Ownership Structure and Risk-taking Behavior: Evidence from Banks in Korea and Japan

Transcription

1 MPRA Munich Peronal RePEc Archive Ownerhip Structure and Rik-taking Behavior: Evidence from Bank in Korea and Japan Sun Eae Chun and Mamoru Nagano and Min Hwan Lee CHUNG-ANG UNIVERSITY, NAGOYA CITY UNIVERSITY, INHA UNIVERSITY September 2010 Online at MPRA Paper No , poted 23. September :08 UTC

2 Ownerhip Structure and Rik-taking Behavior: Evidence from Bank in Korea and Japan Sun Eae Chun* Mamoru Nagano** Min Hwan Lee*** *Firt author, Aociate Profeor, Graduate School of International Studie, CHUNG-ANG UNIVERSITY, 221, Heukeok-dong, Dongjak-gu, Seoul , Korea. Tel: , Fax: , ** Correponding author, Profeor, Graduate School of Economic, NAGOYA CITY UNIVERSITY, Yamanohata 1, Mizuho Nagoya , Japan. Tel/Fax: , *** Aitant Profeor of Finance, Diviion of Global Finance and Banking, College of Buine Adminitration, INHA UNIVERSITY, Incheon , Korea. Tel: , Fax: ,

3 Ownerhip Structure and Rik-taking Behavior: Evidence from Bank in Korea and Japan Abtract Thi tudy analyze the effect of managerial ownerhip on the rik-taking behavior of Korean and Japanee bank during the relatively regulated period of the late 1990 to the early It find that managerial ownerhip alone doe not affect either the rik or the profit level of Korean bank. In contrat, an increae in managerial ownerhip add to the total rik of Japanee bank. However, increaed rik-taking behavior doe not produce higher level of profit for Japanee bank. The coefficient of the interaction term between franchie value and managerial ownerhip are negative and tatitically ignificant for both the Korean and the Japanee banking indutrie. Thi mean that an increae in managerial ownerhip at bank with high franchie value dicourage rik-taking behavior. The reult confirm the diciplinary role of franchie value on the rik-taking behavior of bank. It alo fall in line with previou literature upporting the moral hazard hypothei baed on reearch into the economie of the U.S. and other countrie. JEL Claification: Keyword: G20, G21 G32 Bank ownerhip tructure, managerial ownerhip, moral hazard, franchie value, rik-taking behavior

4 I. Introduction Limited liability allow hareholder to keep all upide gain while haring their loe with bondholder. Shareholder, therefore, have a trong incentive to increae rik. Bondholder, particularly depoitor, alo have weak incentive to monitor and limit uch rik-taking behavior becaue they are hielded from it conequence by the financial afety net of limited liability. Thi lead to the moral hazard problem aociated with depoit inurance. The monitoring function, therefore, fall on regulator, including depoit inurer. However, many tudie ugget that the incentive of bank manager may differ from thoe of external tockholder. If the manager largely invet in non-diverifiable (i.e., firm-pecific) human capital, and manager of failed firm have difficulty finding comparable job due to a reputation for incompetence, they may act in a rik-avere rather than in a value-maximizing manner in order to keep their job (Berle and Mean, 1932; Jenen and Meckling, 1976). Thi tockholder-manager agency conflict may help offet the moral hazard problem by aligning the interet of rik-avere bank manager with thoe of bank regulator. Neverthele, the conflict between tockholder and manager can be mitigated if the manager interet are aligned with thoe of external tockholder. Thi can arie through inider ownerhip, which can be created when bank manager are compenated with tock or tock option, and are thu granted ownerhip of hare. While numerou tudie have documented an invere relationhip between rik-taking by non-bank firm and managerial control, the conflict of interet i more complicated in the banking ector.

5 Thi i becaue of the preence of bank regulator, who by their action et the rule and regulation regarding rik-taking by bank. Le regulated environment can exacerbate tockholder-manager conflict over level of rik-taking. Such condition occur when, for example, buine activitie and interet rate are deregulated, or when cloure rule are not trictly enforced. Deregulated environment give bank tockholder greater incentive and abilitie to increae rik than tightly regulated one do. In addition, ownerhip tructure i expected to have a much tronger effect on the level of rik taken by bank during period of deregulation than during period of regulation. Franchie value the preent value of a firm future economic profit a a going concern alo work to reduce the rik-taking incentive of bank. Thi i becaue bank with high franchie value have much to loe if a riky buine trategy lead to inolvency. Therefore, franchie value help to mitigate the moral hazard problem aociated with the afety net. Keeley (1990) claim that the decline in franchie value of the US bank in the 1960 and 1970 can explain the increae in their rik-taking behavior in the Thi paper examine the relationhip between the ownerhip tructure and riktaking behavior of bank in Korea and Japan during the relatively regulated period of the late 1990 through the mid The literature about the effect of managerial ownerhip on the rik-taking behavior of bank i mainly baed upon U.S. banking experience of the Moreover, it differ on the exact relationhip between ownerhip tructure and rik-taking. Therefore, an examination of the relationhip between ownerhip tructure and the rik-taking of bank in Korea and Japan could provide better inight into the iue. The organization of the paper i a follow. Following the introduction, Section II

