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Tuesday, May 18, 2021

RBI proposal on capping bank CEO tenure is not supported by any cogent evidence

It may be prudent for the RBI to publish an empirical study on the impact of CEO tenure on bank performance before translating this proposal into an enforceable regulation.

Written by Pratik Datta |
Updated: July 31, 2020 9:58:34 am
Bank governance seeks to curb such excessive risk-taking. (File Photo)

Last month, the Reserve Bank of India released a discussion paper on governance in commercial banks in India. The apparent objective is to align the current regulatory framework with global best practices while being mindful of the context of the domestic financial system. However, the proposal to cap the tenure of a bank CEO needs to be supported by adequate empirical evidence rooted in Indian realities.

The paper proposes to cap the maximum tenure of a promoter/major shareholder of a bank as a CEO or a Whole Time Director (WTD) at 10 years. The rationale offered is that 10 years is an adequate period for a promoter/major shareholder of a bank as CEO/WTD to stabilise its operations and to transition the managerial leadership to a professional management. The corresponding limit for a CEO who is not a promoter/major shareholder is 15 consecutive years. Thereafter, that individual is eligible for re-appointment as CEO or WTD only after the expiration of three years.

Ordinary corporate governance norms exhort managers to run a company in the interest of shareholders. Global experience suggests that this approach may not be suitable for all types of banks. First, banks are highly leveraged, creating powerful incentives for shareholders to engage in risky strategies at great risk to creditors, including retail depositors. Second, bank failure could involve systemic risk, which could result in a government bail-out. This moral hazard creates even more high-powered incentives for shareholders to engage in risky strategies. Third, financial assets held by a bank are hard to monitor and measure. Consequently, external scrutiny of a bank by depositors and creditors, among others, is difficult. Overall, these unique factors are likely to encourage bank managers to take excessive risks to maximise shareholder value.

Bank governance seeks to curb such excessive risk-taking. It encourages prudent risk-taking by bank managers such that shareholders’ interests are secondary to depositors’ interests. This is the main logic for regulating the banks’ board structure and managerial compensation, as suggested in the Basel Committee on Banking Supervision guidelines and the Financial Stability Board principles respectively. From this perspective, it is unclear whether imposing a maximum cap on CEO tenure to separate ownership from management would encourage prudent risk-taking by the management.

Research suggests that CEO tenure could have important implications for corporate performance. This is because the managers’ decision horizons are usually shorter than the investment horizons of other corporate stakeholders, which may encourage myopic decisions by a CEO.

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For Indian banks, the limited empirical evidence seems to suggest that bank performance improves with increasing CEO tenure. For instance, a paper by Jayati Sarkar and Subrata Sarkar (2018), published in International Journal of Financial Studies, examines whether board governance structures (including CEO tenure) impact the performance of Indian state-owned and private commercial banks both in terms of asset quality and profitability. It uses a sample of 25 state-owned banks, 14 old private banks and seven new private banks for a period of 12 years from 2000 to 2012.

The paper finds that an increase in CEO tenure is associated with significant improvements in asset quality with an accompanying increase in the overall performance of the bank. Moreover, the effect of CEO tenure increases rapidly with the year of CEO tenure. Consequently, the later years of a CEO’s tenure are more effective than the initial years in affecting bank outcomes. Further, CEO tenure effects are stronger in private banks, both old and new. These findings seem to be at odds with RBI’s suggestion to cap CEO tenure.

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Concerning public sector banks (PSBs), the P J Nayak Committee report had identified shorter tenure of chairmen and executive directors as a key reason for weaker empowerment of their boards. This conclusion was based on a working paper from ISB-Hyderabad authored by Krishnamurthy Subramanium, Arkodipta Sarkar and Prasanna Tantri (2014). This paper argues that an incoming CEO in a PSB is likely to be wary about the quality of bank assets during his predecessor’s tenure. Given the threat of prosecution, the incoming CEO is unlikely to lend until he understands and obtains full information about the bank’s existing assets. Accordingly, the paper finds that the quarter in which a new CEO takes charge, market-adjusted lending declines by 1.7 per cent and the stock price also falls by 1.1 per cent. In such circumstances, a shorter tenure creates incentives for the incoming CEO to engage in earnings management to present an overtly positive view of the bank’s business and financial position. In contrast, CEOs with longer tenure have lower incentives to engage in earnings management. Although these findings do not apply to private banks, they seem to suggest a case for a minimum CEO tenure but not maximum CEO tenure.

To clarify, this is not to suggest that the proposal on CEO tenure cap in the RBI paper is incorrect. What is merely being highlighted is that the proposal does not appear to be supported by any cogent evidence, empirical or otherwise, which is available in the public domain. This assumes significance in light of the recent decision of the Supreme Court in Internet & Mobile Association of India (IAMAI) v. RBI. In this case, the Court struck down an RBI circular prohibiting dealing or settling in virtual currencies on the ground that RBI did not adduce any cogent evidence of the likely harm that its circular sought to address. While there is no direct parallel that can be drawn, it may be prudent for the RBI to publish an empirical study on the impact of CEO tenure on bank performance before translating this proposal into an enforceable regulation.

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This article first appeared in the print edition on July 31, 2020 under the title ‘Short may not be sweet’. The writer is senior research fellow at Shardul Amarchand Mangaldas & Co., New Delhi. Views are personal. The author acknowledges useful discussions with Veena Sivaramakrishnan.

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