International Journal of Managerial Finance

Corporate governance structure and capital adequacy: implications to bank risk

taking
Heba Abou-El-Sood,
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Implications to
Corporate governance structure bank risk
and capital adequacy: taking

implications to bank risk taking

Heba Abou-El-Sood 165
Accounting Department, Faculty of Commerce, Cairo University, Cairo, Egypt
Received 28 April 2016
Revised 30 August 2016
Accepted 30 August 2016
Abstract
Purpose – The purpose of this paper is to show the importance of policy discussions on the role of
governance in limiting excessive risk-taking at times of turmoil.
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Design/methodology/approach – Corporate governance measures are regressed on measures of risk

taking using a sample of US bank holding companies (BHCs) during 2002-2014.
Findings – Results show that BHCs with more concentrated shareholders, more managerial ownership,
smaller boards, and less outside directors undertake less risky investments with respect to total assets, loans,
and off-balance-sheet items. Capital adequacy effect is overpowering pushing for more risky positions.
Finally, banks with good governance push for less risky positions, even with larger capital ratios, during the
financial crisis period relative to the precrisis boom.
Practical implications – This paper extends research on the association between bank ownership
structure and risk taking. It adds to prior research by examining a key feature of banks, namely, their
bank-specific capital adequacy. The relevance of this study stems from recent initiatives undertaken by the
Basel Committee, the Group of Thirty (G30), and bank regulators to address deficient corporate governance
structures that led to bank breakdowns.
Originality/value – One of the innovations of this paper is the use of risk-weighted measures to proxy for
risk taking in banks, using risk weights used by bank regulators to adjust for operational risk, credit risk, and
market risk.
Keywords Financial crisis, Banks, Corporate governance, Capital adequacy, Risk taking
Paper type Research paper

1. Introduction
Many failures of financial institutions that took place during the financial crisis of late 2007
have been attributed to poor corporate governance practices that failed to manage bank risk
taking amidst a massive economic meltdown. Accordingly, boards of directors have
contributed to the collapse of many banks through the failure to: assess risks taken by their
institutions; evaluate the vulnerability of banks to economic shocks; and act with prudence
(Group of Thirty, 2012). As banks act as effective monitors of other banks’ performance, one
of the main issues that bank regulators has focused on is mitigating bank excessive risk
taking (Furfine, 2001). Bank failures and bank runs occur due to undertaking risky asset
positions coupled with opaque, highly technical information in banks. The regulatory
interest of mitigating excessive risk taking is due to the importance of banks in financing
economic activities and injecting liquidity into the economic system (Bryant, 1980).
The opaque and asymmetric information highlights how differences in information
available to different parties in a financial contract disrupt the financial markets and
adversely affect the economic activities. Although information asymmetry exists in all
corporations, it plagues banks more than other sectors. Asymmetric information between

JEL Classification — G21, G28, G30, G32, M41, G01

This paper has benefited from the valuable comments of John O’Hanlon, Ken Peasnell, participants International Journal of Managerial
at the Lancaster University Management School Accounting and Finance seminar series, the AUS 5th Finance
Vol. 13 No. 2, 2017
Annual Research Symposium in Business and Economics, the 2013 joint BAFA Northern Area Group pp. 165-185
and Interdisciplinary Perspectives Special Interest Group annual conference, and from valuable © Emerald Publishing Limited
1743-9132
remarks of anonymous reviewers. DOI 10.1108/IJMF-04-2016-0078
 IJMF bank stakeholders results in agency problems, which affect the efficiency of financial
13,2 markets, cause a decline in investment, and provide additional mechanisms for financial
crises (Bernanke and Gertler, 1989).
The aim of this paper is to complement prior empirical literature and provide novel
findings relevant for regulatory initiatives to enhance stability and resilience by examining
the association between bank governance and risk taking and how regulatory capital
166 adequacy affects the association for further regulatory deliberations. It provides measures
of bank risk taking that have not been examined in prior studies that fit in well with
the regulatory aim of mitigating excessive risk taking. This study attempts to answer the
question of whether a bank’s corporate governance structure acts as a regulatory tool to
manage risk taking, especially at times of economic turmoil, and whether regulatory capital
adequacy affects the association.
Corporate governance mechanisms have been viewed as ways for mitigating agency
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problems, understanding, and assessing a firm’s risk factors, and applying risk
management systems. In this context, this study yields several key findings.
First, concentrated ownership and managerial ownership are negatively associated with
measures of risk taking. On the other hand, board size and outside directorship are
positively associated with bank risk taking. Second, the study examines the effect of
regulatory capital adequacy on the association between bank corporate governance and risk
taking. In doing so, the effect of the bank-specific regulatory capital ratio on the association
is tested. Then, whether this effect differs between well-capitalized banks, which exceed the
minimum regulatory capital threshold, and poorly capitalized banks is further investigated.
The results of the empirical tests suggest that as the regulatory capital ratio gets larger,
bank holding companies (BHCs) are generally willing to take more risk. Furthermore,
in well-capitalized BHCs, this effect is more pronounced. Finally, the paper explores whether
the regulatory capital effect on the association between ownership structure and risk taking
is different for BHCs during the financial crisis period 2007-2009 and the precrisis boom of
2002-2006. During the financial crisis, BHCs take less risky investments. This association is
exacerbated in banks with good governance structures. The results also suggest that banks
with good governance structures are willing to take less risk during a period of financial
crisis relative to a boom period even if they have relatively larger capital cushion exceeding
regulatory minimum thresholds.
The contribution of this study is three-fold. First, the relevance of this study stems from
recent initiatives undertaken by the Group of Thirty (G30), the Basel Committee, and bank
regulators to address deficient corporate governance structures that led to bank
breakdowns during the recent financial crisis of late 2007 (Group of Thirty, 2012). The key
principles discussed have been monitoring risks on an ongoing basis, role of the board and
composition of the board (Bank for International Settlements, 2015). The main concern is to
enhance governance structures in an attempt to mitigate excessive risk taking. Second, this
paper extends research on the association between bank ownership structure and risk
taking. It adds to prior research by examining this association in relation to a key feature of
banks, namely, their bank-specific capital adequacy ratio. Prior studies have only treated
regulation as an exogenous factor of a more (less) stringent system affecting banks rather
than a bank-specific element embedded in regulatory capital ratios (Saunders et al., 1990;
Konishi and Yasuda, 2004; Caprio et al., 2007; Laeven and Levine, 2009; Shehzad et al., 2010).
Furthermore, this paper investigates other elements of corporate governance than
ownership structure, namely, board characteristics. Finally, the study constructs a unique
data set that fully articulates accounting and regulatory capital data from fiscal-year-end FR
Y-9C along with corporate governance dimensions related to the board structure.
One of the innovations of this paper is the use of the risk-weighted assets to total assets
ratio to proxy for risk taking in banks to align the findings with the regulatory emphasis.
 Additionally, the ratio of risk-weighted loans to assets is used in another specification. Implications to
On average, loans comprise 65-80 percent of US commercial banks’ and thrifts’ balance bank risk
sheets (Ryan, 2007)[1]. Therefore, the ratio of risk-weighted loans to assets provides an taking
operational measure of the degree of risk inherent in one of the largest assets in a bank’s
balance sheet. Finally, we use the ratio of the risk-weighted off-balance-sheet (OBS) items to
assets as a proxy for the degree of risk inherent in the OBS positions. The use of these three
variables is intended to overcome some of the measurement problems in variables used in 167
prior research[2]. The variables in this study adjust assets, loans, and OBS items for risk
weights used by bank regulators to represent credit, operational, and market risks.
The remainder of this paper is organized as follows. Section 2 provides a theoretical
framework and sheds light on prior work on bank corporate governance, capital adequacy,
and risk taking. Section 3 develops the research hypotheses. Section 4 describes the research
design. Data sources and sample selection are discussed in Section 5. The descriptive
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statistics and empirical results are reported in Section 6. Section 7 concludes.

