A Debate over Directors Raises Questions about Governance in Indian BanksPublished: May 04, 2007 in India Knowledge@Wharton
One of corporate India's more dramatic boardroom tussles has come to an unexpected end. The board of India's private sector UTI Bank decided on April 30 that P. J. Nayak, its chairman and managing director (CMD) would be reappointed as a "whole-time chairman" after his present term ends on July 31. The position of managing director will not be filled. (The bank will also change its name to Axis Bank beginning August 1.)
The decision marks an end to a standoff between Nayak and his board, which wanted him to pick one of the two roles -- either chairman or managing director. Nayak refused to choose. Three weeks ago, when Nayak said he would not stay on after his current term expires on July 31, the bank's board decided to appoint a search committee to hire a chief executive, and do away with the post of chairman and managing director (CMD).
Weeks earlier, the finance ministry had asked public sector banks to reorganize their boards and remove some independent board directors to make way for government nominees. These two developments have sparked a debate over the role of the government and the central bank in the running of publicly held banks.
Some industry watchers underline the government's right -- as the biggest shareholder -- to reorganize public sector bank boards. They also question the degree to which independent directors are effective. India Knowledge@Wharton spoke with several bank CEOs -- many off the record -- and faculty at Wharton and the Indian School of Business to better understand the implications of the top-level reshuffles at Indian banks.
Nayak is widely regarded as one of the brightest CEOs among Indian bankers. Yet, many observers agree with the desire of the Reserve Bank of India (RBI) to split his twin roles of chairman and managing director. In fact, those roles are divided at all other Indian private sector banks. According to one public sector bank CEO: "Ideally, the posts of chairman and managing director should be split. The CMD is usually very powerful but has no control. Bank chairmen should be eminent personalities who can use their sphere of influence to induct professionals to the board."
UTI Bank said in a letter to the Bombay Stock Exchange that while its board had approved Nayak's continuation for two more years as CMD, the central bank -- the RBI -- didn't agree. "[The] RBI has declined to give approval and has proposed instead that the office of chairman and MD should be bifurcated into two in accordance with the recommendations of the Dr. Ganguly Group Report on Corporate Governance and in accordance with international best practices," the letter stated. UTI Bank also conveyed Nayak's reservations to the stock exchange: "Mr. Nayak has informed the RBI and the remuneration and nomination committee of the board of the bank that after having spent over 7.5 years as CMD of the bank, it would not be possible for him to function in a different and lesser capacity in the bank."
Pros and Cons
Wharton management professor Michael Useem, who directs the school's Center for Leadership and Change Management and studies corporate governance, says that while it might appear to be a good idea to split the roles of chairman and CEO (or managing director), that case is not supported by overwhelming evidence. "The academic [research says] that it doesn't matter either way if one person wears both of those hats," he says. "Many American executives have also said for a long time that they want to perform both roles."
Useem also doesn't necessarily see the developments at UTI Bank as linked with the government's move on independent directors. Earlier this year, India's finance ministry ordered all publicly held banks to reduce the number of shareholder directors by 50%. Sixteen of the 28 public sector banks are listed on the stock markets, with the government's shareholding varying between 51% and 80%. The ministry also said in the same order that it would increase the number of government-appointed "independent" directors at these banks, ostensibly to ensure adequate representation for different sections of society.
"This is troublesome on several fronts," says Sanjay Kallapur, associate dean of faculty development and professor of accounting with a specialty in corporate governance at the Indian School of Business in Hyderabad. "The rights of minority shareholders in public sector banks are severely restricted," he says, noting that their voting power is limited to 1% regardless of the size of the shareholding, and that they do not have the right to sue bank management for lapses such as misstatements in prospectuses. "Independent directors 'elected by shareholders' were the best hope for their protection," he says. One bank CEO notes, "It's a big corporate governance issue and there should be a proper debate before sweeping changes are made."
Public sector bank boards are required to have an executive CMD, one executive director, one nominee of the finance ministry, one RBI nominee, two union nominees, one chartered accountant and six independent directors. Under the category of "independent directors" fall both the shareholder directors (usually those nominated by minority shareholders), and the "independent" directors nominated by the government. The finance ministry says these independent directors will be specialists in rural banking, agriculture, technology, small- and medium-enterprise development and a variety of other subjects.
