Electronic copy available at: http://ssrn.com/abstract=2208903

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Corporate Governance and Bank Performance: The Case of Bangladesh

Mohammad Ziaul Hoque

Department of Accounting and Finance, Monash University, Australia

Md. Rabiul Islam

Department of Economics, Monash University, Australia

Hasnan Ahmed

School of Business, United International University, Bangladesh

ABSTRACT

This paper empirically investigates the influence of corporate governance mechanisms on financial performance of 25 listed banking companies in Bangladesh over the period 2003-2011. Estimated results demonstrate that the general public ownership and the frequencies of audit committee meetings are positively and significantly associated with return on assets (ROA), return on equity (ROE) and Tobins Q. Directors ownership and independent directors have significant positive effects on bank performance measured by Tobins Q.

Keywords: Corporate governance, audit committee meetings, financial performance JEL Classification: G32, G34, G38

I. INTRODUCTION Bank governance has become a prominent issue ever since the collapse of many banks during

and after global financial crisis. For instance, 80 American banks died between 2007 and

2009 due to onslaught of global financial crisis and a number of banks have become

moribund throughout the globe. Recent bank failures, high incidents of loan defaults, bank

insolvency have lighted the importance of good governance. Therefore, regulators in

developing countries like Bangladesh have become more concerned about the financial heath

and governance of banking industry.

Electronic copy available at: http://ssrn.com/abstract=2208903

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A large body of empirical studies on corporate governance have emerged during the

last decade which focused mainly on the relation between corporate governance and firm

performance. The issue of bank governance and bank performance has received inadequate

attention, particularly in developing countries like Bangladesh. The nature of bank business is

different than that of non-bank business: bank receives deposits and provides loans; bank

uses money of depositors to create riskier assets. Depositors bear the risk of losing money as

they do not know how banks used their money. For example, demand deposits which are

short-term liabilities are invested in long term assets such as home loans for 20 years. Good

governance in the banking industry is required to maintain public trust and confidence in the

banking industry; to run an efficient financial system without excessive risk exposures; to

establish an efficient and reliable depository and financing system to fuel the wheels of the

economy. The diverse stakeholders such as directors, investors and depositors have direct

interest in bank performance ( Adams and Mehra, 2003) unlike the non-banking firms.

Bank intermediates between savers (depositors) and borrowers and influence money

demand and supply in the economy. Regulators make sure that deposits do not lose money

and borrowers return money and that economy does not suffer in any way and as such they

interact with the banks for day to day operations through banking laws and regulations.

Unlike non-financial institutions, banks are subject to dual monitoring: one by the regulatory

bodies and the other by the bank board. The monitoring and oversight of the regulators and

the compliance of banks with regulatory requirements (John, Mehran and Qian, 2003)

provides an alternative governance mechanism which is absent in non-financial industry. It

follows that effective supervision of banking industry by the regulators can work as

complementary force for good governance. Apart from monitoring, regulators such as central

bank of a country intervene in the management of banks in terms of makeup of board of

directors and their responsibilities relating to supervision of banking activities. For instance,

Electronic copy available at: http://ssrn.com/abstract=2208903

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Bangladesh Bank- central bank of Bangladesh- capped the number of directors of bank board

to thirteen directors and provides approval to the appointment of bank CEOs.

There is very little literature which focused mainly on bank governance issue (Adams

and Mehran, 2003; Spong and Sullivan, 2007) and most of the existing literature focused

mainly on non-bank firm governance and have narrowly focused on the bank governance

issues. As such the objective of this paper is to narrow down this gap and to contribute to the

body of knowledge relating to bank governance. Particularly, this paper investigates the

impact of governance on bank performance in Bangladesh which is an emerging economy in

South Asia, where institutional, regulatory and legal environment are different than those in

force in developed economies. In order to promote good governance in the banking sector,

regulatory response was provided by the Bangladesh bank and other regulatory organisations.

The Companies Act 1994 is the law which mainly governs incorporated entities in

Bangladesh. The act provides for certain supervisory functions and rights to the shareholders

to attend meetings, appoint and remove directors, and to obtain financial information as well

as to approve the balance sheet annually. The other prominent legal and regulatory

frameworks were provided by the Banking Companies Act 1991, the Financial Institutions

Act 1993, the Securities and Exchange Commission Act 1993, and the Bankruptcy Act 1997

etc.

These legal and regulatory frameworks were found to be inadequate and inefficient

for promoting good governance in Bangladeshi banking sector. Bangladesh Bank - the central

bank of the country - promulgated codes of corporate governance for banks in 2003. It

distilled rules and regulations relating to responsibilities and authorities of the Chairman,

CEO and Board of Directors. Other prominent features of this bank governance were related

to instituting committees such as Audit Committee and guidelines for appointment of bank

directors. Therefore, this study contributes to the literature as the first paper that explicitly

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investigates the impact of these latest governance directives unleashed by the Bangladesh

Bank on the performance of Bangladeshi banking sector in terms of good governance.

The remainder of the paper proceeds as follows. Section II provides an overview of

bank governance in Bangladesh; Section III briefly presents the theoretical perspective;

Section IV describes previous studies and hypothesis development; Section V reports data

and research methodology; Section VI presents the analysis of the empirical results, and;

Section VII provides conclusion.

II. BANK GOVERNANCE IN BANGLADESH: AN OVERVIEW

Banking sector in Bangladesh has been featured by myriad decreasing profitability,

increasing non-performing loans, increased loan loss provisions, eroded credit discipline, low

recovery rate, inferior asset quality, poor governance, excessive interference from the

government of the day and the bank-owners, weak regulatory and supervisory role etc.

(Hassan, 1994; USAID, 1995; Haque et al., 2007). Internal control system along with

accounting and audit qualities are believed to have been substandard (World Bank, 1998;

CPD, 2001). The reports by the Banking Reform Commission (BRC) (1999) and Bangladesh

Enterprise Institution (BEI) (2003) raised serious concerns on the banking sector and

criticized the quality of governance.

Banking sector in Bangladesh is constituted by 57 banks and almost all of them are

commercial banks. The four largest banks are owned by the state and rest are owned by the

private investors. Of them, 27 banks are listed with the Dhaka Stock Exchange (DSE) as of

December 2009. In addition to directives of the Bangladesh Bank, Bangladesh Enterprise

Institute (BEI) has published The Code of Corporate Governance for Bangladesh in 2004.

Securities and Exchange Commission (SEC) issued guidelines in the form notification in

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2006 for the listed firms in order to enhance corporate governance in the interest of investors

and the capital market. These guidelines prescribed dealt with the matters relating to (i) board

size, number of independent directors, appointment of Chairman and CEO and Directors'

Report to shareholders; (ii) Appointment of CEO, Head of Internal Audit, and Company

Secretary, attendance of Board Meeting by CEO and Company Secretary; (iii) Audit

Committee and its reporting to Board of Directors/ Commission and to the shareholders; and

(iv) engagement of external auditors etc. All listed companies (including listed banking

companies) in Bangladesh are required to follow these prescribed guidelines. They have to

provide reporting the status of compliance on corporate governance in Director's Report.