6 decribe the background of the financial indutrie in Korea and Japan. Section III review the literature on the relationhip between the ownerhip tructure and rik-taking behavior of bank. Section IV invetigate the empirical model and explain the data employed in thi reearch. Section V preent the reult of the empirical etimation, while Section VI conclude the tudy. II. The Background of the Financial Indutrie in Korea and Japan Thi paper examine the relatively regulated period of 1997 to 2005 for Korea, and of 1996 to 2006 for Japan. In both countrie, the indutrial organization of the banking ector wa gradually changed in the late 1980 and dramatically reformed in the Triggered by the bankruptcy of the Continental Illinoi National Bank and Trut Company, a major U.S. commercial bank, new international guideline for commercial bank were introduced under the uperviion of the Bank for International Settlement (BIS). Commercial bank in Korea and Japan had to comply with thee new guideline, which began to influence their ownerhip tructure in the late In 1990, dometic financial authoritie reflected the above international banking uperviion, thereby further promoting the tructural change of the Korean and Japanee banking indutrie in the decade that followed. Until the mid-1990, the government of Korea and Japan intervened heavily in the management of bank through meaure uch a credit allocation and the appointment of bank CEO. In thoe year, neither ownerhip tructure nor franchie value wa related to the rik-taking behavior of individual bank. Thi wa epecially true in Japan, which

7 introduced what i commonly dubbed a the financial convoy ytem. 1 In Korea, too, the government placed heavy impoition on bank management, although to a leer extent. Under thee financially repreed circumtance, the level of rik taken by bank were not reflected in their balance heet, nor were differentiating trategie even neceary. However, the government began to promote financial liberalization and deregulation in the mid-1990 in order to enhance the competitivene of their repective banking indutrie. They deregulated interet rate and permitted new bank to enter the market while implicitly protecting bank o that they would urvive. A a reult, competition grew intene and bank engaged in aggreive rik-taking behavior, which combined with governmental forbearance from bank cloure to become one of the main caue of the 1997 financial crii a experienced in Korea, and of the prolonged luggihne of the Japanee banking ector. The Korean Banking Indutry The 1988 BIS capital tandard wa introduced to the Korean banking indutry in 1992, but wa not implemented until Following the 1997 financial crii, BIS capital tandard were further tightened. Lee (2000) tudied the relationhip between riktaking and capital regulation in the Korean banking ector during the 1990, and find that capital and rik level are poitively related. In addition, Chun and Lee (2000) look at the effect of trict capital regulation at the end of the 1997 financial crii, and find that it forced commercial bank to reduce their ownerhip of riky aet. Thi led to the ocalled credit crunch, which worened the economic receion caued by the financial crii (Chun and Lee, 2000).

8 The Korean banking ector underwent comprehenive financial retructuring after the 1997 financial crii. At the end of 1997, uperviory bodie were conolidated into a controlling agent, the Financial Superviory Commiion (FSC), and BIS capital regulation were tightly enforced. In 1998, accounting tandard were trengthened with the claification rule for non-performing loan aligned to the bet international practice. Forward-looking criteria were alo employed. Further, Prompt Corrective Action (PCA) wa ued to retructure individual financial intitution. When the firt round of financial retructuring wa completed in the context of a tabilized financial market at the end of 1999, a partial depoit inurance guarantee ytem wa introduced. Thi wa meant to alleviate the moral hazard problem aociated with the depoit inurance ytem, and to introduce market dicipline in the banking ector. The financial retructuring of the banking ector reulted in bank merger that ignificantly reduced the number of Korean bank from 26 in 1997 to thirteen in The firt bank merger wave hit Korea during the period of 1997 to 2001, when the government launched financial tructural reform a a way of tabilizing the dometic banking ytem. Converely, the econd wave occurred in late 2001, when individual commercial bank ought to trengthen their competitivene within the market. 2 A the reform progreed, the banking ector became heavily concentrated. Thi development ha helped to enhance the franchie value of bank (Lee and Nagano, 2008). The Japanee Banking Indutry In Japan, financial liberalization wa initially introduced in 1979, and wa trongly encouraged by the government and the new trend of international regulation

