The Effect of Foreign Strategic Investment on Chinese Banks Corporate Governance 1

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1 The Effect of Foreign Strategic Investment on Chinese Banks Corporate Governance 1 Yuhua Li, Assistant professor, School of International trade and Economics, Jiangxi University of Finance and Economics, China Zhi Liu, Postgraduate student, Jiangxi University of Finance and Economics, China ABSTRACT This paper employ hand-collected data concerning foreign strategic investment and corporate governance in the Chinese banking sector, we examine whether foreign strategic investment improve the corporate governance of Chinese banks and whether corporate governance improve performance of Chinese banks. We found that foreign strategic investment increases the binding force for top three shareholders in state-owned commercial banks and national joint-stock commercial banks. The binding force for the first largest shareholder could reduce their decision making power and improve the ROE, CAR, and NPL of Chinese banks. No matter for state-owned commercial banks and national joint-stock commercial banks or rural-owned commercial banks and city commercial banks, the binding force for top three shareholders enhances their performance. INTRODUCTION With the increasing depth of market-opening in China s banking sector, foreign financial institutions strategic investment in Chinese banks also rises. The foreign strategic investment is considered as an important way for Chinese banks to introduce capital and advanced knowledge. Through introducing foreign strategic investment, Chinese banks expect to improve their operational efficiency, profitability, non-performing loan ratio (NPLR), and corporate governance through changing the shareholding structure, perfecting principal-agent mechanism, learning advanced management experience and financial knowledge from foreign strategic investors. However, the foreign strategic investors sold large stock shares of Chinese banks during , which triggered a discussion about the effect of foreign strategic investment on Chinese banks. Supporters of foreign strategic investment argue that foreign investors hold a certain percentage of shares which have a lock-up period of at least three years, and have rich management experience and advanced technology, they would have an incentive to improve Chinese banks corporate governance and performance. Opponents insist that the proportion of equity shares hold by foreign strategic investors is smaller, potential interest conflicts between Chinese banks and their foreign strategic investors would be more strongly since the Chinese government permitted foreign banks to operated RMB service from December 2006 and foreign banks can do their own business and not need to train their potential competitors. Under the context, it is interesting to examine whether foreign strategic investors improve the corporate governance and performance of Chinese banks. Driving by these factors, do the foreign strategic investments have a positive effect on the corporate governance of Chinese banks? Do the influences vary to the type of Chinese banks? 1 The paper has been financially supported by the National Natural Science Foundation of China ( ) and Jiangxi Province Social Science Twelve Five Project (13YJ09). The Journal of International Management Studies, Volume 12 Number 1, February,

2 THEORETICAL MECHANISM Previous literatures on the impact of foreign strategic investors could be divided into several aspects: (1) Foreign banks have a comparative advantage in corporate governance, management and technology, and the spillovers and competitive effects of foreign investors could improve Chinese banks governance and performance (García-Herrero and Santabárbara, 2008; Berger et al., 2009). (2) The Chinese government limited the maximum equity stake of foreign strategic investment, and the foreign financial institutions are not familiar with Chinese banking market. In that case, foreign investors lack incentive to promote the governance and performance of Chinese bank (Shen et al., 2009; Laurenceson and Qin, 2008). Clarke (2005) found that foreign financial institutions are allowed to enter in domestic banking sector, the local banks that introduced foreign financial institutions have better performance. Yupana et al. (2001) found that the companies which have more concentration shareholding of foreign investors have better stock performance. Sadao (2006) found that the