Other regulatory measures include: proper test for appointment of directors,

disqualification of directors on the ground of conviction, appointment of qualified and

experience directors, capping of the number of directors to 13, non-eligibility of close

relatives of the directors for the position in bank board, limitation of the directors loans to

50% of paid up value of the shares held by the directors, criminalising insider trading and

constitution of audit committee of board of directors .These regulatory response may lead, it

is expected, to better disclosure of financial information, uplifting standard of banking

activities. Recently, the financial markets of developing economies like Bangladesh have

experienced rapid changes due to the growth of wider range of financial products. As a result

of this, banks have been involved with high risk activities such as trading in financial markets

and different off-balance sheet activities more than ever before (Greuning and Bratanovic,

2003), which necessitates an added emphasis on good governance of banks in Bangladesh

(Haque et al., 2007). Given that Bangladeshi banking sector is relatively less efficient and

less experienced for asset and liability management, good governance is even more required

to establish a sound banking system.

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The Bangladeshi banking sector is dominated and controlled by founder family

members who are also dominant player in corporate sector, foreign owners and the

government. Farooque et al (2007) reports that five largest shareholders hold more than 50%

of ordinary shares, most of the CEOs and the directors are from controlling families. Asian

Development Bank (2003) finds that important decisions taken at a family meeting are

stamped at board meeting. Company board has less independence due to dominance of

family-appointed directors who set the addendum of the board meeting to implement their

own agenda. The management and the board are intertwined which reduces the opportunity to

prevent insider trading ; the independent or non-executive directors who have social or family

connection with controlling shareholder group fails to provide independent judgment and

minority shareholders rights are largely ignored or supressed (Farooque et al 2007). The

existence of conflict between family member dominated board members and minority

shareholders has been a regular feature in Bangladesh like other developing countries (Oman

et al , 2003).

Given the existence of family members dominated board and the dominance of

majority shareholders over minority shareholders, the implementation good governance

practices in Bangladeshi banking sector may experience serious setbacks which may not yield

expected results. Our study would like to examine the justification of such apprehension.

III. THEORETICAL PERSPECTIVE

Prior research in the area of corporate governance depicts the intricacies of multi-faceted

nature and behaviour of the companies. One argues that no one theoretical perspective can

fully encapsulate the complicacies of an organization (Cullen et al, 2006), that necessitates

various theories to provide better explanation for corporate governance characteristics and

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mechanisms from different point of view and different dimensions. Daily et al. (2003) opined

that a multi-theoretic approach to corporate governance is essential recognising the many

mechanisms and structures that might reasonably enhance organisational functioning. As

governance literature suggests, the study will explain the complicacies of relevant governance

mechanisms in the light of the two corporate governance theories agency theory, and

stewardship theory of which agency theory will dominate and the rest one is situational

explanatory.

Cullen et al. (2006) suggest that the agency and stewardship theories centre upon the

firm and the attainment of corporate goals. At the level of the firm, agency theory focuses

upon the conflicting interests of principles and agents. Stewardship theory purports interest

alignment between the steward and organizational objectives. Agency theory explains the

agency problems arising from the separation of ownership and control. It provides a useful

way of explaining relationships where the parties interests are at odds and can be brought

more into alignment through proper monitoring and a well-planned compensation system

(Davis et al., 1997). The agency problem arises when the desires or goals of the principal

and agent conflict, and it is difficult or expensive for the principal to verify what the agent is

actually doing (Eisenhardt, 1989). Principal can curb agency conflicts by establishing

appropriate incentives for the agent and by incurring monitoring costs. Jensen and Meckling

(1976) define agency costs as the sum of, (a) the monitoring expenditures by the principal,

(b) the bonding costs, and (c) the residual loss. Conflicts of interest, together with the

inability to costlessly write perfect contracts and/or monitor the controllers, ultimately reduce

the value of the firm. The agency problem not solved by contracting is addressed through the

use of various governance mechanisms. Agency theory provides a basis for firm governance

through the use of internal and external mechanisms (Roberts et al., 2005) that protect

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shareholder interests, minimise agency costs and ensure agent-principal interest alignment

(Davis et al., 1997).

Another perspective that seeks to explain the behaviours is stewardship theory. The

stewardship perspective suggests that the attainment of organisational success also satisfies

the personal needs of the steward. The steward identifies greater utility accruing from

satisfying organisational goals than through self-serving behaviour. Stewardship theory

recognises the importance of structures that empower the steward, offering maximum

autonomy built upon trust. This minimises the cost of mechanisms aimed at monitoring and

controlling behaviours (Daviset al., 1997). For finding answers to the research questions,

empirical data have been examined from the perspective of agency theory, and stewardship

theory has been used as complementary to explain agency theory from broader perspective.

IV. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Prior studies on the relationship of corporate governance mechanisms and corporate

performance are seen to include various internal and external mechanisms, among which

board size, board composition, board committees, CEOs position-duality, CEOs incentives

and ownership interest, ownership concentration of insiders and outsiders, multiple

directorships, debt financing, market for corporate control etc. are mentionable. Financial

performance measures being used are accounting based measures and market based

measures. To address problems mentioned above, the study discusses below relevant

governance mechanisms and performance measures in the perspective of existing literature.

A. BOARD SIZE

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The board of directors is the top executive body of a company and assigned with the

responsibility of formulating policies and strategies and supervising operations of the

company. Fixing the optimal number of board of directors is a dilemma, although Bangladesh

Bank pronounced that the board of directors of the bank-companies shall be constituted of

maximum 13 (thirteen) directors. However, the directors of the banks, where the number of

directors is more than this number, shall be allowed to complete their present tenure of office

(BRDP circular no. 16 dated 24-07-2003). Companies Act 1994 (Bangladesh) limits the

minimum number of directors to be at least 3 for a public limited company. The proverb too

many cooks spoils the broth may be true for being so many number of directors and again

decision-making precision may be hampered because of being too small number of directors.

Empirical evidence indicate that the size of the board does matter as it affects the extent of

monitoring, controlling and decision making in a company (Monks and Minow, 1995;

Haniffa and Hudaib, 2006). Yermack (1996) find out an inverse relationship between board

size, and profitability and Tobins Q. Haniffa and Hudaib (2006) find board size negatively

significant-association with market performance and positive significant association with

accounting performance measure that indicate contradictory results of the board size, while

Holthausen and Larcker (1993) find no association between these two variables.

B. BOARD COMPOSITION

INDEPENDENT DIRECTORS: The board is the vital part of a company that acts on behalf of the

owners. The board is assigned with delegated authorities by the owners to formulate policies

and strategies, ensure internal control, monitor, evaluate and compensate the top management

to enhance the effectiveness of the organization. So, the successfulness of a company mostly

depends on the balanced composition of board consisting of inside and outside directors.

Most regulatory efforts have concentrated on the issue of independence of the board. In an

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attempt to reduce the CEOs influence over the board, many countries have introduced

requirements that a minimum fraction of the board be composed of so-called independent

directors. The rationale behind these regulations is that if directors are not otherwise

dependent on the CEO they are more likely to defend shareholders interests (Becht et al,

2005). In Bangladesh, SEC in its notification (Feb. 20, 2006) made it compulsory to appoint

at least one-tenth of the total number of companys board of directors subject to a minimum

of one, independent director to enhance core competencies considered relevant in the context

of each company. Chiang (2005) argues that as the independent directors are more

specialized to monitor the board than the inside directors to run the business successfully by

reducing the concentrated power of the CEO, it helps the company to prevent misuse of

resources and enhance performance. Krivogorsky (2006) also observes significant positive

relationship between independent directors and performance of 81 European companies. In

contrast, directors who are unrelated to the firm may lack the knowledge or information to be

effective monitors. Yermack (1996), Agrawal and Knoeber (1996) and Bhagat and Black

(1998) find a negative relationship between the proportion of independent directors and

performance.