Under the new rules the finance ministry introduced, a maximum of three shareholder-directors is allowed at public sector bank boards, with the number being directly proportional to the extent of the floating stock in the market. In the earlier dispensation, all six independent directors could have been shareholder-directors. Significantly, the finance ministry and the RBI have removed their nominees from the management committees of bank boards, too. These committees are empowered by the board to make big-ticket credit decisions. The government says the action is self-explanatory -- it does not want to be seen directly influencing critical credit judgment.
Useem prefers to be "agnostic" on the issue involving the replacement of independent bank directors, since not all the factors driving those moves are publicly known. "In a general sense, it does run against conventional wisdom on what makes for strong, independent boards of directors, and the government's move is troublesome," he says, "but the Indian government may have its reasons in the public interest." Useem adds that in publicly listed companies, "it is essential for those independent shareholder representatives to be able to provide the guidance that any company benefits from at the top."
No proven format for board composition exists, says Useem, who stresses that idea in a January 2006 paper he co-wrote with Andy Zelleke, a lecturer in Wharton's legal studies and business ethics department, titled, "Oversight and Delegation in Corporate Governance: Deciding What the Board Should Decide." In the paper, Useem and Zelleke write, "Structural factors like smaller boards, more independent directors and non-executive chairs may indeed impact top decisions, although the subsequent effect of the decisions on company performance has not been clearly established."
The researchers point to the composition of Enron's board before it collapsed in December 2001 to support their case. "Outwardly, it appeared to be a well structured and composed board for making judicious decisions, with 13 prominent independent directors led by a chair who was not also CEO," they write. "Yet, a look at its inner workings, reconstructed by investigators after the collapse, revealed sub-optimal inner decisions despite arguably favorable outward appearances."
Kallapur, however, describes the government's move to install its nominees on bank boards to represent interest groups as a "retrograde step." He draws attention to a 2001 report by an RBI-appointed advisory group on corporate governance headed by R. H. Patil, former chairman of India's National Stock Exchange. According to the report: "It has been observed that most of the nominees representing particular sectional interests argue vociferously in favor of their own narrow interests with considerable disregard to the health of the banking institution as whole. It has also been noted that boards do not function in a manner that would lead to a healthy balance of the interests of the shareholders and stakeholders."
Useem notes that in the U.S. context, he has found several boards of directors to be "relatively passive, although not exactly rubber stamps of management." They were "not adding a terrible lot of additional input towards exercising independent influence or voice in the firm." Notwithstanding that, the boards of many U.S. companies are now moving towards playing a more active role, he says. "That's all for the good, since top management can walk into a room now and test ideas and strategies with a group if they are independent-minded people who should give hard headed and informed feedback as to whether a strategy, a decision, an acquisition, a divestiture, a new policy, a new product, is a good or a bad idea."
Enter the 'Lead Director'
In the midst of the debate over board composition, Useem finds one idea promising. "A relatively new concept is that of a lead director. Many American companies have adopted it," he says. "The lead director is below the chairman, but has the ability to call a separate meeting of board directors to discuss issues. It is working well at Tyco, where [former] E.I. du Pont de Nemours & Co. chairman and CEO John Krol is the lead director, and Edward Breen is the chairman and CEO." Tyco, a $41 billion diversified company based in West Windsor, N.J., had adopted a series of governance reforms following the exit of its former chairman Dennis Kozlowski, who was convicted in June 2005 of misappropriating nearly $400 million. Interestingly, 10 of Tyco's 11 board directors are independent, excluding Breen.
The reduction in the number of independent directors on bank boards runs counter to the approach taken by India's securities market regulator, the Securities & Exchange Board of India (Sebi). In recent months, Sebi has focused on ensuring that independent directors make up at least 50% of the boards of all publicly held companies. That is consistent with the board composition requirements set out in Clause 49 of the listing agreement companies enter into with stock exchanges.
But the government's decisions on the composition of bank boards are governed by the Banking Companies (Acquisition and Transfer of Undertakings) Act of 1970 -- which was enacted to facilitate the acquisition and nationalization of a host of private banks in 1970 -- that allows it to override Clause 49 provisions. K. C. Chakrabarty, chairman and managing director of public sector Indian Bank, supports this view: "The government has a majority stake, therefore it must have a larger say."
