. In Pakistan, SECP has established and issued the first Code of Corporate Governance for Pakistani corporate sector in March 2002. Afterward it was subsequently implemented in all the listed companies of three stock exchanges in Pakistan. In two years time, the Pakistan Institute of Corporate Governance in public private partnership was established by SECP

LITERATURE REVIEW

In 2007, a survey was conducted by International Finance Corporation and SECP to find out the current practices of corporate governance in corporate sector of Pakistan. The results of the survey showed that there are 92% companies who prepare annual “statement of Ethics and Business Policy”, only 48% made “vision and Mission Statement”, and none of them have Code of Corporate Governance. Apart from this, in board of directors, only 50% of the firms in Pakistan include non-executive directors in their board structure. It is also found that 46% have introduced transaction administration procedure while 53% have not implemented a formal remuneration system in their organization. Only 45% of the firms have an improvement plan for corporate governance. For the improvement in corporate governance, 69% identified barriers while 42% made an excuse that they do not have qualified staff to make any improvement in corporate governance practices. Whereas 21% of the firms claimed that corporate governance procedures are sensitive information which cannot be shared with competitors.

Mahar et al (2008) found that implementation of corporate governance system may cause some weaknesses, strengths and economic implications. There is no second thought that a better corporate governance practices are an important factor for improving the firm value in either developing or developed markets. Whereas, the influence of corporate governance on firm value is different in mature and emerging markets due to their dissimilar social, economic and regulatory cultures in these countries. These differences which affect the firm value should be understood by financial managers, academic investigators, or public corporations regulators. Kashif et al (2008) used the several variables to measure the causal relationship between corporate governance practices and firm value.

Burki et al (2007) identified the improvement in corporate governance in Pakistan’s banking sector and its impact on banking efficiencies. They used dummy variables as a proxy of corporate governance changes in the banking sector of Pakistan. The result showed that the change in corporate structure has a significant impact on banking efficiencies. Driffield et al., (2007) explored that higher ownership concentration have a positive impact on firm value and its capital structure. In case of low ownership concentration, strict managerial approach influences the capital structure of the firm. Friend et al (1998) studied an important role of ownership concentration in the performance of firm. When ownership concentration is high then they can influence on the managers decision in getting the objective of an organization.

Baysinger et al (1985) experimented that the accounting performance of an organization is positively correlated with no. of independent directors in the board. Hambrick et al (2000) also found the same results. Agrawal et al (1996) found that the numbers of independent director is negatively correlated with accounting performance of the company, whereas, studies by Klein (1998), Bhagat et al (1997), and Hermalin et al (1991) have found no significant relationship between independent directors and the accounting performance of an organization. Similarly, Jeffrey et al (1990) determined no relationship between the outside directors and the firm performance.

METHODOLOGY

This study will explore the practices of corporate governance in banks in Pakistan and measure its impact on their efficiency.

The secondary data of corporate governance and banking performance variables of thirty banks will be used for the analysis purpose over the period of 2001-2009. The chosen study period experienced huge structural changes in the banking sector of Pakistan. Many foreign banks are acquired by the private banks. Small banks are merged with large banks. Due to this reason, this study included only those banks which are performing their operations consistently over the period of last one decade. The selected thirty banks include all types of banks such as private, public, foreign and Islamic. But the number of private banks is more than public, foreign due the liberalization reforms of the banking sectors.

The banking efficiencies are estimated with the help of Data Envelopment Analysis (DEA). As there are two approaches used by the researchers in past, one is parametric approach i.e., Stochastic Frontier Approach (SFA) and other is non parametric approach Data Envelopment Analysis (DEA). Both approaches have been criticized by the researcher due their limitations. In spite of that DEA was used more frequently than Stochastic Frontier approach due to its simplicity of assumptions. For this purpose, net capital and deposits are taken as input variables and loans and advances and net investments as output variables. The data envelopment analysis is applied under the variable return to scale model. The total efficiencies are then categorized as Technical Efficiency, Allocative Efficiency and Cost Efficiency. The data is collected from State Bank of Pakistan.

The corporate governance variables such as ownership concentration (OC), board size (BS), independent Audit Committee (IAC) and tier shari’s compliance structure (TSC) in case of Islamic banks is used. These variables are chosen on the basis of previous literature. The ownership concentration is defined as the majority of the shares are held by a small group of investors. For this ownership concentration value is determined by the following assumption

Ownership Concentration = % of shares held by top five shareholder

Board size (BS) is consisted on number of total directors in the banks. It includes both executive and non-execute members of the bank. Independent Audit Committee (IAC) is defined as the number of non-executive member of audit committee in the audit team of the bank.