NON-INDEPENDENT AND NON-EXECUTIVE DIRECTORS: The composition of board structure

is an important mechanism because the presence of non-independent and non-executive

directors represents a means of monitoring the actions of the executive directors and of

ensuring that the executive directors are pursuing polices consistent with shareholders

interests (Fama, 1980). Some authors argue that boards dominated by non-executive directors

may help to alleviate the agency problem by monitoring and controlling the opportunistic

behaviour of management and also by ensuring that managers are not sole evaluators of their

own performance (Williamson, 1985; Jensen and Meckling, 1976; Baysinger and Hoskisson,

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1990). Such boards may also help in reducing management consumption of perquisites

(Brickley and James, 1987), removing non- performing CEOs and other board personnel

(Weisbach, 1988; and Pettigrew and McNulty, 1995) and working as external forces to

seriously consider the responsibilities of managers and inside directors for the greater benefit

of the shareholders. In contrast, the view that the board of directors may resolve agency

problems through monitoring has been challenged by managerial hegemony theory, which

views boards as passive instruments that hold allegiance to the managers who selected them,

lack knowledge about the firm, and depend on top executives for information (Kosnik, 1987).

Both anecdotal and empirical evidence suggests that outside directors are not always effective

monitors of managers (Baysinger and Hoskisson, 1990; Hill and Snell, 1989). It is evident

from skimming through the relevant disclosure of information of this study that almost all

non-executive directors have multiple shareholdings and directorships. So, it is not

unjustified to raise the issue that they are to remain busy with so many works in different

places round the clock and have little time to look into one thing of a particular company

minutely other than to have birds eyes view.

Empirical evidence on the non-executive directors and performance is mixed. Some

authors found positive relationship between the outside directors and the firms performance

(Choi, Park, and Yoo, 2007; Pearce and Zahra, 1992; Stearns and Mizruchi, 1993; and Wang

et al, 2007). In contrast, in the UK, Weir and Laing (1999) found insignificant relationship

between non-executive director representation and performance. However, Baysinger and

Hoskisson (1990) and Harmalin and Weisbach (1991) find no relationship between board

composition and performance when both relate to the same year. Haniffa and Hudaib (2006)

also found no relationship and commented that boards dominated by non-executive directors

do not seem to affect performance regardless of the measures used.

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C. CEO REMUNERATION

To curb agency conflicts and to reduce agency costs, a company may choose three

types of CEO incentive alignment mechanisms to implement to monitor the CEO -the CEO

duality mechanism, CEO ownership mechanism, and CEO compensation mechanism. CEO

duality determines the relationship of CEO to the chairperson of the board of directors and it

occurs when the same person holds the position of CEO and chairperson of the board. The

agency model argues that boards dominated by executive directors are more difficult to

control, a situation that would clearly apply to duality (Fama and Jensen, 1983). In case of

banking sector in Bangladesh, Bangladesh Bank rules and SEC guidelines regarded the

practice of duality undesirable. As a result, agency conflict in this sector is expected and

believed to have been seemingly minimized to some extent. The second one is CEO

ownership mechanism an incentive alignment device that a company may implement to

align management to the interest of the outside shareholders and thus reduces agency

problem. Due to convergence of interest, so much ownership of managers in a company

increases, so much goal congruence of the management and the outside shareholders is

believed to be achieved. However, Jensen and Rubacks (1983) entrenchment hypothesis

posit different point of view that the more shares management holds, the higher the

possibility that manager decision-making is overly conservative due to security of their

positions. It appears that the impact of the CEO share-ownership and the firms value is more

complex than is presumed in the literature. Interesting enough that the CEOs in banking

sector are hardly seen to have possessed shares of the same bank while dealing with primary

data for this study and as a result no hypothesis is required to be drawn in this respect. The

last usual one is CEO compensation mechanism that implies that a company may pay higher

remuneration to the managers, especially to the CEO to align interest with shareholders

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interest as financial incentives. This alignment should induce CEO to take actions that create

firm value and thus curb agency conflict.

Using time series data from the UK and Germany, Conyon and Schwalbach (2000)

find a significant positive association between cash pay and company performance in both

countries. In contrast, Brick et al (2006) argues that an excessive level of compensation for a

CEO provides an indicator of poor corporate governance structure and that this is a precursor

to the underperformance of firms. Basu et al. (2007) also finds that relative to ownership and

monitoring variables, excessive pay levels have a negative association with subsequent

accounting performance. Similar negative relationship between excess director compensation

and firm performance is reported by Brick, Palmon and Wald (2006). Recently, Duffhues and

Kabir (2008) questions about the conventional wisdom of using executive pay to align

managers interest with those of shareholders after finding no systematic evidence that

executive pay of Dutch firms is positively related to corporate performance.

D. AUDIT COMMITTEE

Consistent with the agency theory, audit committee works as an additional control

mechanism that ensures that the shareholders interests are being safeguarded. In consistent

with the Cadbury proposal as to formation of audit committee, Bangladesh Bank and SEC

have made it compulsory for all banks to constitute a board audit committee consisting of a

minimum of three members and it will hold at least three meetings in a year. The committee

will review the financial reporting process, the internal control system and management of

financial risks, the audit process, conflicts of interest, infringement of laws etc. Thus, audit

committee works as another internal control mechanism in the board structure, the impact of

which should be to improve the quality of the financial management of the company and

hence its performance (Weir et al, 2002). As constitution of audit committee is mandatory

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for banking companies in Bangladesh, every company has an audit committee in existence

but there is no way to understand the effectiveness with the merely existence of the

committee. In this case, the total numbers of meeting held in a year have been used as a proxy

to internal control mechanism to judge the effectiveness of the committee in this study.

Relatively little has been reported showing the impact of audit committee and

corporate performance. However, Klein (1998) finds that neither the presence of an audit

committee nor its structure has an effect on accounting and market performance. The author

(2002) also finds a negative relation between audit committee independence and abnormal

accruals. Again, Brown and Caylor (2004) shows the evident that solely independent audit

committees are positively related to dividend yield, but not to operating performance or firm

valuation. Similarly, Vafeas and Theodorou (1998) find no evidence to support the view that

the structure of subcommittees significantly affected performance. On the other hand, after

surveying the international companies, Ho (2005) reports that audit committee has strong and

positive relationships with the average return on equity.