2. Background
The USA risk-based capital requirements increasingly have emphasized the role of bank
capital as a cushion to allow banks to absorb adverse shocks. Therefore, bank regulators use
risk-based capital requirements to mitigate the excessive risk taking by banks (Abou-El-Sood,
2012). Moreover, they impose certain penalties on those banks that hold too little capital, and
reduce the effect of some regulations and allow expanded activities for well-capitalized banks.
For US banks, the Federal Deposit Insurance Corporation (FDIC) classifies the ranges of
regulatory capital ratios describing the banks’ capitalization status[3]. Banks having a tier 1
capital ratio above 6 percent are classified as well capitalized[4]. If banks fall below the
minimum regulatory requirement set by the Basel Committee of 4 percent for tier 1 capital,
the regulatory intervention becomes very costly[5]. The cost of regulatory intervention can
escalate to putting banks into receivership/conservatorship, if they become significantly
undercapitalized or critically undercapitalized[6]. The level of regulatory tier 1 capital is an
important determinant of a bank’s health and performance. Nonetheless, the question of
whether bank regulatory capital adequacy affects the association between corporate
governance and risk taking has not been tested.

3. Hypotheses development
The structure of large financial institutions gives rise to three sets of principal–agent problems:
between management and the shareholders, between blockholders and minority shareholders,
and between the insiders and other stakeholders. The existence of blockholders, as a governance
mechanism, can directly influence the bank’s decision-making as concentrated ownership
facilitates monitoring of bank managers and mitigates agency costs (Grove et al., 2011).
The effect of blockholders is magnified given the opaque nature of banks and the complexity of
banking operations. Although few prior studies claim that ownership concentration is positively
associated with bank risk taking due to the monitoring role regulation plays in banks (Park and
Peristiani, 2007; Elyasiani and Jia, 2008; Gropp and Köhler, 2010), it has been argued that
ownership concentration is associated with less risk taking for different reasons. Blockholders
are better able to negotiate managerial incentive contracts to align owner–manager interests
compared to small investors (Levine, 2004; Iannotta et al., 2007; John et al., 2008; Shehzad et al.,
2010). Concentrated ownership, especially of institutional investors, increases the pressure on
boards to become more diligent (Gillan and Starks, 2000). Moreover, blockholders tend to be
more knowledgeable in monitoring the management of underperforming entities (Watson, 2005).
Concentrated ownership strengthens the benefits of monitoring. As contractual agreements with
managers facilitate monitoring, concentrated ownership raises shareholders’ sensitivity toward
risk. Hence, shareholders have reduced comparative advantage in bearing risk (Heinrich, 2000).
 IJMF Konishi and Yasuda (2004) provide evidence that, when the bank has a large franchise value,
13,2 stakeholders advocate less risky investments as they are threatened by the possibility of losing
a bank’s charter, or its franchise value, in case of liquidation. Barry et al. (2011) and Laeven and
Levine (2009) attribute the results to differences in ownership structures. Thus, controlling for
bank franchise value, it is conjectured that there is a negative association between ownership
concentration and risk-taking behavior. The hypothesis is expressed as follows:
168 H1a. There is a negative association between the ownership concentration of BHCs in
one year and risk taking in the subsequent year.
When managers have ownership stake in banks, the larger stakes held by owners reduce
their tolerance toward risks (Heinrich, 2000). Hence, they become less willing to invest in
excessively risky positions. Saunders et al. (1990) find that banks with managerial
ownership exhibit relatively low risk-taking behavior. John et al. (2008) find that managers
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who have ownership control invest in suboptimally conservative positions. Hence, there is a
need to test whether managerial ownership is associated with less risk-taking behavior.
The following hypothesis presents this conjecture:
H1b. There is a negative association between managerial ownership of BHCs in one year
and risk taking in the subsequent year.
Board decisions and firm performance are attributed to the characteristics and preferences
of the boards of directors (Graham et al., 2013). Adams (2009) argues that larger boards and
more outside directorship are associated with poor bank performance in terms of receiving
bailout funds amidst the financial crisis. Furthermore, Adams and Mehran (2014) and
Minton et al. (2014) find that board characteristics are associated with firm performance and
risk taking in banks. The link between corporate governance structures and risk taking in
banks has been discussed by Kirkpatrick (2009). Weak corporate governance structures in
banks lead to insufficient risk monitoring by the board, which eventually leads to excessive
risk taking. Moreover, larger boards and more regulatory restrictions on outside
directorship in parent banks outweigh the benefits of these governance mechanisms, which
eventually undermine performance. As larger boards may exhibit inefficiencies, it is a
feature that hinders board communication, coordination, and decision-making abilities to
mitigate excessive risks ( Jensen, 1993).
Regarding outside directorship, Fama and Jensen (1983) argue that outsiders and
independent board members strive to protect their reputation as diligent monitors of managers.
Hence, outside directors tend to enhance general bank performance (Cornett et al., 2008).
However, in banks, managerial discretion is highly regulated by supervisory authorities
restricting the adverse effect of excessive risk taking (Demsetz and Lehn, 1985). Subsequently,
it is argued that bank regulators and supervisory authorities provide effective monitoring,
which reduces the diligence required by independent board members (Hagendorff et al., 2013).
Therefore, the following hypotheses express the association with risk taking:
H1c. There is a positive association between board size of BHCs in one year and risk
taking in the subsequent year.
H1d. There is a positive association between outside directorship on the board of BHCs
in one year and risk taking in the subsequent year.
Regulators have formulated the regulatory capital adequacy ratios in such a way as to
mitigate excessive risk taking by requiring a larger capital cushion to cover expected
and unexpected losses of risky investments as well as by imposing certain constraints
and sanctions if the minimum capital ratios, required by bank regulators, have not been
met. Accordingly, banks are inclined to increase their risky investments when they have
the necessary regulatory capital cushion[7]. Hence, it is expected that the regulatory
 capital adequacy attenuates the negative association between ownership concentration Implications to
and managerial ownership, on one hand, and risk taking on the other hand. The effect is bank risk
also to accentuate the positive association between board size and outside directorship taking
on one hand and risk taking on the other hand. The following hypotheses capture
this argument:
H2a. The larger the regulatory capital ratio, the less negative is the association
between ownership concentration of BHCs in one year and risk taking in the 169
subsequent year.
H2b. The larger the regulatory capital ratio, the less negative is the association between
managerial ownership of BHCs in one year and risk taking in the subsequent year.
H2c. The larger the regulatory capital ratio, the more positive the association between
board size of BHCs in one year and risk taking in the subsequent year.
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H2d. The larger the regulatory capital ratio, the more positive the association
between outside directorship of BHCs in one year and risk taking in the
subsequent year.
A well-capitalized BHC, with at least 6 percent tier 1 capital, is free from certain regulatory
constraints. Therefore, according to Elyasiani and Jia (2008), the performance and stability
of well-capitalized banks are stronger than those of banks that are not well capitalized.
Shrieves and Dahl (1992), Calomiris and Wilson (2004), and Flannery and Rangan (2008)
provide evidence of the significant association between regulatory capitalization and
asset risk for US banks. Jeitschko and Jeung (2007) attribute these results to “the asset
substitution effect of capital,” where increased capitalization induces banks to increase asset
risk. Therefore, this paper examines whether the effect of the regulatory capital ratio on the
association between ownership concentration and risk taking is more pronounced for BHCs
that fall above the well-capitalized threshold than those that fall below it. The following
hypothesis expresses the conjecture:
H2e. The effect of the regulatory capital ratio on the association between corporate
governance and risk taking is more pronounced for BHCs that fall above the
well-capitalized threshold than for those that fall below it.
Good corporate governance mechanisms have been linked to enhanced firm performance.
Leung and Horwitz (2010) find that a more concentrated equity ownership by managers is
associated with good firm performance, as opposed to highly risky performance, during the
Asian financial crisis. Furthermore, Sanya and Wolfe (2011) show that in a period of
economic boom prior to the recent global financial crisis, European banks facing an
increasing portfolio risk are reluctant to diversify their risks in the presence of blockholders.
On the other hand, failure in risk management systems of many failed banks during the
financial crisis of late 2007 has been attributed to deficient corporate governance
mechanisms. Boards of directors of failed banks did not take into account the risk factors
before approving the company strategy. Kirkpatrick (2009) suggests that board’s
disclosures of the foreseeable risk factors and about systems for monitoring and managing
risk were severely lacking in many failed banks. According to Conyon et al. (2011), weak
governance structures have contributed largely to the undue risk taking in banks during the
financial crisis. Grove et al. (2011) corroborate prior results as they find a significant positive
association between concentrated ownership and a bank’s loan quality, a measure of
financial performance, during the financial crisis period. The effect of regulatory capital
adequacy is argued to differ during the period of turmoil and precrisis booms as banks are
keen to create credit through transactions that are unrelated to the creation of real assets
(Werner, 2010). Hence, to examine whether the association between corporate governance
 IJMF and bank risk taking differs in the precrisis boom of 2002-2006 relative to the financial crisis
13,2 period of 2007-2009, the third hypothesis is as follows:
H3. The effect of the regulatory capital ratio on the association between corporate
governance and risk taking is less pronounced for BHCs during a period of financial
crisis relative to a boom period.

