Eurasian Economic Review, 3(2), 2013, 183-202

DOI: 10.14208/eer.2013.03.02.005

THE IMPACT OF OWNERSHIP CONCENTRATION, COMMISSIONERS

ON BANK RISK AND PROFITABILITY: EVIDENCE FROM
INDONESIA†
Mamduh M. Hanafi*, Fitri Santi**, and Muazaroh***

Abstract: We investigate corporate governance and risk in Indonesian banking.

More specifically, we investigate whether ownership concentration and
commissioners affect bank risk and profitability. Using a sample of 117 Indonesian
banks (for ownership concentration analysis), and 28 public banks (for
commissioner analysis), we find that ownership concentration and governance by
larger numbers of commissioners improves a bank’s profitability and it’s handling of
risk. The impact of commissioners on bank risk and profitability takes non-linear
forms. We also show that various types of commissioners have different impacts
on bank risk and profitability. Our study highlights the importance of corporate
governance in the banking industry.

Keywords: Bank Risk, Corporate Governance, Ownership Concentration,

Commissioners, Indonesia
JEL Classification: G21, G3

1. Introduction

The impact of ownership on a company’s performance remains unclear.

Berle and Means (1933) indicate that broader ownership reduces
shareholders’ power to control a firm’s management effectively. Likewise,
Schleifer and Vishny (1986) point out that ownership concentration
enhances corporate control due to an improvement in the degree to which
management is monitored. Shareholders in firms with dispersed ownership
have little incentive to monitor the firms’ management. Meanwhile,
shareholders in firms with concentrated ownership tend to have strong
incentives to monitor the firm’s management, since any cost stemming from
a low degree of monitoring will be mostly borne by large shareholders.
However, more recent literature suggests that large shareholders may have
negative effects on company’s performance (La Porta et al. 1999; La Porta
†
We would like to thank Hakan Danis and two anonymous referees for comments,
th
suggestions and discussions. We are grateful to participants at the 9 EBES Conference.
We are also grateful to DIKTI for providing us with funding support. The views expressed in
this paper are those of the authors and do not necessarily represent those of the Universitas
Gadjah Mada, of the University of Bengkulu, or of the STIE Perbanas. This research is part
of our reseach funded by DIKTI Indonesia, under a research shceme: “Hibah Kerjasama
Luar Negeri dan Publikasi Internasional, 2010.”
* Corresponding Author: Department of Management, Faculty of Economics and Business
(FEB), Universitas Gadjah Mada (UGM), Yogyakarta, Indonesia.
Email: mamduhmh@ugm.ac.id
** Department of Management, Faculty of Economics, University of Bengkulu, Bengkulu,
Indonesia. Email: pipietbkl@yahoo.com; fitri_santi@unib.ac.id
*** Department of Management, Faculty of Economics, STIE Perbanas Surabaya,
Indonesia. Email: muazperbanas@yahoo.com
 Hanafi et al. / Eurasian Economic Review, 3(2), 2013, 183-202

et al. 2000; Claessens et al. 2002). Large shareholders may expropriate

minority or public shareholders, extract private benefits at the expense of
minority shareholders and overall company, resulting in lower company’s
performance (Claessens et al. 2002). Analysis of this controversy requires
empirical investigation.
The impact of commissioners on bank performance is even more
unclear. There have been few studies that have investigated the effect of
Boards of Directors or commissioners on bank risk. A few studies report a
positive effect in an inverted U-shape pattern for the effect of Boards of
Directors on bank performances (Andres and Vallelado, 2008 and Pathan,
2009 for US). Empirical findings for emerging countries are practically non-
existent. While previous literature investigates the effect of a Board of
Directors’ independence on bank performance (Andres and Vallelado, 2008
and Pathan, 2009), we introduce different dimensions of bank
commissioners. Specifically, we introduce internally hired, controlling, and
independent commissioners, and investigate the effect of different types of
commissioners on bank risk. Different types of commissioners may
represent different interests. For example, controlling commissioners may
represent the interests of controlling or majority shareholders. Independent
commissioners may represent the interests of public shareholders, while
internally hired commissioners may represent the interests of the bank
itself. The difference between the interests represented may result in
different impacts of various types of commissioners on bank risk and
performance.
This study investigates the effect of ownership concentration,
commissioners, and different types of commissioners on bank risk taking
and profitability. Using a sample of 117 Indonesian banks (for ownership
concentration analysis), and 28 public banks (for commissioners analysis),
we find that ownership concentration and larger commissioners improves
bank risk and bank profitability. The impacts of commissioners on bank risk
and profitability takes non-linear forms and they are not homogenous. Our
study highlights the importance of corporate governance in the banking
industry.
We believe that we can contribute to existing literature by adding
evidence on the impact of ownership concentration and commissioners
from developing countries. Aside from the status of developing country,
Indonesia is noted for its different structure for board of directors. Indonesia
uses a two-tier system, in which commissioners monitor the directors of the
company. Hence our study provides evidence from a country with a two-tier
system. Moreover, we investigate the impact of different types of
commissioners on bank risk and performance, and show that the impact of
various types of commissioners may not be the same.
We have organized this paper as follows. In the next section, we
provide a literature overview. Section 3 discusses research methodology.
Section 4 discusses empirical findings. the last section concludes.