E. OWNERSHIP CONCENTRATION Ownership structure that shows the concentration of ownership by inside shareholders or

outside shareholders plays a vital role in effective corporate governance. It is argued that

when firms effectively become controlled by larger shareholders, deviations in the control of

cash flow rights induce such controlling shareholders to expropriate wealth by seeking

personal benefits at the expense of minority shareholders. The existence of controlling

shareholders thus implies agency costs arising from conflicts between controlling

shareholders and outside investors (Shleifer and Vishny, 1997; Claessens et al., 2000, 2002;

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and La Porta et al., 2000; Lemmon and Lins, 2003; Chen and Lee, 2008). Chen and Lee

(2008), referring many other examinations of the relationship existing between ownership

structure and firm value, asserted that within family firms, the family members can accrue

additional benefits based upon their high level of insider ownership, as well as the low levels

of external stockholders and foreign ownership (Yeh et al., 2001; Randoy and Goel, 2003;

Brunello et al., 2003). Empirical results on the relationship between ownership concentration

and corporate performance are ambiguous. In the banking sector of Bangladesh, ownership

pattern includes sponsor/director ownership, institutional ownership, government ownership,

foreign ownership and public ownership. Of those, government ownership, and foreign

ownership are negligible and the study investigates the effectiveness of governance

mechanism on the performance with the rest three types of ownership concentration while

examining relationship.

SPONSORS OR DIRECTORS OWNERSHIP: With a fiduciary obligation to shareholders, and the

responsibility to provide strategic direction and monitoring, the boards role in governance is

very important (Gillan, 2003). In the banking sector of Bangladesh, on an average 85 percent

directors of a company are non-executive-non-independent directors holding much shares in

their companies, and almost all CEOs do not hold shares of their respective companies who

take only cash remuneration in the form of cash salary and cash bonuses. Similarly debt-

equity ratio on an average is 15 times than the equity. In this perspective, to seek to maximize

their best interest, it is usual to have agency problems between different groups between

managers and directors, between directors and outside shareholders, and between directors

and creditors/depositors. As a result, the agency costs are believed to be enhanced to curb

agency problems. According to the convergence-to-interest model, there is a relationship

between directors shareholdings and performance because the greater the financial stake, the

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greater the costs for not maximizing shareholders wealth (Jensen and Meckling, 1976). As

the agency costs relating to managers are obviously increased to align the managers, the

board of directors is supposed to maximize their wealth at the expense of creditors/ depositors

interests. In that case, the board of directors maximize return on shareholders equity by

expropriating return on total assets and the difference between the two returns is worth

mentioning but nothing matters how big volume of shares the directors are holding rather

than to be working as non-executive-non-independent directors. In this situation, the

relationship between board shares and performance is ambiguous as the different researchers

found. Using 123 Japanese firms-level data from 1987 to 1995, Chen, Guo and Mande (2003)

report a monotonic relation between Tobins Q and managerial ownership. They find that Q

increases monotonically with managerial ownership, thus, suggesting greater alignment of

managerial interests with those of stockholder with the increase in ownership. Referring

empirical researches in respect of the relationship between performance and managerial share

ownership, Haniffa and Hudaib (2006) commented that the size of insider ownership does

matter and the effect can be both positive and negative. The positive relation at low levels of

managerial ownership suggests incentive alignment while the negative relation at high levels

of managerial ownership provides evidence that managers become entrenched and can

indulge in non-value-maximizing activities without being disciplined by shareholders

(Himmelberg et al., 1999).

INSTITUTIONAL OWNERSHIP: Compared to total ownership, share of institutional ownership

records 8 to 9 percent in the banking sector in Bangladesh, but considering the increased

investment in shares and role of institutional ownership in the mechanisms of corporate

governance, it has come in relevance. Institutional investors generally do have some

characteristics that make them unique and distinct shareholders. Firstly, institutional investors

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typically hold shares as part of a portfolio investment strategy as can therefore be

distinguished, at least commercially, from other shareholders. A second and related point, is

that although ownership of shares in investment-companies, is legally attributable to the

institution, the shares are economically attributed to the ultimate investors and clients of the

institution (Jonathan, 2007). Institutions are financial intermediaries who do not hold the

shares for their own benefit as the financial returns are distributed to their investors and

clients (Tan and Keeper, 2008).

Shleifer and Vishny (1997) states that the institutional ownership can reduce the

agency cost and enhance firms performance through the reduction of managerial

opportunism and minority expropriation. But institutional investors as external investors

cannot influence the key decisions about companies operation. Lehmann and Weigand

(2000) find positive impact of ownership concentration on profitability for firms with

financial institutions as largest shareholders which is consistent with the view that banks are

better (more efficient) monitors to lower the agency costs. Ho (2005) reports that significant

institutional investors holdings raise board vigilance, which in turn has a positive effect on

firm performance. Short and Keasey (1997) show that in the absence of other large external

shareholders, institutional investors have a significant positive effect on the firm

performance. On the other hand, Agrawal and Knoeber (1996) find no significant relationship

between performance and institutional stockholding. Dhnadirek and Tang (2003) found no

significant association between institutional ownership and firm performance. They argued

that the external monitoring by terms of institutional ownership does not always result in

greater profitability or better corporate governance. Hence, the impact of institutional

ownership on companys performance has remained explored without any consensus. The

study seems that only institutional ownership cannot be effective to enhance the operating

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performance by interfering the activities of management as the role is laid on the board of

directors.

GENERAL PUBLIC OWNERSHIP: Jensen and Meckling (1976) apply agency theory to the

modern corporation and model the agency costs attached to outside equity: when ownership

and control of corporations are not fully coincident, there is potential for conflicts of interest

between owners and controllers. These conflicts of interest, together with the inability to

costlessly write perfect contracts and/or monitor the controllers, ultimately reduce the value

of the firm (Cullen et al, 2006). Furthermore, incentives to perform direct monitoring are

weaker for dispersed ownership due to free-rider problems (Gugler, 2001; and Grossman and

Hart, 1982). Domination by large shareholders may also damage performance due to large

exposure to a firms risk (Demsetz and Lehn, 1985; Haniffa and Hudaib, 2006). Berle and

Means (1932) argue that when ownership becomes increasingly dispersed, shareholders

become powerless to control professional managers as they cannot effectively carry out

monitoring of management, the diffuseness of ownership and performance should have a

negative relationship.

According to convergence-of-interest model of Jensen and meckling (1976), the

increase of managerial ownership strengthens corporate performance as the interests of

management and stockholders are aligned. But Demsetz (1983) refuted this view, identifying

offsetting costs of insider ownership. He posits that no single ownership structure is suitable

for all situations if the value of the corporations assets is to be maximized (Welch, 2003).

Consiquently, this gave rise to the belief that the ownership structure of the firm was an

endogenous variable. That is, the ownership structure depends on the individual

characteristics of the organization (Fishman et al, 2005). Only for this reason, different

empirical studies on the association between ownership concentration and corporate

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performance give ambiguous results. Holderness and Sheehan (1988) found a positive

correlation between shareholdings of large investors and firm performance. Similarly, in the

UK, Leech and Leahy (1991) found a positive relationship between external shareholdings

and performance. In contrast, Demsetz and Lehn (1985) and Demsetz and Villalonga (2001)

found no empirical relationship between ownership structure and profitability, and Murali

and Welch (1989) and Weir et al. (2002) also drew the same conclusion.

F. COMPANY SIZE

The size of company (proxied by total assets) is considered in this study as control variable to

have a relationship with other factors, for example, there is a strong relationship between

firm size and CEO compensation (e.g., Murphy, 1985). The literature is in harmony with

this tendency. On average, larger companies are better performers as they are able to

diversify their risk (Ghosh, 1998). Furthermore, larger company has larger market share and

market power in respect of customers and volume of investment. Larger firms have larger

investors bases than smaller ones. Again, company size may be measured in different ways

such as sales turnover, total assets, capital employed, etc. In this study, total assets have been

used as the measure of company size. Actually, to measure the magnitude of a company, total

assets is such a determinant that may preferably be used than other measures as the

accounting measure because sometimes a medium firm may have larger sales volume, for

example, due to increase in assets turnover.

