The Effects of Corporate Governance on Idiosyncratic Risk ...globalbizresearch.org/Vietnam_Conference/pdf/V535.pdf · malpractice and reducing risk of financial industry is critical.

Proceedings of the Second Asia-Pacific Conference on Global Business, Economics, Finance

and Social Sciences (AP15Vietnam Conference) ISBN: 978-1-63415-833-6

Danang-Vietnam, 10-12 July, 2015 Paper ID: V535

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www.globalbizresearch.org

The Effects of Corporate Governance on Idiosyncratic Risk:

Evidence from Taiwan Financial Institutions

Tsun-Jen Wei,

National Kaohsiung First University of Science and Technology, Taiwan.

Email: [email protected]

Hsien-Ming Chen,

Department of Finance,

Chang Jung Christian University, Taiwan.


Chu-Hsiung Lin,

Department of Finance,



Jui-Heng Kang,



____________________________________________________________________

Abstract

We use the data of Taiwanese financial institutions from 2006:Q1 to 2012:Q4 to examine the

effects of corporate governance mechanisms on idiosyncratic risk. Our results show that the

firms with better corporate governance mechanisms (including more independent board,

better transparency) tend to have a lower idiosyncratic risk. However, firms with higher

foreign ownership appear to have a higher idiosyncratic risk.

___________________________________________________________________________.

Key Words: dynamic panel regression, corporate governance, idiosyncratic Risk.

mailto:[email protected]







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1. Introduction

The financial industry is an indicator of national economic development and plays an

important role in economic activities. If the financial industry is mismanagement, financial

institutions will lose financial intermediation functions, and affects the development of other

industries. In addition, if a financial crisis occurs, the crisis would seriously affect the

financial order and economic development. Therefore, some series of financial industry

problems, like the Iceland financial crisis and the Lehman Brothers bankruptcy, raised the

global financial crisis. Thus, in the academic field, find out the mechanisms of avoiding

malpractice and reducing risk of financial industry is critical.

Since the opening to establishing private banks in Taiwan in 1991, Taiwan has adopted a

series of financial reforms, which have substantially increased the number of financial

institutions in Taiwan. Consequently, harsh competition has occurred between financial

institutions, and credit quality have deteriorated, bank profits have decreased, and

non-performing loan ratios have increased, thereby increasing the risk and damaging the

rights of stakeholders. Therefore, how to decrease the risk and avoid financial crisis of

Taiwan is an important issue.

BASEL III suggested to strengthened corporate governance to prevent the risk occurring

from the financial industry. Besides, previous studies also indicate that corporate governance

serve as a type of a mechanism, protect minority shareholders and stakeholders, and enhance

the wealth of shareholders. Lin, et al. (2010) specified that through the design of the corporate

governance mechanism could reduce the agency problems and decrease idiosyncratic risk.

Firms with better corporate governance mechanisms have fewer agency problems. The

idiosyncratic risk of the firm and capital costs would be reduced, thereby enhancing corporate

performance and shareholder wealth. Hence, if financial institutes establish better corporate

governance mechanisms can reduce the risk to improve the financial industry environment

and to avoid malpractice of the financial industry.

However, the literatures regarding the effects of corporate governance quality on the risk

of financial institutions is lack. Furthermore, after reviewing the literature, numerous studies

have focused on exploring the relationship between partial corporate governance mechanisms

and firm performance. Few studies have explained the relationship between corporate

governance and risk. Thus, to make up the gap in the literatures, this study provides direct

empirical evidences of the effects of corporate governance quality on risk. This paper follows




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Lin et al. (2010) to use idiosyncratic risk as the proxy for the level of risk in financial industry.

The idiosyncratic risk represents the risk link with how the financial institutes operate their

own business and systems.

In this study, the financial holding industry, banking industry, and securities industry in

Taiwan were the research subjects. Empirical evidence was used to analyze the relationship

between financial corporate governance mechanisms and idiosyncratic risk. Flannery and

Hankins (2013) indicated that dynamic panel data regression has become increasingly vital in

the corporate finance field. In addition, if explained variables of lag periods are included in

independent variables, dynamic panel data regression must be used to avoid biased parameter

estimates. Thus, this paper modified the empirical model by Lin et al. (2010) and used

dynamic panel data regression in this study. This study also referred to Arellano and Bond

(1991) and conducted generalized method of moments (GMM) regression to estimate the

regression parameters. Furthermore, the Sargan test was used to examine the effectiveness of

the instrumental variables adopted by the dynamic panel data regression.