companies which have higher proportion of foreign shareholding exhibit the higher market value. Li et al. (2016) found that foreign strategic investors do not improve the cost and profit efficiencies of Chinese bank in the whole, but the specific cooperation items between them improves the efficiency of Chinese banks. Seo et al. (2013) found that the entry of foreign capital improve the efficiency of Chinese banks and impel Chinese banks polish up their competency of operation. Zhu et al. (2008) found that the Chinese banks which introduced foreign strategic investors tend to improve return on assets (ROA) and capital adequacy ratio (CAR) of Chinese banks. Gao (2000) argued that Chinese special market conditions and institutions lead to the efficiency loss of Chinese state-owned banks, the introduction of foreign strategic investment would promote a reform of property rights and break the balance of the interests. As far as we know, few literatures examine the effect that foreign strategic investors on corporate governance. Many literatures focus on the effect about corporate performance. Only few literatures (e.g., Zhu et al., 2008 and Li et al., 2016) analysed how the foreign strategic investment affect Chinese banks corporation governance, however, their research lack of quantitative analysis. These research do not consider the following points: First, because the potential benefits and conflict with foreign investors varies with the different type of bank, so the incentive to improve corporate governance of different types of Chinese banks are difference; Second, for the research on foreign strategic investment in China, few studies focus on corporate governance of Chinese banks, but corporate governance plays an important role in the efficiency of Chinese banks; Third, a few of scholar focus on whether the improvement of Chinese banks corporation governance promote their ROA, NPLR and CAR. Shareholding structure is the foundation of corporate governance, our paper primarily focus on the effects of foreign strategic investment on bank shareholding structure of Chinese bank. If foreign strategic investment has impact on shareholding structures, the research on how the banks performance is influenced indirectly by the change on shareholding structures would be further studied. Hypotheses Shareholding structure is an important determinant of corporate governance, which determines the distribution of control power, the structure of corporate board directors, and the structure of board supervisors. If the shareholding structure is reasonable, it would diversify the composition of the board directors and more easily balance the interest network. In the 1990s, Chinese banks had highly concentrated shareholding, especially, the five state-owned commercial banks (SOCBs) whose main shareholder is the Ministry of Finance of China, led to its single background of senior executives and neglected risk control. During the time, the non-performing loans (NPL) rise a lot. At "2005 China Forum" which hold by Moody's Investors Services and the Hong Kong and Shanghai Banking 16 The Journal of International Management Studies, Volume 12 Number 1, February, 2017

3 Corporation Limited (HSBC), Xiao Chuang Zhou, the president of People's Bank of China mentioned that Chinese bank sector face serious problems before Under these conditions, Chinese bank sector wants to improve the corporate governance by introducing external capital. Foreign strategic investors possess strong capital, advanced management experience and technology, the introduction of foreign strategic investors would benefit Chinese banks shareholding structure, thereby raising the expectation of bank performance. A good expectation could decrease the cost of trader-seeking which can improve the shareholding structure. Hypothesis 1: Foreign strategic investments improve Chinese bank's shareholding structure. However, it may have different effects on different type of Chinese banks corporation governance. (1) Since the Chinese government permitted foreign banks to operated RMB service from the end of 2006, potential interest conflicts between Chinese banks and the foreign strategic investors was more strongly. Both SOCB and national joint-stock commercial banks (JOCBs) have broad local customers and market, in which they would compete with foreign financial institutions. It means that SOCBs and JOCBs have more strongly conflict with foreign strategic investors, finally lead to foreign strategic investors