G. DEBT FINANCING

Debt financing or leverage may play a significant role in governance mechanisms especially

in the banking sector for two unique characteristics of banks opacity and strong regulations.

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Due to opacity, depositors do not know the true value of a banks loan portfolio as such

information is incommunicable and very costly to reveal, implying that a banks loan

portfolio is highly fungible (Bhattacharya et al., 1998). As a consequence of this asymmetric

information problem, bank managers have an incentive each period to invest in riskier assets

than they promised they would ex ante (Arun and Turner, 2003). The opaqueness of banks

also makes it very costly for depositors to constrain managerial discretion through debt

covenants (Capiro and Levine, 2002). Referring different studies Haniffa and Hudaib (2006)

assert that debt forces managers to consume fewer perks and become more efficient to avoid

bankruptcy, the loss of control as well as loss of reputation (Grossman and Hart, 1982). Debt

contracting may also result in improved managerial performance and reduced cost of external

capital (John and Senbet, 1998). In short, debt may help yield a positive disciplinary effect on

performance. On the other hand, debt can increase conflicts of interest over risk and return

between creditors and equity holders. Like other variables, relationship of gearing ratio with

performance shows conflicting results in different studies. Dowen (1995), McConnell and

Servaes (1995), Short and Keasey (1999) and Weir et al. (2002) found a significant negative

relationship between gearing and corporate performance. However, Hurdle (1974) found

gearing to affect profitability positively.

H. BANK PERFORMANCE MEASURES

A companys operations and successfulness are integrally connected. Studies show that the

concept of companys performance is multidimensional. But the fact is that the companys

investors, shareholders and other stakeholders find its successfulness in the financial

performance. The financial performance measures can be divided into two major types: (1)

accounting- based measures (e.g., Return on Assets, Return on Equity, or Return on Sales),

21

and (2) market- based measures (e.g. Tobins Q ratio). There has been extensive empirical

research using different performance measures for examining the relationship between

corporate governance and firms performance. There are some researches where either

accounting-based measure or market-based measure has been used but some researchers have

used both the measures. When both the measures have been used, almost all the researchers

have found significant relationship with one measure but no relationship with other measures.

This may be attributed for using different type of numerators and denominators used for

calculating financial performance.

Different researchers argue differently in favour of their using measurement base.

Some argue that if the capital market is unstructured and much volatile, Tobins Q ratios of

different companies give misleading results. Accounting measures have been criticised on

the grounds that they are subject to manipulation, that they may systematically undervalue

assets as a consequence of accounting conservatism and that they may create other distortions

as well (Sanchez-Ballesta and Garcia-Meca, 2007). Joh (2003) argues that accounting

profitability is a better performance measure than stock market measures for at least three

reasons. First, market anomalies may act as an impediment to all available information being

reflected in the stock price. Second, a firms accounting profitability is more directly related

to its financial survivability than is its stock market value. Finally, accounting measures allow

users to evaluate the performance of privately held firms as well as that of publicly traded

firms.

In the perspective of the literature review above, the study aims at investigating

empirically as to whether the number of board members; proportion of independent

directors, and proportion of non-independent non-executive directors in the board; CEO

compensation; number of audit committee meetings; proportion of board ownership,

22

proportion of institutional ownership, and proportion of general public ownership; debt-

equity ratio; and company size have any significant influences on corporate performance.

V. METHODOLY AND DATA

A. EMPIRICAL METHODOLOGY

To investigate the effects of corporate governance variables on financial performance of

Bangladeshi listed banking companies, this study uses the following dynamic panel

regression model:

)1(lnlnlnlnln

1110987

654321,10

itititititit

ititititittiiit

uDEQTACEOACMGNPINOSDONINEINDBMPERFOMPERFOM

In this model, the dependent variable is banks financial performance (PERFOM) measured

by return on total assets (ROA), return on shareholders equity (ROE) and Tobins Q (Q). The

independent variables consist of eight corporate governance variables, namely number of

board members (in logarithm) (lnBM), proportion of independent director (IND), proportion

of non-independent and non-executive directors (NINE), sponsor/director ownership (SDO),

institutional ownership (INO), general public ownership (GNP), number of audit committee

meetings (in logarithm) (ACM), and Chief Executive Officers compensation (lnCEO); and

two control variables, such as company size proxied by total assets (in logarithm) (lnTA) and

debt-equity ratio (in logarithm) (lnDEQ). itu is the random error term and subscripts i and t

represent firm and time period, respectively.

The panel model in equation (1) includes the lagged dependent variable

( 1, tiPERFOM ) as one of the explanatory variables and thus the use of ordinary least squares

(OLS) estimator could lead to inconsistent estimates. Allowing fixed effects with time

dummies ( ittiit fu , where if indicates time invariant bank level fixed effects, t

23

represents time dummies and it is the serially uncorrelated error term) we can remove time

invariant within group omitted variable bias. Still there is a clear simultaneity problem as the

lagged dependent variable ( 1, tiROA or, 1, tiROE or, 1, tiQ ) is correlated with the error term

it by virtue of its correlation with the time-invariant component of the error term, if . In this

case, the usual approach to estimating a fixed-effects model - the least squares dummy

variable estimator (LSDV) - generates a biased estimate of the coefficients because the

lagged dependent variable is correlated with the error term, even if it is assumed that the error

term is not itself autocorrelated (Greene, 2003).

Therefore, in presence of lagged dependent variable as a regressor, the usual ordinary

least squares (OLS) estimator suffers from biases due to unobserved heterogeneity and

possible endogeneity of the regressors. Due to the possibility of unobserved firm-specific

effects, the OLS estimator may result in upwardbiased estimates of the autoregressive

coefficients if firm-specific effects are important (Bond, Elston, Mairesse and Mulkay, 1997).

A within group estimator (LSDV), after transforming the data to deviations from firm mean,

in order to eliminate firm-specific fixed effects, is not consistent either because the

transformed lagged dependent variable and the transformed error term are negatively

correlated (Nickell, 1981).

This issue may be addressed by applying the generalized method of moment (GMM)

dynamic panel estimator where the endogenous explanatory variables are instrumented with

their suitable lags so that the instruments are not correlated to the error term. Anderson and

Hsiao (1982) suggested a first-differenced transformation to eliminate time invariant fixed

effects and constant in GMM estimation. Arellano and Bond (1991) argue that the Anderson-

Hsiao estimator fails to take all orthogonality conditions and thus the estimator becomes

inefficient. They propose a difference GMM estimator, allowing lagged values of the

24

endogenous regressors as instruments. However, Arellano and Bover (1995) and Blundell

and Bond (1998) argue that the lagged level of the endogenous variables may be poor

instruments for the first differenced variables and therefore they suggest lagged differences as

instruments, which is popularly known as system GMM.