170
4. Research design
Risk taking is a multifaceted phenomenon that cannot be captured by a single
measure. Therefore, the dependent variable (Risktakingit+1) is a novel proxy for the degree
of bank risk taking captured in each of the risk-weighted assets (RWA) portfolio,
the risk-weighted loan (RWL) positions, and the risk-weighted derivatives and OBS items.
The variables used in prior studies have been criticized for not directly measuring
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management risk-taking decisions. Therefore, data used to calculate the dependent

variables are obtained from schedule HC-R in annual FR Y-9C regulatory reports filed at
the FDIC. RWA proxies for the degree of riskiness in the bank’s asset portfolio. It is
calculated as the summation of total assets risk weighted at 0, 20, 50, and 100 percent all
divided by the sum of total assets and OBS items[8]. RWL proxies for the degree of
riskiness in the bank’s loan portfolio. It is calculated as the summation of loans risk
weighted at 0, 20, 50, and 100 percent all divided by the sum of total assets and OBS items.
For reporting regulatory capital ratios in FR Y-9C reports, the credit exposure of the
derivative contracts comprises the credit equivalent amount while the face value of
the OBS items is multiplied by a credit conversion factor and then the resulting credit
equivalent amount is risk weighted[9]. OBS is calculated as the summation of OBS items
and derivative contracts risk weighted at 0, 20, 50, and 100 percent all divided by the sum
of total assets and OBS items (Board of Governors of the Federal Reserve System, 2007).
Hence, the dependent variables reflect the regulatory aim of mitigating risk and they tie in
well with the regulatory risk classes. For the main inferences, a year and firm fixed-effects
model and a two-way clustering technique are used to adjust the standard errors.
This specification controls for heteroscedasticity and intertemporal firm-specific and
year-specific dependence in regression residuals[10].
The following regression model is used to test H1a, H1b, H1c, and H1d[11]:

Risktaking it þ 1 ¼ b1;1 þb1;2 BLOCK it þb1;3 M AN AGERit þb1;4 BS it

X
n
þb1;5 OU T it þ b1; j Controlsjit þeit (1)
j¼1

The dependent variable in this model, Risktakingit+1, denotes the risk-weighted investments of
either assets, loans, or OBS items, respectively[12]. The dependent variables are measured as
discussed earlier[13]. The explanatory variable BLOCKit proxies for ownership concentration.
BLOCKit is a dummy variable that equals 1 if the BHC has a blockholder controlling at least
10 percent of equity and voting rights and zero otherwise[14]. According to Caprio et al. (2007),
a bank is classified as having a blockholder if the shareholder has voting rights that sum to
10 percent or more. Otherwise, the bank is classified as widely held. On the basis of the
conjecture in H1, we expect ß1,2 to have a negative sign. MANAGERit is a proxy for
management ownership and board structure. It denotes a dummy variable that equals 1 if the
BHC has a manager or executive who has at least 5 percent equity stake and zero otherwise.
ß1,3 is expected to be negative as managers are inclined to minimize risky activities to protect
their human capital ( Jensen and Meckling, 1976). BSit denotes board size and it is measured by
the natural log of the number of directors on the board. OUTit denotes outside directorship and
 is measured by the ratio of outside directors to the total number of directors on the board. Implications to
According to Adams (2009), the board size and outside directorship are associated with poor bank risk
performing banks that received bailout funds during the financial crisis period. Adams and taking
Mehran (2014) suggest that regulatory restrictions of parent boards outweigh the beneficial
effects of independent boards, which adversely affect bank performance. Therefore, the
coefficient ß1,4 and ß1,5 are expected to be positive.
The model uses NPLit, SIZEit, and FRVit as control variables. NPLit denotes 171
nonperforming loans to assets. It is used as a proxy for risk inherent in loans, the largest
asset in the bank’s portfolio (Konishi and Yasuda, 2004; Shehzad et al., 2010). BHCs
with a larger base of nonperforming loans to assets, i.e. larger risk exposure in one year,
are expected to reduce their risky loan positions in the subsequent year. SIZEit denotes the
natural log of total assets to allow for a possible nonlinear association with risk[15].
Larger BHCs are more stable and have more diversified operations. Therefore, these
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BHCs are expected to have better opportunities to invest in a broader range of loans and
other asset positions (Sullivan and Spong, 2007). The bank size is expected to be
negatively associated with subsequent year risk taking. To control for the effect of deposit
insurance and the potential moral hazard that managers face in financial institutions,
franchise value, FRVit, is used as a proxy for the management incentive to exploit the
deposit insurance available for BHCs to take excessive risk. Konishi and Yasuda (2004)
define franchise value as the value forgone in the event of bank failure, receivership, or
conservatorship. FRVit equals market value of equity plus book value of liabilities to book
value of total assets. We expect a negative association between franchise value and bank
risk. The management of a bank holding company with a higher franchise value has
fewer incentives to take on excessive risks. Therefore, these BHCs are less likely to use
the moral hazard inherent in deposit insurance (Marcus, 1984). Lee (2002) finds that the
association between shareholder concentration and risk taking is positive when the
bank’s probability of failure is low. Therefore, in an alternative specification, a market-based
probability of default measure is used to control for the bank’s probability of failure.
The Black‐Scholes‐Merton (BSM) measure established in the finance literature has
been further adapted by Hillegeist et al. (2004) to proxy for the probability of default
(Abou-El-Sood, 2016)[16].
The following model is used to test H2a, H2b, H2c, and H2d on the effect of regulatory
capital adequacy:

Risktaking it þ 1 ¼ b2;1 þb2;2 BLOCK it þb2;3 M AN AGERit þb2;4 BS it þb2;5 OU T it

X
n X
n
þb2;6 TCAP it þ b2; j I nteract_TCAP jit þ b2; j Controlsjit þeit (2)
j¼1 j¼1

