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Regulation and
Diversification, corporate bank risk-
governance, regulation and bank taking

risk-taking
Ahmed Imran Hunjra, Mahnoor Hanif and Rashid Mehmood
University Institute of Management Sciences,
PMAS-Arid Agriculture University Rawalpindi, Pakistan, and Received 22 March 2020
Revised 8 June 2020
18 July 2020
Loi Viet Nguyen Accepted 18 July 2020
Ministry of Finance, National Institute for Finance, Hanoi, Vietnam

Abstract
Purpose – The purpose of this paper is to investigate the impact of diversification, corporate governance
and capital regulations on bank risk-taking in Asian emerging economies.
Design/methodology/approach – The authors applied the generalized method of moments to analyze a
sample of 116 listed banks of ten Asian emerging economies for the years 2010–2018.
Findings – The authors found that diversification, board size, CEO duality and board independence, block
holders and capital regulations significantly affect bank risk-taking. In particular, nontraditional income
sources such as noninterest income and adoption of diversification strategies minimize bank risk-taking.
Practical implications – It is expected that the outcomes of this study can be used by banks in Asian
emerging economies that seek to reduce risk-taking by managing the diversification of their income streams
and managing the impacts of capital regulation and implementing sound corporate governance features in
monitoring their operations. This study suggests practical risk minimizing strategies for banks. First is the
sourcing of nontraditional income and adoption of diversification strategies. Second, maintaining
nonexecutive directors on the board would enhance monitoring of business activities. Third, maintaining
deposit insurance would reduce bank’s risk. Government provides insurance to depositors to motivate them to
deposit their funds into the banks. This, in return, facilitates banks to overcome risk. However, banks need to
be cautious of any increase in capital ratio, as channeling funds into risky investments would increase risk.
Originality/value – This study is the first to investigate the impacts of corporate governance,
diversification and regulation on bank’s risk-taking in a cross-country setting of ten Asian emerging
economies.
Keywords Diversification, Regulation, Corporate governance, Asian emerging economies,
Bank risk-taking, Capital regulations
Paper type Research paper

1. Introduction
The 2008–2009 Global Financial Crisis has attracted much research interest in bank risk-
taking and bank instability (Abedifar et al., 2013; Bourkhis and Nabi, 2013; Al-Khouri and
Arouri, 2016). A banking crisis can lead to credit tightening (Marinkovic and Radovic, 2014)
which can affect the scope of banks’ operations and in turn affect other sectors which
depend on bank credit.
The failure of large financial institutions during the financial crisis has partly been
attributed to increased risk-taking and the divergence of bank services into nonbank Journal of Financial Reporting and
Accounting
activities (DeYoung and Torna, 2013). Regulators in many jurisdictions proposed © Emerald Publishing Limited
1985-2517
regulations to limit some of these nontraditional bank activities, with banks confronted with DOI 10.1108/JFRA-03-2020-0071
JFRA increased capital regulations and other improvements related to risk-taking, and corporate
governance mechanisms. These regulations aim to reduce bank risk-taking, improving
credit quality and liquidity while maintaining profitability.
The primary objective of the current study is to examine the impact of diversification,
capital regulation and corporate governance on bank risk taking in Asian emerging
economies. Our research is motivated by the ongoing process of financial liberalization in
the Asian emerging economies, where the banking sector serves as a catalyst for promoting
economic activities in other sectors of the economy by providing loans to finance investment
projects and routine transactions. Over the past few decades, financial liberalization and
deregulation have led to emergence of financial institutions in the private sector and rapid
growth in their capital markets (Cremers and Nair, 2005; Gompers et al., 2003; Zhang et al.,
2013).
In a competitive business environment, banks are no longer solely dependent on their
traditional source of interest income. Banks also derive noninterest income for their financial
stability and survival. This income sourcing strategy is especially prevalent in banks in
developing countries which are generally less efficient in their operations and less developed
in their marketing strategies, compelling them to adopt diversification policies (Brahmana
et al., 2018 and Nisar et al., 2018). During the past two decades, there has been increasing
growth in multiple sources of revenue of banks (Asif and Akhter, 2019). Income
diversification is crucial for sustained bank profitability and plays a significant role in
controlling bank risk and smoothing financial system operations (Zhou, 2014).
Regulators have been increasing their efforts to monitor banks to avoid excessive risk-
taking (Luu, 2015). Regulatory reforms are intended to reduce excessive risk-taking by
banks, limiting bank failures and ensuring the soundness of the financial system (Dias,
2020). Capital regulation affects the risk-taking of banks lowering the threshold of
regulatory arbitrage through financial innovation (Ashraf et al., 2016). In particular, capital
regulation increases capital requirements of banks (Hunjra et al., 2020).
Corporate governance is another factor that contributes to risk exposure of banks.
Diamond and Rajan (2009) argue that financial institutions with efficient corporate
governance mechanisms increase control through appropriate incentives for risk-taking so
as to order maximize shareholder value. Stulz (2015) argues that banks with good
governance policies experience an optimal level of risk that helps managers to increase
value for shareholders. Although in response to the 2008 financial crisis, there has been
increasing regulatory and governance reforms (Boubaker and Nguyen, 2014a, 2014b), the
corporate governance system in emerging economies is still weak (Mehmood et al., 2019).
For a sample of 116 listed banks of ten Asian emerging economies for the years of 2010–
2018, we show that diversification of income streams, the board of directors, CEO duality,
board independence, block holders and capital regulations are significantly correlated with
bank risk-taking. We find that banks get diversification benefits by relying more on
noninterest income activities such as fee and commission-based income and trading income.
We further find that regulation is negatively associated with banks’ risk-taking with
deposit insurance.
Our study differs from previous studies and contributes to the extant literature in two
ways. First, our sample covers banks from a cross-country setting of a large number of
Asian emerging economies. Most prior studies tend to focus on banks in a single
jurisdiction. Second, our study considers diversification, capital regulation and corporate
governance simultaneously. Most previous studies have only considered one of these
variables in their analysis of bank risk-taking.
 The remainder of this paper is organized in the following manner. Section 2 discusses the Regulation and
theoretical basis and literature review to support the development of hypotheses. Section 3 bank risk-
outlines data, variables, mathematical model and techniques. Section 4 presents the results
of descriptive analysis, correlation and model analysis, and Section 5 concludes this paper.
taking

