ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846
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Corporate Governance in Banks in India

Rekha Misra (rekhamisra@rbi.org.in) is the director and Anwesha Das (ecowesha@yahoo.co.in) is a researcher at the Department of Economic Policy and Research, Reserve Bank of India.

 

While several committees have examined and suggested ways to improve corporate governance in banks in India, this study makes an attempt to prepare a benchmark index for the board composition aspect of corporate governance. A comparison between the indices for public sector banks with private sector banks reveals that differences in governance structures cannot be explained fully in terms of ownership only. This is a welcome feature, as with some efforts on the part of the majority shareholder, corporate governance in all the banks can be brought on par with the best-performing bank, by ensuring greater compliance with corporate governance benchmarks.

 

The views expressed in the article are personal and do not represent the views of the authors’ institution.
 

The link between efficiency and good corporate governance has been in focus in recent times. Good corporate governance structures encourage companies to provide accountability and set in place control systems. A fundamental reason why corporate governance has moved onto the economic and political agenda worldwide has been the rapid growth in international capital markets. Effective corporate governance enhances access to external financing by firms, leading to greater investment, higher growth and employment. Investors look to place their funds where the standards of disclosure, of timely and accurate financial reporting, and of equal treatment of all shareholders are met. Good corporate governance improves the credibility of firms, mitigates discord between different stakeholders, reduces legal costs and improves management–labour relationships in the process.

India has a bank-based financial system and banks form the fulcrum of the financial system. While banks finance firms, they themselves need to be financed and have to attract investors. Given the predominance of banks and the significance of good corporate governance practices in enhancing the credibility of institutions, it is relevant to study corporate governance in banks in India. Against this backdrop, this study aims to analyse corporate governance in the major public sector banks (PSBs) and private sector banks (PVBs) in the country. This analysis is based on the computation of a benchmark index and the calculation of a corporate governance index on the basis of this benchmark index. Accordingly, the study is organised thus. The following section provides the genesis and tenets of corporate governance. Existing literature on corporate governance is briefly discussed thereafter. Further, the methodology for computing corporate governance index is discussed, following which are the details of index for PSBs and PVBs along with the validation and concluding observations.

Genesis and Tenets of Corporate Governance

According to the Sarbanes-Oxley Act of 2002, corporate governance is a framework of rules and practices by which a board of directors ensures accountability, fairness and transparency in a company’s relationship with all stakeholders. The genesis of corporate governance can be traced to the East India Company which had a board known as Court of Directors and its structure was very similar to the modern-day board of directors. Since its genesis, basic governance issues have been those of power and accountability. The power structure in the corporate system, its exercise and the degree of accountability are very crucial. The relationship between these three determines the extent of agency problem in a modern corporation. Adam Smith (1776–89) drew attention to the agency problem in The Wealth of Nations. The agency problem is inherent in the relationship between the providers of capital and their agents who put that capital to use, that is, between shareholders and boards. The structure and composition of boards, the requirements for disclosure, and the balance of power between shareholders and directors have a strong bearing on the resolution/persistence of agency problem.

The independence of a board is a very important element for the resolution of the agency problem. The board performs two important functions, which are providing resources and monitoring. However, the desired characteristics of the outside board members are different for a board focusing on monitoring, compared to a board focusing on providing resources. It is the non-affiliated outside directors—usually termed as independent directors—who are expected to perform both the monitoring role on behalf of the shareholders, as well as the resourcing role for the firms. In the world of corporate governance, it is often observed that the number of independent/outsider directors required by law is contingent on the presence/absence of a promoter on the board. Where promoters sit as chairpersons or managing directors on the boards of the banks, insider control is further enhanced due to management control by insiders. As the separation of decision-making from shareholders to the board may yield results detrimental to the shareholders, for the shareholders’ rights to hold, it becomes important for shareholders to be able to appoint/remove/have some representation on the board.

Promoters, when they also own a major stake in the firm, have an incentive to monitor the management to increase their share value and may help the minority shareholders. However, the interests of minority shareholders need to be safeguarded, where the interests of the controlling shareholders may overshadow their interests. Large shareholders have the voting power necessary to safeguard the value of their investments. Unlike small shareholders, they can easily accumulate their votes together. They also incur lower costs of monitoring, as they can pool their resources to span a large scale of their investments. This is the basic premise of the “efficient monitoring hypothesis” propounded in literature (Fama and Jensen 1983; Jensen and Meckling 1976).