In model (2), TCAPit is a measure of regulatory capital adequacy. It is obtained from

schedule HC-R in FR Y-9C filings and is calculated as tier 1 capital scaled by the sum of total
assets and OBS items[17]. When a bank has a larger regulatory capital base, it is expected to
invest in risky positions, as it possesses the adequate cushion to absorb potential shocks.
According to prior results of Jeitschko and Jeung (2007), among others, ß2,6 is expected to
have a positive sign, indicating that a larger tier 1 capital ratio in one year is associated with
more risk-taking behavior in the subsequent year. The variables of interest are the
interaction terms of each of the corporate governance explanatory variables with TCAPit.
It is conjectured that TCAPit attenuates the negative association for each of BLOCKit and
MANAGERit and accentuates the positive association for each of BSit and OUTit. Hence, all
interaction coefficients are expected to be positive.
 IJMF To test H2e on the effect of being well capitalized or poorly capitalized on the association
13,2 between corporate governance and risk taking, model (3) is used:
Risktaking it þ 1 ¼ b3;1 þb3;2 BLOCK it þb3;3 M AN AGERit þb3;4 BS it þb3;5 OU T it
X
n
þb3;6 TCAP it þb3;7 W ELLit þ b3; j I nteract_TCAP_W ELLjit
172 j¼1

X
n
þ b3; j Controlsjit þeit (3)
j¼1

In model (3), the dummy variable WELLit takes the value of 1 if the BHC is well capitalized
having a tier 1 capital ratio of at least 6 percent and zero otherwise. In the main specification, the
regulatory ratio of 6 percent is used as a cutoff point. In another specification, WELLit takes the
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value of 1 if the BHC has above median tier 1 capital ratio and zero otherwise. This specification
allows for testing the robustness of the effect of being well capitalized or poorly capitalized
based on a sample specific rather than a regulatory threshold[18]. The coefficient ß3,7 is expected
to have a positive sign. Moreover, the variables of interest are the interaction terms between
each of the corporate governance explanatory variables with both TCAPit and WELLit.
Finally, to test H3 of the effect of a period of financial crisis relative to a precrisis boom
period, we use a dummy variable CRISISit that equals 1 during the period 2007-2009 and
zero otherwise. Model (4) is used to test H3:
Risktaking it þ 1 ¼ b4;1 þb4;2 BLOCK it þb4;3 M AN AGERit þb4;4 BS it
þb4;5 OU T it þb4;6 TCAP it
X
n
þb4;7 CRI SI S it þ b4;j I nteract_CRI SI S jit
j¼1

X
n X
n
þ b4; j I nteract_TCAP_CRI SI S jit þ b4;j Controlsjit þeit
j¼1 j¼1

(4)
The relevant coefficient in model (4) ß4,7 is expected to be negative. The coefficients on the
interaction terms between each of the corporate governance variables with TCAPit and
CRISISit are expected to be negative indicating more conservative risk policies during times
of economic turmoil even when the capital cushion allows for risky investments.

5. Data and sample

The sample consists of US BHCs for the period 2002-2014. The accounting and regulatory
data are collected from BHCs’ annual regulatory reports FR Y-9C filed at the US Federal
Reserve Bank[19]. US banks are required by the Federal Reserve to file consolidated balance
sheets and income statements along with other data pertaining to the banks’ regulatory
capital. The study period starts in 2002 to obtain detailed data of regulatory capital and
risk-weighted positions from FR Y-9C reports. Data on ownership structure and board
characteristics are hand collected from individual BHC proxy statements filed at the Securities
and Exchange Commission and reports available at the Bankscope database maintained by
the Bureau van Dijk. To calculate the market value of equity, we use price data and the
number of common shares outstanding from the Center for Research in Security Prices.
A data set is constructed, where the accounting data obtained from annual FR Y-9C
filings articulate fully with regulatory data. The data set also includes variables pertaining
 to ownership structure, board characteristics, and market prices. Observations with Implications to
missing accounting, regulatory, market, or ownership concentration data are deleted. bank risk
Also observations at the top and bottom 1 percent of the sample are winsorized to exclude taking
extreme observations[20]. In unreported robustness tests, however, the results remain
unchanged if no winsorizing is performed or if the observations at the 1st and 99th
percentiles are trimmed. Although the requirement that data be available on BHCs for the
period 2002-2014 may introduce a survivorship bias, this may not be an issue in the banking 173
industry since the FDIC generally does not allow large BHCs to fail through providing
deposit insurance and bailouts. The final sample consists of 1,389 firm-year observations
covering the period of 2002-2014.

6. Results
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6.1 Descriptive statistics

In Table I, the measure of tier 1 capital (TCAPit) has a mean (median) of 12 percent (11 percent)
consistent with the results of prior research on the tier 1 capital ratio[21]. The mean (median)
risk-weighted assets to total assets and OBS items is 51 percent (51 percent). On average,
sample BHCs have a proportionately large loan portfolio as shown by the mean (median) RWL
of 55 percent (56 percent). On the other hand, sample BHCs have proportionately small
positions of OBS items as shown by the mean (median) OBS of 5 percent (1 percent).
On average, blockholders constitute 17 percent of sample BHCs, while 8 percent of sample
BHCs have managerial ownership. The mean outside directorship is 19 percent[22].
Table II presents the Pearson and Spearman correlation results. The correlations
between all independent variables and measures of the dependent variable Risktakingit+1,

Variables Mean Median SD

Risktakingit+1: RWA 0.51 0.51 0.11

Risktakingit+1: RWL 0.55 0.56 0.13
Risktakingit+1: OBS 0.05 0.01 0.27
TCAPit 0.12 0.11 0.07
BLOCKit 0.17 0.00 0.03
MANAGERit 0.08 0.00 0.05
BSit 2.85 2.74 0.09
OUTit 0.19 0.18 0.14
NPLit 0.01 0.01 0.02
SIZEit 13.91 12.89 1.76
WELLit 0.68 1.00 0.31
CRISISit 0.42 0.00 0.32
FRVit 1.04 1.03 0.20
Notes: Risktakingit+1 ¼ the dependent variable that proxies for risk taking for bank holding company i at
year t+1, measured by: RWA ¼ the ratio of risk-weighted assets to the sum of total assets and off-balance-
sheet items, RWL ¼ the ratio of risk-weighted loans to the sum of total assets and off-balance-sheet items and
OBS ¼ the ratio of risk-weighted off-balance-sheet items to the sum of total assets and off-balance-sheet items,
TCAPit ¼ the ratio of tier 1 capital to the sum of total assets and off-balance-sheet items for bank holding
company i at year t, BLOCKit ¼ a dummy that equals 1 if the bank holding company has a blockholder that
controls 10 percent or more of voting rights and zero otherwise, MANAGERit ¼ a dummy that equals 1 if the
bank holding company has a manager who owns 5 percent or more of the bank shares and zero otherwise,
BSit ¼ the natural log of the number of directors on the board, OUTit ¼ the ratio of outside directors to the
total number of directors on the board, NPLit ¼ nonperforming loans to assets, SIZEit ¼ natural log of total Table I.
assets, WELLit ¼ a dummy that equals 1 if the bank holding company has a tier 1 capital ratio of at least Descriptive statistics –
6 percent and zero otherwise, and CRISISit ¼ a dummy that equals 1 if the year is 2007, 2008, or 2009 and zero US bank holding
otherwise, and FRVit ¼ market value of equity plus book value of liabilities to total book value of assets companies (2002-2014)
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13,2

174
IJMF

Table II.