2. Literature review and hypotheses

Bank risk-taking is a topical area of research in the finance and banking literature and a
crucial issue of concern for bank regulators. Bank risk-taking influences the likelihood of
bank failure at the micro-level and affects the sustainability of the banking system at the
macro-level. Van Greuning and Brajovic Bratanovic (2009) indicate that insolvency and
credit risk are significant risks for banks. Banks take risk in the presence of information
asymmetry and limited capital. This is considered a moral hazard issue, when an entity has
an incentive to increase its exposure to risk because it does not bear the full costs of that risk.
While capital requirements are implemented to moderate the risk-taking behavior of banks,
the moral hazard theory does not always support this argument.
There are several ways banks mitigate risk. Portfolio theory suggests that banks obtain
risk reduction benefits if noninterest revenue sources are not perfectly correlated with
interest revenue. In contrast, if noninterest revenue sources are risky and highly correlated
with interest income, banks will face higher risk. Nguyen et al. (2012) investigate the
relationship among market power, revenue diversification and bank stability using a sample
of US banks from 1994 to 2009. They conclude that revenue diversification strategies
significantly increase the stability of the banking sector. Deng et al. (2013) analyze the
features of revenue diversification and found a positive impact of larger institutional
ownership on diversification which in turn helps lower bank risk. Saunders et al. (2014)
found that revenue diversification increases profits and decreases insolvency risk of US-
based banks. In contrast, using a sample of European banks; Maudos (2017) found that
noninterest income has a positive effect on bank risk. Abedifar et al. (2018) explore the
relationship between noninterest income and credit risk in a sample of US banks from 2007
to 2016. Their findings suggest smaller banks which were heavily engaged in prudential
activities tend to have low credit risk. For a sample of 1,397 banks from ASEAN-5 and
BRICS economies, Moudud-Ul-Huq (2019) found that BRICS banks achieve higher benefits
from both revenue and assets diversification than ASEAN-5 banks. For a sample of 69
Islamic and conventional banks in Gulf Cooperating Council countries, Al-Khouri and
Arouri (2019) conclude that income diversification has a positive impact on bank risk-
taking, whereas asset diversification has a negative impact on bank risk-taking. Nguyen
(2019) documents a positive impact of revenue diversification on the risk-taking of
commercial banks operating in Vietnam. The positive relationship signifies that an increase
in nontraditional sources of income in banks increases the operational risk of banks. We
extend the analyses by examining the following hypothesis:

H1. Income and assets diversification have a significant impact on bank risk-taking.
Capital regulations are important considerations in the analysis of bank risk-taking
activities. The literature provides convincing arguments about the relationship between
capital regulation and bank risk-taking. Some suggest that capital regulation increases bank
stability by increasing their risk absorbing and risk-bearing capabilities (Kim and
Santomero, 1988; Blum, 1999; Altunbas et al., 2007). Van Roy (2008) argues that strict
requirements of capital induce to compensate loss with the optimum choice of increasing
risk. Ashraf et al. (2020) conducted a study of a sample of international banks from 111
countries and found that stringent capital regulation reduces banks’ exposure to risk. On the
JFRA other hand, Nguyen et al. (2019) analysis of a sample of Asian banks concludes that strict
capital regulation increases banks’ probability of default. Shrieves and Dahl (1992) used a
simultaneous equation model to examine the capital behavior of US banks and find a
positive relation between changes in capital and bank risk.
Jacques and Nigro (1997) found a negative association between capital regulation and
risk level using a similar methodology for US commercial banks. Their findings justify that
risk-based capital standards are useful in decreasing portfolio risk of banks. Rime (2001)
explores the alterations in Swiss banks’ capital and risk and concludes that regulatory
pressure positively impacts the bank’s capital ratio but has an insignificant impact on risk-
taking behavior of banks. Swiss banks fulfill capital ratio requirements raising capital
through equity issues or retained earnings without reducing their risk-taking. Konishi and
Yasuda (2004) document a negative relation between capital regulation and bank risk-taking
behavior of 48 regional banks in Japan. A study in the context of emerging economies
conducted by Godlewski (2005) examines the impact of bank capital on risk and finds that
bank regulation, legal environment and capitalization positively affect bank risk-taking.
Dick (2006) reveals a significant positive association between bank deregulation and
increases in loan losses. Altunbas et al. (2007) found that bank capital increases risk. Capital
requirement limits the risk-return frontier of banks; therefore, a decrease in leverage portion
may encourage the bank to reanalyze the combination of portfolio of its risk-based assets
that possibility leads to an increase in bank’s risk-taking (Kim and Santomero, 1988).
According to a study by Ashraf et al. (2016), risk-based capital regulation decreases portfolio
risk of assets in commercial banks. Their findings signify that risk-based regulation of
capital motivates banks to invest in risky assets until banks optimally set risk weights. Maji
and De (2015) found a negative impact of capital regulations on risk-taking in Indian banks.
The reason of negative impact of capital regulation portfolio risk of banks is that
commercial banks in developing countries heavily rely on income generated by portfolio of
loan. Heryan and Tzeremes (2017) and Salachas et al. (2017) argue that less capitalized
banks are more risky. In this study, we examine the following hypothesis in relation to
Asian emerging economies:

H2. Capital regulation has a significant impact on bank risk-taking.

The relation between corporate governance and banks’ risk-taking has been a common topic
of analysis. Extant literature offers mixed arguments about the role of board of the directors,
CEO duality, board dependence and block holders in bank risk-taking behavior. Caprio et al.
(2007) highlight that a lack of transparency in bank corporate governance system helps
managers to manipulate valuations and earnings. Boards of directors play a crucial role in
the banking sector than in any other sector (Felicio et al., 2018). They have responsibilities to
not only their shareholders but also regulators and depositors (Pathan, 2009). According to
Sullivan and Spong (2007), ownership structure leads to increase risk aversion of banks.
External governance also plays an important role in bank debt monitoring, ultimately
decreasing bank risk-taking (Boubaker et al., 2018). Cheng (2008) reveals that a large board
results in banks engaging in less risk-taking activities. Wang (2012) also confirms such an
inverse relationship between board size and banks risk-taking. Boubaker et al. (2017)
suggest that the largest shareholders positively affect bank debts. CEO power is another
determinant of risk-taking in banks. Altunbas et al. (2020) found that the power of the CEO
is a significant driver of risk in banks. According to Adams et al. (2005), powerful CEOs
follow policies that lead to an increase in risk. Sayari and Marcum (2018) reveal that dual
responsibilities of CEO as chairman of board ignores the ability and role of board to monitor
and control management and negatively affects ability of CEO to take right decision for
investment which ultimately directs firms to increase risk taking. When CEO does not hold Regulation and
a dual role, he performs his duties with more responsibilities that allow him to take an bank risk-
effective decision. Further, while not taking a dual role, CEO can allocate resources
effectively with least risk involved. According to Felicio et al. (2018), corporate governance
taking
significantly affects bank risk-taking. Minton et al.’s (2014) analysis of a sample of US-based
banks indicates that independent directors with financial expertise result in increased risk
before the financial crisis.
Directors have the authority to identify and manage conflict of interests between
shareholders and managers (Jensen and Meckling, 1976; Boubaker and Nguyen, 2012).
Akhigbe and Martin (2006) argue that banks with the presence of more independent
directors stock volatility tend to decrease in the long run. Brick and Chidambaran (2008) find
an inverse impact of nonexecutive directors on the risk-taking of banks. Coles et al. (2008)
and Boone et al. (2007) find that independent directors have a negative relationship with the
risk level of the firm. Pathan (2009) documents an agency issue between shareholders of
banks and their debt-holders particularly depositors. This is because shareholders in the
banking sector prefer maximizing risk. Block owners control firms effectively. Controlling
owners may overcome agency issues between owners and managers. Therefore, block
holders minimize the agency costs and inefficiency (Korczak and Korczak, 2009). Chang
(1998) defines the concept of block holders as those large shareholders having 5% or more
ownership of the firm. Esty (1998) argues that the largest block holders decrease risk-taking
by banks. Al-Smadi (2019) finds an inverse relationship between corporate governance and
risk-taking. Based on this literature, we develop the following hypothesis for Asian
emerging economies:

H3. Corporate governance has a significant impact on bank risk-taking.