Firms with controlling shareholders face a two-level agency problem: between controlling shareholders and management and between minority shareholders and controlling shareholders. The problem between controlling shareholders and minority shareholders will be less severe if either outside independent directors are abundantly present on the board, or the management is independent from the controlling shareholders. From the foregoing, it can be concluded that one of the most important tenets of corporate governance is the composition of the board and its effectiveness.

Effective Corporate Governance

The composition of the board is critical in determining its effectiveness. E Fama (1980) posits that the presence of non-executive directors on a board represents a means of monitoring the actions of the executive directors and ensures that the interests of the executive directors are consistent with the interests of the shareholders. The relationship between firm performance and board independence varies depending on the context in which the firm is operating. For instance, T Randøy and J I Jenssen (2004) argue that firms in highly competitive industries will already be “monitored” by the market and therefore need fewer outside board members. Such companies need stronger inside resource links.

Existing empirical studies show mixed results regarding the relationship between firm performance and board independence (for example, Dalton et al 1998; Dulewicz and Herbert 2004; Peng 2004; Weisbach and Hermalin 2003). Some scholars argue that a supermajority of independent directors will lead to worse performance (Bhagat and Black 1999). Firms may strategically comply with the institutional demands for more outside directors, while subtly limiting the independence of the board. Various tactics may be employed to neutralise the independence of members. For example, by appointing outside directors who are demographically similar, and therefore more sympathetic to chief executive officers (CEOs) (Westphal and Zajac 1995). The CEOs may also appoint directors with an experience on other passive boards (Zajac and Westphal 1996). Alternatively, CEOs may appoint individuals from strategically irrelevant backgrounds to discourage effective participation in strategic decision-making (Carpenter and Westphal 2001).

Besides the composition of the board, the skill set of the board members is equally important. A Hillman et al (2000) discuss that there is a need to look at skills distinct from monitoring. A varied skill set is also important. B Boyd (1990) argued that good governance is achieved when board members are appointed for their expertise to help firms successfully cope with environmental uncertainty. Researchers have also focused on the impact of duality (CEO as the chairperson of the board) on the effectiveness of the board. The results of research are ambiguous (Finegold et al 2007). There is a negative relationship between duality and firm performance when the board focuses on monitoring, and vice versa when the board focuses on providing resources. From the foregoing, it is evident that the researchers have focused on various aspects of corporate governance, with relation to the composition of board, role of independent directors, skill sets of board members and also duality. However, the desirability or not of each of these attributes depends on the environment in which the institution functions.

Methodology and Rationale

Corporate governance in Indian banks has attracted attention especially after the P J Nayak Committee (2014) which analysed the governance structure in Indian PSBs. PSBs account for around 75% of the total assets of scheduled commercial banks (SCBs) in India. However, in recent years, PSBs are losing their share to PVBs. India has already moved towards a differentiated banking regime. Now, licences for scheduled PVBs are also freely available. With these developments, it is very important to analyse the corporate governance in SCBs in India and also whether there is any difference in the corporate governance of PSBs and PVBs.

As is evident from the discussion earlier, board composition, its independence and effectiveness are the most important parameters of corporate governance. This study aims to analyse corporate governance in Indian banks on the basis of these parameters. The methodology adopted for preparation of the benchmark index is a combination of the legal requirements, along with guidance available in literature for variables where legal requirements are not spelt out. The constituents which determine the effectiveness of the board are: independence of the board, the qualification/diversity of the board, presence of promoters in the board, evaluation and duality, that is, whether the chairperson and managing director are one or separate.

The product markets in which PSBs and PVBs operate differ in their competitiveness. The former (playing dominantly in the infrastructure and utilities segment) is an oligopolistic market. The latter operates in more generic and hence more competitive markets. Requirements to make corporate governance effective should vary accordingly between these two bank groups. The benchmark index has been calculated separately for PSBs and PVBs. The article endeavours to measure the quality of corporate governance by a distance to frontier approach. As mentioned before, corporate governance in PSBs and PVBs in India are practised according to certain laws. The underlying assumption is that the provisions laid down by laws have certain merit to them.