9 impoed by the BIS during the firt half of the Conequently, the Japanee banking ector experienced dramatic tructural change in the Financial liberalization wa generally complete when the time depoit interet rate wa deregulated in During the firt 1990, the entire commercial banking ector performed quite oundly, while ome non-bank firm declared inolvency. Between 1996 and 1998, during the Hahimoto adminitration, the Japanee government conducted another comprehenive round of financial reform, which i known a the Japanee Big Bang. They made it poible to etablih financial holding firm without obtaining prior approval from the financial authoritie, and anctioned regulatory change that liberalized market entry requirement. Following the ratification of thee meaure, Japanee bank etablihed holding firm and conolidated the ubidiarie of trut bank, ecuritie companie, and aet management buinee under thee holding companie. During thi period, Japan experienced the bankruptcie of two major bank, the Hokkaido Takuhoku Bank and the Japan Long-Term Credit Bank. In repone to banking ector turmoil, the Financial Superviory Agency (FSA) wa etablihed in 1998 to accede to the uperviory role previouly pread acro the Minitry of Finance and the Bank of Japan. The FSA introduced new criteria for the aement of banking aet, which caued increae in the Non-performing Loan (NPL) ratio of bank. Moreover, tightened fical policy under the Koizumi adminitration dragged down the growth of the Japanee economy. Between 1998 and 2006, there were fourteen bank merger, three major corporate reorganization, and four tranfer of buine operation from bankrupt bank. 3 The

10 bank merger wave reulted in ignificant tructural change in the depoit and lending market, which became remarkably concentrated during thi period. While competition increaed in metropolitan area, the banking ector remained oligopolitic in local citie. Thee differing degree of ownerhip concentration acro metropolitan area and local citie have reulted in varying bank franchie value. III. Literature Review and Hypothee (a) Earlier Reearch on the Relationhip between Franchie Value and Ownerhip Structure Earlier reearch ha eparately examined the diciplinary role of franchie value and the effect of ownerhip tructure on bank rik. Franchie value can help to leen the moral hazard problem by increaing the incentive of bank to operate afely, thereby aligning their interet with thoe of depoit inurer and bank upervior. Keeley (1990) document the decline in U.S. bank franchie value during the 1950, 1960, and 1970, when the country banking indutry experienced deregulation and faced increaed competition from non-bank financial intitution. He argue that the drop in franchie value led to increaed rik-taking and heightened rate of inolvency in the Galloway, Lee, and Roden (1997) alo find that bank holding companie (BHC) with higher franchie value conitently undertook lower level of rik between 1977 and 1994, while BHC with lower franchie value engaged in greater rik for mot of the year within thi period. Banking literature preent evidence that managerial hareholding i an important determinant of bank rik-taking, but empirical reult in thi

11 phere are mixed becaue they depend on the different meaure of bank rik ued and the different regulatory environment conidered. Accordingly, there i no conenu on the exact form of the relationhip between bank rik and managerial ownerhip. (b) Regulatory Condition and Rik-taking Behavior The following reearch contrat ample period repreenting the deregulated and the regulated period of banking uperviion. They reveal that bank rik and managerial ownerhip were poitively correlated during the deregulated period, but negatively or inignificantly related during the regulated period. Saunder, Strock, and Travlo (1990) impoe linearity on the relationhip between the two factor in their tudy of large bank, which lated from 1978 to Their concluion for the 1979 to 1982 period of deregulation i that tockholder-controlled bank (bank whoe manager hold a relatively large proportion of tock) exhibited ignificantly higher rik-taking behavior than manager-controlled bank did (thee bank being thoe whoe manager hold a relatively mall proportion of tock). Chen, Steiner, and Whyte (1998) reexamine the agency problem poed by managerial ownerhip during the relatively regulated ample period of the late 1980 and the early They find that the extent of managerial ownerhip i inverely related to the variou meaure of depoitory intitution rik. Further, Chen, Steiner, and Whyte (1998) provide evidence of nonlinearity in the relationhip between rik-taking and managerial ownerhip. Cebenoyan et al. (1995) find that, in 1988, aving and loan aociation (S&L) with high level of managerial ownerhip engaged in greater rik than S&L with lower level of managerial ownerhip. Thi i in the context of a year

12 that i widely regarded a a time of regulatory leniency and forbearance (Cebenoyan et al., 1995). In contrat, S&L with high level of managerial ownerhip aumed lower level of rik in 1991, a year of regulatory tringency and non-forbearance (Cebenoyan et al., 1995). Further, Kole and Lehn (1999), Anderon and Fraer (2000), and Konihi and Yauda (2004) have examined the relationhip between bank rik-taking behavior and ownerhip tructure before and after the regulatory change. (c) Internal Governance and Rik-taking Behavior Exiting literature alo how that internal control i related to the rik-taking behavior. Gorton and Roen (1995) ue a corporate control approach to explain increaed rik-taking behavior by bank in the In a banking environment with few good invetment opportunitie, poor corporate control mechanim, and information aymmetrie that allowed manager to control bank, bad manager engage in more, but ultimately unprofitable, rik in order to convince external tockholder that they are good manager taking on good rik. Under the corporate control hypothei, bank with entrenched manager who own mall amount of tock will engage in unprofitable riktaking. However, manager who poe large tockholding, and who have hence placed coniderable peronal wealth at take, will attempt to take on only profitable rik. Gorton and Roen (1995) find that in , BHC with high level of managerial tock ownerhip acquired lower credit rik while thoe with low level of ownerhip exhibited entrenchment effect. Thi finding i conitent with the corporate control hypothei.