3. Method and mode of analysis

We analyze the impact of diversification, corporate governance and regulation on bank risk-
taking. We extract data of 116 listed banks operating in ten Asian emerging economies from
DataStream and Global Financial Development Database from 2010 to 2018. Table 1 shows
the total number of listed banks in the selected countries is 215. This sample has been
reduced to 116 listed banks after screening for the availability of data. We extract
macroeconomic data from the World Development Indicators database. Further, to test
hypotheses, we apply the generalized method of moments (GMM) developed by Arellano
and Bond (1991) and Arellano and Bover (1995). We use the two-step dynamic panel

Countries Total no. of listed banks Selected

China 19 7
India 38 20
Indonesia 43 17
Lebanon 6 6
Malaysia 10 8
Pakistan 37 20
Philippines 18 18
Thailand 17 12
Turkey 16 8 Table 1.
Vietnam 11 3 Sample selection
JFRA estimation which is appropriate for long cross-sectional and short time-series data. This
regression technique overcomes endogeneity problem in dependent variables and deals with
autoregressive features of the dependent variable along with unabsorbed firm-specific
features (Gonzalez, 2013).
We use two risk proxies: the Z-score and nonperforming loans (NPLs) ratio. The Z-score
is a measure of the financial health of the bank, measured as the return on assets (ROA) plus
capital asset ratio scaled by the standard deviation of ROA (Laeven and Levine, 2009). A
higher Z-score implies lower risk. It is a measure of insolvency which is the situation where
losses are greater than equity. Nonperforming loans ratio is the ratio of nonperforming loans
to total loan (Zheng et al., 2020). A nonperforming loan represents a loan for which debtor is
unable to pay scheduled payments for at least 90 days. A higher nonperforming loan ratio
implies a higher risk.
We use leverage, liquidity, bank size and assets growth as bank-level control variables.
For the country-level control variables, we use interest rate, inflation rate and gross
domestic product (GDP). Past studies provide insight into the influence of selected control
variables on bank risk-taking. Ashraf et al. (2016) found a negative impact of size and
liquidity on the risk-taking of banks. Growth in assets shows a significant and positive
impact on risk (Nguyen, 2019). Asset growth demonstrates the behavior of managers in
banks when they face risk. We use GDP growth rate and inflation rate and interest rate as
proxies for economic activity. Ghosh (2015) demonstrates that GDP growth has a negative
impact on nonperforming loans, whereas inflation has a positive impact on bank risk
measured by nonperforming loans. The negative impact of GDP on risk indicates that there
is an increase in revenue demand during cyclical improvements. The positive impact of
inflation on risk implies that a high inflation rate leads to an increase in the real income of
borrowers, and as a result, bank risk is increased. Inflation has an adverse impact on loan
repayment activity, which leads to an increase in bank risk measured as nonperforming loan
(Ghosh, 2015). Dell’Ariccia and Marquez (2006), Rajan (2006) and Delis and Kouretas (2011)
found negative effects of interest rate on the credit risk of banks.
We have two measures of diversification: income diversification and asset
diversification. Income diversification is taken as the ratio of noninterest income over
operating income (Meslier et al., 2014), whereas we compute asset diversification as the ratio
of noninterest-bearing assets over total assets (Edirisuriya et al., 2015). We take board size,
CEO duality, board independence and block holders as our measures of corporate
governance. Board size is the total number of directors; CEO duality takes the value of 1 if
the CEO also acts as the chairman of the board, 0 otherwise. Board independence is the
percentage of independent directors on board as measured by Aebi et al. (2012). However, we
calculate block holders as the ratio of shares held by block holders who have 5% or above
ownership. We follow Naushad and Malik (2015) to measure block holders. Capital assets
ratio and deposit insurance are the measures of regulation in our study. As per Maji and De
(2015), we take the sum of Tier 1 and Tier 2 capital divided by the risk-weighted asset to
calculate capital asset ratio. We take value 1 for the presence of deposit insurance in the
country and 0 otherwise (Anginer et al., 2012; Fu et al., 2014). Following Lepetit et al. (2008),
leverage is measured as total equity to total assets, whereas the natural log of total assets is
taken as the proxy of bank size. As per Wagner (2007), we take liquidity as the ratio of
deposits to total assets. Asset growth is another bank related control variable, measured as
annual change in total assets. We take the deposits rate as the proxy of interest rate (Nguyen
et al. (2012). Inflation rate is the percentage change in the consumer price index, whereas
GDP growth rate is taken as the annual change in gross domestic product (Table 2).
Our statistical model is described as follows:
Variable Description
Regulation and
bank risk-
Z-score The sum of the return on assets and equity/assets scaled by the standard taking
deviation of ROA
Nonperforming loans ratio Ratio of nonperforming loans to gross loans
Income diversification Ratio of noninterest income to total operating income
Asset diversification Ratio of noninterest-bearing assets to total assets
Board size Number of directors on the board
CEO duality A dummy variable taking the value 1 if the CEO acts also as the chairman of
the board, otherwise 0
Board independence Proportion of independent directors on the board
Blockholders Percentage of shares held by blockholders
Capital adequacy ratio Tier 1 capital plus Tier 2 capital divided by total risk-weighted assets
Deposits insurance A dummy variable taking the value of 1 if deposit insurance is present, 0
otherwise
Leverage Equity to total asset ratio
Liquidity Deposit to total asset ratio
Size Natural log of total assets
Assets growth Annual percentage change in total assets
Interest rate Deposit rate
Inflation rate Percentage change in the consumer price index Table 2.
GDP growth rate Annual growth rate in GDP Variables definitions