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2. Literature Review

2.1. Ownership Concentration and Bank Risk

The impact of ownership concentration on risk taking currently remains

unclear. The literature on corporate finance comes up with two different
arguments regarding this issue. One argument supports the idea that
ownership concentration improves control over firms’ management (Berle
and Means, 1933; Schleifer and Vishny, 1986). Large or concentrated
ownership reduces free-rider problems, since the benefit of effective
monitoring outweighs the cost of managerial underachievement. By way of
contrast, Stulz (1988) questions the advantage of large shareholding, since
large shareholders can expropriate the welfare of outside investors. Large
ownership concentration allows investors to gain control for a company,
and these investors may extract private benefits of control at the expense
of other investors (La Porta et al. 1999). Claessens et al. (2002) find
evidence that large shareholders are more likely to seek their own private
interests and hence can expropriate the role of outside investors, notably
when their control rights exceed their cash flow rights. Large investors
expropriate small investors through various mechanisms: buy company’s
assets from other company under their control at the above market price,
hire and pay excessive salaries to their incompetence relatives, transfer
business opportunities to other company under their control (Demsetz and
Lehn, 1985; La Porta et al. 2000). La Porta et al. (2000) further argue that
the conflict between large and small shareholders becomes more serious in
countries with weak legal investor protection. The conflict becomes highly
relevant in Indonesia, since La Porta et al. (2000) categorize Indonesia as a
country with weak legal investor protection.
These two opposing arguments highlight how the link between
ownership concentration and risk management is essentially an empirical
question. In the banking context, such a link becomes more complex, since
banking firms have depositors and non-banking firms do not. More
precisely, bank shareholders can collude with managers against depositors
to engage in excessive risk-taking, which in turn may cause deterioration of
the capital adequacy ratio and increase non-performing loans (Boyd et al.
1998).
With regards to ownership concentration, only a few studies
examine its link to risk management in the banking context. For instance,
Ianotta et al. (2007) analyze 181 large banks from 15 European countries
and report that those with concentrated ownership tend to have better loan
quality, lower asset risk, and lower insolvency risk. More recently, Shehzad
et al. (2010) have found that at low levels of shareholder protection and
supervisory control, ownership control reduces bank risk taking. Meanwhile,
ownership concentration increases a bank’s capital adequacy ratio
conditional on shareholder protection. Conversely, Laeven and Levine
(2009) emphasize that ownership concentration positively affects a bank’s
risk taking.

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To the best of our knowledge, research on ownership concentration

has mainly been conducted in a cross-country setting. Therefore, our
research is probably the first to investigate this issue in a single country
setting by building on the work of Soedarmono et al. (2010). Broadly
speaking, from 99 Indonesian commercial banks’ monthly data over the
period 2004-2007, they found that a higher capital adequacy ratio is
associated with an increase in efficiency, but with a decrease in risk taking
and profitability. From this finding, we may argue that Indonesian banks are
likely to suffer from a managerial self-interest problem and hence,
ownership consolidation to enhance the shareholders’ domination becomes
necessary. Focusing on a single country offers advantages. We believe
that it enables us to eliminate cultural and institutional differences among
countries, thus eliminating possible confounding effects in cross-country
studies.
Our study is similar to that of Shehzad et al. (2010), but differs in
several respects. First, we will use the standard deviation of four previous
quarter returns on equity (ROEs), instead of the non-performing loans ratio
that they used. The ROE fluctuation used in this study measures bank
income stability, which is another important concern in bank literature (for
example in the issue of bank diversification). Second, we incorporate bank
profitability as a dependent variable.

2.2. Commissioner Power and Bank Risk

Problems with firms’ management are basically due to the separation of

ownership and control. This mechanism creates problems with the
divergent objectives of shareholders and managers, where managers may
not always maximize shareholders’ interests. Such problems have been
widely explored in the literature on corporate finance, but little has been
done in the banking literature.
Hughes and Mester (1994) are the first to highlight that bank
managers are not maximizing shareholders’ value. The possible
explanation is that managers’ wealth, such as a portfolio of tangible and
financial assets as well as human capital (talent, job related experience), is
mostly concentrated in the firms where managers work. As a consequence,
managers tend to protect their self-interests by selecting “excessively safe
assets” or by diversification (Smith and Stulz, 1985; May, 1995).
Bris and Cantale (2004), in particular, attempt to model theoretically
a bank’s behavior in managing capital and risk in the presence of self-
interested managers in the banking context. According to them, self-
interested managers will respond to higher capital requirements by driving
a bank’s portfolios to become too safe and therefore less profitable. In other
words, more “socially desirable” risky loans are bypassed. By contrast,
Gorton and Rosen (1995) show that a higher proportion of self-interested
managers is associated with an increase in bank’s risk-taking, if
shareholders cannot fully control managers.

