Roles of Outside Directors in Cooperative Financial Institutions International conference International competition in banking: theory and practice Sumy, Ukraine, May 2425, 2012 Nobuyoshi Yamori, Nagoya University Kozo Harimaya, Ritsumeikan University Kei Tomimura, Aichi University 1

Motivation Governance in cooperative financial institutions Examine the relationship between governance structure and performance for cooperative financial institutions (co-ops). In particular, whether the existence of outside directors in credit associations have an impact on management performance? The Financial Services Agency recommended appointing outside directors at board as a means for strengthening governance for co-ops. Also, examine the differences between co-ops and stock banks. 2

Background Shinkin banks (credit associations) Cooperative regional financial institutions serving small and medium enterprises and local residents. Playing a substantial role in the Japanese banking markets. 12.0% loan market share and 11.6% deposit market share at the end of FY Many co-ops failed after the 1990s bubble burst in Japan. The FSA has been promoting region based relationship banking since FY

Share of the loan market in Japan - At the end of FY Other financial institutions 4

Number of depository financial institutions in Japan FY1980FY1990FY2000FY 2010 City banks Trust banks Long-term credit banks 3330 Regional banks Regional banks II Credit associations Credit cooperatives

Governance structures in credit association Board Members Selection committee Candidate for representative council members Representative council members 6

Samples Three types of regional financial institutions in Japan Regional banks: consist of regional banks and regional banks (former mutual banks). about 80% of them are publicly listed. Credit associations (Shinkin banks) Credit cooperatives (Shinkumi banks): mutual capital structure co-ops. some differential type of institutions (only for the members of specific business and occupation) are excluded. 7

Previous literatures Outside directors in stock companies The role of outside directors are positively evaluated given a certain set of circumstances. Weisbach (1988), Daily and Dalton (1992), Byrd and Hickman (1992), Shivdasani (1993), Barnhart and Rosenstein (1994), Brickley et al. (1994), Kiel and Nicholson (2003), etc. Very little research has been conducted for co-ops. 8

Analytical framework Measuring bank efficiency Test whether a structural cost difference exists among the three types of regional financial institutions (regional banks, credit associations, and credit cooperatives). Measuring the SFA efficiency scores for each sub sample by using the pooled data from FY 1999 to FY Effects of governance on efficiency Examine whether governance structure (inc. outside directors ) have significant influences on efficiency by using the data for FY1999 and FY Compare the estimated results for the three types of regional financial institutions. 9

Methodology Efficiency measurement Standard translog functional form in the stochastic frontier modeling. Inefficiency term (u) is assumed to be half-normally distributed. To obtain yearly efficiency measures of each bank, pooled data set is used (not employed panel data analysis). v; iid N(0, σ v 2 ) u; iid N + (0, σ u 2 ) 10

Data Bank-specific financial variables (Cost function) Output: interest on loans and discounts (y 1 ), other interest income (y 2 ), and commissions and fees (y 3 ) - Input prices: personnel expenses/number of employees (w 1 ), interest expense/deposits (w 2 ), non- personnel expenses/book value of fixed assets (w 3 ) - Cost: sum of three input expenses (operating and interest expenses) 11

Descriptive statistics (Cost function) - Pooled data over the period from FY 1999 to FY Variables Regional banks Credit associations Credit Cooperatives MeanStd. Dev. MeanStd. Dev. MeanStd. Dev. Total cost (C)29,01220,9095,1126,1091,7761,980 Interest on loans and discounts (y 1 )34,76427,0065,1906,6491,9052,306 Other interest and dividend income (y 2 ) 9,87810,4151,5551, Fees and commissions (y 3 )6,5666, The price of labor (w 1 ) The price of deposits (w 2 ) The rental price of capital (w 3 ) Observaions (Unit Person Millions of Yen % 12