Bank Riski;t ¼ ai;t þ b 1 ð DiversificationÞi;t þ b 2 ðCorporate GovernanceÞi;t

þ b 3 ð RegulationÞi;t þ b 5 ð LeverageÞi;t þ b 6 ð LiquidityÞi;t
þ b 7 LnðTotal AssetsÞi;t þ b 7 ð Asset GrowthÞi;t
þ b 7 ðInterest RateÞ þ b 7 ð InflationÞ þ b 7 ðGDP GrowthÞ
þ m i;t

4. Results
We apply descriptive statistics to summarize the data of our study. We use the correlation
matrix to describe the relationship between explanatory variables and to identify any
potential multicollinearity issue.
The correlation matrix provided in Table 3 shows there is no high correlation among the
explanatory variables; therefore, there is no issue of multicollinearity.
Table 4 presents descriptive statistics of variables used in our study; the average value of
Z-score shows that banks are running under sound financial position and chances of
bankruptcy do not exist. This further suggests investors may buy or sell stocks of banks in
selected countries. The ratio of nonperforming loans is very low which shows that banks
also keep a close look at monitory nonperforming loans. The mean value of income
diversification shows that banks in this region diversify about one-third of their risky
investments by investing in noninterest income activities. About half of the assets of banks
relate to noninterest bearing assets. The average board size is 7 members ranging from 6 to
15; CEOs of banks rarely act as the chairman of the board. Board independence is small at
13%, and more than half of bank ownership comes from large shareholders, indicating the
dominance of block holders in banks. Capital asset ratio is showing 16% that on average
banks in Asian emerging economies maintain reasonable capital to finance their risk-based
assets. About 80% of the banks have deposit insurance to protect their depositors.
 JFRA

Table 3.
Correlation analysis
Variables 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