The legal guidelines have been customised to suit the indigenous evolution of the structure and functions of the banking system in India. For instance, the Banking Acquisition Act, 2005 that carries corporate governance guidelines for the PSBs, posits that the board be representative of all its stakeholder groups, along with outsider directors with auditing experience. This goes with the egalitarian outlook that is a part and parcel of the aims and objectives of the PSBs. Similarly, the detailed guidelines on the number of independent directors that the Companies Act, 2013 spells out for the PVBs are a cautionary move to protect the bank and its dispersed shareholders from the promoters, who, according to economic theory, would be guided by self-interest rather than shareholders’ welfare. In the case of PSBs, the listing agreements of the Securities and Exchange Board of India (SEBI) that are prepared for the purpose of ensuring sound corporate governance of listed companies, come only second to the Banking Companies (Acquisition and Transfer of Undertakings) Act (BCA), 2005 and the Nationalised Banks (Management and Miscellaneous Provisions) Scheme, 1970, State Bank of India (SBI) Act, 1955 and the guidelines issued by the Reserve Bank of India (RBI) in this regard.

Having set the existing legal framework to be the benchmark form of corporate governance to be followed, both in form and in principle, we proceed to capture how far our banks stand from this frontier. To calculate the corporate governance index for PSBs, we have considered seven major PSBs accounting for around two-thirds of the total assets of PSBs. The PVBs which form the sample for this study account for around three-fourths of the total assets of PVBs. All figures are as of March 2015.

Public Sector Banks

The attributes that make for an effective board of a PSB are outlined below. The maximum score allocated to each attribute is 10.

Size of the board: One strand of thought in literature is that it takes more compromises for a larger board to reach consensus, even though decisions of larger boards may be less extreme, leading to less variable corporate performance (Lipton and Lorsch 1992). M Jensen (1993) even puts a specific limit on board size with his finding that firms with a board size greater than seven or eight members function inefficiently. He attributes it to the ease it offers to CEOs who want to control and manipulate the board. Boards can be large based on the resource dependency theory. However, with a very large board size, the advisory function is weakened because of poor communication and decision-making. On the other hand, proponents supporting a larger board size argue that with a large board, the firm has a larger pool of expertise which helps improve strategic decision-making (Pearce and Zahra 1992).

The board size of PSBs follows from law. As per the BCA, the central government shall, in consultation with the RBI, constitute the first board of directors of a corresponding new bank, consisting of not more than seven persons. The board size thereafter would be nine members. Of these, not more than four whole-time directors are to be appointed by the central government after consultation with the RBI. One director would be from among those employees who are workers under the clause(s) of Section 2 of the Industrial Disputes Act, 1947 (14 of 1947), to be nominated by the central government in such a manner as may be specified in a scheme made under this section.

One director, from among the employees who are not workers under the clause(s) of Section 2 of the Industrial Disputes Act, 1947 (14 of 1947), is to be nominated by the central government after consultation with the RBI. The act also specifies the number of directors to be elected by the shareholders, depending on the capital issued under clause (c) of sub-section (2B) of Section 3: (i) one director if it is not more than 16% of the total paid-up capital (PUC); (ii) two directors if it is more than 16% but not more than 32% of the total PUC and (iii) three directors if it is more than 32% of the total PUC, to be elected by the shareholders, other than the central government, from amongst themselves.

The BCA allows for a board size of 11.1 This is after taking the upper limit of the number of whole-time executive directors allowed and the medium range of PUC issued that year (more than 16% but not more than 32% of the total PUC).2 The range dictates the number of shareholder directors required to be included in the board and the highest range is that of more than 32%. In the index construction, the PSBs are penalised if they fall short of the board size that they are required to maintain by law and by their ownership pattern. The penalty is allotted such that for every two members that the board falls short of the score reduces by one.