13 (d) Franchie Value and Ownerhip Structure in Bank and Non-financial Firm Demetz, Saidenberg, and Strahan (1997) argue that franchie value and managerial ownerhip hould be treated a independent variable in an examination of rik-taking behavior. Rik averion on the part of manager may counteract the rik preference of owner, thu offetting the moral hazard problem. In addition, the interet of owner and manager would be aligned at bank with high franchie value, though not at bank with low franchie value. Previou tudie have indicated the relationhip between franchie value and ownerhip tructure in both non-financial firm (ee e.g., Demetz and Lehn [1985]; Mork, Shleifer, and Vihny [1988]) and in bank (ee e.g., DeYoung, Spong, and Sullivan [1996]; Booth, Cornet, and Tehranian [2002]; Gonzalez [2005]). Franchie value i inverely related to rik-taking, even after controlling for ownerhip tructure (inider holding and large block holding). According to Anderon and Fraer (2000), managerial hareholding were poitively related to total and firmpecific rik in the late 1980, when banking wa relatively le regulated and under coniderable financial tre. However, thi relationhip turned negative in the early 1990 becaue legilation deigned to reduce rik-taking wa enacted in 1989 and (e) Study Hypothee and Literature on Korean and Japanee Bank Few urvey have explicitly examined the agency problem in either the Korean or the Japanee banking indutrie. According to reearch publihed between the year of 1994 to 2000 (Lee, 2004, ), bank manager in poition of greater moral hazard tend to have more incentive to align their interet with thoe of tockholder. They take on more rik and higher level of managerial ownerhip when compared with

14 thoe in poition of leer moral hazard. However, thi relationhip only held over the relatively deregulated period of 1994 to Konihi and Yauda (2004) examine the rik-taking activitie of Japanee bank during 1990 to 1999, and find that hareholder ownerhip had a nonlinear relationhip with rik, and that decline in franchie value increaed the taking of rik. Literature urveying the rik-taking behavior of bank in the Korean or the Japanee banking ector only examine the 1990, and neglect to explore the interaction between franchie value and managerial ownerhip. In contrat, thi paper focue on the relatively regulated period of the late 1990 and the early 2000, and examine the diciplinary role of franchie value by taking account of the interaction between franchie value and managerial ownerhip. In doing o, it tet the moral hazard hypothei, and obtain inight on the agency problem and the diciplinary role of franchie value in period of relative financial tability in Korea and Japan. It alo invetigate whether riktaking behavior reulting from increaed level of managerial ownerhip lead to higher profit. IV. Empirical Model and Data 1. Model We ue the panel etimation model, which combine data for variou commercial bank over the ample period in equation (1), to examine the relation among rik, ownerhip tructure, and franchie value for bank in Korea and Japan. Following Saunder, Strock, and Travlo (1990), we aume that, at leat in the hort term,

15 managing performance can be viewed a an endogenou deciion variable, which i affected by ownerhip tructure, franchie value, and other control variable. 4 Rik 2 = γ j + γ 1Inide + γ 2Inide + γ 3Outide + γ 4Qratio 1 γ + 5 Qratio 1 * Inide + Control Variable + Dum + ε t (1) We capture the difference in cro-ectional bank unit by pecifying an intercept coefficient for each cro-ectional unit in the panel model, and etimate the difference in intercept uing dummy variable. Thi i a fixed effect model becaue the regreion line i raied or lowered by a fixed amount for each individual. However, individual difference can alo be treated a random diturbance drawn from pecified ditribution in a random effect model, in which cae, it become part of the model diturbance term (Judge et al., 1988; Baltagi, 2008). The method of ordinary leat quare i the bet unbiaed linear etimator for fixed effect model, and the method of generalized leat quare i the bet unbiaed linear etimator for random effect model. Random effect model require no correlation between the regreor and the individual attribute repreented by intercept coefficient. The Hauman pecification tet wa employed to chooe between the fixed effect model and the random effect model, and it rejection of the null hypothei uggeted that the random effect model wa not appropriate and that the fixed effect model hould be employed (Hauman and Taylor, 1981).