1. Z-score 1.000 – – – – – – – – – – – – – – – –
2. Nonperforming loans ratio 0.225 1.000 – – – – – – – – – – – – – – –
3. Income Diversification 0.166 0.155 1.000 – – – – – – – – – – – – – –
4. Asset diversification 0.007 0.214 0.101 1.000 – – – – – – – – – – – – –
5. Board size 0.093 0.432 0.088 0.241 1.000 – – – – – – – – – – –
6. Duality 0.019 0.434 0.085 0.387 0.454 1.000 – – – – – – – – – – –
7. Board independence 0.012 0.362 0.312 0.032 0.321 0.106 1.000 – – – – – – – – – –
8. Blockholders 0.236 0.112 0.132 0.512 0.108 0.066 0.152 1.000 – – – – – – – – –
9. Capital adequacy Ratio 0.108 0.120 0.009 0.110 0.224 0.077 0.326 0.336 1.000 – – – – – – – –
10. Deposit insurance 0.089 0.536 0.076 0.378 0.481 0.662 0.036 0.008 0.099 1.000 – – – – – – –
11. Leverage 0.046 0.160 0.080 0.134 0.332 0.105 0.071 0.017 0.405 0.258 1.000 – – – – – –
12. Liquidity 0.200 0.035 0.027 0.229 0.112 0.181 0.601 0.022 0.118 0.012 0.483 1.000 – – – – –
13. Ln(total assets) 0.202 0.207 0.038 0.116 0.317 0.293 0.610 0.110 0.151 0.362 0.141 0.163 1.000 – – – –
14. Asset growth 0.091 0.101 0.028 0.077 0.042 0.006 0.032 0.097 0.007 0.024 0.021 0.139 0.044 1.000 – – –
I15. Interest rate 0.011 0.294 0.118 0.225 0.329 0.467 0.591 0.196 0.019 0.420 0.005 0.066 0.160 0.03 1.000 – –
16. Inflation 0.081 0.515 0.098 0.341 0.426 0.510 0.441 0.124 0.019 0.492 0.072 0.009 0.311 0.019 0.472 1.000 –
17. GDP growth 0.035 0.131 0.014 0.022 0.323 0.094 0.236 0.058 0.116 0.121 0.068 0.201 0.089 0.137 0.130 0.270 1.000
Variables Mean Median Maximum Minimum SD Obs.
Regulation and
bank risk-
Z-score 4.2017 4.3698 6.3873 0.1496 108.88 844 taking
Nonperforming loans ratio 0.0569 0.0318 0.8823 0.001 0.0750 781
Income diversification 0.3134 0.2969 2.7722 0.974 0.2261 844
Asset diversification 0.4663 0.4339 1.0167 0.0697 0.1696 844
Board size 7.0112 10.130 15 6 1.0326 844
Duality 0.2124 0.1231 1 0 0.5610 844
Board independence 0.1308 0.2212 0.3263 0.1023 0.6257 780
Blockholders 0.551 0.1127 0.8661 0.6120 0.2416 780
Capital adequacy ratio 0.1654 0.1532 0.9765 0.0108 0.0749 780
Deposit insurance 0.7997 1 1 0 0.4004 844
Leverage 0.1012 0.0907 0.7376 0.113 0.0931 844
Liquidity 0.7572 0.7509 2.7803 0.0343 0.2783 844
Ln(total assets) 14.303 13.934 20.579 9.2091 2.1532 844
Asset growth 0.1636 0.1235 3.8663 0.372 0.2427 728
Interest rate 0.0533 0.0483 0.2334 0.0119 0.0400 687
Inflation 0.0484 0.0408 0.1867 0.0374 0.0337 844 Table 4.
GDP growth 0.0542 0.0552 0.1111 0.0019 0.0201 844 Descriptive statistics

In Table 5, we show the findings of GMM analysis and in particular the impact of the
independent variables on bank risk (proxied by Z-score and nonperforming loans). Model 1
represents the effects of income diversification and capital asset ratio on risk, Model 2
represents the effects of deposit insurance and assets diversification on risk and Model 3
represents combined effects of both measures of diversification (income diversification and
assets diversification) and both measures of regulation (capital asset ratio and deposit
insurance) on bank risk-taking. We run Sargan test in our study to confirm the validity of
our instruments. We find insignificant p-values indicating that our instruments are valid.
We apply Arellano–Bond test to verify autocorrelation. Results show significant p-values of
AR1 but insignificant values of AR2 which reveals that there is no autocorrelation in second
lag. We find that income diversification has a positive impact on bank risk-taking measured
by NPLs indicating that when banks shift to noninterest incomes, they face more credit risk
(NPLs). The reason of high risk is because of high default percentages that are result of
instability of economic situations in developing countries (Lee et al., 2014; Pennathur et al.,
2012). However, with an increase in noninterest income, there is increase in z-score
indicating that insolvency risk is reduced when banks go for nontraditional income sources.
This result is consistent with the findings of Maudos (2017), that banks with income
diversification have less chances of insolvency as compared to banks that only rely on
traditional incomes. Asset diversification is also significantly positively associated with
bank risk-taking as measured by NPLs. The result implies that assets diversification
strategy of banks induce management to take risk as banks have not expanded their
noninterest bearing assets (Moudud-Ul-Huq, 2019). Therefore, this diversification strategy
increases risk of banks. In addition, assets diversification significantly and positively
influences z-score which implies that banks decrease insolvency risk which implies that
assets diversification is a useful strategy to reduce insolvency risk.
Board size is negatively associated with bank risk-taking suggesting that firms with
large board size tend to undertake less risk (Cheng, 2008). Our findings suggest that small
boards tend to endorse risky policies that are aligned with the interest of shareholders
(Wang, 2012). Ayadi and Boujelbène (2015) argue that small members on board confirm a
better internal control system that helps to minimize agency issues between management
 JFRA

Table 5.

estimation
dynamic panel
Two-step system
Z-score Nonperforming loans ratio
Variables Model 1 Model 2 Model 3 Model 1 Model 2 Model 3