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In the empirical literature, the evidence on the impact of separation

of ownership and control on a bank risk taking is also mixed. Saunders et
al. (1990) find that “entrenched-manager-controlled” banks are less risky
than “shareholder-controlled” banks during the 1979-1982 period of relative
deregulation. Conversely, Sullivan and Spong (2007) empirically highlight
how managerial stock ownership boosts risk-taking strategies indicating
that hired managers are more likely to have incentives in line with those of
shareholders. Some papers also find U-shaped relationships between
managerial ownership and bank risk taking, which is also due to managerial
entrenchments (Chen et al. 1998; Anderson and Fraser, 2000).
In the section above, we discuss how ownership concentration can
alleviate the problems between shareholders and managers, as large
shareholders have high incentives to monitor firms’ behavior. Aside from
larger shareholders, CEO (Chief Executive Officer) power can also
influence bank’s managerial decisions which in turn affect risk
management. CEO power a priori comes from two sources: CEO duality
and “internally-hired” CEO (May, 1995; Adams et al. 2005). CEO duality, a
situation in which CEO also chairs the board directors (management),
tends to restrict information flow to other board members and hence,
reduces the board’s independent oversight of manager (e.g. Fama and
Jensen, 1983; Jensen, 1993). Meanwhile, an “internally-hired” CEO
indicates that such a CEO has long-term involvement with the firm’s
management and hence, adds to “CEO power” to influence board
decisions. However, research on the impact of CEO power on risk
management is very scarce. In the banking literature, Pathan (2009) is the
first contribution to investigate such issues by using a sample of US banks.
This study extends Pathan (2009) and Andres and Vallelado (2008)
in several directions. First, we analyze the impact of CEO power on bank
risk in an emerging economy (Indonesia). However, the Indonesian
corporate governance system does not recognize the CEO, but instead the
commissioner board. Therefore, the term “CEO power” is translated into
“commissioners’ power”. Second, aside from analyzing “commissioner
duality” and “internally-hired commissioners” as developed by Pathan
(2009), we also analyze the impact of independent commissioners (or
“externally-hired commissioners”) on bank risk management. This
consideration refers to Bank Indonesia Rule No. 8/4/PBI/2006 that
promotes independency and transparency of the board of commissioners.
Third, while Pathan (2009) analyzes the impact of CEO power on bank risk-
taking, we analyze the commissioners’ power on a broad set of risk
indicators (bank capitalization, risk-taking and profitability).
Using sample of 69 commercial banks from six OECD countries,
Andres and Vallelado (2008) find an inverted U-shaped relationship
between bank performance and board size, and between the proportion of
non-executive directors and performance. Their results show that bank
board composition and size are related to directors’ ability to monitor and
advise management. Their findings also show that larger and not

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excessively independent boards might prove to be more efficient in

monitoring and advising functions, and create more value.
The Indonesian governance structure follows a two-tier system (see
figure 1). Shareholders take ultimate power in corporations, including
banks. Through shareholders’ general meetings, shareholders appoint
bank commissioners and bank directors. Directors take responsibility for
running banks’ operations, while commissioners take responsibility for
supervising and advising bank directors. Bank commissioners may
recommend to shareholders the appointment or dismissal of certain
directors, however shareholders make the final decision. Indonesian
supervisory agencies, such as Bank Indonesia (Indonesia’s central bank)
and the Indonesian Capital Market Supervisory Agency (Bapepam),
develop a set of regulations regarding the governance of private banks and
public banks. The regulations cover several aspects such as minimum
number of bank directors, bank commissioners, the existence of
independent commissioners, minimum frequency of commissioners
meetings in a year, the requirement that bank directors pass fit and proper
tests by Bank Indonesia, and many other aspects. For public banks,
Bapepam requires that public banks to have independent commissioners.
Independent commissioners are expected to represent the interests of
public shareholders. Bank Indonesia requires that the percentage of
independent commissioners is at least 50%.

Shareholder
Appoint Appoint

Monitor and advise

Directors Commissioners
Figure 1. Governance structure of Indonesian banks

3. Research Methodology

3.1. Data

We collect financial data from quarterly bank balance sheets and income
statements for 117 Indonesian banks from the period 2002-2008. We also
manually collect ownership and commissioners’ data during the same
period. The data mainly come from Bank Indonesia. For public bank, we
also cross check our data with other source of data, Thompson One data.
The banks we use as our sample include 5 state owned banks, 26 regional
development banks, 16 joint venture banks, 10 foreign owned banks, and
60 privately owned banks.
For ownership concentration analysis, we use all 117 Indonesian
banks. However, for commissioners’ analysis, we focus on public banks,
since we want to investigate the effect of independent commissioners. Only

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public companies are required to designate independent commissioners.

Our sample for commissioners’ analysis consists of 28 public banks, and
covers the period 2002-2008.

3.2. Variables Definitions and Model Specification

We use the following model specifications to investigate the effect of

ownership concentration, commissioners, and different types of
commissioners on bank risk:

The effect of ownership concentration on bank risk:

n
ܴ‫ܯ‬௜ǡ௧ ൌ ߙ଴ ൅ ߙଵ ܱܹܰ௜ǡ௧ ൅ ¦D X
i 2
i i ,t ൅ ߝ௜ǡ௧ (1)

The effect of number of commissioners on bank risk:

n
ܴ‫ܯ‬௜ǡ௧ ൌ ߚ଴ ൅ ߚଵ ‫ܯܱܥ‬௜ǡ௧ ൅ ଶ
ߚଶ ‫ܯܱܥ‬௜ǡ௧ ൅ ¦E X
i 2
i i ,t ൅ ߝ௜ǡ௧ (2)