16 Rik in equation (1) repreent bank j rik in time t. A in Chen, Steiner, and Whyte (1998), we ue the two-index model to generate rik meaure. The two-index model i repreented a follow: R = + β R + β R + e α 0 MKt MKt IN INt Here, R repreent the return on the tock of the th j bank at time t. R MKt deignate the market index (either the Korea Compoite Stock Price Index [KOSPI] or the Tokyo Stock Price Index [TOPIX]) at time t. R INt denote the hort-term interet rate erie indicated by daily change in yield on 30-day Treaury bill, and e repreent random error term. Variou rik meaure can be derived from the above two-index model. Total rik σ i meaured a the tandard deviation of weekly return on each bank tock. Unytematic rik σ ε i meaured a the tandard deviation of reidual error term from the model. Sytematic rik i repreented by β MK, return, or market beta. the coefficient of market portfolio Thee meaure are employed becaue management can affect both ytematic and unytematic rik, given that bank are imply portfolio of primary financial aet. For example, a bank inveting heavily in Treaury ecuritie would be relatively low-rik and have a low market beta. Thu, ytematic rik can be influenced by management deciion. Bank may alo find it difficult to diverify unytematic rik if lending i concentrated in certain region or on certain product.

17 Inide refer to the percentage of equity held by manager and director at the th j bank at time t. For Japanee bank, Inide refer to the portion of equity owned by table hareholder (thoe who do not engage in hort-term tock trading, including director, manager, and bank a organization). It i generally believed that Japanee firm are controlled by table hareholder (Kang et al., 1999). Thi i expected to have potentially the ame effect on rik-taking a managerial ownerhip doe in the U.S. 2 Inide, the quare of Inide, allow for the poibility of a nonlinear relationhip between managerial ownerhip and rik-taking behavior. Thi i to accommodate the obervation of McConnell and Servae (1990), Gorton and Roen (1995), and Cebenoyan et al. (1999). The corporate control hypothei predict a ignificant poitive coefficient for Inide, and a ignificant negative coefficient for 2 Inide. The monitoring of managerial rik-taking could be affected by the tructure of ownerhip a well a by the regulatory tructure. We include Outide a a proxy for the tructure of ownerhip. Outide i meaured a the percentage of hare held by external block holder. 5 The information aymmetry hypothei (Ro [1989]; Zeckhaue and Pound [1990]) predict that the opaque nature of banking give external tockholder, including intitutional invetor, little control over bank manager. Thi hypothei anticipate that the coefficient for Outide will be inignificant. Converely, Pound (1988) prudent man hypothei predict the oppoite. According to thi hypothei, intitutional invetor a large block holder have greater expertie, reource, and incentive for monitoring bank management, and are le ubject to the information aymmetrie uffered by other tockholder. Therefore, the prudent man hypothei

18 enviion that Outide will have a negative relationhip with the rik meaure and a poitive one with profitability. Outide may repreent concentrated ownerhip, which i often ued to identify hareholder monitoring. The literature ha ued intereting way to invetigate the relationhip among ownerhip concentration, firm rik, and regulation. Under the ubtitution hypothei, owner are more active when there i le regulation. Gonzalez (2005) and Kim et al. (2007) conduct extenive review on the literature about the ubtitution hypothei. Demetz and Lehn (1985), Himmelberg, Hubbard, and Palia (1998), and Holderne, Krozer, and Sheehan (1999) find a poitive relation between ownerhip concentration and firm rik. Kim et al. (2007) ugget that thi i indicative of monitoring by large hareholder. Anderon and Fraer (2000) and Konihi and Yauda (2004) find that rik-taking by hareholder commonly increae during le regulated period while decreaing during period of tringent regulation. 6 Q 1 repreent the franchie value of bank j at time t-1. In order to take account of the fact that rik-taking behavior i affected by the previou year franchie value rather than by the current one, franchie value wa lagged. Tobin q, defined a the ratio of the market value of a firm to the replacement cot of it aet, i an attractive theoretical meaure with which to determine franchie value. 7 Following Keeley (1990) technique for deriving a proxy for franchie value, we ued a imple etimator of q, the um of the market value of common equity (price per hare time number of hare) plu the book value of liabilitie divided by the book value of aet. To examine the interaction between managerial tock ownerhip and franchie value, we added the lope interaction variable Qratio * Inide 1. The coefficient indicate