This study explored the effects of corporate governance quality on idiosyncratic risk.

Corporate governance involves ownership structure, board structure, executive incentive, and

information disclosure. The results show that when the high proportion of independent

directors and supervisors in the board associated with lower idiosyncratic risk. Moreover,

higher information transparency indicates less idiosyncratic risk. The main contribution of

this study is the comprehensive investigation on the effects of the corporate governance

mechanism on idiosyncratic risk in financial industry.

The literature mainly focuses on exploring the effects of the corporate governance

mechanism on operating performance or conceptually explains the influence of parts of the

corporate governance mechanism on idiosyncratic risk. These studies have failed to examine

the effects of the entire corporate governance mechanism on idiosyncratic risk. Only Lin et al.

(2010) used general industry as the research subject and comprehensively focused on the

effect of internal and external corporate governance mechanisms on idiosyncratic risk.

However, they did not examine the financial industry. Because the financial sector is a

franchise industry and is closely related to the public, a firm must possess a strong corporate

governance mechanism. We conducted comprehensive analysis to determine how the

corporate governance mechanisms influence idiosyncratic risk. This study can serve as a

reference for government agencies and financial institutions in promoting corporate




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governance so that the essence of corporate governance can be implemented to maintain

stakeholder interests. Thus, corporate organizations and operations can develop steadily.

Section II presents a literature review; Section III introduces data sources, variable definitions,

and the research model; Section IV shows the empirical analysis results; and Section V the

conclusions.

2. Literature Review

2.1. Financial Institutions and Corporate Governance

The financial industry is the primary industry in a nation. However, Taiwan’s financial

industry lacks industrial competitiveness. Since 1980, to adapt to the globalization and

liberalization trends in the global financial markets, the government has gradually relaxed the

financial regulatory measures and reduced the regulatory thresholds for establishing banks.

The government hopes that by enabling fully competition in the financial industry, the

industry could improve efficiency and establish fair competition in the financial system.

Because of the special nature of the financial industry, poor operations affect the firm role

as funding agencies and the national economic development. Chen (2005) presented

characteristics of the financial industry and the necessity of strengthening corporate

governance. First, the financial industry is the economic lifeline of a nation. Corporate

borrowing, fund collection, and international trade are dependent on the financial sector. If

the financial sector possesses poor corporate governance, the funding agency function would

be compromised and would affect the economic sector. Major funding in the financial

institution is obtained from the public. Specifically, banking funds are primarily obtained

from the community. Although banks possess low equity funds, they operate large-scale

businesses. With this operation from a high financial leverage, corporate governance must be

implemented to safeguard the rights and interests of depositors. Regarding the financial

industry, integrity and trust are essential; therefore, the managerial style and ethical standards

determine the stability of a bank and bank performance. Taiwan’s financial institutions have

focused on a personal-network and family-oriented business model in financial institutions,

which is a substantial barrier to corporate governance. Taiwan’s financial institution requires

a stable corporate governance mechanism to reduce the risks and problems in moral issues.

To implement a stable corporate governance system and promote the healthy

development of the financial market, the Taiwanese government has made several major




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revisions to the legal regulations and initiated a series of complementary measures and reform

items.

2.1.1 Improving the independency of board

To prevent the board from becoming a formality, the Securities and Futures Commission

of Ministry of Finance, beginning in February 22, 2002, implemented an independent director

and supervisor system in two stages. During the first stage, initial public offering (IPO) and

over the counter (OTC) firms must disclose in their annual report whether the board of

directors comply with crucial resolutions made by directors and supervisors and the opinions

of both parties. In addition, to apply for becoming a listed or OTC firm, firms must establish

at least two independent directors and one independent supervisor. If these firms failed to

follow these requirements, they could not be listed. The second stage involved publically

promoting these regulations to encourage all the listed and OTC firms to implement these

regulations.

2.1.2 Strengthen the information transparency

Financial holding corporations should disclose all net operating income. This included a

financial holding corporation’s banks, insurance, securities, and investment firms; current

regulations do not specifically require that corporations reveal all of their businesses and

regions of operation. Consequently, corporate profit sources are vague to the public.

Regarding corporate expansion and globalization, financial institutions must revise disclosure

items to respond to global trends. Domestic banking businesses focus on lending, but the

competent authority has not regulated the disclosure lending structure. Consequently,

investors are unable to obtain the lending policies of various banks or subsequently assess

potential credit risks.