The data of above mentioned variables are combined in two of the following econometric models. The following models are multiple linear regression models in which financial performance variables are independent whereas corporate governance variables are dependent. The significance of these models is test with ANOVA.

Model-I TE

Model-II

Assumptions:

In the above mentioned models the coefficients of board size are, > 0, whereas, > 0 are the coefficients of ownership concentration. The independent audit committee coefficients are, >0.

RESULT AND ANALYSIS:

In the first part of the analysis, banking efficiencies are computed by applying Data Envelopment Analysis over the period of 2001-2009. The banking sector is divided into three categories, State Owned Banks, Private and Foreign Banks. The results show that the overall average technical efficiency of Pakistan banking sector is 0.84, in which state owned banks is having 0.84, private banks 0.83 and foreign banks 0.81. Similarly, the average allocative efficiency of overall banking sector is 0.76. Whereas, the allocative efficiency of state owned, private and foreign is attributing 0.80, .80 and 0.74 respectively. At the same point of time, cost efficiency of overall Pakistan banking sector is 0.64, in which state owned, private and foreign banks are attributing 0.68, 0.67 and 0.60 respectively. There is no significant difference among the average technical, allocative and cost efficiencies of all segments of Pakistan banking sector.

The second part of the analysis shows the results of multiple regression analysis. In which two efficiencies (technical and allocative) of different segments of banking sectors (State Owned, Private and Foreign banks) are regressed over corporate governance variables, such as board size, ownership concentration and independent audit committee. The results show that the model 1 and 2 for overall banking sector are significant at 1%, 5% and 10% level of Significance. Further, the coefficients of board size, ownership concentration and independent audit committee, 0.104, -.561 and .27 for model-1,.14, -0.648 and 0.32 for model- 2 are also significant respectively. Same analysis is performed for all three segments of banking sectors.

For state owned banks, the model 1, 2 and 3 are highly significant. The coefficients of board size, ownership concentration and independent audit committee for both models are also highly significant.

In case of private banks all models are highly significant at 1, 5 and 10% level of significance. The coefficients of board size and ownership concentration for private banks against all models are insignificant. But the independent audit committee coefficients for private bank, .11 and .37 are highly significant.

The results show that both models are highly significant in case of foreign banks at 1, 5 and 10% level of significance. The coefficients of board size and ownership concentration in case of foreign banks are insignificant for model 1 and 2. The independent audit committee coefficients for foreign banks, 0.43 and 0.36 are highly significant. (See Table 1-1)

Table-1-1

Items

TE

Overall Banks

Overall Model

(0.00***)

BS

0.104 (0.00***)

OC

-.561 (0.00***)

IAC

.27 (0.01***)

Mean

0.84

St Dev

0.05

R Square

0.54

Foreign Banks

Overall Model

(0.00***)

BS

0.84 (0.27)

OC

-1.73 (0.31)

IAC

.43 (0.00***)

Mean

0.81

St Dev

0.052

R Square

0.91

Private Banks

Overall Model

(0.00***)

BS

.439 (0.32)

OC

-.26 (0.49)

IAC

.11 (0.00***)

Mean

0.83

St Dev

0.048

R Square

0.839

State Owned Banks

Overall Model

(0.00***)

BS

.932 (0.01***)

OC

-.78 (0.00***)

IAC

.38 (0.00***)

Mean

0.84

St Dev

0.05

R Square

0.87

Note:

** Significant at 5% & 10% level of Significance

*** Significant at 1%,5% & 10% level of Significance

CONCLUSION:

This paper explores some important connections between banking efficiencies and corporate governance practice of Pakistan. This is the first effort in this regard. Previously, there are so many studies conducted on the subject of measuring efficiencies of Pakistan banking sector, but no one yet examines the impact of corporate governance on banking efficiencies. The mean technical efficiency of overall banking sector is 0.84, which is very close to world average banking efficiency 0.86 as estimated by the World Bank.

The role of corporate governance is becoming very critical now days while determining the performance of a corporate. The results of this study also are an evident of this comment and find a significant impact of corporate governance practice in the banking sector on their efficiencies. The board size, ownership concentration and independent audit committee has a very significant role in changing the technical and allocative efficiencies of public limited banks. The ownership concentration has negative relationship with technical and allocative efficiencies of public banks. On the other hand board has size positive impact on public banks efficiencies. In case of foreign and private banks, their efficiencies are only affected by independent audit committee. The role of independent audit committee in public, private and foreign banks are very important i.e., the efficiency of banking sector increases if it poses an independent audit committee in their governance structure.

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