Composition of the board: Board independence should be higher for PSBs than PVBs for greater focus on the monitoring function. Large shareholders typically enjoy substantial representation on the board either directly or indirectly. By virtue of this representation, they are able to affect their desired level of monitoring. They are helped in this process by access to better quality of information and the management. Minority shareholders have less influence on the decisions of the board when compared to large shareholders. This is why, in the case of majority shareholder-owned PSBs, the presence of an outside monitor benefits the minority shareholders.

In India, Section 149(6) of the Companies Act, 2013 defines an independent director to mean a director other than a managing director or a whole-time director or a nominee director who conforms to the criteria mentioned therein. The amended Clause 49 of the Listing Agreement defines an independent director to mean a non-executive director, other than a nominee director, who possesses certain criteria, which have been elaborated in the agreement and which are mostly similar to those laid down under the act and the rules. PSBs are corporations established under the Nationalised Banks (Management and Miscellaneous) Scheme, 1970. The Companies Act, 2013 does not apply to them.3

PSBs often deem the shareholder directors and nominee directors as independent directors. For instance, where superseding laws clash with Clause 49 regulations, as per the former, PSB boards keep shareholder directors and nominee directors on their board and qualify them as independent directors. However, in the light of the agency problem (majority–minority shareholder) faced by PSBs, and given the ambiguity regarding the true independence of directors nominated by the majority shareholders, only shareholder directors are considered independent directors in the context of PSBs.4 The law stipulates the number of shareholder directors to be held on the board of a PSB based on the extent of non-promoter shareholding in the PSB.

Following from above, the next attribute is whether the number of shareholder directors are in tandem with the level of paid-up capital issued at the time. If a PSB falls short of the level of minority shareholder representation that the law finds appropriate for protecting the majority–minority agency problem, then the bank is penalised such that we subtract from the maximum score of 10, an amount that is calculated by applying the fraction of required shareholder directors missing among total shareholder directors required, to the total score of 10.5 One measure of the effectiveness of corporate governance in PSBs is the extent to which the minority shareholders are able to influence important corporate decisions. Of these decisions, the minority shareholders have no say as to the appointment and removal of majority of board members for most listed PSBs. Minority shareholders have representation on the board and are privy to the board’s decisions. But given their minority status, they are not in a position to resist any decision with their votes and methods. For example, cumulative voting can bring outside block-holders and dispersed shareholders together to counter the majority shareholders in any decision, is not practised in India.

Presence of insider directors: While minority shareholder directors are outsider directors, the boards of PSBs are dominated more by insider directors, including executive directors, employee representatives, and the nominee directors (who are considered as insider directors by SEBI’s Clause 49 for state-owned enterprises [SoEs]). The stewardship theory of corporate governance suggests that more insider directors can guide a firm better through strong inside resource links when the markets for the firm’s products are highly competitive. The PSBs face competition in offering some of their banking services and products from their private sector counterparts. Also, SoEs have to be accountable for how all their stakeholders fare and from that end, the law requires representation of employees at various levels on the board of the banks.

The scoring is done as follows: the nominee directors are counted out because they are a constant for all banks. The number of insider directors are then calculated as a percentage of the total number of directors. The optimum percentage is arrived at by taking one worker, one non-worker employee director and three whole-time executive directors.6 While the law allows at the most four whole-time/executive directors, considering that they are all appointees of the controlling shareholder, the majority–minority agency problem will be more balanced if a bank instead of having all the four, leaves enough room for representative directors of other stakeholders. Keeping the stewardship theory in mind, we believe three, including the CEO, to be an optimum number. If the percentage thus calculated for each of the banks goes above this optimum percentage, and so does the optimum share of executive director group of insiders, the score is cut by two points. That is, if any one of the percentages is broached, the score gets cut by one point. In addition, for each type of employee representatives missing from the board, the score gets reduced by one point.

Presence of duality: For PSBs, the shareholding pattern is such that majority shareholders have controlling rights, leaving the minority shareholders with not much ability to effectively monitor instances where the interests of the controlling shareholder are aligned with the interests of the management but misaligned with their interests. Thus, there is a need to shield the board from the management, who are at present, in essence, appointees of the controlling shareholder, to enable such monitoring. This is the rationale behind not wanting the CEO to be the chairperson of the board of directors.7 Literature also finds a negative relationship between duality and firm performance when a major function of the board is monitoring (Finkelstein and D’Aveni 1994; Rashid 2010). Accordingly, the presence of duality is penalised with a score cut of 50%.8 The score gets cut by 100% only for banks which follow the more dispersed-shareholder-oriented Companies Act, 2013 for the appointment of their board members. This is because a non-dual set-up may bring more positive change in the functioning of the board of these banks.