(2002-2014)
diagonal) and
Spearman (below

holding companies
diagonal) correlation
The Pearson (above

coefficients – US bank
Risktakingit+1 Risktakingit+1
Variable Risktakingit+1RWA RWL OBS TCAPit BLOCKit MANAGERit BSit OUTit NPLit SIZEit FRVit

Risktakingit+1RWA 0.482 (o 0.001) 0.199 ( o 0.001) 0.025 (0.050) −0.017 (0.005) −0.019 ( o0.001) 0.010 (0.014) 0.012 (0.009) −0.071 ( o 0.001) −0.296 (0.043) −0.259 ( o0.001)
Risktakingit+1RWL 0.397 ( o0.001) 0.292 ( o 0.001) 0.015 (0.062) −0.018 (0.006) −0.013 (0.005) 0.009 (0.011) 0.010 (0.001) −0.041 ( o 0.001) −0.263 (0.060) −0.234 ( o0.001)
Risktakingit+1OBS 0.182 ( o0.001) 0.253 (o 0.001) 0.076 (0.042) −0.013 (0.007) −0.010 (0.005) 0.011 (0.016) 0.014 (0.011) −0.051 ( o 0.001) −0.239 (0.163) −0.201 ( o0.001)
TCAPit 0.019 (0.069) 0.011 (0.051) 0.063 (0.080) 0.028 (0.080) 0.013 (0.091) 0.018 (0.062) 0.020 (0.050) −0.003 (0.931) −0.215 ( o0.001) −0.124 ( o0.001)
BLOCKit −0.010 (0.018) −0.012 (0.008) −0.020 (0.013) 0.020 (0.081) 0.312 (0.003) −0.009 (0.132) −0.217 (0.102) 0.100 (0.002) 0.001 (0.978) 0.029 (0.856)
MANAGERit −0.010 (0.001) −0.010 (0.002) −0.018 (0.010) 0.009 (0.073) 0.292 (0.014) −0.092 (0.090) −0.102 (0.100) 0.081 (0.013) 0.012 (0.819) 0.196 (0.091)
BSit 0.008 (0.011) 0.001 (0.010) 0.018 (0.017) 0.021 (0.089) −0.014 (0.102) −0.087 (0.067) 0.120 (0.020) −0.007 (0.024) −0.019 (0.090) −0.100 (0.041)
OUTit 0.006 (0.010) 0.007 (0.009) 0.019 (0.008) 0.031 (0.075) −0.190 (0.092) −0.100 (0.096) 0.097 (0.021) −0.018 (0.042) −0.098 (0.072) −0.110 (0.046)
NPLit −0.064 (0.075) −0.017 (0.071) −0.064 ( o 0.001) −0.002 (0.789) 0.095 (0.010) 0.079 (0.029) −0.004 (0.104) −0.009 (0.073) 0.044 (0.226) 0.032 (0.137)
SIZEit −0.198 (0.011) −0.183 (0.061) −0.190 (0.140) −0.200 (0.001) 0.001 (0.771) 0.010 (0.305) −0.010 (0.122) −0.086 (0.059) 0.039 (0.316) 0.139 (0.002)
FRVit −0.201 (0.001) −0.197 (o 0.001) −0.197 ( o 0.001) −0.109 ( o 0.001) 0.021 (0.095) 0.119 (0.095) −0.078 (0.030) −0.109 (0.039) 0.031 (0.029) 0.107 (0.014)
Notes: Risktakingit+1 ¼ the dependent variable that proxies for risk taking for bank holding company i at year t+1, measured by: RWA ¼ the ratio of risk-weighted assets to the sum of total assets and off-balance-sheet items,
RWL ¼ the ratio of risk-weighted loans to the sum of total assets and off-balance-sheet items, and OBS ¼ the ratio of risk-weighted off-balance-sheet items to the sum of total assets and off-balance-sheet items, TCAPit ¼ the
ratio of tier 1 capital to the sum of total assets and off-balance-sheet items for bank holding company i at year t, BLOCKit ¼ a dummy that equals 1 if the bank holding company has a blockholder that controls 10 percent or more
of voting rights and zero otherwise, MANAGERit ¼ a dummy that equals 1 if the bank holding company has a manager who owns 5 percent or more of the bank shares and zero otherwise, BSit ¼ the natural log of the number of
directors on the board, OUTit ¼ the ratio of outside directors to the total number of directors on the board, NPLit ¼ nonperforming loans to assets, SIZEit ¼ natural log of total assets, and FRVit ¼ market value of equity plus
book value of liabilities to total book value of assets. p-values in parentheses
 RWA, RWL, and OBS are significant at conventional levels and have the expected signs. Implications to
The control variables NLPit, SIZEit, and FRVit and the dependent variables are negatively bank risk
correlated at conventional significance levels[23]. taking
6.2 Regression results: corporate governance mechanisms and risk taking
Table III displays the regression results using the three measures of Risktakingit+1, RWA,
RWL, and OBS in each of the three main columns. In the first column showing results of risk 175
taking in total asset investments, BLOCKit is negatively associated with bank risk taking
with a coefficient of −0.16, which is consistent with prior work (Saunders et al., 1990; Gropp
and Köhler, 2010). The coefficient of MANAGERit, −0.14, is also negative and significant at
conventional levels. It is consistent with the finding that manager-concentrated ownership
mitigates risk taking (Laeven and Levine, 2009). The coefficients on BSit and OUTit, of 0.04
and 0.09, respectively, are positive and significant as expected. The results may be
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explained in light of Adams and Mehran (2014), who illustrate that the beneficial effect
of board size on bank performance declines when boards get larger. Hence, the positive
effect of board size, BSit, on risk taking in this study. With respect to the variable OUTit,
regulatory restrictions may apply on subsidiary boards influencing board composition

Risktakingit+1
RWA RWL OBS
Variables Pred. Coef. t-stat. Coef. t-stat. Coef. t-stat.

Intercept +/− 0.32 1.01 0.18 1.01 0.51 0.69

BLOCKit − −0.16 −2.09** −0.17 −2.10** −0.14 −1.92*
MANAGERit − −0.14 −2.50*** −0.13 −2.58*** −0.09 −1.99**
BSit + 0.04 1.93* 0.05 1.92* 0.03 1.90*
OUTit + 0.09 2.00** 0.09 1.98** 0.10 1.99**
NPLit − −0.49 −1.92* −0.32 −1.91* −0.16 −1.91*
SIZEit − −0.03 −1.18 −0.04 −1.89* −0.03 −1.30
FRVit − −0.14 −1.99** −0.15 −1.97** −0.14 −2.18**
Year fixed effects YES YES YES
Firm fixed effects YES YES YES
Adjusted R2 29.18% 31.74% 15.01%
No. of Obs. 1,389 1,389 1,389
Notes: The model estimated is as follows:
Risktaking it þ 1 ¼ b1;1 þ b1;2 BLOCK it þb1;3 MANAGERit þb1;4 BS it
X
n
þb1;5 OU T it þ b1; j Controlsjit þ eit (1)
j¼1

where Risktakingit+1 ¼ the dependent variable that proxies for risk taking for bank holding company i at year
t+1, measured by: RWA ¼ the ratio of risk-weighted assets to the sum of total assets and off-balance-sheet
items, RWL ¼ the ratio of risk-weighted loans to the sum of total assets and off-balance-sheet items and
OBS ¼ the ratio of risk-weighted off-balance-sheet items to the sum of total assets and off-balance-sheet items,
BLOCKit ¼ a dummy that equals 1 if the bank holding company has a blockholder that controls 10 percent or
more of voting rights and zero otherwise for bank holding company i at year t, MANAGERit ¼ a dummy that Table III.
equals 1 if the bank holding company has a manager that owns 5 percent or more of the bank shares and zero Regression results of
otherwise, BSit ¼ the natural log of the number of directors on the board, OUTit ¼ the ratio of outside the association
directors to the total number of directors on the board, NPLit ¼ nonperforming loans to assets, SIZEit ¼ between corporate
natural log of total assets, and FRVit ¼ market value of equity plus book value of liabilities to total book value governance and
of assets. All dependent variables are log transformed; A two-way clustering technique is used to risk-taking behavior –
adjust standard errors. Significance is one tailed unless the sign of the coefficient is indeterminate. US bank holding
*,**,***Significant at the 10, 5 and 1 percent level, respectively companies (2002-2014)
 IJMF of the parent board, which eventually counteracts the beneficial effects of independent
13,2 boards with more outside directorship. Coefficients in the second column show the
association between the corporate governance measures and risk-taking behavior within
the loans portfolio.
The results are collectively significant at conventional levels with coefficients of
BLOCKit, MANAGERit, BSit, and OUTit being equal to −0.17, −0.013, 0.05, and 0.09,
176 respectively. Results of the model regression risk taking in OBS positions on the
explanatory variables are presented in the third column. In general, blockholders, managers
owning shares, and larger boards have a more significant effect on BHCs risky loans than
on the risky OBS positions as evident by the more economically significant coefficients of
−0.14, −0.09, and 0.03 for BLOCKit, MANAGERit, and BSit, respectively. Outside
directorship, OUTit, affects risk taking in OBS positions relatively more than it does in loans
as apparent by the coefficients of 0.10 in risky OBS items relative to 0.09 in risky loans.
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Collectively, the empirical results are significant at conventional levels and support H1a,
H1b, H1c, and H1d.