2.1.3 The Best-Practice Principles of Corporate Governance

To implement a corporate governance system, the Taiwanese government released the

Corporate Governance Best-Practice Principles for TSEC/GTSM Listed Companies, which

was approved by the Securities and Futures Commission, in October 2002. The content

contains provisions regarding protecting shareholder equity, strengthening board

responsibilities, exerting the supervisor functions, respecting stakeholder rights and interests,

and enhancing information transparency.




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2.2 The Corporate Governance and Risk in Financial Industry

The majority of the literature explores only the relationship between partial corporate

governance mechanisms and risk. Regarding internal corporate governance mechanisms,

empirical studies have indicated that strong corporate governance could reduce the capital

costs of firms, but they failed to explain the relationship between corporate governance and

the idiosyncratic risk of capital cost. Himmelberg et al. (1999) stated that when managers

possessed high shareholding ratio idiosyncratic risk was reduced. Regarding the external

governance mechanism, Jin and Myers (2006) conducted an empirical study from a national

perspective. They found that firms possessing less information transparency exhibited high

idiosyncratic risk. However, they did not research the quality of firm-level governance and its

effects on idiosyncratic risk. Moreover, Gasper and Messa (2006) used data obtained from

CRSP Compustat to analyze the effects of product market competition on idiosyncratic risk.

The study showed that highly competitive product markets exhibited increased idiosyncratic

risk. Ferreira and Laux (2007) explored the effects of the market for corporate control on

idiosyncratic risk. Their results indicated that firms that possessed numerous anti-takeover

provisions had low idiosyncratic risk. Unlike previous studies, Lin et al. (2010) examined the

effects that comprehensive corporate governance, which involved internal and external

mechanisms, has on idiosyncratic risk. The results indicated that when the shareholding ratio

by external blockholders, ratio of independent directors and supervisors on boards, and

shareholding ratio by managers were high, and when information was obtained in a timely

manner, then idiosyncratic risk was reduced. In other words, improved internal corporate

governance mechanisms effectively reduce idiosyncratic risk. Legal regulations and product

market competitiveness have no substantial effects on idiosyncratic risk, thereby indicating

that external corporate governance mechanisms cannot reduce idiosyncratic risk.

Regarding the financial industry, scholars have mostly focused on parts of corporate

governance mechanisms and their effects on system risk or corporate governance mechanisms

and their influence on partial idiosyncratic risk. Saunders et al. (1990) examined the

relationship between bank ownership structure and risk taking. The results indicated that total

risk, non-system risk, and the shareholding ratio of operators are significantly positively

correlated. In addition, the non-significant relationship between system risk and the

shareholding ratio of operators indicated the importance of idiosyncratic risk. Chen (2003)

examined factors from 1996 to 2001 (i.e., the period of Taiwanese bank recession) that




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influenced bank risk-taking behavior. They found that corporate governance mechanisms had

a significant effect on bank credit risks and overall risks. Chen et al. (1998) used 302 banks

from 1988 to 1993 as their sample. The study indicated that the shareholding ratio of

management (including managers and directors) was negatively correlated with the risk proxy

variables in two-factor market models.

In other words, when the shareholding ratio of management increased, risk aversion

behaviors also increased, thereby supporting the relative risk aversion hypothesis. Cebenoyan

et al. (1995) found that when institution investors possessed high shareholding ratios, the

risk-taking rate of the bank was reduced, thereby supporting the efficient monitoring

hypothesis. However, Li (2002) showed that high shareholding ratios by institution investors

increased bank credit risk, market risk, and overall risk. This relationship supported the

conflict of interest hypothesis. Kan (2003) indicated that no significant correlation was

observed between the shareholding ratio by legal personalities of institutions and the

nonperforming loan ratio of a bank.

3. Methodology

3.1 The Data

Financial institutions issued by the Taiwan Stock Exchange were recruited as research

subjects, including independent banks of the listed and OTC firms, financial holding banks,

and securities industry. Research data included the Taiwan stock index, firm stock price, and

financial reports. All data were obtained from the Taiwan Economic Journal (TEJ) and

Market Observation Post System based on public-issued listed and OTC firms.

Because the insurance industry lacks information disclosure mechanisms, these firms

were not included in this study. For the research sample, 33 firms were selected including

nine independent banks, 14 financial holding banks, and 10 securities firms. Prior to 2006,

TEJ only collected semiannual reports of the financial industry firms and not quarterly reports;

therefore, this study began its examination from the first quarter of 2006 to the fourth quarter

of 2012; the period was 7 years, overall. The study examined the data of the quarterly reports

for each year.