The effect of number of internally-hired commissioners, number of

controlling commissioners, and number of independent commissioners on
bank risk:
ଶ ଶ ଶ
ܴ‫ܯ‬௜ǡ௧ ൌ ߜ଴ ൅ ߜଵ ‫ܥܫ‬௜ǡ௧ ൅ ߜଶ ‫ܥܫ‬௜ǡ௧ ൅ ߜଷ ‫ܥܥ‬௜ǡ௧ ൅ ߜସ ‫ܥܥ‬௜ǡ௧ ൅  ߜହ ‫ܥܦܰܫ‬௜ǡ௧ ൅ ߜ଺ ‫ܥܦܰܫ‬௜ǡ௧ ൅
n

¦G X
i 2
i i ,t ൅ ߝ݅ǡ‫ݐ‬ (3)

RMi,t refers to the risk and profitability measures for bank i at period
t. We use three indicators of bank risk and profitability measures (RMi,t):
standard deviation of return on equity (RISK), capital adequacy ratio (CAR),
and return on assets (ROA). The capital adequacy is the ratio of total
capital for credit risk to risk weighted assets. We define return on assets as
the ratio of earning after tax to total assets. Xi,t refers to a set of control
variables (LTA (log total assets) as proxy of size of the bank, LOTA (loans
to total assets ratio), and DEPO (total deposits to total assets ratio) (Andres
and Vallelado, 2008). OWNi,t refers to ownership concentration for bank i at
period t (in percentage). COMi,t refers to number of commissioners (number
of persons) for bank i at period t. ICi,t refers to number of internally hired
commissioners for bank i at period t. CCi,t refers to number of controlling
commissioners for bank i at period t. INDCi,t refers to number of
independent commissioners for bank i at period t.
We use two indicators of ownership concentrations: (1) percentage
owned by the largest shareholder, and (2) the sum of the percentages of
the five largest shareholders. For the commissioners, aside from calculating
the total numbers of commissioners for each bank, we also calculate total
number of various types of commissioners. We define three types of

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commissioners: internally-hired commissioners (IC), controlling

commissioners (CC), and independent commissioners (INDC). Internally-
hired commissioners are those who have served the banks in the past, as
directors. To alleviate potential conflict of interest, Bank Indonesia requires
that ex-bank directors only become commissioners at least one year after
their retirement. Hence, we examine whether the commissioners served as
directors between two and five years before starting their service as
commissioners. If they meet these tests, then they are included as
internally hired commissioners. Public banks are required by Bapepam to
have independent commissioners. These commissioners are expected to
represent public or minority shareholders. This regulation is intended to
alleviate potential agency conflict between majority (controlling) and
minority (public) shareholders. Independent commissioners are designated
by the banks. Controlling commissioners are defined as those who
represent majority shareholders. Controlling commissioners are nominated
by controlling shareholders.

Table 1. Descriptive statistics for ownership concentration, bank risk

taking and profitability
Variables Obs. Mean Median Max. Min. Std dev

ROA 2974 2.18 2.49 79.50 -787.00 18.74

CAR 2981 41.76 20.70 5049.71 -55.43 171.29
SDROE 2332 7.10 3.90 138.70 0.06 11.43
LTA 2981 14.51 14.40 19.53 9.39 1.88
OWN1 2871 65.92 63.12 100.00 10.18 26.01
OWN2 2374 17.81 15.80 58.32 0.10 13.40
OWN3 1532 10.24 9.02 36.02 0.10 6.85
OWN4 1035 7.56 6.99 19.00 0.08 4.13
OWN5 762 5.90 5.44 16.38 0.11 3.38
OWN1-2 2373 77.82 80.00 100.00 18.85 21.89
OWN1-5 2806 84.08 98.67 100.00 20.11 25.92
Notes: The variables are return on assets (ROA), capital adequacy ratio (CAR), standard
deviation of return on equity (SDROE), logarithm of bank's total assets (LTA), the ownership
st
percentage held by the 1 largest shareholder (OWN1), the ownership percentage held by
nd rd
the 2 largest shareholder (OWN2), the ownership percentage held by the 3 largest
th
shareholder (OWN3), the ownership percentage held by the 4 largest shareholder (OWN4),
th
the ownership percentage held by the 5 largest shareholder (OWN5), the sum of ownership
st nd
percentage held by the 1 and 2 largest shareholder (OWN1-2), and the sum of ownership
st th
percentage held by the 1 to 5 largest shareholder (OWN1-5).

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4. Empirical Findings

4.1. Results for Ownership Concentration

4.1.1. Descriptive Statistics

The descriptive statistics of all variables we use are reported in Table 1.

Ownership concentration 1 (OWN1) is the percentage of ownership held by
the first largest shareholder. Our consideration on this proxy is based on
the phenomenon that bank ownership in Indonesia is highly concentrated.
From the descriptive data on Table 1, the mean of ownership percentage
by the first largest shareholders is 66%. Ownership concentration 2
(OWN1-5) is the sum of ownership percentage held by the first until the fifth
largest shareholder. Our sample banks exhibit the high ownership
concentration typical of the banking Industry in Indonesia. The mean of the
first largest shareholder is 66%, the mean of the second largest
shareholder is 17% and the mean of the 3th, 4th, and 5th is 10%, 7.5%, and
6% respectively.