6.3 Regression results: regulatory capital adequacy and risk taking

In Table IV, the coefficients of TCAPit show that when BHCs have relatively larger tier 1
capital cushion, they invest in more risky positions. The coefficients of all the interaction
terms BLOCKit × TCAPit have the expected signs and are generally significant at
conventional levels. The results show that for BHCs with larger tier 1 capital, relative to
those with lower tier 1 capital, the corporate governance measures are associated with more
risk taking in total assets, loan positions, and OBS items. The coefficients are 0.12, 0.16, and
0.10 for concentrated ownership; 0.08, 0.10, and 0.08 for managerial ownership; 0.05, 0.02,
and 0.02 for board size; and 0.09, 0.10, 0.07 for outside directorship, respectively. Hence, the
empirical results support H2a, H2b, H2c, and H2d.
To test H2e, a cutoff point of 6 percent tier 1 capital ratio, set by bank regulators to
classify BHCs as being well-capitalized, has been used. The results reported in Table IV
show that the effect of the regulatory capital, TCAPit, on the association between the
corporate governance mechanisms and risk taking is more pronounced for well-capitalized
BHCs, i.e. those BHCs retaining at least a 6 percent tier 1 capital ratio, than for poorly
capitalized BHCs. Hence, the positive significant coefficients indicate the tendency to invest
in relatively highly risky assets, loan positions, and OBS positions. These results may be
attributed to the benefits that banks enjoy when they hold excess capital than the minimum
required by regulators, which includes improved risk sharing. Even then, general
equilibrium effects may imply a positive association between capital and risk (Gale, 2010).
Collectively, the findings support H2e. Jeitschko and Jeung (2007) may provide an
interesting explanation to the findings of H2e. In poorly capitalized BHCs, the regulatory
effect dominates bank risk taking due to banks being prone to strict regulatory scrutiny.
On the other hand, in well-capitalized BHCs, shareholders and managers dominate the
regulatory effect and push for more risk taking.

6.4 Regression results: precrisis boom and the financial crisis period
Table V presents the results of regressing each of RWA, RWL, and OBS on the explanatory
variables of interest. The negative coefficient −0.04 of CRISISit shows that BHCs are more
inclined to take risky investments on the upside of the economy than on the downside.
As shown by the interaction terms of BLOCKit, MANAGERit, BSit, and OUTit with CRISISit,
the financial crisis period has accentuated the negative association for concentrated
ownership and managerial ownership, i.e. taking less risky investments during the crisis
period. Moreover, during the financial crisis, smaller boards and those with less outside
directors push for less risky investments. During the crisis period, the effect of the tier 1
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Risktaking it+1
Model (2) Model (3)
RWA RWL OBS RWA RWL OBS
Variables Pred. Coef. t-stat. Coef. t-stat. Coef. t-stat. Coef. t-stat. Coef. t-stat. Coef. t-stat.

Intercept +/− 0.41 0.74 0.32 0.31 0.59 0.74 1.46 1.04 1.31 0.11 1.61 1.09
BLOCKit − −0.19 −1.14 −0.17 −0.91 −0.11 −1.00 −0.17 −0.90 −0.18 −1.19 −0.18 −0.27
MANAGERit − −0.14 −1.20 −0.14 −1.16 −0.13 −1.07 −0.16 −0.1.00 −0.19 −0.98 −0.10 −0.1.04
BSit + 0.03 1.21 0.03 1.89* 0.02 1.30 0.02 1.10 0.04 1.21 0.02 0.99
OUTit + 0.04 1.18 0.05 1.09 0.02 1.12 0.01 1.00 0.03 1.16 0.02 1.14
TCAPit + 1.31 1.89* 1.26 2.21** 1.39 1.89* 1.15 1.10 1.48 1.01 1.41 1.09
BLOCKit ×TCAPit + 0.12 1.99** 0.16 2.91*** 0.10 1.96**
MANAGERit ×TCAPit + 0.08 1.97** 0.10 1.96** 0.08 1.98**
BSit ×TCAPit + 0.05 1.89* 0.02 1.88* 0.02 1.92*
OUTit ×TCAPit + 0.09 1.91* 0.10 1.90* 0.07 1.89*
WELLit + 0.09 1.99** 0.19 2.01** 0.11 1.80*
WELLit ×BLOCKit ×TCAPit + 0.12 2.69*** 0.13 2.83*** 0.14 3.01***
WELLit ×MANAGERit ×TCAPit + 0.08 2.19** 0.09 1.96** 0.06 1.97**
WELLit ×BSit ×TCAPit + 0.02 1.79* 0.03 1.80* 0.02 1.79*
WELLit ×OUTit ×TCAPit + 0.06 1.97** 0.05 1.99** 0.07 2.00**
NPLit − −0.39 −1.75* −0.40 −1.79* −0.28 −1.53 −0.44 −1.79* −0.45 −1.71* −0.30 −1.71*
SIZEit − −0.02 −1.12 −0.03 −1.51 −0.03 −1.08 −0.02 −1.11 −0.03 −1.96* −0.03 −1.09
FRVit − −0.15 −2.13** −0.17 −2.16** −0.12 −1.92* −0.16 −2.02** −0.17 −2.12** −0.14 −2.18**
Year fixed effects YES YES YES YES YES YES
Firm fixed effects YES YES YES YES YES YES

(continued )
177
taking

Regression results of
Implications to

governance and risk-

regulatory capital on
bank risk

Table IV.

bank holding
the effect of the

companies (2002-2014)
taking behavior – US
between corporate
the association
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13,2

178
IJMF

Table IV.
Risktaking it+1
Model (2) Model (3)
RWA RWL OBS RWA RWL OBS
Variables Pred. Coef. t-stat. Coef. t-stat. Coef. t-stat. Coef. t-stat. Coef. t-stat. Coef. t-stat.

Adjusted R2 37.20% 39.21% 20.91% 32.81% 36.84% 20.03%

No. of Obs. 1,389 1,389 1,389 1,389 1,389 1,389
Notes: The models estimated are as follows:
Risktaking it þ 1 ¼ b2;1 þ b2;2 BLOCK it þb2;3 MAN AGERit þb2;4 BS it þ b2;5 OU T it
n
X n
X
þb2;6 TCAP it þ b2;j I nteract_TCAP jit þ b2;j Controlsjit þeit (2)
j¼1 j¼1

