Banking Sector Reforms

Will capping the bank CEO tenure make difference

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Bank CEO tenure and appointement

Mains level : Paper 3- Governance of the banks

The article examines the utility of the proposed limit on the banks CEO tenure.

Context

  • Last month, the Reserve Bank of India released a discussion paper on governance in commercial banks in India.
  • It has a proposal to cap the tenure of bank CEOs.

Details of the proposed limit and rationale

  • 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.
  • This move aims to separate ownership from management.
  • 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 professional management.
  • The corresponding limit for a CEO who is not a promoter/major shareholder is 15 consecutive years. T
  • Thereafter, that individual is eligible for re-appointment as CEO or WTD only after the expiration of three years.

Why banks are different from other companies: 3 Reasons

  • Ordinary corporate governance norms exhort managers to run a company in the interest of shareholders but it may not be suitable approach for all types of banks.
  • 1) Banks are highly leveraged, creating powerful incentives for shareholders to engage in risky strategies at great risk to creditors, including retail depositors.
  • 2) 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.
  • 3) Financial assets held by a bank are hard to monitor and measure.
  • Consequently, external scrutiny of a bank by depositors and creditors is difficult.
  • These unique factors are likely to encourage bank managers to take excessive risks to maximise shareholder value.

Purpose of Bank governance

  • Bank governance seeks to curb such excessive risk-taking discussed above.
  • It encourages prudent risk-taking such that shareholders’ interests are secondary to depositors’ interests.
  • This is the main logic as suggested in the Basel Committee on Banking Supervision guidelines and the Financial Stability Board principles respectively.

Will capping the CEO tenure help

  • It is unclear whether imposing a maximum cap on CEO tenure would encourage prudent risk-taking by the management.
  • For Indian banks, the limited empirical evidence seems to suggest that bank performance improves with increasing CEO tenure.
  • A paper published in International Journal of Financial Studies finds that an increase in CEO tenure is associated with significant improvements in asset quality and performance of the bank.
  • The effect of CEO tenure increases rapidly with the year of CEO tenure.
  • 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.
  • These findings seem to be at odds with RBI’s suggestion to cap CEO tenure.

Consider the question “Examine the factors that justify the application of stricter governance principle for the banks. What would be the impacts of the RBI’s proposed limit on the CEO term of the banks on governance?

Conclusion

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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