19 whether managerial ownerhip ha an encouraging or depreing effect on rik a the franchie value of a bank increae. Negative and ignificant coefficient imply that an increae in managerial ownerhip at bank with high franchie value dicourage riktaking activity, which upport the hypothei that franchie value play a diciplinary role in regulating rik-taking by bank. We ued three control variable in the model: LTA, CAP, and FA. LTA, the log of the total aet of the th j bank at time t, hould have an offetting effect on rik-taking becaue large bank tend to hold more diverified aet portfolio, reulting in lower level of rik. Neverthele, the implicit guarantee provided by the government for large bank through endorement of the too big to fail notion may encourage bank to take more rik. CAP, the capital-to-aet ratio (hareholder equity a a proportion of total aet) of the th j bank at time t, repreent financial leverage and hould be negatively related to the rik meaure. A the capital-to-aet ratio of an intitution rie, it level of rik i expected to fall. Although we choe the capital-to-aet ratio to ignify financial leverage, the equity-to-aet ratio i alo one of the mot commonly ued proxie for bank rik. When equity level are low, bank rik i high; thi i becaue capital repreent collateral againt liabilitie and protect bank from inolvency when aet value decline (Pringle, 1974; Santomero and Waton, 1977; Taggart and Greenbaum, 1978; Buer, Chen, and Kane, 1981; Marcu, 1983; Houton and Jame, 1995). Conervative owner or manager will maintain high level of capital. Further, Barth, Bartholomew, and Bradley (1990); Cebenoyan, Coperman, and Regiter (1995); Gibon (1995); and Knopf and Teall (1996) ued the capital-to-aet ratio a a proxy for bank rik in their tudie of Japanee bank.

20 Latly, write-off for loan loe could be ued a another meaure of bank rik (Gorton and Roen, 1995). We alo ued the variable CAP a a dependent variable for bank rik in Korea and Japan, and report the reult of etimation thu derived. In addition, we employed the ratio of write-off to total aet a a dependent variable repreenting rik appetite in Japanee bank. 8 The final control variable i FA, the fixed aet ratio (i.e., the ratio of property, plant, and equipment to total aet) of the th j bank at time t. It hould be poitively related to the rik meaure becaue fixed aet erve a a meaure of both operating leverage and liquidity of the aet portfolio. Year dummy variable were included in order to capture year- pecific characteritic. Return on aet (ROA) wa alo ued a an independent variable in a eparate model in order to analyze the effect of inider ownerhip and franchie value on the profitability of bank. The banking ytem differ between the two countrie. For example, keiretu bank in Japan extract rent from their client firm (Weintein and Yafeh, 1998) in exchange for maintaining cloe relationhip with them. Thee bank preure their client firm to maintain high level of bank debt at high interet rate. Therefore, they are likely to be more profitable than other type of bank. To ee whether thi affect the ROA for Japanee bank, we included an additional equation with a keiretu dummy variable for Japanee bank. 2. Data

21 We ued panel data on commercial bank from the relatively regulated period of 1997 to 2005 for Korea and 1996 to 2006 for Japan. Since bank rik are meaured by capital market rik, ample bank hould be lited on a tock exchange. The number of lited bank varie greatly during the ample period becaue the banking ector were undergoing financial retructuring, and merged bank are treated a new bank. Table 1 how the number of bank urveyed per year. Table 1 here Our panel i unbalanced, and the etimation could be biaed by the election of only urviving bank. Thi i becaue rikier bank preumably drop out of the ample on a more frequent bai. Further, new entrant may aume different rik-taking behavior from exiting bank. It i widely recognized that, when thi i the cae, ordinary leat quare (OLS) etimate uffer from election bia. Therefore, we apply a two-tep Heckman procedure (Heckman, 1979) and calculate the Mill ratio to check the urvival bia in our ample. The reult are reported in the Appendix. 9 Data on Korean tock market return were obtained from the Korea Stock Reearch Intitute (KSRI). Data on managerial ownerhip and large block holder were acquired from the databae of the Korea Lited Companie Aociation (KLCA) and the annual report of individual bank. Balance heet data and equity market value were both ecured from the Fnguide 10 databae and the Financial Superviory Service (FSS). 11 Japanee tock market data (i.e., the Tokyo tock market index and the tock price of individual bank) were procured from FinancialQuet, the online databae of the

22 Japanee buine newpaper publiher NIKKEI, while ownerhip data were from Bloomberg and Thomon Reuter. The financial data on commercial bank are from the Kaiha Zaimu Karte of the Tokyo Keizai Shimpo. Table 2 how the lit of variable and their decription. Table 2 here V. Empirical Reult 1. Decriptive Statitic Table 3 provide decriptive tatitic for the ample of the Korean banking ector, which cover the year of 1997 to It how that the level of total rik, meaured a the tandard deviation of weekly tock return erie, i percent, and that the mean level of unytematic rik, meaured a the tandard deviation of the reidual of the index model, i 8.70 percent. It alo reveal that the mean market beta, while poitive, equal le than one. Additionally, the average level of officer and director ownerhip i 0.25 percent, with a tandard deviation of 0.65 percent, and a maximum hare of 3.84 percent. In comparion, the mean average of ownerhip by external block holder i percent. At 0.99, our meaure of franchie value fall jut below one. Thi mean that, on average, the market value of aet i 0.08 percent maller than the book value of aet for the bank in the ample. The tandard deviation of 0.03 reveal ome diperion in franchie value, but mot ample bank have franchie value approximating the average.

