To Join or Not to Join? Do Banks That Are Part of a Financial Holding Company Perform Better Than Banks That Are Not?

Beginning of article

I. INTRODUCTION

Following in the footsteps of the United States in terms of its financial regulations, in the year 2000 Taiwan started to allow banks, securities, and insurance companies to consolidate and form financial holding companies (FHCs). During the 4 yrs that followed, 14 FHCs were established and 13 banks joined 12 of the FHCs, (1) whereas 35 banks chose not to join. Under the regulatory framework for FHCs in Taiwan, an FHC is considered to be a conglomerate that combines at least two or three financial institutions, ranging from banking to securities-related business and insurance. A question that is commonly asked by policy makers, bankers, and academics is: Do banks that join an FHC (FHC bank hereafter) perform better than banks that do not (independent bank hereafter)? This phenomenon is referred to as the joining the FHC effect.

Supporters of the joining the FHC effect argue that FHC banks which engage in deposit-loan activity are able to facilitate the efficient provision of other financial services such as insurance or the underwriting of securities (Diamond 1991; Rajan 1992; Saunders and Walter 1994; Stein 2002). Similarly, securities and insurance underwriting, brokerage and mutual fund services, and other activities can produce additional information that improves loan-making decisions. Thus, a bank within a financial conglomerate enjoys the so-called 3Cs. namely, cross-selling, cost savings, and capital sharing, and benefits from economies of scale and scope that boost performance and market valuations. This diversification effect could occur only in the case of FHC banks. In addition, under the financial holding company structure, a service bank is theoretically able to provide customers with one-stop shopping for banking, insurance, and securities services.

An alternative view suggests that there is no joining the FHC effect, as independent banks may have a specialization advantage and lower systemic risk. (2) For example, some independent banks are specialized in credit card or custodian business, in which case joining the FHC has no particular advantages for them. In addition, an independent bank could have lower systemic risk because an FHC bank with diversified activities will reinforce the agency problem between insiders and outsiders. In particular, this conflict of interest tends to occur in an FHC bank when the bank makes a loan to the firm and also sells its securities (Kroszner and Rajan 1994; Puri 1996; Gande et al. 1997; Schenone 2004). Furthermore, Laeven and Levine (2007) found that the diversification discount, not the diversification premium, exists in a financial conglomerate, implying that the synergy effect is small. Stiroh and Rumble (2006) demonstrated that the diversification effect in a U.S. FHC is negatively affected by the bank's involvement in noninterest income activities. Therefore, specialization advantages, low agency costs, and diversification discount suggest that the independent bank can perform better.

There are few empirical studies comparing the performance of these two groups, probably because the direct comparison between the two groups has often been criticized, as banks with superior financial performance are more likely to be invited to join an FHC. Thus, it would not be surprising to find their continued superior performance well after they join the FHC. For example, Shen (2002) used descriptive statistics to examine CAMEL indicators of 50 U.S. FHC banks and 44 U.S. independent banks between 1997 and 1998, and found that, on average, the former outperform the latter. Hsu and Chang (2005) used ordinary least squares (OLS) to study the impact of the passage of the FHC Act on bank operational efficiency in Taiwan. They found that FHC banks outperformed independent banks both before and after the passage of the FHC Act. Thus, the above studies demonstrated that the FHC banks outperform independent banks most likely due to the endogeneity problem. In other words, joining an FHC is not exogenously given or randomly determined; rather, it is determined as a result of self-selection mechanisms that are affected by performance. The usual OLS estimators are thus likely to be biased and the results may be misleading. However, these studies do not consider the issue of endogeneity when a bank joins an FHC, thereby biasing the result. This work tries to fill this gap.

We compare the performance of the FHC and independent banks by taking the endogeneity problem into account using Taiwan bank data. That is, a bank with good performance prior to joining the FHC should be compared with a bank with equally good initial performance. Traditional ways of resolving this endogeneity problem include estimating the regression model based on Heckman (1979)'s two-step estimation method. However, the two-step models must satisfy an identification requirement of needing at least one variable that affects choice, but does not have a partial effect on the outcome variable (Maddala 1987; Hofler Elston, and Lee 2004).