Although GMM estimates do come with a price of possibly poor finite sample

performance, Blundell and Bond (1998) observe that system GMM estimator produces

efficiency gain when the number of time series observation is relatively small in Monte Carlo

simulations. Furthermore, Beck, Levine, and Loayza (2000) argue that system GMM estimator

is efficient in exploiting time series variations of data, accounting for unobserved country

specific effects, allowing for the inclusion of the lagged dependent variables as regressors and

thereby providing better control for endogeneity of the entire explanatory variables. Therefore,

we will emphasize more on two-step system GMM estimation in our empirical study although

OLS level and Within Group or, fixed effects estimates are also reported.

Arellano and Bover (1995) and Blundell and Bond (1998) prescribe several standard

tests that are needed to satisfy while using system GMM estimators. F-test examines the joint

significance of the estimated coefficients. The validity of the instruments used can be tested

by reporting both a Hansen test of the over-identifying restrictions, and direct tests of serial

correlation in the residuals or error terms. The key identifying assumption in Hansen test is

that the instruments used in the model are not correlated with the residuals. The AR(1) test

checks the first order serial correlation between error and level equation. The AR(2) test

examines the second order serial correlation between error and first differenced equation. The

null hypotheses in serial correlation tests are that the level regression shows no first order

serial correlation as well as the first differenced regression exhibit no second order serial

correlation.

25

B. DATA ANALYSIS

The sample companies used in this study are banking companies listed on the Dhaka Stock

Exchange (DSE) in Bangladesh. As at December 31, 2009, a total of 27 banking companies

were listed on the main board of the DSE. Excluding two banking companies- one for being

listed at the end of 2007 and another for data missing, a sample of 25 banking companies is

used in this study. The study is conducted on nine years data from 2003 to 2011 of the

companies under study. The study primarily collected data from the published annual reports

of the company. Besides, the companies websites and DSE websites were the supplementary

sources of data for the study. The reason for considering data from 2003 is that the

Bangladeshi listed banking companies, in compliance with Bangladesh Banks (Central

Bank) directives, instituted audit committees and additional regulatory reforms only from

2003 and we want to examine their impact on banks financial performance.

The dependent variable is corporate performance and three measurements, viz., return

on assets (ROA), return on equity (ROE), and Tobins Q are taken into account as proxies for

accounting-based measure of performance and market-based measure of performance. All

performance data refer to the end of the respective financial years as reported in the

companies financial statements. Market price of shares of a company at the close of the

financial year as published by SEC has been considered to calculate market capitalization. As

interest expenses of a bank are considered as operating expenses, profit before taxation has

been taken into account in calculating return on assets. In calculating total assets, fictitious

assets that have no real value have been excluded. Tobins Q has been calculated by market

capitalization plus total debt divided by total assets and considered as the higher the value of

Q, the more effective the governance mechanisms, and the better the markets perception of

the companys performance (Weir et al., 2002). Similarly, a higher ROE and a higher ROA

26

indicate effective use of companys assets in serving shareholders economic interests

(Haniffa and Hudaib, 2006). The nature of the panel data used in this study is unbalanced

since data is not available for all the sample companies over the entire sample periods.

Table-1: Descriptive Statistics: 2003-2011

Variables Mean Std. Dev. Minimun Maximum Observation ROA 2.722 1.705 -0.133 17.205 223 ROE 19.083 9.985 -5.231 48.912 222 Q 1.133 0.301 0.120 2.386 222 BM 13.243 3.871 6.000 27.000 223 IND 4.010 6.254 0.000 23.714 221 NINE 85.836 9.816 56.667 100.000 220 SDO 39.435 24.154 0.000 96.150 220 INO 12.090 12.262 0.000 46.610 220 GNP 42.250 24.420 0.000 95.850 220 ACM 8.085 8.282 0.000 73.000 222 CEO 5.145 2.812 2.842 11.300 221 TA 55242 44250 3970 275429 222 DEQ 14.806 4.909 5.703 33.671 222

Notes: The sample contains 25 Bangladeshi listed banking companies over the period 2003-2011. ROA= return on total assets (in percentage), ROE= = return on shareholders equity (in percentage), Q = Tobin's Q, BM = number of board members, IND = independent directors (in percentage), NINE = non independent and non executive directors (in percentage), SDO = sponsors or directors ownership (in percentage), INO = institutional ownership (in percentage), GNP = general public ownership (in percentage), ACM= number of audit committee meetings, CEO = CEO remuneration (in million Taka), TA = total assets (in million Taka), DEQ = debt-equity ratio (in percentage).

Table-1 presents summary statistics for the key variables used in this study over the period

2003 to 2011. There is a wide variation in corporate governance and financial performance

measures across the banking companies. The average value of ROA, ROE and Tobins Q are

2.72%, 19.08% and 1.13, respectively, indicating consistent increase in accounting as well as

market return in Bangladeshi listed banking sector. The average board size is 13.24, which is

more or less within the size as recommended by Bangladesh Bank but still the number is high

in at least 25 percent companies. As per rule, the maximum number of board members will

be 13, however, where the number of directors is more than this number, shall be allowed to

complete their present tenure of office (circular no. 16 dated 24-07-2003). The proportion of

independent directors, on an average is 4.01% ranging from 0% to 23.71%, suggesting that

there are some companies where there is even no independent director at all in their board;

27

although, SEC rules (2006) recommend maintaining at least one-tenth of the total or

minimum one independent director in every company. The average proportion of non-

independent non-executive directors in the board is 85.84%, implying that that the board is

composed of mainly non-independent outside directors. It is said that the directors are

businessmen having directorships in at least 5 other multi-faceted companies. The same trend

is observed while surveying annual reports for this study.

In respect of ownership, the average proportion of shareholdings by the board of

directors is 39.43% indicating concentrated ownership and quite strong voting power of the

directors. The average value of institutional ownership is 12.09%, indicating poor holdings

suggesting negligible voting power in selecting directors in the board. The average

proportion of general public ownership is 42.25 and standard deviation is 24.42, indicating

defuse ownership pattern among the general public who hold lesser proportion of ownership

in most of the companies.

On an average, the audit committee meets 8.08 times per year, however, there are

companies that do not hold any audit committee meeting, implying serious shortfall in the

effectiveness of audit committee and slackness in the internal control system. The average

amount of CEO compensation per year shows that the most of the companies pay Tk. 5.14

million while the maximum is 11.30 million indicating a very wide variation among the

companies in terms of CEO remuneration. Average book value of banks total assets is Taka

55242 million indicating smooth increase of assets over the sample period. Assets have

mainly been accumulated by the process of reinvestment of a part of earnings apart from the

amount of earnings taken as dividend from the business. It is for obvious reason that the

depositors find it convenient to invest their savings elsewhere other than banks at a higher

rate of return as the bank rate of interest on different deposits are getting down over times.

The overall mean for debt-equity ratio is 14.81, indicating that the investment of depositors

28

and creditors in the banking business is on an average 14.81 times as much as the investment

of the shareholders. It also implies that in every Taka of assets in the business, the depositors

and creditors claim is fifteen times larger than the common shareholders.

It becomes salient form the above discussion and as received from banks statements

that the average rate of interest on deposits (7 percent or less) in the bank and yearly rate of

inflation (on average 8 percent, source: CIA World Fact book) are more or less equal in the

country. The directors are prominently non-independent outside businessmen having

concentrated ownership in the bank. CEOs are highly paid professionals without position-

duality and ownership interests. The shareholders are getting average yearly return at the rate

of 19.08 percent on their investment having been the owners of only one-fifteenth in the total

assets invested in the banks. Average assets of banks are getting increased overtime and the

debt-equity ratio is gradually decreasing due to less rate of interest on deposits. The situation

leads one to comment that banking business is such an attractive less-risky business that pays

off the businessmen higher rate of return with minimum investment at the expense of

depositors money under the direct supervision of the government.