3.2 The Variable Definitions

3.2.1 Ownership structure

This study used the shareholding ratio by external block holders and by institutional legal

personalities as the proxy variables for the ownership structure. This study defined the




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external block holder ownership (BOR) as the shareholding ratio of block holders who were

not identified as directors and managers. The institutional ownership (IOR) was defined as the

sum of the ratio of foreign legal personality ownership from the investment sample firms

(FOREIGN), investment trust and consulting ownership (ITCS), and the dealer shareholding

ratio (DEALERS). This study predicted that when the external block holder shareholding

ratio and the institutional legal-personality shareholding ratio were high, then the supervising

ability of a firm would be high and idiosyncratic risk would be low.

3.2.2 Managerial incentives

This study used managerial ownership ratio (MOR) as the proxy variable of the

managerial incentive mechanism. We predicted that when the managerial shareholding ratio

was high, the interests of the managers and shareholders would be consistent and

idiosyncratic risk would be low.

3.2.3 Board composition

This study defined the independent director and supervisor ratio to the overall director

and supervisor seats (INDR) as the number of seats of independent directors and supervisors

of the sample firm divided by the total seats of the board of directors and supervisors. This

study predicted that a high ratio of independent directors and supervisors to the director and

supervisor seats would elicit a highly independent board. Thus, the managerial supervisory

capacity would be strong and the idiosyncratic risk low.

3.2.4 Information transparency

This study used information timeliness and disclosure rating as proxy variables of

information transparency. This study predicted that when the information transparency is high,

the quality of corporate governance is strong and therefore idiosyncratic risk is low.

3.2.4.1 Information timeliness

Timeliness of information (TIMELINESS) was used as the first proxy variable of

information transparency (Ashbaugh et al., 2006). The regression equation is established as

follow:

, 0 1 2 3 4× Δі τ і,τ і,τ і,τ і,τ і,τ і,τRET = β β NIBE β LOSS β NIBE LOSS β NIBE ε (1)

where ,τiRET represents the average stock return of firm i in quarter τ ; ,τiNIBE

denotes the quarterly net income of firm i in quarter τ divided by the shareholder equity




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market cap at the beginning of the quarter; ,τiLOSS represents a dummy variable. When

,τiNIBE is a negative number, ,τiLOSS is 1; otherwise, ,τiLOSS is 0; ( ,τΔ iNIBE )

represents the quarterly net income change of firm i in quarter τ divided by the

shareholder equity market cap at the beginning of the quarter. Regression analysis on data of

quarter τ of all firms is conducted using (1). The regression residual i resulting from the

regression analysis is squared and multiplied by 1 . The product is information timeliness

( ,τiTIMELINESS ) of firm i in quarter. When TIMELINESS is high, the data respond to

return in a timely manner; therefore, firm information transparency level is high.

3.2.4.2 Disclosure rating

Information disclosure assessment (INF) was used as the second proxy variable

representing information transparency. To measure the degree of information disclosure, this

study cited the assessment results of the information disclosure and transparence ranking

system provided by the Taiwan Securities and Futures Institute. The following paragraphs

present the assessment ranks converted into numeral codes for measurements, as shown in

Table 1.

Table 1: The rating scale of information transparency

The Rating Scale Codes

A＋ 5

A 4

B 3

C 2

C－ 1

3.2.5 The measurement of idiosyncratic risk

This study follows the direct decomposition method by Xu and Malkiel (2003) to

estimate idiosyncratic risk. In addition, by establishing the market model, we estimated the

volatility sequence of idiosyncratic and systemic risks. To solve the heteroscedasticity and

heavy-tailed distribution patterns concerns that the sequence of returns possessed, when

estimating idiosyncratic risk, we used a GARCH model to modify the direct decomposition

method by Xu and Malkiel (2003).




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і,τ і і m,t і,tr α β r ε (2)

, , , / , ,i t i i m t i mv t i b v t i tr r r r (3)

(2) Is the market model, where α i and β i represent parameters to be estimated; ,i tr

denotes the excess return of stock i on day t ; ,m tr depicts the excess return of the market

portfolio on day t , and ,εi t represents the residuals. The equation (3) is three factor model

proposed by Fama and French (1993), wherei

r ,i

k represent parameters to be estimated;

,mv tr represent the market size factor,

/ ,b v tr and represents the book to market value factor.