Risktaking it þ 1 ¼ b3;1 þ b3;2 BLOCK it þb3;3 MAN AGERit þb3;4 BS it þ b3;5 OU T it

n
X n
X
þb3;6 TCAP it þ b3;7 W ELLit þ b3;j I nteract_TCAP_W ELLjit þ b3;j Controlsjit þeit (3)
j¼1 j¼1

where Risktakingit+1 ¼ the dependent variable that proxies for risk taking for bank holding company i at year t+1, measured by: RWA ¼ the ratio of risk-weighted assets
to the sum of total assets and off-balance-sheet items; RWL ¼ the ratio of risk-weighted loans to the sum of total assets and off-balance-sheet items; OBS ¼ the ratio of
risk-weighted off-balance-sheet items to the sum of total assets and off-balance-sheet items; BLOCKit ¼ a dummy that equals 1 if the bank holding company has a
blockholder that controls 10 percent or more of voting rights and zero otherwise for bank holding company i at year t; MANAGERit ¼ a dummy that equals 1 if the bank
holding company has a manager that owns 5 percent or more of the bank shares and zero otherwise; BSit ¼ the natural log of the number of directors on the board;
OUTit ¼ the ratio of outside directors to the total number of directors on the board; TCAPit ¼ the ratio of tier 1 capital to the sum of total assets and off-balance-sheet
items; WELLit ¼ a dummy that equals 1 if the bank holding company has a tier 1 capital ratio of at least 6 percent and zero otherwise; NPLit ¼ nonperforming loans to
assets; SIZEit ¼ natural log of total assets; FRVit ¼ market value of equity plus book value of liabilities to total book value of assets; All dependent variables are log
transformed; A two-way clustering technique is used to adjust standard errors. Significance is one tailed unless the sign of the coefficient is indeterminate; Only the
coefficients of relevant interaction terms are reported. *,**,***Significant at the 10, 5 and 1 percent level, respectively
 Risktaking it+1
Implications to
RWA RWL OBS bank risk
Variables Pred. Coef. t-stat. Coef. t-stat. Coef. t-stat. taking
Intercept +/− 1.37 0.79 1.27 1.09 1.18 1.09
BLOCKit − −0.08 −0.97 −0.09 −0.89 −0.07 −1.07
MANAGERit − −0.03 −0.80 −0.05 −0.65 −0.04 −1.00
BSit + 0.01 1.01 0.01 0.99 0.01 1.08 179
OUTit + 0.02 1.03 0.04 0.83 0.03 1.01
TCAPit + 1.21 1.51 1.17 0.98 1.06 0.69
CRISISit − −0.04 −0.12 −0.04 −0.23 −0.03 −0.19
CRISISit× BLOCKit − −0.05 −1.90* −0.08 −1.98** −0.05 −1.78*
CRISISit× MANAGERt − −0.04 −2.99*** −0.09 −1.82* −0.06 −1.85*
CRISISit× BSit − −0.03 −1.81* −0.04 −1.80* −0.03 −1.79*
CRISISit× OUTit − −0.04 −1.83* −0.04 −1.83* −0.03 −1.78*
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CRISISit× TCAPit + 0.11 2.71*** 0.09 2.69*** 0.08 2.01**

CRISISit× BLOCKit ×TCAPit − −0.15 −2.16*** −0.19 −1.92** −0.10 −1.96**
CRISISit× MANAGERt ×TCAPit − −0.09 −3.19*** −0.11 −2.96*** −0.07 −2.37***
CRISISit× BSit ×TCAPit − −0.04 −1.79* −0.05 −1.81* −0.04 −1.84*
CRISISit× OUTit ×TCAPit − −0.08 −1.90* −0.08 −1.89* −0.06 −1.83*
NPLit − −0.12 −1.73* −0.11 −1.77* −0.22 −1.92*
SIZEit − −0.03 −1.38 −0.03 −1.74* −0.02 −1.24
FRVit − −0.15 −1.97** −0.16 −1.98** −0.11 −2.07**
Year fixed effects YES YES YES
Firm fixed effects YES YES YES
Adjusted R2 32.07% 35.18% 23.91%
No. of Obs. 1,008 1,008 1,008
Notes: The model estimated is as follows:
Risktaking it þ 1 ¼ b4;1 þ b4;2 BLOCK it þb4;3 MANAGERit þb4;4 BS it þb4;5 OU T it þ b4;6 TCAP it
X
n
þb4;7 CRI SI S it þ b4;j I nteract_CRI SI S jit
j¼1

X
n X
n
þ b4;j I nteract_TCAP_CRI SI S jit þ b4; j Controlsjit þeit (4)
j¼1 j¼1

where Risktakingit+1 ¼ the dependent variable that proxies for risk taking for bank holding company i at year
t+1, measured by: RWA ¼ the ratio of risk-weighted assets to the sum of total assets and off-balance-sheet
items, RWL ¼ the ratio of risk-weighted loans to the sum of total assets and off-balance-sheet items and
OBS ¼ the ratio of risk-weighted off-balance-sheet items to the sum of total assets and off-balance-sheet items,
BLOCKit ¼ a dummy that equals 1 if the bank holding company has a blockholder that controls 10 percent or
more of voting rights and zero otherwise for bank holding company i at year t, MANAGERit ¼ a dummy that Table V.
Regression results of
equals 1 if the bank holding company has a manager that owns 5 percent or more of the bank shares and zero
the effect of the
otherwise, BSit ¼ the natural log of the number of directors on the board, OUTit ¼ the ratio of outside regulatory capital on
directors to the total number of directors on the board, TCAPit ¼ the ratio of tier 1 capital to the sum of total the association between
assets and off-balance-sheet items, CRISISit ¼ a dummy that equals 1 if the year is 2007, 2008 or 2009 and zero corporate governance
otherwise, NPLit ¼ nonperforming loans to assets, SIZEit ¼ natural log of total assets, and FRVit ¼ market and risk-taking
value of equity plus book value of liabilities to total book value of assets; All dependent variables are log behavior – precrisis
transformed; A two-way clustering technique is used to adjust standard errors. Significance is one tailed boom (2002-2006) and
unless the sign of the coefficient is indeterminate; Only the coefficients of relevant interaction terms are the financial crisis
reported. *,**,***Significant at the 10, 5 and 1 percent level, respectively period (2007-2009)

capital ratio on the association between the corporate governance measures and risk taking
is less pronounced, compared to the precrisis boom. Therefore, even with higher regulatory
capital, banks with good governance mechanisms push for less risky positions during the
financial crisis period relative to the boom period, as evident by the negative coefficients on
 IJMF the interaction between CRISISit, TCAPit, and each of the explanatory variables. Collectively,
13,2 the empirical evidence supports H3. The results can be explained in light of a macroeconomic
framework (Trani, 2012). An economic shock leads not only to tighter regulation on banks, but
also to higher agency costs. Hence, banks with good governance structures push for less risky
positions during the financial crisis period relative to the precrisis boom.

180 7. Conclusion
This study is motivated by the policy discussions on bank risk taking and concerns about
recent bank governance breakdowns during the aftermath of the financial crisis of 2007.
An overlooked aspect in prior work has been banks’ endogenous decision to modify their
risk-weighted investments in adherence to regulatory capital required ratios. This study
examines the effect of the bank-specific regulatory capital adequacy on the association
between corporate governance mechanisms and bank risk taking. Furthermore, prior work
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is extended to include measures of ownership structure and board characteristics.