L1. 0.184*** (3.130) 0.150 (0.821) 0.120 (0.601) 0.055*** (21.122) 0.733*** (7.341) 0.7587*** (6.581)
L2. 0.179*** (3.571) 0.386*** (3.304) 0.38*** (2.764) 0.035*** (55.121) 0.133** (2.503) 0.1279** (2.395)
Income diversification 1.004*** (5.391) – 0.980*** (5.973) 0.021*** (3.183) – 0.003 (0.865)
Asset diversification – 1.336 (1.177) 2.340** (2.245) – 0.012** (2.593) 0.037* (1.912)
Board size 0.312** (2.070) 0.101*** (3.110) 0.756** (1.971) 0.511* (1.973) 0.306** (2.223) 0.694*** (5.986)
Duality 0.211* (1.910) 0.388*** (2.910) 0.323* (1.783) 0.056 (1.012) 0.669*** (4.801) 0.091* (1.961)
Board independence 0.112** (2.011) 0.396** (2.411) 0.963* (1.791) 0.007* (1.977) 0.003 (1.047) 0.071* (1.791)
Blockholders 0.102*** (4.236) 0.369 (1.023) 0.306** (2.311) 0.263** (2.360) 0.009** (2.136) 0.006* (1.925)
Capital adequacy ratio 0.594** (2.021) – 0.163* (1.772) 0.027*** (3.633) – 0.020 (0.863)
Deposit insurance – 0.245 (0.231) 1.769** (1.913) – 0.044* (1.802) 0.027* (1.850)
Leverage 0.806 (0.610) 5.478 (1.237) 4.419 (1.145) 0.052** (2.532) 0.014 (0.303) 0.033 (0.431)
Liquidity 1.228** (2.571) 0.720 (0.593) 0.59*** (3.532) 0.075*** (5.369) 0.029* (1.702) 0.025 (1.110)
Ln(total assets) 0.117** (2.064) 0.259 (1.144) 0.234* (1.846) 0.001 (0.473) 0.011* (1.862) 0.012* (1.905)
Asset growth 0.088* (2.062) 0.853** (2.397) 0.422 (1.289) 0.032*** (6.417) 0.009 (1.153) 0.012* (2.106)
Interest rate 0.558* (1.972) 2.200 (0.332) 0.402* (1.853) 0.955*** (1.446) 0.170 (0.572) 0.112** (2.160)
Inflation 0.138* (1.813) 0.533* (1.756) 2.921 (0.693) 0.064** (2.132) 0.301** (2.753) 0.337** (2.495)
GDP growth 0.617** (2.617) 0.211* (1.836) 0.504 (0.579) 0.030*** (3.781) 0.097 (1.553) 0.138* (0.832)
Constant 5.635*** (4.163) 1.144 (0.271) 1.336 (0.375) 0.036 (0.893) 0.1375 (1.196) 0.185 (1.523)
Sargan 6.707 8.701 6.191 7.213 8.261 4.112
p-value 0.237 0.119 0.261 0.194 0.132 0.361
AR1 (p-value) 0.048 0.027 0.045 0.027 0.036 0.021
AR2 (p-value) 0.203 0.391 0.491 0.509 0.233 0.121

