Abstract
This article examines the effect on market valuation of both corporate governance and the diversity of activities conducted by GCC commercial banks. It shows evidence on the endogenous effect of corporate governance and the characteristics of the banking industry in determining the diversification level of a bank. Empirical findings show a bias in results using ordinary least squares regressions. When controlled for endogeneity, they indicate a negative (but weak) association between the diversification index and the market valuation—consistent with the agency-based hypothesis. Interestingly, foreign banks and corporate shareholders are effective monitors who invest in more diversified GCC banks with higher valuation multiples. Conversely, domestic corporate shareholders—related by a complex web of relationships—invest in less diversified banks with a lower market valuation. In addition, diversified commercial banks with either subsidiaries in developed countries or involvement in market-based activities have higher market valuation. The latter may be explained by the effect on performance of the recent bubble in the Arab stock market.
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Notes
Dharwadkar et al. (2000) argue that firms in emerging countries face unique agency problems related to principal-principal conflicts of interests.
For example, the Basel committee expects the board of directors to establish bank strategies, approve business plans, and establish policies that will govern their daily operations and risks (Basel Committee Report on Banking Supervision 1999).
This is consistent with prior results documented in the non-financial industry, where Berger and Ofek (1995), Lang and Stulz (1994), Servaes (1996), and Denis et al. (1997) show evidence of value destruction related to business diversification. Graham et al. (2002) show that some of the diversification discount occurs because firms acquire already discounted business units, and not because diversification destroys value. Villalonga (2004) finds either no evidence of such diversification discount or a diversification premium instead, especially in business adding new business segments.
In a study of 1005 Indian non-financial firms, Douma et al. (2006) distinguish between foreign and domestic, strategic and financial shareholders. They argue that strategic shareholders (i.e., from the same industry) are motivated by non-financial goals, whereas financial shareholders, such as banks, institutional investors, and mutual funds, have a financial incentive and emphasize liquidity results (page 640).
Kang and Stulz (1997) document that institutional investors tend to invest in larger, familiar, and actively-traded companies.
Barth et al. (1999) further support this argument that in countries with less financial system development, government ownership of banks is prevalent.
Levine (2004) argues that corporate governance should be studied with respect to banking than that of other non-financial firms as banks are more opaque and display greater asymmetry in information dissemination since they are already heavily regulated.
In addition to data availability constraints, a recent survey of the Economic and Social Commission for Western Asia (ESCWA) reports a significant improvement of the economic growth of GCC countries following the economic slowdown in 2001. In real term, ESCWA indicates an economic growth rate of 1.1% in 2002 followed by 8.7% in 2003 and 7.2% in 2004 (National Accounts Studies of the ESCWA region, Bulletin No.25).
In line with Lie and Lie (2002), valuation multiples are adjusted using the median valuation multiple of comparable firms. Further robustness analysis were implemented using the average valuation multiple. These results are consistent with the main findings of the article.
Due to weak disclosure practices, there is no data availability to generate accurate measures of other commonly used internal corporate governance mechanisms. For example, Fama and Jensen (1983) argue that outside directors perform their monitoring role better than their inside counterparts. Anderson et al. (2004) argue that effective monitoring is potentially an acquired skill where boards with greater tenure provide greater monitoring. The disclosed reports by GCC banks (annual reports, etc.) do not include clear information on board members to verify whether they are affiliated or fully independent. Also, there is no complete information on the experience of board members to calculate their tenure.
Since the balance sheet reflects historical rather than replacement value of the total asset, the present article uses the Return-on-Equity (ROE) rather than the Return-on-Asset (ROA).
A 3SLS regression was also run as a reliability check on 2SLS results, as it allows for potential endogeneity and cross-correlation between the equations. The coefficient estimates on all variables are identical to 2SLS estimates.
Laeven and Levine (2005) use the index of restrictions on banks activities. Since there is no information about such an index in the GCC, a banking development index is calculated as part of the financial development index of the IMF (Creane et al. 2005). The financial development index includes three themes: the monetary sector development and monetary policy, the banking sector development, and the nonbank financial sector development. This article refers to the banking sector development theme which examines the size, the structure, and the efficiency of the banking sector. This index is equal to the average ranking of both the Banking Sector and the Regulation and Supervision per country. Commercial banks in the GCC have an average development index of 7.524. It is higher than banks in other countries of the Middle East and North-African (MENA) region (the average banking development index for the MENA region is 5.6).
Adams and Mehran (2003) calculate an average board size of 18 members in US bank holding companies from 1986 to 1999.
Although not reported in this article, further descriptive statistics were calculated on a country basis, these are available upon request. These numbers show no significant difference in the valuation multiples across the GCC countries. Most commercial banks do undertake retail, corporate, or investment activities; however, a large number of commercial banks in different countries, do not act in the Islamic finance or the insurance industries (such as in Kuwait, Oman, Qatar and the UAE) which require specialized structures.
A Pearson’s correlation coefficient is a measure of linear association. Before calculating Pearson’s correlation coefficients, the data was screened and there is no evidence of non-linear relationships.
This is almost consistent with the correlation coefficients in Table 2 that exhibit a negative correlation between the market valuation multiples on the one hand, board size, domestic corporate ownership, and financial leverage on the other. In contrast with the analysis in the correlation table, however, the multivariate regression technique indicates the effect of one variable after controlling for all the others.
Islamic banks have two boards: a board of directors and a “Sharī`ah ” board including religious experts. Due to the existence of a “Sharī`ah ” board which affects both the size of the board of directors and its independence level, the present study does not include Islamic banks. Moreover, since both investment and financing practices of Islamic banks do not deal with lending activities, an additional bias may also affect the relationships between the asset size, the leverage and the market valuation of commercial banks.
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Acknowledgements
I would like to thank Mike Wright and Igor Filatotchev for their suggestions. I am grateful to seminar participants at the American University of Beirut for their helpful comments. Finally, I would like to thank Danielle Asaad and Romy Haddad for their research assistance. Any inaccuracies or errors are entirely my own.
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Chahine, S. Activity-based diversification, corporate governance, and the market valuation of commercial banks in the Gulf Commercial Council. J Manage Governance 11, 353–382 (2007). https://doi.org/10.1007/s10997-007-9034-5
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DOI: https://doi.org/10.1007/s10997-007-9034-5