Table-2: Correlation Matrix: 2003-2011

ROA ROE Q BM IND NINE SDO INO GNP ACM CEO TA DEQ ROA 1.00 ROE 0.53** 1.00 Q 0.31** 0.16** 1.00 BM 0.13** 0.08 0.12 1.00 IND -0.07 -0.06 0.16** -0.15** 1.00 NINE 0.09 0.17** -0.12 0.22** -0.69** 1.00 SDO -0.11 0.06 0.16** 0.20** -0.07 -0.03 1.00 INO -0.10 -0.16** -0.01 -0.03 0.41** -0.42** 0.18** 1.00 GNP 0.22** -0.02 0.16** 0.00 -0.07 0.02 -0.49** -0.27** 1.00 ACM -0.08 0.03 0.11 0.10 -0.14** 0.15** 0.06 -0.23** 0.03 1.00 CEO 0.05 -0.02 0.29** -0.02 0.29** -0.40** 0.08 0.17** 0.27** 0.03 1.00 TA -0.02 0.03 0.42** 0.04 0.19** -0.21** -0.01 0.04 0.17** 0.45** 0.45** 1.00 DEQ -0.36** -0.08 -0.07 -0.14** 0.06 0.11 0.06 -0.06 -0.16** 0.08 -0.26** 0.04 1.00 Notes: ** indicates 5% level of significance. See also notes to Table 1.

29

Table-3: Variance Inflation Factor (VIF) & Tolerance (TOL): 2003-2011

BM IND NINE SDO INO GNP ACM CEO TA DEQ VIF 1.23 2.3 2.42 2.13 1.52 2.41 1.44 2.2 1.85 1.55 TOL 0.81 0.43 0.41 0.46 0.65 0.41 0.69 0.45 0.54 0.64 Notes: See notes to Table 1.

Table 2 shows the pair-wise correlation matrix for the variables reported in this study. This

correlation matrix examines the pattern of relationships between the variables under

consideration. Among the independent variables, the coefficients of correlation between

IND and NINE (-0.69), and between GNP and SDO (-0.49) are higher than the

coefficient of correlation between other corporate attributes but did not reach beyond 0.80 in

any way.One of the suggested rule of thumb for multicollinearity test is that if the pair-wise

or zero-order correlation coefficient between two regressors is high, say, in excess of 0.8,

then multicollinearity is a serious problem (Gujarati, 2004). The estimated pair-wise

correlation coefficient is less than 0.70 and thus the explanatory variables are unlikely to have

multicollinearity problems. Variance Inflation Factor (VIF) or Tolerance (TOL), a formal test

of multicollinearity, concludes with the same findings. According to Haan (2002), some

researchers use a VIF of 5 (TOL of 0.2) and others use a VIF of 10 (TOL of 0.1) as a critical

threshold and the results of this study show that the VIF and TOL of the explanatory

variables reported in Table 3 are far lower than the threshold level. Therefore, it is evident

that the estimated regression results are less likely to have multicollinearity problems.

VI. EMPIRICAL RESULTS

Table 4 summarizes dynamic panel regression results of 25 Bangladeshi listed

banking companies, based on the pooled OLS (columns 1, 4 & 7), fixed effects (columns 2,

5 & 8) and system GMM (columns 3, 6 & 9) estimators for the dependent variables, return

30

on total assets (ROAit), return on Shareholders equity (ROEit) and Tobins Q (Qit),

respectively. Since a lagged dependent variable is included in the regression models as an

explanatory variable, both OLS and fixed effects estimators are likely to suffer from

estimation biases due to possible endogeneity of the regressors. Therefore, this study

concentrates on a system GMM estimator that captures unobserved heterogeneity and reduces

endogeneity bias in the estimation. System GMM estimator satisfies a battery of the

specification tests, namely the F-test for joint significance, Hansens test for instrument

validity and the AR(1) and AR(2) tests for first-order and second-order serial correlation,

respectively. The coefficients of one period lagged ROA, ROE and Q are found to be positive

and statistically significant in all cases at the 1% level. Therefore, for Bangladeshi listed

banks, previous years financial performance has significant positive impact on current years

financial performance.

Table-4: Effects of Corporate Governance Mechanisms on Financial Performance of Bangladeshi Listed Banking Companies: 2003-2011

ROAit ROEit Qit

OLS FE GMM OLS FE GMM OLS FE GMM (1) (2) (3) (4) (5) (6) (7) (8) (9)

ROAi,t-1 0.83*** 0.80*** 0.45** (6.62) (6.32) (2.39) ROEi,t-1 0.89*** 0.89*** 0.69*** (11.63) (11.69) (6.54) Qi,t-1 0.74*** 0.80*** 0.49** (4.52) (4.92) (2.31) lnBMit 0.71* 0.68* 0.92 0.32 0.30 1.20 0.07 0.06 0.14 (1.69) (1.67) (0.98) (0.17) (0.15) (0.23) (0.77) (0.83) (0.35) INDit -0.02 -0.02 0.06 0.07 0.07 0.39 0.01** 0.01* 0.05* (-0.70) (-0.81) (0.95) (0.49) (0.48) (1.22) (2.04) (1.68) (1.90) lnNINEit -2.17 -1.72 0.01 -6.28 -6.57 -0.10 0.18 0.25 0.39 (-1.34) (-1.25) (0.02) (-0.85) (-0.85) (-0.50) (0.70) (0.95) (0.30) SDOit -0.01 -0.01 0.01 0.01 0.01 0.01 0.01** 0.01** 0.01* (-1.04) (-0.72) (0.60) (0.43) (0.40) (0.15) (2.15) (2.06) (1.81) INOit -0.02 -0.04 0.01 -0.06 -0.06 -0.02 -0.01 -0.01 -0.01 (-0.18) (-0.05) (1.09) (-1.04) (-1.00) (-0.25) (-1.29) (-1.04) (-1.00) GNPit 0.02 0.02 0.03** 0.06** 0.06* 0.07** 0.01 0.01 0.01** (1.25) (1.30) (2.65) (2.02) (1.88) (2.22) (1.50) (1.33) (2.18) ACMit 0.01 0.01 0.03*** 0.01 0.01 0.03** 0.01 0.01 0.03** (0.86) (0.86) (3.30) (0.15) (0.14) (2.39) (0.68) (0.79) (2.32) lnCEOit -0.12 -0.16 -0.24 -1.24 -1.25 -3.82 0.03 0.03 -0.14 (-0.88) (-1.22) (-0.47) (-1.41) (-1.40) (-1.55) (0.74) (0.71) (-0.60)

