Banks collect deposits from households and allocate funds to borrowing firms in the real economy. Banks play two fundamental roles in fund allocation: selecting the best borrower from potential borrowers and monitoring them (Diamond 1984, 1991). The successful fulfillment of those two roles builds on a good bank governance system that aims to protect or balance the interests of depositors and equity holders. Therefore, we raise an interesting research question: how does bank governance affect the bank’s two fundamental roles: the selection ability and the monitoring ability? Prior papers focus on the impact of bank governance on the bank’s risk and performance (Caprio et al. 2007; Ellul & Yerramilli 2013). However, our research question has not been previously explored systematically.
Our research question is underexplored because of some empirical challenges. An ideal experiment for this research question is to regress loan outcomes on the change in bank governance. Given this experiment, two main empirical challenges related to data are: (1) the bank panel databases hardly exist, and (2) the universe of loan data from all banks is proprietary. Furthermore, in developed economies, the bank governance system has been in place for a long time, and bank governance distribution over banks is homogenous.
To address those empirical challenges, we manually built a bank panel database from annual reports disclosed by banks from 2007 to 2020. Our bank panel database consists of publicly traded and private banks and thus covers almost all banks in China. This bank panel database includes three datasets: financial data, loan structure data, and governance data. For the loan data, we collect the loan announcements of publicly traded firms in Chinese non-financial sectors and use the stock market reaction to capture the bank’s two roles.
The bank governance reform in China is a good laboratory to explore this research question. Before 2001, most banks in China were fully owned by the government and ran like government units without a banking governance system. The reform of the banking sector in China was to modernize the banking system after 2001 by learning from the model of developed economies. Specifically, the regulators have initiated governance reform in China since 2006 and issued a series of non-compulsory guidelines. The main provisions of those guidelines advise commercial banks in China to transplant the governance and organization forms from banks in developed economies. Therefore, bank governance in China displays differential organization forms.
Does bank governance improve bank’s selection ability?
We try to understand whether bank governance improves the bank’s selection ability. Generally, a well governed bank can select a better borrower, and thus a better borrower experiences a positive abnormal return around the loan announcement. First, we propose the test of the difference in means. This test mimics a long-short strategy that buys the stocks of firms borrowing from banks with a better governance component and shorts the stocks of firms borrowing from banks with a worse governance component. We do not find that an investor can earn a significant portfolio return from the long-short strategy. Secondly, we propose a within-firm estimator regression analysis. Still, we do not find any significant associations. Therefore, the banking governance reform in China does not improve the banks’ selection ability.
Does bank governance enhance bank’s monitoring ability?
We try to understand whether the borrower’s stock return reflects the monitoring efforts of a well-governed bank by generating abnormal returns in the long term after the loan announcement.
To explore this question, we propose the test of difference in means. When a typical investor forms a strategy by buying stocks of firms borrowing from banks with a better governance component and shorting stocks of firms borrowing from banks with a worse governance component, this typical investor can gain the portfolio return of this long-short strategy for holding this portfolio annually after the loan agreement announcement. We find that when a typical investor can earn a significant abnormal return by trading governance components. Trading by independent director, ownership concentration, government as the top 1 shareholder, CRO, risk committee size, and risk committee chair will allow a typical investor to earn an abnormal return of 6.7 percentage points, 7.3 percentage points, 5.1 percentage points, 6.3 percentage points, 8.4 percentage points, and 5.4 percentage points, respectively. Therefore, bank governance does impact the bank’s monitoring ability to some degree.
To provide more convincing empirical results, we leverage a within-firm estimator to rule out the confounding factors from borrowing firms. The within-firm estimator compares the different outcomes of different banks within the same firm. We document that a one standard deviation change in governance component leads to a change in buy-and-hold abnormal return (4.2% for independent directors, 3.6% top1 shareholding, 3.2% government as the top 1 shareholder, 6.4% for risk committee meeting). In sum, a well-governed bank with more independent directors, lower top 1 shareholdings, government as top 1 shareholder, and lower risk committee meetings can generate a higher buy-and-hold abnormal return. We conclude that the bank governance reform in China enhances the bank’s monitoring abilities.
This paper explores the impact of the bank governance components on bank lending activities by leveraging the banking governance reform in China as a laboratory. The banking governance reform in China is an ideal laboratory because commercial banks transplant the corporate governance system from developed economies. We find that the bank governance reform in China does not improve the bank’s selection abilities but enhances the bank’s monitoring abilities. In the future, the research question of how a bank’s governance system affects financial stability via the lending channel should be explored more.
Gang Bai is an Associate Professor at the Southwestern University of Finance and Economics.
Hengguo Da is an Assistant Professor at the Southwestern University of Finance and Economics.
This post was adapted from their paper, “The Value of the Banking Governance Reform in China,” available on SSRN.