This study applies the matching theory to control for the endogeneity of the decision to join the FHC. This matching theory has been developed mainly in the medical and biological research fields, but has been widely used in economics and finance. In standard medical or biological studies, the observations that make up an experiment are referred to as the treatment sample. Nonparticipants in the experiment who have characteristics similar to those of participants are referred to as the control sample. The changes between the treatment sample and the control sample that are a result of the experiment are referred to as the experiment or treatment effect. The basic concept of matching theory is that when making a comparison, the treatment sample (the FHC bank in our case) should have characteristics similar to those of the control sample (the independent bank in our case). If they have similar characteristics, then they could be regarded as randomly sampled and the resulting difference between the two matched observations is the treatment effect. See Rubin (1973) for details.

Our study contributes to the literature in three respects. First, this is the first study to compare the joining the FHC effects using matching theory, which requires that the two types of banks have similar characteristics. Thus, the event of joining the FHC becomes the only difference between the two types of banks, excluding other factors. Our results are thus more reliable than the analyses that do not consider the endogeneity bias or nonrandom sampling bias. Next, our study complements the literature regarding the synergy effect of conglomerates (Billett and Mauer 2000a, 2000b; Hadlock, Ryngaert, and Thomas 2001). The existence of the joining the FHC effect indirectly supports the view that the synergy effect exists for banks that join an FHC. Lastly, on practical grounds, independent banks may consider joining FHCs to increase their value in terms of capital adequacy, asset quality, and liquidity sufficiency, given our results that FHC banks are strong in each of these three dimensions.

The remainder of this work is organized as follows. Section II provides a brief introduction to FHC banks in Taiwan. Section III discusses the matching methodology and its application. Section IV discusses the econometric method. Section V presents the empirical results concerned with the calculation of the propensity scores used in creating the matched samples and the estimated results. Section VI concludes the study.

II. A BRIEF ACCOUNT OF FHCS IN TAIWAN

In following the global trend of financial liberalization, Taiwan's government lifted the long-standing restrictions on the establishment of financial institutions in 1988. The Banking Act was amended in 1989, which permitted new entrants into the banking industry, but this consequently resulted in an overbanking problem in the domestic financial market. The resulting cut-throat competition seriously worsened the financial conditions in banks. According to Taiwan's Ministry of Finance, the overall non-performing loan ratio climbed from 3% at the end of 1995 to a record high of 8.78% in March 2002. The banking sector in Taiwan thus suffered from increasing nonperforming loans and decreasing profitability.

To alleviate the overbanking and overcompetition problems and in an attempt to bring the financial industry competitively in line with global financial markets, the Taiwan government decided to implement banking reforms. In addition, at almost the same time, in the United States, the announcement of the Citigroup merger speeded up the process of financial consolidation, and subsequently Congress passed the Gramm-Leach-Bliley Act (GLBA). Under the FHC structure, a financial institution could engage in banking, insurance, and securities business at the same time. The GLBA thus encouraged the financial regulators in Taiwan to speed up the reforms. As a result, Taiwan passed the amended Banking Law and the Financial Institutions Merger Act in 2000. In 2001, the Financial Holding Company Act was promulgated to encourage consolidation within and across the banking-related sectors. The FHC should hold at least 25% shares of the bank, insurance company, and securities, and thus hopes to create economies of scale and scope.

Since the passage of the FHC Act, 14 FHCs have been successively established. In the early stages, 13 banks joined the FHCs. Subsequently, an additional four banks joined. Thus, there are a total of 17 FHC banks and 17 independent banks in our sample for the period from 2002 to 2006. Table 1 presents the lists of the names of the FHC and independent banks.

TABLE 1
FHC Banks versus Independent Banks

FHC Banks                                  Independent Banks

First Commercial Bank                  Hsinchu International Bank

Hua Nan Commercial Bank                Taichung Commercial Bank

Cathay United Bank                     Tainan Business Bank

Bank SinoPac                           Taitung Business Bank

E.SUN Commercial Bank                  En Tie Commercial Bank

Taishin International Bank             Farmers Bank

Mega International Commercial Bank     Taiwan Cooperative Bank

China Development Industrial Bank      Chang Hwa Bank

Chinatrust Commercial Bank             Bank of Overseas Chinese

Taipei Fubon Bank                      Cosmos Bank

Chiao Tung Bank                        Pan Asia Commercial Bank

Fuhwa Commercial Bank                  Bank of Kaohsiung

Jih Sun International Commercial Bank  Union Bank of Taiwan

International Bank of Taipei           Chinese Bank

Grand Commercial Bank                  Far Eastern International Bank

Fubon Commercial Bank                  Taiwan Business Bank

Cathay Bank                            Ta thong Bank

Note: Source: Website of the Financial Supervisory …