Effect of Proactive and Reactive Outside Directors’ Behavior on Banks’ Financial Performance

Abstract

The board of directors plays a significant role in monitoring and advising managers. Board of directors are usually consisted of inside directors and outside directors. Inside directors are defined to be all employee directors, whereas outside directors are defined to be all non-employee directors (Beasley, 1996). Fama and Jensen (1983) argue that outside directors have strong incentive to monitor managers effectively in agency settings and not to collude with top managers to expropriate stockholder wealth. In addition, Weisbach (1988) argues that outside directors pay great attention to firm’s financial performance by replacing poor performing chief executive officers. In this study, we examine the influence of proactive and reactive outside directors’ behavior on banks’ financial performance in the Korean banking industry. We define proactive outside directors’ behavior as the board meeting attendance ratio by outside directors and reactive outside directors’ behavior as the board meeting frequency. We use non-performing loans (so-called bad loans) to measure banks’ financial performance (Barseghyan, 2010) because non-performing loans are the most common proxy to measure banks’ financial performance and the most common reason why banks fail (Beattie et al., 1995). We hypothesize that not all outside directors’ behavior would play a major role in improving banks’ financial performance. Results of this study indicate that only proactive outside directors’ behavior significantly improves banks’ financial performance, whereas reactive outside directors’ behavior does not play a significant role in improving banks’ financial performance. Overall, results of this study suggest that proactive outside directors’ behavior is an important dimension of improving banks’ financial performance, but not reactive board behavior. In addition, this study contributes to bank literature by examining the effect of outside directors’ behavior on non-performing loans.