Notes: ***, ** and * show significance levels at 1%, 5% and 10%, respectively. Sargan is a test for over-identifying restrictions; AR1 is Arellano–Bond first-
order autocorrelation; and AR2 is Arellano–Bond second-order autocorrelation
and owners. This ultimately motivates board to take risky decisions. Moreover, negative Regulation and
coefficient of board size with z-score indicates that banks increase insolvency risk owing to bank risk-
more board members. Our findings follow the results of Pathan (2009) indicating that large
board size increases insolvency risk. CEO duality has a significant and positive relation with
taking
risk-taking of banks, suggesting that when CEOs act in dual roles, leads to an increase in
risk-taking. Our findings are consistent with Adams et al. (2005) and Altunbas et al. (2020),
who argue that powerful CEOs make policies that involve more risk-taking. CEO duality has
a significant and positive impact on z-score suggesting a decrease in insolvency risk of
banks when CEO holds more power. The results are following the study of Pathan (2009)
indicating that when CEO holds power, they control decision-making in a way that
decreases risk-taking.
Board independence has a significant negative effect on bank risk-taking. The findings
are consistent with Coles et al. (2008) and Boone et al. (2007), who reveal that an increase in
independent directors increases the level of board monitoring that helps to control risk.
Boards of directors with more independent members take less risky decisions than boards of
directors with more inside members (Goergen, 2000). Board independent significantly
increases risk measured as z-score, as they work effectively and monitor management
(Liang et al., 2013), and as a result, banks take more risk. Further, blockholders have a
significant negative influence on bank risk-taking, consistent with the results of Esty (1998).
When large shareholders have opportunities and incentives to avail corporate benefits, they
may not prefer taking more risk. Further, block holders might not be willing to take more
risk as to survive their benefits. On contrary, block holders significantly and positively
affect the solvency risk of banks. Positive influence suggests that block ownership
overcomes agency issues and helps to align interests between managers and shareholders
despite conflicts between minority and majority of ownerships (Felicio et al., 2018).
Banks’ capital regulation measured capital adequacy ratio by CAR shows a significant
positive relation with bank risk-taking, consistent with the studies of Shrieves and Dahl (1992),
Rime (2001) and Altunbas et al. (2007). Our results suggest that capital regulation encourages
banks to take higher risk by meeting regulatory requirements. Ashraf et al. (2016) suggest that
banks invest more in risky assets in response to capital regulations. Capital regulation has a
significant positive effect on z-score suggesting that with an increase in capital regulation, there is
low solvency risk as banks meet regulatory requirements. Results are consistent with the studies
of Konishi and Yasuda (2004) and Maji and De (2015).
We find that deposit insurance is negatively associated with credit risk measured as
NPLs, supporting the moral hazard minimization effect (Demirgüç-Kunt and Huizinga,
2004). Government provides insurance to depositors motivating them to deposit their funds
into the banks that minimize moral hazard. Therefore, banks can overcome risk. However,
deposit insurance increases solvency risk of banks supporting the findings of Demirguç-
Kunt and Detragiache (2002). Among control variables, leverage shows mixed but
significant effects on each risk-taking measures depending on the nature of risk-taking in
models. However, liquidity and bank size have a negative effect on the risk-taking behavior
of banks. The findings are supported by Ashraf et al. (2016) and Nguyen (2019). When we
take z-score as a measure of solvency risk, results show that liquidity and bank size
significantly increase risk. Large-sized banks are motivated toward risky opportunities that
make them less effective (Vallascas and Keasey, 2012). We find that an increase in interest
rate decreases banks’ risk-taking. This is consistent with the findings of Delis and Kouretas
(2011). However, interest rate increases solvency risk measured as z-score because increase
in interest rate makes it difficult for banks to repay loan that enhances the chances of
insolvency. We also find that inflation because of high-interest rate may have a positive
JFRA impact on banks’ risk-taking, whereas GDP growth has a negative impact on risk-taking.
Our results are consistent with Ghosh (2015). Further, GDP significantly and positively
affects the solvency risk of banks which is consistent with the study of Jumreornvong et al.
(2018). Moreover, inflation has a significant and inverse impact on solvency risk of banks
measured as z-score.

5. Conclusion
We analyze the impact of diversification, corporate governance and regulation on banks’ risk-
taking of ten emerging countries in Asia from 2010 to 2018. We find that both measures of
diversification significantly affect banks’ risk-taking. The diversification of banks into noninterest
income ultimately leads to more risk-taking. In addition, noninterest bearing assets also force banks
to take more risks. Among corporate governance measures, CEO duality has a positive impact on
risk-taking of banks. Other features of corporate governance including board size, board
independence and block holders show significant and negative impacts on banks’ risk-taking.
Regulatory requirements such as capital to risk-weighted assets ratio increase overall banks’ risk-
taking, implying that such capital regulation motivates banks to take higher risk by setting optimal
weights. Capital regulations help to increase firm’s capital that opens ways to take more risk when
channeling funds to an investment. The presence of deposits insurance reduces risk-taking by
banks. Most of the banks provide deposit insurance to motivate depositors to deposit their funds
into the banks. This in return facilitates banks to overcome risk. Government provides deposit
insurance to protect and motivate depositors to deposit their funds into the banks. This in return
facilitates banks to overcome risk of bank run that may occur when depositors withdraw their
deposited amounts simultaneously while concerning more about bank’s solvency. With an increase
in capital ratio, bank managers take more risk by investing funds into a risky investment.
Although diversification has become an important strategy for survival in a competitive
business environment, the adoption of such strategies results in instability and more risk-
taking to achieve higher returns. In terms of corporate governance, banks should give
proper attention to the dual role of CEO and increase the monitoring of business activities to
maintain banking sector stability. Our study has implications for bank managers in a way
that bank regulation regarding capital requirement does not help managers to reduce risk. It
forces bank managers to increase risk-taking in response to meet capital requirements.
Therefore, managers may get benefit from capital regulations by investing funds in more
profitable ways where risk level is low. Banks face more risk when they move to noninterest
income sources. Therefore, we suggest improvement in the banking sector of Asian
emerging economies in a way that they need to manage their noninterest income along with
traditional sources of income to stabilize the system. This study can be extended to include
both listed and unlisted banks. Second, this study can also be extended by incorporating
market-based measures of bank risk-taking such as distance to default risk in line with the
Marton KMV model. Third, this study can be extended by considering both developed and
emerging economies for comparison of results across these two groups of economies.

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Corresponding author
Loi Viet Nguyen can be contacted at: nguyenvietloi@mof.gov.vn

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