lack of incentive to improve these banks corporate governance; (2) Compared with SOCBs and JOCBs, rural commercial banks (ROCBs) and city commercial banks (CCBs) have lower competitive advantage in Chinese banking market, so that foreign strategic investors have more incentive to improve the corporation governance of ROCBs and CCBs. The initial purpose of establishing JOCBs is to provide funds for state-owned enterprises (SOE), even after the shareholding reform, these banks are also important assets of SOEs, so the shareholders of these banks increase the bank's shareholding control. However, the major shareholders of CCBs are usually the local government and enterprises, and the initial purpose of establishing ROCBs is to provide financial support for rural economic development. Thus, the major shareholder of JOCBs and SOCBs have stronger desire to hold their share compare to ROCBs and CCBs,thereby the effect of foreign strategic investors tends to be more positive on ROCB and CCBs. Hypothesis 2: Foreign strategic investments have more incentive to improve the corporate governance of ROCBs and CCBs comparing with SOCBs and JOCBs. The larger equity control of major shareholders may have negative effect on company performance. If the first shareholder has larger equity shares, they would have a greater power in the decision-making process in the board meeting, and have more chance to choose an advantageous strategy for themselves, the other shareholder s equity share is so small that lack the ability to prevent large shareholders against their interest, thereby the equity control of major shareholders may have negative impact on Chinese banks performance. Therefore, the binding force for the first shareholder could avoid the unreasonability of the banks personnel appointment, get efficient internal control, and thus improve the performance of Chinese banks On the other side, if the top three shareholders have larger equity shares, they would have a balanced power in the board meeting and could get reasonable decision under the balanced power. Therefore, the binding force for the top three shareholders could make them get the inconsistent operation targets and causes conflict among them and decrease performance of Chinese banks. Hypothesis 3: Different shareholding structure has different effect on performance of Chinese banks. RESEARCH METHODS This paper employs 45 Chinese banks from 2006 to 2014, including 5 SOCBs, 12 JOCBs, 23 CCBs and 5 ROCBs. Data on financial information of Chinese banks are primary from Bankscope, the official website of Chinese banks, the United Nations database, and financial magazines. Corp_Gov1 represents The Journal of International Management Studies, Volume 12 Number 1, February,

4 the binding force for the largest shareholder, and is to measure the potential damage to the largest shareholder of Chinese banks. It is the second to tenth largest shareholders equity share minus the equity share of the largest shareholder. Corp_Gov2 represents the binding force for the top three shareholders. It is the fourth to the tenth largest shareholders equity share minus the top three shareholders equity share. Strategic is the dummy variable for foreign strategic investment. If the Chinese bank introduced foreign strategic investment, it is 1, otherwise it is 0. The return on equity (ROE), NPLR and CAR are used as measures of bank performance. The SOCBs and JOCBs have large assets and strong appetite for equity control, however the CCBs and ROCBs have a small assets and relatively weak equity control. Therefore, this paper divides the SOCBs and JOCBs into the same category, CCBs and ROCBs are divided into the other category. Type is the type of Chinese bank, 1 refers that a bank is the SOCBs or JOCBs, otherwise it is 0. We also generate the interaction term between the Strategic variables and Type variables to check the impact of foreign strategic investment varies different types. Strategic Type is the interaction term between Strategic and Type, which is used to examine the impact of foreign strategic investment to binding force for the first and top three shareholders of SOCBs and JOCBs. The control variables are in three levels: the macro economy level, the industry level and the individual bank level. GGDP is the growth rate of GDP. IM is the interest margin between the bank loan rate and the deposit rate. CPI is the Chinese GDP deflator by using consumption price index. HHI is the Hector Vinci index reflecting market