Kallapur disagrees. "Governments should set a good example rather than a bad one," he says. "They should voluntarily subject themselves to Clause 49. Of course, the government will argue that it will appoint 'independent' directors, but they should be seen for what they are -- representatives of one group of shareholders, namely the government." Such concerns prompt one public sector bank CEO to remark, "In the risk management matrix, the biggest risk to a bank's operation today is the board itself."
In recent weeks, a large number of public sector bank boards have witnessed the exit of their shareholder directors, which include some well-known names. A review by the daily newspaper Hindustan Times found that 17 independent directors had resigned from the boards of 10 public sector banks in three weeks after the finance ministry order. Into this breach will step the government-nominated "independent" directors.
According to one chairman of a public sector bank, "This is a political move. The government is trying to ensure that nominee directors appointed during the earlier political regime are substituted with their own appointees. With a general election only two years away, the government is not taking any chances." Some observers agree that there might be a grain of truth in this: On one bank's board, the government has nominated a director, ostensibly a social worker, who has not attended a single board meeting. On another bank's board, the government has appointed a member of a regional unit of the ruling Congress party.
Bank managements are not without fault, either. According to Indian Bank's Chakrabarty, "The shareholder directors appointed by most banks are inferior. There is no due screening process by the board. They are typically friends of the CMD. The government therefore had to step in. I am sure the government wants to appoint good people, especially professionals." It isn't exactly urban legend that bank chairmen use this route to have their friends elected to boards. Even though the banks are public firms and their shares are widely held, in reality the financial institutions (mutual funds and insurance companies) own the largest chunks. One call from a bank's CEO to the chiefs of these institutions -- a bit of nudge-nudge, wink-wink -- and a nominee is in.
Grumbling about misuse of authority also swirls around the appointment of CA [chartered accountant or certified public accountant] directors. "The chartered accountant on bank boards is usually a financial broker," says the chairman of a public sector bank. "He is usually a small-time professional but uses his board position to make money by getting loan proposals approved. Sometimes, he also operates in a nexus with the bank management." Bank CEOs complain that bureaucrats or politicians dictate many of these CA appointments; these directors then try to influence the banks' credit decisions.
The Elusive 'Professionals'
The biggest casualties are bank boards that badly need professional directors. Most of India's public sector banks are today grappling with the onslaught of competition from banks that are better equipped in terms of qualified people, technology, speed-to-market, higher productivity and greater efficiency. "Getting good independent directors has been difficult," Kallapur says. "Also, a bank cannot lend to companies (or their subsidiaries) on which its directors sit -- a law that continues from the days when industrial houses owned banks that were subsequently nationalized [in 1969]. Summarily dismissing a director makes it more difficult to get good ones in the future."
Anil Khandelwal, chairman and managing director of the public sector Bank of Baroda is one who is keen on strengthening his board. "Boards of banks with extensive international operations, such as Bank of Baroda and State Bank of India, need professionals who can provide guidance and direction to the bank," he says. "International operations pit us against the best in the most competitive markets."
Kallapur says one reason why banks are not able to recruit professionals to their boards is poor compensation. Bank directors are paid Rs 5,000 ($119) for every board meeting. Says Indian Bank's Chakrabarty: "With the board making large and critical executive decisions, it is imperative that public sector banks pay better remuneration to directors and reduce the number of items on their agendas for board meetings. Boards must discuss policy issues, look at large performance numbers and leave credit decisions to the management. But all this cannot be achieved unless you get professionals, and you will not get good professionals unless you pay [more]."
In addition to the challenge of finding credible independent directors, banks also have to fall in step with the Basel II norms of the Bank for International Settlements in Sweden. Basel II is a modified risk-management matrix that will require all banks to set aside larger amounts of capital to meet future unforeseen risks. According to Khandelwal, "The boards have twin responsibilities -- to ensure success for the bank balance sheet and to finance the success graph of entrepreneurs with good ideas. Banks should have professionals on their boards who can help achieve these two objectives." Indian banks have another year before they begin implementing Basel II capital adequacy norms.
In the midst of the muck-raking and blame game, one question cannot be avoided: Where does all of this leave public sector banks? Are they better equipped to handle the business environment and competition? Kallapur feels Indian banks already "suffer from excessive regulation" with 25% of their assets required to be invested in government bonds and another 40% earmarked for "priority sectors" such as agriculture and small-scale industries. "These requirements cause distortions at the macro level," he says. "If the government appoints its own directors for micromanagement, it could facilitate crony capitalism, which is even worse."