In general, (2) and (3) disregards the issue that data in financial asset time series

possesses heteroscedasticity, which leads to inefficient estimations of the parameters. Thus,

Xu and Malkiel (2003) used rolling methods to estimate the idiosyncratic risk of individual

stocks to solve conditional heteroscedasticity. In (2) and (3), the residuals appeared to possess

a GARCH-model effect. Because of this effect, the idiosyncratic risk of market factors was

estimated.

2

1 (0, )і,t t i,tε |ψ ~ N h (4 )

2 2 2

, 0 1 , 1 2 , 1εi t i t i th h (5)

where 1ψt represents the total information collection prior to period 1t ; 0 , 1 , 2

are parameters that are not negative numbers, and 0 1 < 1 ; 2

, 1i th denotes the estimate of

idiosyncratic risk of stock i at period t ; 2

1i,tε represents the residual square of

idiosyncratic risk of stock i during period 1t ; if 2

i,th were calculated using market

model; 2

,i thF were calculated using three factor model.

Because relevant financial variables could only be obtained from quarterly data reports,

we converted the other research variables into variables representing quarterly data. Daily




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idiosyncratic risk 2

i,th and 2

,i thF were converted into quarterly idiosyncratic risk by adding

all trading days in that quarter. The converted idiosyncratic risks are denoted by ,ij τIV and

,ijFIV

.

3.2.6 Control variables

This study establishes 8 control variables in the study model. The following control

variables were converted into quarterly data. The 8 control variables were firm size

( і,τLNSIZE ), market-to-book ratio ( і,τMTB ), leverage rate ( і,τLEV ), stock turnover ratio

( і,τTURN ), capital expenditure ratio ( і,τCE ), return on assets ( і,τROA ), non-performing

loans ( і,τNPL ), and bank of international settlement ratio ( і,τBIS ).

3.3 Empirical Model

Because the data in this study were panel data that involved cross-sectional and

time-series data of the listed firms in Taiwan’s financial industry from 2006:Q1 to 2012:Q4,

the data were suitable for constructing a panel-data model for statistics analysis, thereby

reducing the collinearity problem. Flannery and Hankins (2013) indicated that when a lagged

period of an explained variable was included in the explanatory variables, a dynamic panel

data-regression model was used to conduct empirical analysis to avoid deviated parameter

estimates. Thus, the dynamic panel data-regression model was established as follows:

,τ ,τ 1 ,τ

2

β β ε , 1,..., , τ 1,...,K

i oi k ki i

k

Y X i N T

(6)

where ,τiY represents the idiosyncratic risk ( ,τiIV or ,ij

FIV

) of firm i in quarter τ ;

,τkiX denotes the K th explanatory variable of firm i in quarter τ ; 0 1β ,β ,...,βK

represent the parameters to be estimated; and ,τεi denotes a random error item.

4. Results

4.1 Descriptive Statistics

This study used the Taiwan financial holdings, banks and securities firms from 2006:Q1

to 2012:Q2 as samples. Descriptive statistical analysis was conducted to obtain the mean,




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standard deviation, median, and quartiles of the various research variables. Table 2 presents

the descriptive statistical analysis of the overall sample.

The results presented in Table 2 are the results of the descriptive statistics of all sample

variables. First, by observing the block holder shareholding ratio, the mean shareholding ratio

of the external block holders of the sample firms was established as 4.08% (SD 0.0833). The

first quartile and the third quartile were 0, which indicated that the external block holder

shareholding ratio in the sample firms was generally low and the differences were not

significant. Regarding the shareholding ratio of institutional legal personalities, foreign

ownership possessed the highest shareholding ratio, with a mean of 16.12% and a median of

10.55%. The results indicated that foreign ownership was relatively strong compared with

other types of legal-personality ownership.

In addition, the shareholding ratio presented a negative skew, thereby indicating that

foreign ownership had a relatively high shareholding ratio in specific firms. The results in the

table show that the mean value of the managerial shareholding ratio was 0.25%. The data

indicated that in over half of the sampled firms, the managerial shareholding ratio was 0%. If

these firms do not have a comprehensive and stable supervising mechanism or transparent

information disclosure policy, then these firms have severe agency problems and information

asymmetry concerns.

Regarding board composition, the mean value was 12.44 (SD 0.1001), and the sample

firms showed only a slight difference, thereby indicating that employing independent

directors and supervisors was common in the sample firms. Regarding operating performance,

the mean value of the return on assets was 0.53% and the standard deviation was 0.0133,

which indicated that the average performance of the financial industry from 2006 to 2012 was

relatively poor.