4.1.2. The Impact of Ownership Concentration on Bank Risk

We report regression results on ownership concentration in Table 2. In the

model of capital adequacy ratio, the ownership concentrations have
positive signs for all specifications: OWN1 (the largest shareholders) and
OWN5 (the five largest shareholders). The regression coefficients are
significant at 1%, with the highest R2 which comes from model 1. We obtain
positive signs when we use return on assets (ROA) as the dependent
variable. When we use the standard deviation of return on equity (SDROE),
we obtain negative signs for the regression coefficients. These findings
seem to suggest that ownership concentration reduces bank risk taking, or
improves bank risk, and increases bank profitability.
This finding is different from that of Saunders et al. (1990), which
was that stockholders’ banks (defined as banks in which management own
substantial shareholdings) increase risk taking behavior, while
management banks (defined as banks in which management own a small
portion of shareholdings) reduce risk taking behavior. However, our results
are consistent with those of Hamadi (2010) who finds that firm
performance, measured by Tobin’s Q, is positively affected by large
shareholders in family firms, but negatively affected by large shareholders
organized in voting blocks. Our finding also supports Shehzad et al. (2010)
who find that ownership concentration increases the capital adequacy ratio
in countries with weak shareholder protection. Our findings suggest that
conflict between managers and stockholders in the Indonesian market is
relatively diminishing. This contention is supported by the fact that
ownership in Indonesian banks tends to be very concentrated. As argued
by Schleifer and Vishny (1986), concentrated ownership may create
another type of conflict, namely conflict between majority and minority

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shareholders. However, our results do not seem to confirm the arguments

of Schleifer and Vishny (1986).

Table 2. Regression of ownership concentration on bank risk

Panel A: Dependent variable: CAR
Model 1 Model 2 Model 3
Coef Prob Coef Prob Coef Prob
Intercept 101.3977 0.00 92.0468 0.00 91.7720 0.00
OWN1 0.2955 0.00
OWN1-2 0.1205 0.00
OWN1-5 0.0816 0.00
LTA -6.1874 0.00 -5.1795 0.00 -4.8947 0.00
LOTA -2.6E-05 0.43 -4.5E-06 0.57 0.0E+00 0.59
2
Adj R 0.60 0.69 0.49
Observation 2810 2331 2740
Panel B: Dependent variable: SDROE
Model 1 Model 2 Model 3
Coef Prob Coef Prob Coef Prob
Intercept 7.2985 0.00 13.4763 0.00 11.0530 0.00
OWN1 -0.0174 0.00
OWN1-2 -0.0374 0.00
OWN1-5 -0.03 0.00
LTA -0.0741 0.00 -0.4051 0.00 -0.2312 0.00
LOTA -2.70E-06 0.60 -1.13E-06 0.60 -2.45E-06 0.63
2
Adj R 0.09 0.05 0.09
Observation 2747 2332 2747
Panel C: Dependent variable: ROA
Model 1 Model 2 Model 3
Coef Prob Coef Prob Coef Prob
Intercept -5.3649 0.00 -6.1744 0.00 -4.2366 0.00
OWN1 0.0144 0.00
OWN1-2 0.0148 0.00
OWN1-5 0.0054 0.00
LTA 0.4598 0.00 0.5101 0.00 0.4078 0.00
LOTA -4.80E-06 0.83 -5.36E-07 0.88 3.76E-07 0.83
2
Adj R 0.32 0.34 0.13
Observation 2805 2326 2735
Notes: Dependent variables are capital adequacy ratio (CAR), standard deviation of return
on equity (SDROE), and return on assets (ROA). Independent variables are ownership
percentage held by the first largest shareholders (OWN1), the sum of ownership percentage
st nd
held by the 1 and 2 largest shareholder (OWN1-2), the sum of ownership percentage
held by the first until the fifth largest shareholders (OWN1-5), the logarithm of bank’s total
asset (LTA), loans to total assets ratio (LOTA).

As in any other Asian country, ownership in Indonesia is generally

still concentrated in the hands of a bank’s founding family. On average, the

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founding family still holds around 70% of their shares, leaving 30% for
public investors. The founding family places their people as commissioners
(we refer it as controlling commissioners, that is commissioners who
represent the interests of founding family) and also the bank’s managers.
Agency conflict between controlling and public investors, or in other words,
agency conflict between majority and minority shareholders, becomes more
serious than agency conflict between shareholders and managers.
The findings above seem to suggest that ownership concentration is
effective in controlling bank risk taking. Such effectiveness may be caused
by effective direct monitoring by shareholders, or may come from an
indirect cause. If shareholders are concentrated, then their stakes in the
banks are large, making them more conservative. Another possible reason
is that concentrated ownership may create more homogenous behavior.
Thus, shareholders may behave in very conservative or risky ways. In this
case, shareholders seem to be more conservative. 1 Our findings are not
consistent with the option pricing framework (Merton, 1977). That limited
liability creates incentive for stockholders to increase the risk of the firm by
increasing leverage has been widely noted (see Galai and Masulis, 1976
for example). In particular, to the extent that debt holders (depositors) can
only monitor and control stockholders' actions imperfectly and ex post,
stockholders can increase the value of their equity call options by
increasing the risk of the underlying assets of the bank (firm).
There are several possible reasons for this finding. Indonesian
shareholders may have limited diversification. In this situation, they become
risk averse. This argument is similar to that for bank managers. The risk
taking incentives of bank managers will depend on the degree to which
their best interests or preferences are tied to those of value-maximizing
stockholders. If managers' wealth is largely in a non diversifiable human
capital (bank-specific) form,2 they may act in a risk-averse rather than a
value-maximizing manner (see Kane, 1985 and Benston et al. 1986, in
which case their optimal degree of risk taking would be less than that
desired by stockholders).
While this explanation is possible, we have looked at another
potential explanation, which is indirect monitoring by a central bank (Bank
Indonesia, BI). Through concentrated ownership, the central bank may be
able to monitor banks more effectively. The task of the central bank in
monitoring banks is simplified by concentrated ownership. Thus it can
monitor fewer shareholders, making the monitoring more effective. Such
conjecture is not implausible. Conversations with bank analysts and central
banks officials reveal that Bank Indonesia has a policy of requiring banks to
declare controlling shareholders. The controlling shareholders will be held
responsible, should the bank fail. The responsibility is even beyond limited
liability.