concentration rate in Chinese banking sector. Lnasset is the logarithmic of Chinese bank s total assets. LIST is a dummy variable, 1 is that the Chinese bank is listed on the stock exchange market, otherwise it is 0. LEV represents the capital leverage ratio, which is the total liability divided by total assets. C 1, C 2, C 3, C 4, and C 5 are intercept items. μ 1, μ 2, μ 3, μ 4, and μ 5 are the error terms. The estimation models are constructed as follows: Corp_Gov1=C 1 +β 1 Strategic+β 2 Type +β 3 Strategic Type+β 4 Lnasset +β 5 LIST+β 6 HHI+β 7 GGDP +μ 1 (1) Corp_Gov2=C 2 +β 1 Strategic+β 2 Type +β 3 Strategic Type+β 4 Lnasset+β 5 LIST+β 6 HHI+β 7 GGDP+μ 2 (2) ROE=C 3 +β 1 Corp_Gov1+β 2 Corp_Gov2+β 3 IM+β 4 CPI+β 5 LEV+μ 3 (3) CAR=C 4 +β 1 Corp_Gov1+β 2 Corp_Gov2+β 3 IM+β 4 CPI+β 5 LEV +μ 4 (4) NPL=C 5 +β 1 Corp_Gov1+β 2 Corp_Gov2+β 3 IM+β 4 CPI+β 5 LEV +μ 5 (5) Model (1) and (2) are to examine the impact foreign strategic investment on the binding force for first shareholders of Chinese banks and for top three shareholders respectively. Model (3)-(5) are used to examine the effects of binding force for top shareholders on Chinese banks ROE, CAR, and NPL respectively. RESULT AND ANALYSES Table 1 shows the descriptive statistics of all variables. The minimum value of Corp_Gov1 and Corp_Gov2 is -1, because the Agricultural Bank of China has only one shareholder before the share reform. The mean value of Strategic is 0.422, which means that the proportion of Chinese banks introducing foreign strategic investment in the whole sample is The average value of Type is 0.406, which means that the proportion of SOCBs and JOCBs in the sample is The HHI is 0.134, which is calculated by the asset scale, indicating that China's banking sector is not a highly competitive industry. 18 The Journal of International Management Studies, Volume 12 Number 1, February, 2017

5 Table 1: Descriptive Statistics Variable Obs. Mean Std. Dev. Min Max Corp_Gov Corp_Gov Strategic Lnasset LIST HHI Type CPI IM LEV GGDP Table 2 shows the impact of foreign strategic investment on corporate governance of Chinese banks. The Hausman test is implemented on the analysis of the influence of foreign strategic investment on performance of Chinese banks, and the random effect model is employed. The L.Strategic was the lagged one year variable of Strategic. The coefficient on the Corp_Gov2 is negative and significant at the 10%, indicating that foreign strategic investment as a whole reduce the constraint power of the top three shareholders. Because the equity share of top two and three shareholders were relatively low in China s banking sector, the introduction of foreign strategic investment improve the expectation on bank performance, and the top two and three shareholders tend to increase their equity shares. The coefficient of Strategic Type on Corp_Gov2 is positive and significant at 1%, which indicates that foreign strategic investment increase the constraint on the top three shareholders of SOCBs and JOCBs. There are several potential reasons. The equity share of the top three shareholders in SOCBs and JOCBs before introducing foreign strategic investment was too high, whereas the equity share in ROCBs and CCBs before introducing foreign strategic investment was relatively low. Therefore after introducing foreign strategic investment, public is more confident with SOCBs and JOCBs and may increase the shares of the fourth to tenth shareholders, the equity share of top three shareholder in SOCBs and JOCBs was reduced, as a consequence, the binding force for the top three shareholders decline, and the ownership structure is improved. Table 2: The effect of foreign strategic investment on shareholding structure VARIABLES Corp_Gov1 Corp_Gov2 L. Strategic * (0.027) (0.042) Type ** (0.119) (0.166) Strategic Type *** (0.072) (0.070) Lnasset (0.082) (0.129) LIST ** (0.057) (0.092) HII (1.943) (2.947) GGDP (0.376) (0.515) Constant 0.817* The Journal of International Management Studies, Volume 12 Number 1, February,