Diversity of the board: The need for the monitoring function also dictates a certain kind of qualification to dominate the board’s expertise spectrum. Keeping this in mind, the board has been scored based on the presence of a sufficient number of outside directors with financial expertise. However, it is not to be overlooked that banks, even under the state mandate, need to cater to financial needs across a certain cross section of the economy. Thus, comprehending the need for minimum variation in the field of expertise of outside directors, while acknowledging the importance of having outside directors who are qualified in financial accounting, such directors should form at least one half of all outside directors. The score cut here follows the same logic as with the shareholder director numbers on the board.

There are, however, some bank-specific calls that deviate from theory in non-systematic ways. There are banks with no outsider directors at all but with single chartered accountants who are nominated by the controller shareholder and there are banks where the financial expertise is at or above the desired level, but the board lacks other variations in expertise. Since the absence of outsider directors is already penalised in the shareholder director section, the former group of banks are penalised based on how many more financial experts should have been present even if nominated, such that some semblance of the monitoring function can be pursued. The latter group of banks only get a score cut of one because of the lack of other expertise on the board.

Evaluation of board: A consultative report prepared by the Deloitte Group (2014: 3) lists the performance goals of a board and defines board evaluation as follows:

The Board performs three major roles in a company—sets the strategic direction of the company, monitors the management and provides support and advice. Board evaluation typically examines these roles and the entailing responsibilities. Board evaluation is an annual exercise by choice or by regulatory prescription.

Before SEBI amended its Clause 49 in 2014, board evaluation was not a binding requirement for listed companies in India. As per the Deloitte Group (2014), in companies that had been pursuing the practice of board evaluation, despite it not being part of the law, evaluation was usually led by the chairperson. As per the Companies Act, 2013, with effect from 1 October 2014, it is now mandatory for every listed company to have a formal annual performance evaluation of their board, its committees and individual directors. The act does not lay down the exact methodology of evaluation. The revised Clause 49 attempts that to some extent. Both however relegate the evaluation function to the Nomination and Remuneration Committee (NRC). For the sake of objectivity, it is believed that evaluation should be facilitated by external experts rather than internal ones. The law does not refrain the NRC from incorporating external experts. The independent directors in effect act as the external experts and such a committee should ideally be comprised of only such directors.

The Companies Act, 2013 provides a code for independent directors to follow in the process of board evaluation. It has been summarised by the Deloitte Group (2014: 8) as follows:

The independent directors are required to hold at least one meeting in a year, without the attendance of non-independent directors and members of the management where they are required to review the performance of the non-independent directors and the Board as whole; and also review the performance of the Chairperson of the company, taking into account the views of the executive and non-executive directors … The performance evaluation of the independent directors would have to be done by the entire Board excluding the director to be evaluated and the continuance or extension of the independent director would be determined by the performance evaluation report.

The Companies Act further requires companies to disclose the steps followed in board evaluation.

With respect to PSBs, the Government of India has prescribed board evaluation only to the extent that incentives for the whole-time directors of PSBs can be decided upon.9 Given that the legal framework that can shape an effective mechanism for board evaluation is still evolving, more standard measures practised globally were looked at for constructing the benchmark. In this context, it is important that a clear methodology for conducting the evaluation is spelled out (i) to evaluate all individual directors as well as the whole board, (ii) to have a defined technique of evaluation such as peer review, validation of individual level observations with board level observations, (iii) to define a way of collecting information—questionnaires, interviews, etc. Qualitative inputs are richer and individual interviews may form a part of it. Some of the popular methods adopted internationally quantify them with the help of questionnaires using a rating scale for responses, (iv) to have a designated committee, preferably of independent experts, to carry out the evaluation, and (v) to disclose the results of the evaluation and take it to a logical conclusion. Each of these five attributes carries two points and a bank’s score is deducted according to the number of attributes of the benchmark evaluation method that it fails to meet.