Data Governance related variables (Governance regression) Main variables: number of directors (NS), the ratio of outside directors to all directors (ODR), and the size of representative council members (RCM) - Other control variables: capital asset ratio (CAR), bad loan ratio (BLR), loan to deposit ratio (LDR), log of total assets (LAS), and dummy variable for merged banks (MGDM) 13

Descriptive statistics (Governance regression) - Average values of cross-sectional data for FY 1999 and FY Variables Regional banks Credit associations Credit cooperatives Number of board members (NS) Ratio of outside board member (ODR) Number of representative members (RMB) Capital adequacy ratio (CAR) Bad loans ratio (BLR) Loan-deposit ratio (LDR) The logarithm of total assets (LAS) Observations (Unit Person Millions of Yen % 14

Results - Differences in cost structure - First, we examined the differences in cost structures between regional banks and co-ops (including both of credit associations and credit cooperatives). Next, we further examined the differences in cost structures between credit associations and credit cooperatives. Since F-test rejects the null hypothesis of equal variances at the 1% level, cost structures are significantly different between regional banks, credit associations, and credit cooperatives. 15

Results - Descriptive statistics on efficiency scores - Regional banks Credit associations Credit cooperatives MeanStd Dev. MeanStd Dev. MeanStd Dev All

Results (Governance regression) - Analysis of FY Variable Regional banks Credit associations Credit cooperatives Efficiency Level Efficiency Rank Efficiency Level Efficiency Rank Efficiency Level Efficiency Rank Coefficient Coefficient Coefficient Coefficient Coefficient Coefficient Constant *** *** *** ** NS *** ODR ** * ** *** RCM *** *** CAR *** ** * BLR *** ** LDR *** *** * LAS *** * ** MGDM ** *** ** *** Adj-R Observations

Results (Governance regression) - Analysis of FY Variable Regional banks Credit associations Credit cooperatives Efficiency Level Efficiency Rank Efficiency Level Efficiency Rank Efficiency Level Efficiency Rank Coefficient Coefficient Coefficient Coefficient Coefficient Coefficient Constant *** ** *** *** NS *** *** ODR ** ** RCM *** *** CAR *** *** BLR ** ** LDR *** *** ** ** LAS *** ** *** *** MGDM *** *** * Adj-R Observations

Summary of results The governance structure including outside directors have a significant effect on cost efficiency for credit associations. The findings support the recent Japanese government guidelines for improving governance with regard to co-ops. However, such governance variables have no significant effect on cost efficiency for credit cooperatives. Also, outside directors have no significant effect on cost efficiency for regional banks in the recent sample year. For the listed ones, market-related governance factors are considered to affect any impact on cost efficiency. 19

Further issues Examine differences in the results between three types of banks In particular, what alternative governance factors affect the efficiency for stock-banks? (e.g. listed or unlisted) Examine the effects of regional economic condition Differences in industry structure, loan market competition, etc. Extended global comparative analysis (if possible…) Did the recent financial crisis reveal severe shortcomings in corporate governance for co-ops in Europe or US? 20

References Weisbach, M.S. (1988) Outside Directors and CEO Turnover, Journal of Financial Economics 20, Daily, C.M. and Dalton, D.R. (1992) The relationship between governance structure and corporate performance in entrepreneurial firms, Journal of Business Venturing 7, Byrd, J.W. and Hickman, K.A. (1992) Do outside directors monitor managers?, Journal of Financial Economics 32, Barnhart, S.W. and Rosenstein, S. (1994) Firm performance and board composition: Some new evidence, Managerial and Decision Economics 15, Brickley, J.A., Coles, J.L., and Terry, R.L. (1994) Outside directors and the adoption of poison pills, Journal of Financial Economics 35, Kiel, G.C. and Nicholson, G.J. (2003) Board Composition and Corporate Performance: how the Australian experience informs contrasting theories of corporate governance, Corporate Governance 11, Shiidasani. A. (1993) Board composition. ownership structure and hostile takeovers, Journal of Accounting and Economics 16,

Thank you for your attention 22