Most importantly, new measures of risk taking are used to be in line with risk-weighted
capital measures set by US bank regulators.
Using US BHCs’ accounting, regulatory, market, and corporate governance data during the
period 2002-2014, the findings show that both concentrated ownership structure and
managerial ownership are negatively associated with bank risk taking. On the other hand,
board size and outside directorship are positively associated with bank risk taking.
The effect of the bank-specific regulatory capital measure on the association between
corporate governance measures and risk taking is examined. Further evidence suggests that
the larger the level of the regulatory capital ratio the more risk taking is advocated by banks.
The empirical findings support this argument. This result is particularly relevant to bank
regulators and policymakers as the poorly capitalized banks are prone to more regulatory
scrutiny. Hence, the regulatory effect of mitigating excessive risk taking is dominant. On the
other hand, well-capitalized banks are more inclined to engage in more risky investments due
to the effect of other stakeholders (shareholders/managers) being more dominant.
Finally, the empirical tests show that, given the good corporate governance structures,
banks are inclined to undertake more risky assets, loans, and OBS positions on the upside
and reduce those risky investments on the downside of the economy. The results hold when
banks have larger regulatory capital. This finding is pertinent to bank regulators; good
governance mechanisms act as regulatory tools to mitigate excessive risk taking during
times of economic turmoil, while benefiting from the (risky) opportunities in the market,
during the upside of the economy. The information asymmetry between bank stakeholders
adds to the agency problems, which provide additional mechanisms for the financial crises.
Having good governance structures mitigates this effect.
The findings of this study are particularly relevant in the context of the Basel
Committee and the G30 bank regulatory deliberations on governance structures and their
impact on bank risk taking, especially during periods of economic turmoil. Unlike
nonfinancial companies, banks have unique governance processes and bank-specific
features, which exacerbate information asymmetry and opaqueness of financial
information. Evidence provided in this paper bears on the regulatory aim of risk
mitigation during periods of financial crises. Bank regulators need to stress the alignment
of shareholders’ and managers interests to mitigate excessive risk taking. Large
shareholders play a vital monitoring role. However, when the bank has an adequate
regulatory capital cushion, concentrated owners tend to push for more risky positions.
What is usually considered good governance in nonbanking institutions does not
necessarily apply to banks. Considerations to the mix of corporate governance measures
and capital adequacy decisions can be useful in mitigating risk in on-balance-sheet and
OBS positions with varying degrees.
 Notes Implications to
1. For the sample bank holding companies, loans comprise approximately 66.7 percent of total assets. bank risk
2. Accounting variables used in prior studies are limited to on-balance-sheet risk while stock price taking
volatilities are limited to listed banks (Gropp and Köhler, 2010). Moreover, variables based on
loans or loan loss reserves proxy for risk only indirectly.
3. According to US regulators, banks may be classified into one of the five categories as being
well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, 181
and critically undercapitalized if their regulatory capital ratios are within the ranges specified
by the regulators.
4. Tier 1 capital represents common equity, disclosed reserves, and non-redeemable non-cumulative
preferred stock. Total capital is the sum of tier 1 capital and tier 2 capital. Tier 2 capital is a junior
debt-like measure of capital, which consists of undisclosed reserves, revaluation adjustments,
general provisions and loan loss reserves, hybrid instruments, and subordinated debt. Included in
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total capital is tier 3 capital that meets market risk. Tier 3 capital consists mainly of short-term
subordinated debt, and is normally insignificant in size.
5. It should be noted that subsequent to the interval examined in this study, Basel III has mandated
that 6 percent should become the minimum capital requirement. According to the Federal
Reserve, the new minimum capital requirements are effective in US banks on January 1, 2015.
6. The Federal Deposit Insurance Improvement Act: www.fdic.gov
7. Capital adequacy ratios have been used extensively in prior research as proxies for bank risk
taking (e.g., Shehzad et al., 2010).
8. Under the Federal Reserve’s risk-based capital requirements, assets and credit equivalent
amounts of derivatives and off-balance-sheet items are assigned to one of the several broad risk
categories according to the obligor, the guarantor, or the nature of the collateral. Then, the
aggregate dollar amount in each risk category is multiplied by the risk weight associated with
that category. Risk weights used by the regulators are 0, 20, 50, and 100 percent. The resulting
weighted values from each of the risk categories are added together. Generally, this sum is the
bank holding company’s total risk-weighted assets.
9. Risk weighting of off-balance-sheet items is a two-step process. First, for derivative contracts, the
credit equivalent amount is the sum of the current credit exposure (fair value of the contract, if
positive) and the potential future exposure. For off-balance-sheet items, the credit equivalent
amount is determined by multiplying the face value or the notional amount of the off-balance-
sheet item by a credit conversion factor. Second, the credit equivalent amount is treated like a
balance sheet asset and generally is assigned to the appropriate risk category of 0, 20, 50, or
100 percent.
10. In alternative untabulated tests, we use: a year fixed-effects model with two-way clustering
technique, a firm fixed-effects model using two-way clustering, a year and firm fixed-effects
model clustering by year and a year and firm fixed-effects model clustering by firm.
All alternative specifications lead to similar inferences.
11. To deal with potential causality or endogeneity, the specification allows for the measurement of
the dependent variable at t+1, while independent variables are in contemporaneous form at t.
Therefore, the models test whether contemporaneous corporate governance structures and
regulatory capital adequacy affect risk taking at the subsequent year. Moreover, the fixed effects
specification with demeaning allows time-invariant regressors to be absorbed by the fixed effects.
This basically gets rid of between-subject variability, which may be contaminated by omitted
variable bias, and leaves only the within-subject variability to examine empirically. Thus, the
effects of time-invariant regressors are unidentified in fixed-effects panel data models.
12. The denominator of each of the dependent variables is the total of on-balance-sheet assets and off-
balance-sheet items. This specification gives an economic sense to the findings. Moreover, it ties
in with the regulatory approximate definition of risk-weighted assets as the sum of assets and
off-balance-sheet items all risk weighted after being classified to the relevant risk classes.
 IJMF 13. A log transformation for all dependent variables is used as they represent ratios bounded by
13,2 0 and 1. Using a log-transformed dependent variable specification avoids the possibility that
predicted values fall outside the feasible range. All the dependent variables in the models
discussed in this study are log transformed to get unbiased predictions within the
observable range.
14. Different cutoff points are used for robustness results. Consistent with prior research, we use a
10 percent cutoff point for the main test. Adams and Mehran (2003) find that blockholders have
182 smaller equity holdings of bank holding companies (BHCs) compared to the equity holdings of
nonfinancial firms. Therefore, we use 5 and 1 percent as cutoff points to define a blockholder in a
bank holding company. Empirical results are robust to alternative specifications.
15. Size might capture many other factors. One of which might be that big BHCs are too big to fail.
This aspect is not tested in this study. Hence, SIZEit is used as a control variable.
16. The results of the association between corporate governance mechanisms and risk taking are
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robust to the added BSM control.

17. As a robustness check, I use CAPRit, in lieu of TCAPit, where CAPRit is the regulatory tier 1
capital ratio and is equal to tier 1 capital divided by risk-weighted assets, in line with the capital
measure required by US bank regulators. The results obtained are similar to those obtained in the
main specification.
18. In the alternative specification, the coefficients of the explanatory variables and controls
are significant at conventional levels and in the expected direction in line with the main
inferences.
19. www.chicagofed.org/webpages/banking/financial_institution_reports/bhc_data.cfm
20. These observations might reflect data errors or are unduly affected by some of the variables
being in ratio form (e.g. dividing by a small number).
21. For example, Berger et al. (2008) provide evidence of US banks maintaining a tier 1 capital ratio
well above the minimum ratio of 4 percent required by the Basel committee and US bank
regulators.
22. The use of natural log format in Table I is attributed to consistency to the reader while using the
variables across descriptives, correlation, and regression tables. The value of the natural log can
be easily transformed to get the original value (in case of BSit it is approximately 17 members and
for asset size, Sizeit, it is approximately 1,099,098 in US$ thousands).
23. Further testing for multicollinearity using the variance correlation factor (VIF) indicates no
reason for concern among independent variables and controls. VIF for all relevant variables
are o2.2, which corresponds to R2 of 0.55 among other variables.

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 About the author Implications to
Heba Abou-El-Sood is an Assistant Professor of Accounting and Finance at the Cairo University, bank risk
Faculty of Commerce. She has earned an MPhil Degree in Accounting from the Cairo University, an
MSc in Accounting and Finance from the Boston College, and a PhD in Accounting and Finance from taking
the Lancaster University. She has worked at the Lancaster University before being affiliated to
the Cairo University. She has published papers in the International Journal of Auditing and the
International Review of Financial Analysis, among others. She writes for the International Finance
Magazine, Wealth & Finance Magazine, Public Finance International, and Global Banking & Finance 185
Review. She acts as an ad-hoc reviewer to top-tier journals. Her research interests include financial
accounting, banking regulation, corporate governance, and Islamic finance. Heba Abou-El-Sood can be
contacted at: h.abouelsood@foc.cu.edu.eg
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