1
We thank anonymous referee for suggesting this interpretation
2
For example, if they are fired, they could not find job in other banks or other companies

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Bank Indonesia moves aggressively in an effort to simplify bank

monitoring. In 2006, BI introduced Single Presence Policy, in which there is
a one to one relationship between banks and owners. One party can only
own one bank. In light of our findings, such a policy is plausible.
Nonetheless, the central message of our findings seems to be that there is
simpler and more effective monitoring through simpler bank ownership.

4.2. Results for Commissioners

4.2.1. Descriptive Statistics

For commissioners’ analysis, we focus on public banks. For public banks,

we can identify various types of commissioners, especially independent
commissioners. Our sample consists of 28 public banks, and covers the
period 2002-2008. Table 3 shows descriptive statistics for commissioners
and other variables used in this section.
Our sample shows that the mean number of commissioners is five.
This number is smaller than that reported for six OECD countries (Andres
and Vallelado, 2008) and that for US (Pathan, 2009). Andres and Vallelado
(2008) report that the average size of Board of Directors is 15, while Pathan
(2009) reports that the average size is around 13. This comparison needs
attention, however, since the board structure in Indonesia is different from
that of OECD countries. Indonesia uses a two tier board system, while US
and OECD countries use a one tier board system. Indonesia has a
commissioner board that supervises Directors, while US and OECD
countries have Boards of Directors that consist of inside (management) and
outside (non-management) members. The number of commissioners could
be expected to be less than that of Boards of Directors found in the one tier
system.

4.2.2. The Impact of Commissioners on Bank Risk

Table 4, Table 5, and Table 6 report results of the tests. In Table 4, we

have bank risk taking as the dependent variable. Bank risk taking is
measured by standard deviation of ROE. Table 5 reports regression that
uses CAR as the dependent variable. Table 6 reports regression that uses
ROA as the dependent variable. We also report the best specification for
each regression. Since we use pooled data, we report best specification,
either fixed, random, or both fixed and random specification for pooled
data. We also include non-linear specification by adding the variable of
commissioners squared.

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Table 3. Descriptive statistics for commissioners, bank risk, and

profitability
Obs. Bank Mean Median Max Min Std. Dev.
Dependent variables:
RISK 602 28 8.40 3.75 98.98 0.14 14.80
CAR 602 28 33.93 17.22 5049.71 8.08 209.51
ROA 602 28 1.83 1.92 24.61 -152.99 6.93
Independent variables:
COM 602 28 5 5 12 1 2
IC 602 28 0 0 3 0 1
CC 602 28 3 2 8 0 2
INDC 602 28 2 2 7 0 1
Controlling variables:
TA 602 28 35737 6337 303000 17.5 62458
LOTA 602 28 0.54 0.52 2.18 0.00 0.21
DEPO 602 28 0.74 0.80 1.73 0.00 0.20
Notes: RISK refers to standard deviation of four previous quarter ROEs; CAR is capital
adequacy ratio; ROA is return on assets; COM is the number of commissioners; IC is the
number of internally-hired commissioners; CC is the number of controlling commissioners;
INDC is the number of independent commissioners; TA is size of the bank (total assets in
billion Rupiah); LOTA is loan to total assets ratio; DEPO is deposits to total assets ratio.

Table 4 reports that the number of commissioners (COM) has

positive sign, suggesting that the larger the number of commissioners, the
more bank risk taking there is. When we include commissioner squared to
capture non-linearity, we find negative regression coefficients. Overall, the
number of commissioners has an inverted U-shaped effect on bank risk
taking. The number of commissioner increases bank risk taking, and to a
certain point, an increase in the number of commissioner will decrease
bank risk taking. We find that the turning point for the number of
commissioners is around six. Our findings seem to suggest that a large
number of commissioners results in larger power of bank managers. For
example, large numbers of commissioners tend to face more difficulty
maintaining effective coordination, hence reducing their power. Since the
managers tend to be more risk averse, larger numbers of commissioners
result in lower bank risk.