Once the scores are thus computed, the board composition attributes are summed up to form an aggregate score. All attributes are given equal weights. This is to avoid random judgments on one attribute with respect to others. Techniques like principal components analysis are often employed to derive weights of attributes. These require a large data set. Since we in this article make an attempt to cull out information on some dimensions of governance that are not readily available in the usual databases used in literature, we do not at this stage have that expanse of data.

But it should be noted that the literature also widely uses unweighted indices for index construction (Cooke 1989; Hossain and Hammami 2009). The board composition index (BCI) for each bank is then calculated as its score as a percentage of the maximum score. If some single bank had been taken as a benchmark model and its score taken as the maximum score for the calculation of the index, then changes in the governance mechanism of a bank over time would only be captured in as far as its deviation from this model bank changed over time. The index constructed as above takes care of this and the evolution of the quality of governance of a bank is measured simply on its own merit.

Components of index of effectiveness of board: Based on the benchmarks outlined above and on the data available in the annual reports and other sources like the Prowess database and banks’ websites, the composite index for the effectiveness of the board for each of the banks was constructed (Table 1).

From the above it is evident that there is wide variation in the composite corporate governance index even within the PSBs, with a difference of almost 30 points between the highest and the lowest ranked bank. This result proves that even with similar ownership structure, the corporate governance index may vary sharply within a group, as the determinants of corporate governance go beyond plain ownership.

Private Sector Banks

Size of the board: The Companies Act, 2013, under which the PVBs operate, allows for a maximum board size of 15. The PVBs in India follow the profitable segments of the market. They are not shielded from the vagaries of the market by implicit guarantees. Thus, for PVBs, markets act as an effective external monitor. The board of directors in PVBs should then strive to fulfil the resource dependency theory of corporate governance stated above, wherein, despite the possibility of problems in reaching a consensus, some space needs to be made on the board for a variety of external experts. Following from this, the benchmark size is set, not at the maximum that the law deems fit, but at the median board size for our group of banks, keeping faith in the guidance provided by the market. If a bank lies within the benchmark, they get a full score at this point for this attribute.10 If they overshoot it, their score gets cut by the extent that they overshoot the benchmark.

Presence of independent directors: The markets may well be an external monitor for the PVBs, but they may not be able to detect fast enough the differential benefits accruing to the board. The law takes care of this by providing for internal monitoring. For PVBs, the law prescribes the requirement of independent directors, depending on the extent of influence the insiders and promoters exert on the board. The presence of an executive or promoter chairperson warranties that one-half of the board be comprised of independent directors, as opposed to one-third of the board which is required otherwise. If the PVBs meet these criteria, they get a full score. All PVBs meet these criteria. However, they tend to overshoot this benchmark. As cautioned in literature above, for PVBs that operate in fairly competitive markets, this may result in the resource dependency theory overshadowing the stewardship theory of having some insider guidance. Thus, going over and above the number proposed by law is considered negative. The banks get a score cut by the number by which they exceed the benchmark in this regard.

Direct ownership of promoters: The next measure is the level of direct ownership of promoters in the banks. The SEBI guidelines require the holding of the direct promoter to be at least 20%. A certain amount of direct stake by the promoters is found to bring about an alignment in the interests of controlling shareholders with outside shareholders.11 The scores assigned are as per the extent the direct ownership of promoters exceeds or falls short of SEBI’s designated benchmark.12 Among the set of banks, the one that exceeds by the maximum amount gets a conservative score of nine (allowing for the fact that enough may not be enough when it comes to translating to actual benefits), and the score gets cut by one as the exceeding amount falls in steps.

Stockholding by independent directors: The provisions of Sections 197 and 198 of the Companies Act, 2013 state that an independent director shall not be entitled to any stock option and may receive remuneration by the way of fee provided under sub-section (5) of Section 197, reimbursement of expenses for participation in the board and other meetings and profit related commission, as may be approved by the members. Stockholding by independent directors can only be effective (in terms of aligning their interests with that of the dispersed/minority shareholders), insofar as the insider directors do not hold stocks in the firm. The PVBs get a full score if this criterion is met. If a given number of independent directors are found to hold stocks at the same time as the insider directors hold stocks too, then they are scored based on the fraction of independent directors who do not own stocks and are expected to offer an opinion truly independent of any concerns of material gains.