6 (0.457) (0.723) R-squared Observations Number of Chinese banks Robust standard errors are in the parentheses (*** p<0.01, ** p<0.05, * p<0.1). Table 3 shows the results on the impact of corporate governance on performance of Chinese banks. The variables Corp_Gov1 and Corp_Gov2 lag one year. The coefficient of Corp_Gov1 on ROE is positive and significant, whereas the coefficient of Corp_Gov2 on ROE is negative and significant at 1%. The coefficient of Corp_Gov1 on CAR is positive and significant at 10%. The coefficient of Corp_Gov1 on NPL is negative and significant at 5%, and the coefficient of Corp_Gov2 on NPL is positive and significant at 5%. There are several potential reasons to explain these results. First, the binding force for the first shareholder could make balance among the board of directors and reach the more correct decisions. Second, the binding force for the first shareholder could avoid the reasonability of the banks personnel appointment, get efficient internal control, and thus improve the ROE and CAR and decrease the NPL. Third, the binding force for the top three shareholders could not get the consistent operation targets and causes conflict among the top ten shareholders, which could impede the Chinese banks to chase for short-term interests and ignore the risks, and then decrease ROE and CAR and increase NPL. The regression results show that the coefficient of IM on the ROE is negative and significant at 1%, the coefficient on NPL is positive and significant at 1%. Because the high interest rate margin drives capital flowing to financial institutions. The coefficient of CPI on ROE is positively significant the 5%, probably because higher consumption price index, causing greater demand for capital in the market, thus increasing the bank's CAR and ROE. Table 3: The effect of shareholding structure on bank performance ROE CAR NPL Corp_Gov *** 55.01* ** (2.788) (31.54) (15.77) Corp_Gov *** * 23.71** (1.539) (26.35) (10.40) IM *** *** (0.501) (6.200) (2.281) CPI 0.105** 0.560* (0.039) (0.330) (0.282) LEV * (6.742) (143.3) (39.66) Constant 22.35*** 370.2*** * (6.240) (127.6) (39.92) Observations R-squared Number of Chinese banks Robust standard errors are in the parentheses (*** p<0.01, ** p<0.05, * p<0.1). CONCLUSION Through examining the impact of foreign strategic investment on corporate governance of Chinese banks, and the effect of corporate governance on their performance, we can get several interesting results: First, foreign strategic investment could improve the corporate governance of Chinese banks in terms of 20 The Journal of International Management Studies, Volume 12 Number 1, February, 2017

7 the binding force for top three shareholders. Second, the binding force for the first largest shareholder could reduce their decision making power, lead the board reach reasonable decision, and improve the ROE, CAR, and NPL of Chinese banks. In conclusion, no matter for big banks (state-owned commercial banks and national joint-stock owned commercial banks) or small banks (rural commercial banks and city commercial banks), the binding force for top three shareholders improve their performance. REFERENCES Bennedsen M. & D. Wolfenzon (2000). The balance of power in closely held corporations. Journal of Financial Economics, 58(1-2) pp Berger, A. N., Hasan, I. & Zhou, M. (2009). Bank ownership and efficiency in China: What will happen in the world's largest nation? Journal of Banking & Finance, 33(1) pp Clarke, Geroge R.G. & Cull, R. & Shirely M. (2005). Bank privatization in developing countries: A summary of lessons and findings. Journal of Banking & Finance, 29 pp García-Herrero, A. & Santabárbara, D. (2008). Does the Chinese banking system benefit from foreign investors? BOFIT Discussion Papers, 11, Gao, H. (2000). The entry of foreign banks and the dissolution of China's state owned commercial banks. Journal of Financial Research, 6 pp Laurenceson, J. & Qin, F. (2008). Has minority foreign investment in China's banks improved their cost efficiency? China & World Economy, 16(3) pp Li, Y., Uchida, K., Xu, T. & Wu, Z. (2016). The impact of foreign entry on Chinese Bank. Review of Development Economic, 20(1) pp Sadao, N.(2006). R&D and market value of Japanese firms in the 1990s. Journal of the Japanese and International Economies, 20(2) pp Seo, J., Chao, G. & Park, S. (2013). An empirical study on the impacts of the Chinese banking industry by foreign banks entry. International Journal of Economics and Finance, 5 pp Shen, C., Lu, C. & Wu, M. (2009). Impact of foreign bank entry on the performance of Chinese banks. China & World Economy, 17(3) pp Yupana, W. (2001). Controlling shareholders and corporate value: Evidence from Thailand. Pacific-Basin Finance Journal, 9 pp Zhu, Y., Zeng, Y., Li, P. & He J. (2008). The introduction of strategic investors in Chinese banks: background arguments and comments. Management World, 1 pp The Journal of International Management Studies, Volume 12 Number 1, February,