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Table 4. Regression results of commisioner on risk taking

Dependent Variable: RISK
Model A Model B Model C Model D
Coef. Prob. Coef. Prob. Coef. Prob. Coef. Prob.
Intercept -1.21 (0.82) 28.20 (0.37) 8.48 (0.00) 44.82 (0.14)
COM 4.57 (0.03) 4.85 (0.01)
2
COM -0.43 (0.01) -0.45 (0.01)
IC 1.76 (0.40) 2.03 (0.31)
2
IC -1.49 (0.03) -1.63 (0.02)
CC -1.61 (0.06) -1.55 (0.03)
2
CC 0.07 (0.44) 0.06 (0.60)
INDC 5.74 (0.01) 5.47 (0.01)
2
INDC -1.26 (0.01) -1.13 (0.02)
LTA -1.02 (0.59) -1.54 (0.42)
LOTA -11.27 (0.00) -9.58 (0.02)
DEPO -10.86 (0.05) -9.69 (0.09)
2
R 0.43 0.45 0.43 0.45
2
Adj R 0.38 0.40 0.38 0.39
Fixed Effects (Cross)
Included Included Included Included
Fixed Effects (Period)
Included Included Included Included
Method Pooled least Pooled least Pooled least Pooled least
squares squares squares squares
Notes: Dependent variable is RISK (standard deviation of return on equity). Independent
variables are: COM refers to number of commissioners in bank board of commissioners;
2
COM refers to square of number of commissioners; IC refers to number of internally-hired
2
commissioners; IC refers to square of number of internally-hired commissioners; CC refers
2
to number of controlling commissioners, CC refers to square of number of controlling
2
commissioners; INDC refers to number of independent commissioners; INDC refers to
square of number of independent commissioners; LTA refers to logarithm of bank’s total
asset; LOTA refers to loans to total assets ratio; DEPO refers to deposits to total assets
ratio. P-values are in parentheses.

Our findings seem to be consistent with those of Pathan (2009). He

shows that bank risk-taking is positively related to strong bank boards (i.e.
smaller boards and less restrictive boards) while it is negatively related to
CEO power. These results are consistent with the bank contracting
environment. Particularly, the results for strong boards indicate that if a
bank board better represents the bank shareholder’s interests, then there
will be greater bank risk-taking because shareholders have reasons to
prefer more risk being taken (e.g., Galai and Masulis, 1976; Jensen and
Meckling, 1976; Merton, 1977). Similarly, the CEO power results show that
if bank CEOs have more power or ability to force board decisions, then
their banks will exhibit less risk since bank managers (including CEOs)
have reason to be risk-averse (Smith and Stulz, 1985).

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Table 5. Regression results of commissioners on CAR

Dependent Variable: CAR
Model A Model B Model C Model D
Coef. Prob. Coef. Prob. Coef. Prob. Coef. Prob.
Intercept -87.5 (0.19) 165.8 (0.00) 40.64 (0.00) 171.7 (0.00)
COM 48.07 (0.06) 3.63 (0.00)
2
COM -3.36 (0.06) -0.21 (0.00)
IC -5.66 (0.00) -2.15 (0.12)
2
IC 1.97 (0.00) 1.89 (0.00)
CC 6.50 (0.00) 0.71 (0.22)
2
CC -0.92 (0.00) -0.06 (0.54)
INDC 1.05 (0.32) 2.00 (0.10)
2
INDC -0.49 (0.04) -0.11 (0.69)
LTA -7.45 (0.00) -7.31 (0.00)
LOTA -36.32 (0.00) -37.39 (0.00)
DEPO -10.69 (0.01) -11.83 (0.01)
2
R 0.21 0.67 0.96 0.74
2
Adj R 0.18 0.66 0.96 0.72
Fixed Effects (Cross)
Included Included Included Included
Method Pooled Least Pooled EGLS Pooled EGLS Pooled EGLS
Squares (Cross-section (Cross-section (Cross-section
weights) weights) weights)
Notes: Dependent variable is CAR (capital adequacy ratio). Independent variables are:
2
COM refers to number of commissioners in bank board of commissioners; COM refers to
square of number of commissioners; IC refers to number of internally-hired commissioners;
2
IC refers to square of number of internally-hired commissioners; CC refers to number of
2
controlling commissioners, CC refers to square of number of controlling commissioners;
2
INDC refers to number of independent commissioners; INDC refers to square of number of
independent commissioners; LTA refers to logarithm of bank’s total asset; LOTA refers to
loans to total assets ratio; DEPO refers to deposits to total assets ratio. P-values are in
parentheses.

Interestingly we find a different pattern for capital adequacy ratio

(CAR) in Table 5. Given an inverted U-shape pattern for bank risk taking
found in Table 4, we expect to have a U-shape pattern for CAR in Table 5.
It turns out that the pattern for CAR is an inverted U-shape, which is similar
to that for bank risk taking. One possible explanation for this finding is that
the lower standard deviation reflects lower bank risk. Since the bank incurs
lower risk, the bank needs less capital to cover bank risk. Thus lower CAR
seems to reflect lower bank risk rather than more a conservative preference
of the bank.