Presence of nominee director: Large investors enjoy some advantages over dispersed shareholders in protecting the overall interests of all shareholders, when they can become a part of the board of directors. They are in a stronger position to use the proxy mechanism to discipline inefficient management (Dodd and Warner 1983). For non-financial firms, the exercise of the “voice” option by outside block-holders is typically exercised in India by a covenant that allows banks as creditors to be represented on the board of its debtor company via a nominee director. Following from this, PVBs get a full score if they have such nominee directors present on their board and zero otherwise.

Presence of duality: The duality of the chairperson of the board as CEO is scored in a manner similar to the PSBs.

Diversity of the board: There is a need for diversity of external experts on the board of PVBs from the perspective of resource dependency theory. The directors on the board are counted on the basis of the number of different qualifications and the experience that they possess. This number is then taken as a share of the size of the board of the bank and the maximum of such a share that is observed in the set of PVBs is taken as the benchmark value. The score is cut by one for each drop in rank in the share.

Board evaluation: Board evaluation mechanism is scored following the same guidelines as set for the PSBs. Based on the methodology outlined above, the BCI of PVBs is given in Table 2.

As can be seen from Table 2, there is a variation in the attribute scores for the PVBs but the range is narrow, with the difference between the highest and the lowest score being 5.9, which is much lower than the difference observed across the PSBs. It may be noted here that the PSBs are scored on six attributes and PVBs are scored on eight attributes. Since these attributes differ between PSBs and PVBs, the scores of PSBs cannot be compared with the scores of PVBs. But another observation that follows is that the mean deviation from the maximum score/benchmark is less for the PSBs (16.9) than the PVBs (21.8).

Validation of the Score

The importance of corporate governance lies in the eyes of the investors. The validation of the scores hence is in its movement parallel to the movement in the indicators of investors’ confidence in the banks. Stock price is one such indicator—both in level (closing share price as of 31 March 2015) and its steadiness (as measured by volatility of the stock returns for over the past year and continuing forward into December 2015). The index should also be a predictor of the banks’ performance given in terms of variability in return on assets (RoA) and net profit across the banks at end-March 2015. The latter is expressed as a profit index with the base being taken as the net profit of the bank with the lowest score.13

Tobin’s Q is a common ratio used in literature to indicate investors’ confidence in firm performance and corporate governance indices are often validated against it. It is calculated as the market value and liabilities’ book value divided by the assets’ book value. In the particular case of PSBs, the market value may not provide all the information about investors’ confidence in the stock because of the large and varying degrees of government stock ownership in these banks. Tobin’s Q is thus not being considered by us while validating the index. Table 3 summarises how our BCI is expected to move with relation to these validation metrics. When the actual movement shows any kind of deviation from the expected trend, it is mentioned in the table.

As mentioned earlier, sound governance practices are expected to contribute to higher earnings and greater profitability. Greater corporate governance creates higher firm valuation and results in higher and stable price in the stock market. A survey by the International Finance Corporation shows that investors will pay more for emerging market companies with good governance. More than half of the investors surveyed said that they would be willing to pay at least 10% more for a better-governed firm (Khanna and Zyla 2017).

To validate the corporate governance index of the banks, an attempt was made to analyse how closely the index tracks the profitability, RoA, stock price and stock volatility. As can be seen from the Figures 1–5 (p 102) and Figures 6–8, the index tracks the various indicators and the direction is according to a priori expectations. While Figures 1–4 are for PSBs, Figures 5–8 are for PVBs.

 

 

 

The PSBs and PVBs exhibit distinct features due to the difference in their legislative acts, ownership, business plan, product mix and competition. Hence, the article focuses on evaluating them distinctly and does not compare governance between both groups. In addition to these differences, each attribute of the corporate governance index has both qualitative and quantitative aspects. If one does a purely time series analysis based on quantifiable attributes, then it may not track the corporate governance attributes in the true sense, as qualitative aspects would not be accounted for. Thus, the composite score would not capture the unique features of each group.