Table 2: Descriptive Statistics

Average St. Dev. Q1 Median Q3

і,τIV 1.6953 0.2465 1.5525 1.6855 1.8896

,ijFIV

1.7121 0.2634 1.5888 1.7045 1.9108

і,τBOR 0.0408 0.0833 0.0000 0.0000 0.0000

і,τIOR 0.1701 0.1488 0.0332 0.1189 0.2793

і,τFOREIGN 0.1612 0.1521 0.0411 0.1055 0.2753

і,τITCS 0.0065 0.0071 0.0005 0.0042 0.0098




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і,τDEALERS 0.0038 0.0099 0.0000 0.0009 0.0031

і,τINDR 0.1244 0.1001 0.0000 0.1266 0.2000

і,τMOR 0.0025 0.0040 0.0004 0.0015 0.0048

і,τTIMELINESS -0.1421 0.0555 -0.1233 -0.1167 -0.1132

і,τINF 3.9788 0.8221 4.0000 4.0000 4.0000

і,τLEV 0.8121 0.1634 0.6905 0.9091 0.9532

і,τCE 0.0252 0.0233 0.0122 0.0171 0.0320

і,τMTB 0.0201 0.0048 0.0082 0.0108 0.0129

і,τROA 0.0053 0.0133 0.0012 0.0031 0.0080

і,τLNSIZE 24.2555 1.3434 23.2134 24.1279 25.4434

і,τTURN 0.0045 0.0049 0.0011 0.0025 0.0050

Note: Q1 and Q3 are represented the firth and third quartile. ,τiIV is represented the

idiosyncratic risks of firm i at quarter τ . ,τiBOR ,

,τiIOR , ,τiMOR are represented

the outside block-holder ownership, institutional ownership, managerial ownership of

firm i at quarter τ . ,τiINDR is represented the proportion of independent

supervisor/director in the board of firm i at quarter τ . We take ,τiTIMELINESS for

estimating the information timeliness of firm i at quarter τ . і,τLNSIZE ,

і,τMTB ,і,τLEV ,

і,τTURN , і,τCE and

і,τROA are the control variables.

4.2 Correlation Coefficient Analysis

Before a regression model could be established, high degrees of similarities between

independent variables must be prevented from influencing the study results. We conducted

Pearson correlation coefficient analysis to explore variables related to corporate governance

regarding the extent of relationships and the trend of idiosyncratic risk. These variables were

as follows: an external block-holder shareholding ratio; shareholding ratio by institutional

ownership; shareholding ratio of foreign ownership; shareholding ratio by securities

investment trust and consulting representatives; shareholding ratio by dealers; the number of

independent directors and supervisors; shareholding ratio by managers; information

timeliness; information transparency; and disclosure assessments.

Correlation coefficient analysis indicated that the current idiosyncratic risk and the

idiosyncratic risk for the following period were positively correlated. Regarding internal

corporate governance variables, the shareholding ratio by institutional leg personalities,

shareholding ratio of foreign ownership, shareholding ratio by dealers, and the cost and price

differences were all positively correlated with idiosyncratic risk. However, the correlations

were not significant. All other variables showed significant correlations with idiosyncratic




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risk. When the external block holder shareholding ratio, securities investment trust and

consulting representatives, the ratio of independent directors and supervisors, and the

shareholding ratio by managers were high, then idiosyncratic risk would also be high. In

addition, the two variables related to information transparency (i.e., information timeliness

and information disclosure assessment) were negatively correlated with idiosyncratic risk.

Table 3: Pearson Correlation Coefficients

A B C D E F G H I J K

IVt+1 A 1.00

IV B 0.69 1.00

BOR C 0.09 0.07 1.00

FOREIGN D 0.00 0.02 -0.22 1.00

ITCS E 0.12 0.06 -0.14 0.39 1.00

DEALERS F 0.05 0.06 0.03 0.02 -0.06 1.00

IOR G 0.01 0.02 -0.22 0.99 0.43 0.08 1.00

INDR H 0.15 0.08 0.21 0.14 0.07 -0.02 0.14 1.00

MOR I 0.13 0.10 -0.18 -0.13 -0.17 -0.05 -0.14 -0.12 1.00

TIMELINESS J -0.27 -0.23 -0.08 0.09 0.14 -0.05 0.09 -0.01 -0.07 1.00

INF K -0.19 -0.19 -0.09 -0.03 .217** 0.02 -0.01 0.00 -0.24 0.12 1.00

Note: The definitions of variables are reported in table 2. Bold-faced coefficients are significant at the

1% and 5% level, respectively.