23 The mean value of log of total aet i 23.75, and the average capital-to-aet ratio for the bank in the ample i 4.28 percent. The fixed-aet-to-total aet ratio ha an average of 3.28 percent, with maximum and minimum value of 7.91 percent and 1.28 percent, repectively. The ROA mean i 7.81 percent, with a tandard deviation of 2.76 percent. Table 3 here Table 4 decribe the tatitic for the ample of the Japanee banking ector, which cover the year of 1996 to It how that the level of total rik, meaured a the tandard deviation of weekly tock return erie, i 1.84 percent. Thi i lower than the total rik level of Korean bank. Further, the mean level of unytematic rik i alo lower than in the Korean data. The average level of inider ownerhip i 0.89 percent, with a tandard deviation of 1.32 percent. Generally, inider ownerhip ratio are high for local bank and low for bank with headquarter in the metropolitan area. The Japanee bank have a mean franchie value of one, which i a high a that of the Korean bank. The mean value of the log of total aet i 14.67,while the average capital adequacy ratio and average fixed aet ratio divided by total aet ratio i 4.62 percent and 1.68 percent, repectively. ROA mean ha a negative value of 0.09 percent. Table 4 here 2. Empirical Reult for Korea

24 Table 5 how the etimation for the relationhip between managerial ownerhip and bank rik in Korea, which ue variou meaure of bank rik a dependent variable. Managerial ownerhip and franchie value are included in the model with the interaction term. In cae where the Hauman pecification tet rejected the random effect model, the etimation of the fixed effect model are reported in it tead. We applied the twotep Heckman procedure to correct the ample bia in the model, and preent the reult in Appendix I. When total and unytematic rik are ued a dependent variable, the parameter etimated by the OLS method and the Heckman procedure are imilar, and the Mill ratio i very mall and inignificant. Thi implie that there i no ample bia in the model. The ample period in thi analyi i the late 1990 and early 2000, which wa a relatively regulated time. Previou literature ugget that ownerhip tructure ha a much tronger effect on the rik characteritic of bank during period of deregulation than it doe during period of regulation. Managerial ownerhip, Inide, when controlled for franchie value, affect only one of the three rik meaure ytematic rik. Thi i hown by the negative and tatitically ignificant coefficient of the quare of managerial ownerhip, 2 Inide, in the ytematic rik model. Similarly, franchie value, Qratio(-1), affect only ytematic rik when controlled for managerial ownerhip. However, when the coefficient of the interaction term, Qratio(-1)*Inide, are etimated, the reult obtained are conitent with the moral hazard hypothei. Thee coefficient are negative and tatitically ignificant at 10 percent for all the rik meaure ued a dependent variable. Thi implie that increae in managerial ownerhip at bank with high franchie value curb rik-taking behavior and reduce level

25 of rik. Thi i becaue the cot of bank failure can be dear for the owner of bank with high franchie value, who have much to loe if a riky buine trategy lead to inolvency. A a reult, the aforementioned increae trengthen their incentive to operate afely, thereby aligning their interet with thoe of depoit inurer and bank upervior. The reult concur with previou literature confirming the diciplinary role of franchie value on bank rik-taking. It alo accord with exiting analye of Korean cae by Lee (2004, ), which tate that bank in poition of greater moral hazard tend to have more incentive to align their interet with thoe of tockholder, and are therefore inclined to take on more rik a managerial ownerhip increae. The coefficient of Outide, which i the percentage of hare held by external block holder, i ignificant when total rik and ytematic rik are ued a dependent variable. Thi implie that large external owner affect the managerial deciion and the rik-taking behavior of bank. In the Korean banking ector in general, larger aet entail greater amount of rik. However, large bank are able to diverify, leading to lower rik, and the too big to fail notion may alo to reduce bank rik. According to Oh et al. (2003) and Park and Park (2007), increae in aet ize negatively affect the tability of Korean bank. In our etimation, the larger the aet ize, the greater the ytematic rik. Thi i conitent with previou reearch and the too big to fail doctrine. Our reult alo how that the capital-to-aet ratio doe not ignificantly affect the rik level of bank. A expected, the fixed aet ratio increae the level of total rik and unytematic rik in the model. Finally, the poitive and tatitically ignificant coefficient of the yearly dummy variable for the year of 1997 to 2002 reflect the unfavorable banking environment engendered by high level of rik.