To overcome this problem, the index has been worked out using both qualitative as well as quantitative attributes of corporate governance. As both qualitative and quantitative aspects have been considered while computing the index, it captures the group-specific and institution-specific features more accurately. This is borne out by the fact that the bank-specific composite index for both PSBs and PVBs tracks their profitability, share price and share price volatility closely. The banks with higher composite index have a higher profitability, higher share price and lower share price volatility and vice versa.

 

 

Conclusions

Corporate governance in banks has come to the forefront in recent times. A few committees have examined this and have suggested ways to improve the same. There have been sporadic attempts to analyse corporate governance in banks. However, preparing a composite benchmark index incorporating the legal requirements, as well as the best practices available in literature, has not been attempted so far. This study makes an attempt to prepare such a benchmark index, and studies board composition. It is observed that the legal nuances of governance of banks in India align with literature to a large extent, and corporate governance in banks in India can go a long way simply by adopting the laws in form and substance. Two interesting facts which emerge from the analysis are that firstly, the mean deviation from the respective benchmarks is lower for the PSBs than the PVBs, implying higher legal compliance for the former. Second, the variation in the composite scores is higher for PSBs as compared with PVBs. Thus, even among banks with a uniform ownership structure, there are banks with wide variations in their governance structure and differences in governance structures cannot be explained fully in terms of ownership only.

This has important implications at the current juncture when banks have to meet the enhanced capital requirements under Basel III. The study shows that a higher BCI corresponds to higher RoA and share prices and lower share price volatility. Accordingly, an improvement in BCI should imply increasing success in efforts by the banks to raise capital from the market to meet higher capital requirements. It will also reduce the dependence on the owner for additional capital. As PSBs account for around 75% of the total assets of the banking sector, this should reduce the pressure on fiscal expenditures considerably. The setting up of the bank board bureau is thus a step in the right direction, and similar initiatives can lend higher efficiency and vibrancy to Indian banking space.

Notes

1 The State Bank of India (SBI) is governed by the SBI Act and the board size stipulated therein is 14.

2 The average non-promoter shareholding for PSBs stood at about 30% at end-March 2015.

3 IDBI Bank has “independent” directors apart from the government nominee director. These directors are elected by the shareholders. The SBI Act, 1955 governs the same for SBI and there is no concept of independent directors in that act.

4 In PSBs, the concentration of promoter ownership is high and the promoter nominates majority of the directors on the board and the controlling shareholders have direct and indirect representation on the board. This leaves the predominant agency problem to be one of majority-minority problem.

5 For instance, if three such directors are required and the bank is short of meeting the requirement by one, the score is calculated as: 10-((1/3)*10).

6 A separate optimum share for executive directors is also calculated with similar logic.

7 Both the P J Nayak Committee and Indradhanush have proposed this measure of non-duality. However, the former adds that this should be adopted when there is an arrangement by which the members of the board are appointed by a Bank Investment Company that is granted some autonomy from the government. This is in line with the thinking that non-duality might not bring the necessary change if the controller serves as the chair.

8 This study is a snapshot of the corporate governance of banks as at end March 2015. Some banks like IDBI have gone on to propose non-duality after this.

9 Notification No F No20/1/2005-BOI dated 9 March 2007.

10 If the board falls too short of the benchmark, it will fail some other crucial attribute for an effective board as well and will get a score cut at that attribute. This is how interactions of different attributes are factored in the measure.

11 Support for a piece-wise linear relationship between alignment or convergence of interests between insiders and outside shareholders outweighs the negative entrenchment effects of insiders once the promoter ownership crosses a threshold of around 25% found in both Sarkar and Sarkar (2000), and Kumar (2008). Selarka (2005), and Pant and Pattanayak (2007) find a quadratic and cubic relationship respectively, which supports the basic finding that the interests of controlling insiders and minority outsiders converge once insider control becomes sufficiently high.

12 SEBI rules require that promoters should hold at least 20% of the post-public issue capital and this should be locked in for at least three years. After this, promoters can pare their stake. However, going by above literature, holding this shareholding on an ongoing basis is believed to be more prudent.

13 Calculations are done on data sourced from RBI and SEBI databases.

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Updated On : 12th Jul, 2019

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