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Table 6. Regression results of commissioners on bank profitability

Dependent Variable: ROA
Model A Model B Model C Model D
Coef. Prob. Coef. Prob. Coef. Prob. Coef. Prob.
Constant 2.42 (0.00) 3.94 (0.00) 1.90 (0.00) 3.80 (0.00)
COM -0.31 (0.00) -0.21 (0.05)
2
COM 0.03 (0.00) 0.02 (0.04)
IC -0.41 (0.03) -0.49 (0.00)
2
IC 0.09 (0.15) 0.10 (0.04)
CC -0.21 (0.00) -0.11 (0.18)
2
CC 0.03 (0.00) 0.02 (0.02)
INDC 0.20 (0.05) 0.19 (0.06)
2
INDC -0.05 (0.04) -0.04 (0.07)
LTA -0.06 (0.46) -0.09 (0.25)
LOTA 1.38 (0.00) 1.58 (0.00)
DEPO -1.89 (0.00) -1.94 (0.00)
2
R 0.80 0.83 0.81 0.844
2
Adj R 0.79 0.82 0.80 0.835
Fixed Effects (Cross)
Included Included Included Included
Method Pooled EGLS Pooled EGLS Pooled EGLS Pooled EGLS
(Cross-section (Cross-section (Cross-section (Cross-section
weights) weights) weights) weights)
Notes: Dependent variable is ROA (return on assets ratio). Independent variables are: COM
2
refers to number of commissioners in bank board of commissioners; COM refers to square
2
of number of commissioners; IC refers to number of internally-hired commissioners; IC
refers to square of number of internally-hired commissioners; CC refers to number of
2
controlling commissioners, CC refers to square of number of controlling commissioners;
2
INDC refers to number of independent commissioners; INDC refers to square of number of
independent commissioners; LTA refers to logarithm of bank’s total asset; LOTA refers to
loans to total assets ratio; DEPO refers to deposits to total assets ratio. P-values are in
parentheses.

In Table 6, we find a U-shaped pattern for the effect of

commissioners on bank profitability. An increase in the number of
commissioners reduces bank profitability up to certain point. Beyond this
point, an increase in number of commissioners improves bank profitability.
This finding seems to be inconsistent with the finding for bank risk in Table
4. Given an-inverted U shape relationship between number of
commissioners and bank risk, the ‘law’ of positive relationship between risk
and return would predict an inverted U-shape relationship between number
of commissioners and bank profitability. However, our finding may suggest

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that banks are successful in choosing low risk debtors. Banks incur low
losses from bad debt, and increase their profits.3
This finding is not consistent with that of Andres and Vallelado
(2008) who find an inverted U-shape for the effect of board size on banks’
performance as measured by Tobin’s Q. Using a sample of large
international commercial banks to test hypotheses on the dual role of
boards of directors, and using a suitable econometric model (two step
system estimator) to solve the well-known endogeneity problem in
corporate governance literature, they find an inverted U-shaped relation
between bank performance and board size, and between the proportion of
non-executive directors and performance. Their results show that bank
board composition and size are related to directors’ ability to monitor and
advise management, and that larger and not excessively independent
board might prove more efficient in the monitoring and advising functions,
and create more value.
Different types of commissioners seem to have different impacts on
bank risk taking. For example, while the impacts of total commissioners on
bank risk (RISK) and CAR take an inverted U-shapes, the impacts of
controlling commissioners on bank risk taking (RISK) show non-U shapes
and on CAR show U-shapes. Controlling commissioners seem to better
represent controlling shareholders, who, like shareholders in general, prefer
higher risk taking. Since controlling commissioners are appointed by
controlling shareholders directly, large numbers of controlling
commissioners show more power than small numbers. The problem of lack
of coordination in large commissioners found in the literature may not apply
in the case of controlling commissioners. However the patterns of the
impact of different types of commissioners on other bank risk variables are
still ambiguous.

5. Conclusion

This study investigated risk taking and governance in Indonesian banking.

More specifically, we investigated the effect of ownership concentration and
commissioners on bank risk taking and profitability. For ownership data we
used 117 Indonesian banks in the period 2002-2008. For commissioners’
data, since we wanted to investigate the effect of independent
commissioners which were available only for public companies, we
restricted our sample to only to 28 public banks. We also collected financial
data from quarterly bank balance sheets and income statements for
Indonesian banks between 2002 and 2008.
Our empirical findings show that ownership concentration improves
bank risk taking and profitability. Ownership concentration reduces bank
risk taking (represented by standard deviation of return on equity),
increases capital adequacy ratio (CAR), and increases bank return on
assets (ROA). When we investigated the effect of commissioners, our

3
We thank anonymous referee for this interpretation.

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empirical findings showed that the effect of commissioners on bank risk

taking (RISK) has an inverted U shape. This pattern also holds for capital
adequacy ratio (CAR). We also found that commissioners have an effect on
bank profitability (ROA) in a U-shape pattern. Large commissioners seem
to increase the power of bank managers. Since bank managers tend to be
risk averse, large commissioners tend to reduce bank risks. Lower bank
risks tend to improve banks’ profitability. We have shown that the impacts
of different types of commissioners are not homogenous, although the
impacts need further study.
Our findings show that ownership concentration and number of
commissioners are significant components of bank governance, even in
country with different governance setting. As discussed earlier, Indonesia is
noted by a two-tier system and a more serious agency conflict between
majority and minority (public) shareholders. We believe that our findings
have various policy implications. Firstly, regulators should always devise
optimal mechanism to improve shareholders and commissioners monitoring
on bank risk taking. Thus, simpler shareholders such as few shareholders
may be better for more effective bank monitoring. Secondly, aside from size
and duality dimensions of board of directors discussed in current literature,
we show that different types of commissioners have impacts on bank risk.
We believe that future research could explore the effect of additional
dimensions of board of directors, such as various types of commissioners
discussed in this paper, on bank risk. Regulators should consider a more
complex composition of board of directors that may have impacts on bank
risk.

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