26 Table 6 examine the relationhip between managerial ownerhip and ROA, 2 which act a a proxy for banking profitability. The variable Inide and Inide do not affect bank profit to a ignificant degree. Thu, managerial ownerhip affect neither bank rik a examined in Table 5, nor banking profitability a examined after controlling for franchie value. Contrary to our expectation, franchie value reduce bank profit after it i controlled for managerial ownerhip. Converely, the interaction term between managerial ownerhip and franchie value doe not influence bank profit. Elewhere, the capital-to-aet ratio poitively affect banking profitability, while the fixed aet ratio way it in a negative direction. The negative and ignificant coefficient of the dummy variable for the year of 1997 to 2000 reflect the unfavorable banking environment of the time. Table 5 here Table 6 here 3. Empirical Reult for Japan Table 7 preent the etimation for Japan. A for Korea, the etimation of the fixed effect model are preented in cae where the Hauman pecification tet rejected the random effect model. In addition, the two-tep Heckman procedure wa adminitered to correct the ample bia in the Japanee banking indutry, and the reult are preented in Appendix II. When all three rik meaure are ued a dependent variable, the parameter etimated by the OLS method and the Heckman procedure are

27 imilar, and the Mill ratio i very mall and inignificant. Thee reult imply that the model contain no ample bia. After controlling for the influence of franchie value, the model analyze increae in managerial ownerhip for their propenity to increae total rik. It find that managerial ownerhip doe not affect level of unytematic or ytematic rik. However, franchie value reduce both type of rik. In particular, it role in reducing level of ytematic rik maintain a one percent ignificance level. The coefficient of the interaction term for franchie value and managerial ownerhip are negative and ignificant, maintaining a five percent ignificance level for total rik and a one percent ignificance level for unytematic and ytematic rik. Thee reult confirm that franchie value dicipline rik-taking behavior in the Japanee banking indutry, jut a it doe in the Korean banking indutry. The etimation how that external block holder of Japanee bank do not affect rik level. Thi fall in with the prediction of the information aymmetry hypothei. Aet ize particularly increae level of total rik, thereby upporting the notion of too big to fail. The reult alo confirm that total rik fall a the capital-to-aet ratio rie, and that the parameter of the ratio of write-off to aet are entirely inignificant, probably becaue the variable exclude bad loan from write-off expene. Table 8 how the etimation that ue ROA a a proxy for banking profitability, which i then ued a a dependent variable. By regreing the independent variable in profit calculation, we can examine the corporate control hypothei, which tate that increaed rik-taking behavior reulting from an increae in managerial ownerhip hould produce larger profit. However, increae in total rik reulting from increaed

28 managerial ownerhip do not lead to higher profit for Japanee bank. Thi reult i commonly obtained when the keiretu dummie are added. Table 7 here Table 8 here VI. Concluion Bank tockholder have greater incentive and abilitie to increae rik in deregulated environment than they do in tightly regulated one. Thi i documented by the exiting literature, which demontrate that ownerhip tructure tend to have much a tronger effect on the level of rik taken by bank during deregulated period than it doe during regulated one. Our tudy contribute to the literature by analyzing the effect of managerial ownerhip on the rik-taking behavior of bank in the Korean and Japanee banking indutrie during the relatively regulated period of the late 1990 to early We experiment with a model that include the variable of managerial ownerhip and franchie value, which are ued to produce an interaction term. Managerial ownerhip affect neither the rik level nor the profit level of Korean bank. In contrat, increae in managerial ownerhip heighten the total rik of Japanee bank. However, thi increae in rik doe not produce higher profit for Japanee bank. When the coefficient of the interaction term between franchie value and managerial ownerhip are etimated, we obtain reult that are conitent with the moral

29 hazard hypothei. Thee coefficient are negative and tatitically ignificant when all three rik meaure are ued a dependent variable for both the Korean and the Japanee banking indutrie. Thi indicate that increae in managerial ownerhip at bank with high franchie value dicourage rik-taking behavior. The cot of bank failure can be high for the owner of bank with high franchie value becaue thee owner have much to loe if riky trategie lead to inolvency. Therefore, bank with high franchie value are motivated to operate afely, and thi align their interet with thoe of depoit inurer and bank upervior. Our etimation correpond to the reult detailed in previou literature, which ha etablihed the diciplinary role of franchie value on the rik-taking behavior of bank. While the origin or trend of franchie value may differ in Korea and Japan, it role in curbing the rik-taking incentive of bank i uniform acro both countrie. Exiting literature on the relationhip between managerial ownerhip and riktaking behavior motly focue on the U.S. banking ytem. Our reult how that theorie derived from market-baed ytem uch a the U.S. economy can be applied to other type of financial ytem, uch a the bank-baed economie of Korea and Japan. Our finding may be enhanced by future tudie covering a wider range of international panel data. An examination of the pot-1990 period would be epecially enlightening becaue a large number of developed and emerging countrie have experienced financial deregulation and reregulation ince that time.

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