4.3 Empirical Results

The results presented in Table 4 showed that the entire current idiosyncratic risk of the

model and the idiosyncratic risk for the following period were positively correlated. These

results indicated that the idiosyncratic risk of a firm could change over time. In addition, the

effects of partial corporate governance on idiosyncratic risk were significant. One exception

was that the shareholding ratio by block holders was positively but not significantly correlated

with idiosyncratic risk. The shareholding ratio by managers and was negatively, but not

significantly, correlated with idiosyncratic risk. Reaching more than the 5% level of

significance, the other variables, such as the ratio of independent directors and supervisors on

the board, information timeliness, and information disclosure assessments, were negatively

correlated to idiosyncratic risk. This trend showed that high information transparency levels

indicate low idiosyncratic risk in financial institutions. When the ratio of independent

directors and supervisors on the board was high, the idiosyncratic risk of the firm is low.

These results were consistent with the study predictions. The shareholding ratio by




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institutional legal personalities and idiosyncratic risk were positively correlated, thereby

indicating that when the shareholding ratio by institutional legal personalities was high, the

idiosyncratic risk of the financial institution was also high. This result was inconsistent to our

predictions.

To comprehensively understand the relationship of the shareholding ratio by institutional

legal personalities to idiosyncratic risk, this study defined the shareholding ratio by

institutional legal personalities separately as the shareholding ratio of foreign ownership,

shareholding ratio by securities investment trust and consulting representatives, and

shareholding ratio by dealers.

The results shown in Table 5 indicate that the current idiosyncratic risk and the

idiosyncratic risk of the following period were positively correlated, thereby suggesting that

idiosyncratic risk change over time. By reaching a level of significance of more than 5%, the

ratio of independent directors and supervisors on the board and information transparency

were negatively correlated to idiosyncratic risk. This indicated that a high number of

independent director and supervisors on the board along with high information transparency

lowers the idiosyncratic risk of financial institutions. The shareholding ratio by foreign

investors and idiosyncratic risk were positively correlated. This indicated that when the

shareholding ratio by foreign investors was high, the idiosyncratic risk was high. Regarding

the control variable results, Tables 4 and 5 indicate that at a 5% level of significance, firm

size and idiosyncratic risk were negatively correlated. A large-scale firm experiences low

idiosyncratic risk. In addition, at a 5% level of significance, leverage ratio and idiosyncratic

risk were positively correlated, thereby indicating that when high leverage ratios increase

idiosyncratic risk increases.

This study also used idiosyncratic risk that was estimated by the three-factor model to

verify the stability. The results shown in Tables 4 and 5 are consistent. Therefore, financial

institutions must strengthen corporate governance quality to reduce idiosyncratic risk and

protect the rights and interests of all stakeholders.

Previous studies have focused on exploring whether the corporate governance

mechanisms in general industry could enhance corporate operating performance and

shareholder wealth. These studies have rarely focused on the effects of the quality of

corporate governance in the financial industry on idiosyncratic risk. In addition, relevant

studies have been limited to the influence of partial corporate governance mechanism on




16


idiosyncratic risk. These studies were not comprehensive investigations on the effect of

corporate governance mechanisms in the financial industry on firm idiosyncratic risk. Only

Lin et al. (2010) used general industry as the research subject and comprehensively explored

the effect of the corporate governance mechanism on idiosyncratic risk.

Due to the financial sector is a franchise industry and is closely related to the public, a

financial institution with a strong corporate governance mechanism is essential. This study

comprehensively analyzed the factors of corporate governance that influenced the

idiosyncratic risk in financial industry. These factors can serve as a reference for competent

authorities in governmental sectors and financial institutions that are promoting corporate

governance. Thus, the essence of corporate governance can be implemented to maintain

stakeholder rights and interests and corporate organizations and operations can develop

steadily.

This study was conducted from the corporate governance mechanism perspective for

investigating idiosyncratic risk in financial institutions. By using dynamic panel data

modeling and by using listed and OTC firms from 2006 to 2012 as the study sample, we

explored vital corporate governance mechanisms, such as ownership structure, board

composition, managerial incentive systems, and information transparency and their

relationship with idiosyncratic risk in financial institutions.