31

lnTAit -0.62 -0.77 -0.47 0.01 0.02 -2.04 -0.03 -0.06 -0.07 (-1.05) (-1.13) (-0.82) (0.01) (0.02) (-0.88) (-0.37) (-0.79) (-0.40) lnDEQit 0.22 0.41 0.23 0.30** 0.32** 0.78** 0.09 0.14* 0.66** (0.27) (0.45) (0.37) (2.55) (2.28) (2.38) (1.06) (1.70) (2.30) Constant 15.86* 16.23* 16.70 50.33 52.36 56.75 -1.33 -1.46 -1.30 (1.72) (1.81) (1.61) (1.47) (1.45) (0.98) (-0.94) (-1.13) (-0.05) Observation 167 167 167 167 167 167 167 167 167 R-Squared 0.42 0.44 0.60 0.61 0.46 0.59 F-Test (p-value) 0.00 0.00 0.00 AR(1) Test (p-val) 0.02 0.02 0.01 AR(2) Test (p-val) 0.20 0.21 0.21 Hansen Test (p-val) 0.34 0.44 0.44

Notes: OLS = Ordinary Least Squares, FE = Fixed Effects, and GMM = System GMM estimator. The numbers in parentheses are t-statistics and are based on robust standard errors. *, ** and *** denote 10%, 5% and 1% significance levels, respectively. F-test is the joint significance tests of the estimated coefficients. Hansen test measures the validity of the instruments where the null hypothesis is that the instruments are not correlated with the residuals. The null hypotheses in AR(1) and AR(2) tests are that the error terms in the first difference regression exhibit no 1st order and 2nd order serial correlation respectively. 2nd and 3rd lags of the explanatory variables are taken as instruments for the differenced equation, whereas 1st differences of the explanatory variables are taken as instruments for the level equation in the System GMM. Time and company dummies are included but not reported for brevity. See also notes to Table 1. In order to ensure that the empirical results are not driven by outliers all of the variables are winsorized at the top and bottom 1 percent of their distributions, i.e., values at the 1% and 99% percentiles are reduced. ln indicates natural logarithm.

Board members are found to have positive and significant influence on bank

performance measured by ROA in both OLS and fixed effects estimations; however, the

relationship becomes insignificant though positive in system GMM. The effect remains

positive but insignificant while banks performance is measured by ROE as well as Tobins Q.

These results are consistent with the findings of Holthausen and Larcker (1993), Yermack

(1996), Eisenberg et al. (1998), Hermalin and Weisbach (2000), who suggest that the market

perceives larger boards as ineffective as they tend to be symbolic rather than being part of the

actual management process (Haniffa and Hudaib, 2006).

Neither of the board composition variables -proportion of independent director (IND)

and proportion of non-independent non-executive director (NINE) is turned up to be

32

significant in all the models while bank performance is measured by ROA and ROE.

However, the estimated coefficients of IND are found to be consistently positive and

significant at least at 1% level in all three estimators only when bank performance is

measured by Tobins Q, implying that independent directors help Bangladeshi listed banks to

improve their market based performance. This results is consistent Becht et al (2005) who

argue that independent directors protects interests of minority shareholders against both the

CEOs and the block holders actions.

Among the ownership structure variables, the extent of influence of directors

ownership (SDO), institutional ownership (INO) and general public ownership (GNP) on

bank performance provides mixed evidence. GNP has significant positive effects on banks

performance, whereas SDO exerts significant positive effects only in market based

performance (Tobins Q). INO does not show any significant effects on bank performance

either of the estimators.

The estimated coefficients of the number of audit committee meetings are consistently

positive and significant at 5% level in system GMM estimator, implying that increasing

frequencies of audit committee meetings could significantly raise Bangladeshi banks

performance. On average, each additional meeting of audit committee could raise annual

ROA, ROE and Tobins Q of listed banks by approximately 0.03%. This result is consistent

with the findings of Duncan (1991) and Vanasco (1994) who argue that audit committees

improve firms performance by providing better financial reporting to control firms financial

risk. Therefore, firms that do not comply with audit committee recommendations may face

serious financial irregularities and corporate failures (Mangena and Pike, 2005).

The coefficient of CEOs remuneration (CEO) is insignificant and somewhere

negative in all the measures of performance. The positively significant correlation between

CEO compensation variable and companys total assets indicates that larger banks pay much

33

compensation than the smaller ones to the CEOs. However, the result of negative effect of

CEO compensation on performance is in keeping with the findings of Basu et al. (2007) who

posit that relative to ownership and monitoring variables, excessive pay levels have a

negative association with subsequent accounting performance.

As a control variable, the size of banks (measured by total assets, TA) shows negative

but insignificant effects on financial performance in all three alternative methods. The

coefficient of another control variable financial leverage (measured by debt-equity ratio,

DEQ) is found to have significant positive effects on Bangladeshi banks when their

performances are measured by ROE and Tobins Q. Ultimately the average rate of return on

assets (2.72%) is very negligible due to this non-performing asset against higher rate of return

on equity (19.08%) that is the effect of high degree of trading on equity.

VII. CONCLUSION

The study investigates the extent of compliance with the statutory norms and guidelines

relating to corporate governance and the influence of corporate governance mechanisms on

financial performance of the 25 listed banking companies in Bangladesh. Accounting based

measures such as ROA and ROE and market based measure such as Tobins Q are used to

measure the financial performance of these banking companies over the period 2003-2011.

Estimated results in this study confirm a significant positive association between audit

committee meetings and Bangladeshi banks financial performance. Directors ownership and

independent directors are found to be significantly and positively related with bank

performance. Finally, levered banks are found to perform better than that of non-levered

banks in Bangladesh.

34

The results indicate that a good number of companies does not comply the mandatory

requirements for board size, appointment of independent directors in the board, and holding

audit committee meetings set forth by the central bank and the Security and Exchange

Commission (SEC) implying remarkable shortfall in corporate governance practice in

Bangladeshi banking sector. The board is seen to have been prevalently dominated by the

outside non-independent directors having multiple directorships and the companies are

actually run by the independent managers having no duality and no ownership interest. The

rate of return on shareholders equity is constantly much higher. The debt equity ratio is

gradually decreasing due to decreasing rate of interest on depositors investments in banks.

The CEO remuneration is increasing over the years in keeping with the increase in banks

total assets and the increased percentage of return on shareholders equity.

In this study, various aspects of rules and regulations of corporate governance, its

practices and the influences on the companies performance in the banking sector in

Bangladesh have been examined and analyzed. Based on the analysis, certain findings have

come out and some suggestions have been put forward to improve the situation prevailing in

the arena of corporate governance and practices. This study makes several contributes to the

growing literature on corporate governance. There are few studies regarding corporate

governance mechanisms and companies performance in developing countries. Very few

such studies can be found in the context of financial sector in Bangladesh. From this

perspective, the study has immense value to the planners and regulators. The study will

provide additional support for the view that while much emphasis on corporate governance

mechanisms is necessary to safeguard the interest of stakeholders, good corporate governance

on its own cannot make a company successful. Companies need to balance corporate

35

governance structure with key drivers of performance by taking and implementing strategic

decision and risk management with the efficient utilization of organizations resources.

Using different estimators and alternative performance measures this study

empirically finds that a very few governance variables have significant positive effects on

financial performances of Bangladeshi banking companies. The results in the context of

developing countries contend with the findings of Fahy et al. (2005) and PAIB Committee

(2004) that corporate governance of an organization ensure conformance but does not directly

ensure performance, rather helps to achieve performance. Good corporate governance with

the goal of providing strategic plan and effective risk management and efficient utilization of

organizations resources can achieve performance.

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