ISBInsight: What observed phenomenon prompted you to undertake this research?
Krishnamurthy Subramanian (KS): During many of the recent Chairman and Managing Director (CMD) level changes at Indian banks, we observed that earnings dropped precipitously in the immediate quarter after the change. For example, when Pratip Chaudhuri took over from OP Bhatt as Chairman at State Bank of India, earnings dropped 99%! This happened as a result of a combination of higher provisioning for future loan delinquencies and reduced lending.
In varying degrees, this was observed in many other cases as well. This got us thinking: “is this a one-off case or coincidence or is it an embedded phenomenon?”
Prasanna Tantri (PT): As an investor, I noticed a consistent pattern in prices as a result of leadership change. That prompted me to try and understand what explanations research had to offer. One theory I came across was the ‘Big Bath Theory’, which suggested that incoming CMDs tend to showcase clean-ups on their predecessor’s actions through discretionary loan loss provisions. Thus, they create a smaller income base to show growth during their tenure by, for instance, reversing these provisions later.
However, it was clear that the issue went deeper. Markets continued to react negatively to these transitional announcements more consistently than theories like Big Bath would suggest. The phenomenon warranted further research.
ISBInsight: Why banks in particular?
KS: The systemic importance of banks for the economy is widely understood, so that made them a natural choice. Moreover, no other industry is as well and consistently regulated. That makes data collection and comparisons easier.
The other important reason is that the business of banks is characterised heavily by information asymmetries, which simply means that new leadership does not have the same insight into decisions as the outgoing leadership. This inherent opacity creates gaps in the information needed to make strategic decisions, especially since the decisions are about loan approval and provisioning.
These are, by their very nature, subjective processes dominated by several non-quantitative judgements and at times, even by obfuscation. Hence, insiders have very different information on a bank’s operations or health than outsiders.
We focused on Indian Government Owned Banks (GOBs) because this is one segment where leadership change is not influenced by any factor other than retirement age. This removes any distortion or effect of other factors in analysing what happens. That helped us to pin down the transitional changes to the CMD turnover alone.
PT: GOBs were relevant for us for a couple of other reasons too. Due to their relatively short tenures, they provided us with a large number of data points in the review period. Additionally, as you know,
GOBs are particularly impacted by the ongoing non-performing assets (NPA) problem. They are thus more prone to transitional effects like higher loan loss provisioning or deliberate slower growth.
ISBInsight: Specifically, in light of the bad loans problem you mentioned, what are the key implications of your research?
KS: The high provisioning that marks leadership change would normally be considered a sign of a clean-up and should help the stock. However, as we show, the motivation usually comes from narrow and personal career concerns, and not a desire to come clean on bad loans. As a result, the incentives of bank shareholders and bank senior management are certainly not aligned. This is what we refer to as the famous agency problem.
One key reason for this is the relatively short tenures of CMDs. The time horizon for bank CMDs needs to be considerably longer than the average of under three years that is observed.
Considering the dynamics of the banking world and the conclusions of this research, it is clear that incoming CMDs spend a lot of time overcoming information asymmetries, dealing with legacy issues, and coming up with a roadmap. Before the end of tenure, the CMDs then get into exit mode and personal risk management.
As a result, they will have little incentive to take key strategic decisions, especially if the benefits are to be enjoyed by successors. This creates myopia and leaves them with very little time for implementing strategy or change. Thus, short horizons not just overcompensate for legacy issues, but also create new ones.
Going by our research, a longer tenure of around five or more years would overcome many of the real-life governance challenges that transitions bring. The recommendations of various committees also point towards the need for change. For example, the PJ Nayak Committee recommended that the required improvement in Board oversight can be achieved by splitting the CMD position into two.
PT: The misalignment of incentives between shareholders and top management is certainly one of the important, though not only, contributors to the NPA problem. Another important aspect to consider in this context is that large loan default during a CMD’s tenure leads to Central Vigilance Commission (CVC) action. That makes CMDs either more risk averse, more prone to assigning problems to previous tenures, or both as academic research in this area has shown.
Objective NPA recognition and governance reforms within banks are a first step towards dealing with this systemic issue. This research highlights the specific weaknesses of governance within banks that exacerbate this problem.
Bank management incentives lead to distortionary practices in lending and provisioning. All too often, bank policies are tweaked to manage the personal risks of leadership.
About the Researchers:
Prasanna Tantri is a Senior Associate Director at the Indian School of Business, Hyderabad, India and heads CAF and the National Stock Exchange (NSE)-ISB Trading Laboratory.
Arkodipta Sarkar is attending the Finance PhD programme at the London Business School.
About the Research:
Subramanian, Krishnamurthy, Tantri, Prasanna, Sarkar, Arkodipta, “Effects of CEO Turnover in Banks: Evidence Using Exogenous Turnovers in Indian Banks.” Journal of Financial and Quantitative Analysis (forthcoming).
About the Interviewer:
Ujval Nanavati is a Chartered Accountant, Chartered Financial Analyst, and an alumnus of the Post-graduate Programme in Management from the Indian School of Business, Hyderabad. He works as an independent writer and research analyst.