First, the empirical results showed that regarding ownership structure, the institutional

ownership was positively correlated to firm idiosyncratic risk. After further analysis, the

results showed that the foreign investor shareholding ratio and idiosyncratic risk were

positively correlated. The main reason for this result could be that foreign investment in

Taiwan’s financial institution is primarily short term. Thus, foreign investment did not

achieve the effect of an institutional legal personality on monitoring corporate operations.

Based on board composition, more independent directors and supervisors on the board are

correlated to low idiosyncratic risk. This result indicated that when boards of directors of

financial institutions in Taiwan possessed high independence, the firm idiosyncratic risk

decreased. Finally, high information transparency in a financial institution was correlated to

low idiosyncratic risk. Thus, we recommend that the financial industry increase the board of

director independence and information transparency to reduce idiosyncratic risk.




17


Table 4: The empirical results from dynamic panel data regression: market model

Explanatory variables

(expected sign)

Dependent variable

, 1iIV

Model 1 Model 2

Intercept 3.2832

(0.9217)

3.5423

(0.9387)

,iIV

( )

2.3341

(0.0000) ***

2.5454

(0.0000) ***

,iBOR

(－)

0.1121

(0.5431)

0.1221

(0.5521)

,iIOR

( )

1.2434

(0.0011) ***

і,τFOREIGN

0.9987

(0.0000) ***

і,τITCS

-1.2563

(0.7676)

і,τDEALERS

-0.8876

(0.5521)

,iTIMELINESS

( )

-0.0451

(0.0185) **

-0.0444

(0.0178) **

,iINF

( )

-0.3321

(0.0703) *

-0.3561

(0.0773) *

,iINDR

( )

-0.2122

(0.0340) **

-0.2139

(0.0355) **

,iMOR

( )

-4.2541

(0.6676)

-4.6657

(0.6709)

,iLNSIZE

( )

-2.1231

(0.0000) ***

-2.1333

(0.0000) ***

,iMTB

( )

-3.2122

(0.5143)

-3.3455

(0.5298)

,iLEV

( )

1.1121

(0.7671)

1.1222

(0.7688)

,iTURN

( )

0.2212

(0.0796) *

0.2393

(0.0788) *

,iCE

( )

0.8878

(0.8522)

0.8999

(0.8437)

,iROA

( ) 0.3122 0.3102




18


(0.4771) (0.4777)

Time dummy variables Yes Yes

Industry dummy variables Yes Yes

0.2208 0.2332

18.2119

(0.3229)

19.4531

(0.3131)

Note: ,iIV

is represented the idiosyncratic risk of market model for firm i at quarter . The

definitions of other variables are defined in section 3. The p-value is in bracket. ***, **, and *

significant at the 1%, 5%, and 10% level, respectively.

Table 5: The empirical results from dynamic panel data regression: three-factor model

Explanatory variables

(expected sign)

Dependent variable

Model 1 Model 2

Intercept 2.9877

(0.3565)

2.9889

(0.3566)

,iFIV

( )

3.8901

(0.0000) ***

3.8999

(0.0000) ***

,iBOR

(－)

0.2221

(0.3331)

0.2233

(0.3333)

,iIOR

( )

1.9871

(0.0031) ***

і,τFOREIGN

0.9987

(0.0000) ***

і,τITCS

-1.2563

(0.7676)

і,τDEALERS

-0.8876

(0.5521)

,iTIMELINESS

( )

-0.1111

(0.0085) ***

-0.1231

(0.0088) ***

,iINF

( )

-0.5432

(0.0431) **

-0.5569

(0.0448) **

,iINDR

( )

-0.3321

(0.0255) **

-0.3354

(0.0255) **




19


,iMOR

( )

-3.9908

(0.4444)

-3.9967

(0.4434)

,iLNSIZE

( )

-2.2221

(0.0000) ***

-2.2891

(0.0000) ***

,iMTB

( )

-3.4535

(0.4989)

-3.5643

(0.5001)

,iLEV

( )

1.1321

(0.5998)

1.1443

(0.5988)

,iTURN

( )

0.4509

(0.0888) *

0.4565

(0.0889) *

,iCE

( )

0.8779

(0.7677)

0.8760

(0.7543)

,iROA

( )

0.4454

(0.3339)

0.4631

(0.3341)

Time dummy variables Yes Yes

Industry dummy variables Yes Yes

0.3001 0.3021

18.9978

(0.3209)

19.5678

(0.3087)

Note: ,i

FIVis represented the idiosyncratic risk of three factors model for firm i at quarter .

The definitions of other variables are defined in section 3. The p-value is in bracket. ***, **,

and * significant at the 1%, 5%, and 10% level, respectively.

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