Report on

Priority areas for Reforms of Corporate

Governance in Indian Banking Sector

Sponsored by

National Foundation for Corporate Governance

Research Team

Prof. R. K. MishraDr. N. Rukmini Rao

Institute of Public Enterprise

Hyderabad

January 2013, Hyderabad

Contents

Page. No

Executive Summary

1. Introduction 1 - 14

1.1. Overview of Corporate Governance

1.2. Corporate Governance in Indian Banking Industries

1.3. Relevance of the study

2. Review of recommendations by expert bodies 14 – 38

2.1. Board Composition

2.2. Board Compensation

2.3. Board Committees

2.4. Share Holding Pattern

2.5. Risk Management

3. Research Methodology 39 - 42

3.1. Objectives of the study

3.2. Methodology

3.3. Statistical Tools

4. Data Collection and Analysis 43 - 55

5. Empirical Findings & Recommendations 56 - 59

Table Contents

Page. No

1. Table 3.1 List of Variables 39

2. Table 4.1 Profitability - Variables Entered/Removeda 45

3. Table 4.2 Profitability - Model Summary 45

4. Table 4.3 Profitability - ANOVAa 46

5. Table 4.4 Profitability - Coefficientsa 46

6. Table 4.5 Profitability - Excluded Variablesa 46

7. Table 4.6 Risk Perception - Variables Entered/Removeda 47

8. Table 4.7 Risk Perception - Model Summary 48

9. Table 4.8 Risk Perception - ANOVAa 48

10. Table 4.9 Risk Perception - Coefficientsa 48

11. Table 4.10 Risk Perception - Excluded Variablesa 48

12. Table 4.11 NPA Ratio - Variables Entered/Removeda 50

13. Table 4.12 NPA Ratio -Model Summary 50

14. Table 4.13 NPA Ratio -ANOVAa 51

15. Table 4.14 NPA Ratio -ANOVAa 51

16. Table 4.15 NPA Ratio - Coefficientsa 52

17. Table 4.16 NPA Ratio - Excluded Variablesa 53

18. Table 4.17 TOBIN’s Q - Variables Entered/Removeda 54

19. Table 4.18 TOBIN’s Q - Model Summary 54

20. Table 4.19 TOBIN’s Q -ANOVAa 54

21. Table 4.20 TOBIN’s Q -Coefficientsa 54

Executive Summary

Though outcomes of good corporate governance remains same irrespective of nature

of business, type of ownership, quality of management, business/legal regulations,

and political environment, but the means to achieve this good governance differs a lot

based on the factors mentioned above. Some of the parameters that may influence

corporate governance include ownership structure, board philosophy, industry

segment, maturity of business, management process, level of competition,

international business participation, and size of the company.

Lot of effort is being put both nationally and internationally in understanding and

suggesting good practices that can improve governance of banking sector. In India

also several initiatives have been taken up in understanding nuances of banking sector

governance.

The research team at IPE made an attempt to understand the linkages between

ownership, governance and performance of banking sector in India. In this pursuit,

the team gathered recommendations of few important reports like OECD principles,

Dr. A. S. Ganguly Committee report and Basel recommendations on ownership

structure and governance mechanisms of banking industry. In addition to this, data on

various parameters coming under the category of ownership, governance and

performance of banks was collected. Over and above, views of present and

prospective board members of Indian banking sector on issues related to corporate

governance in banking industry were collected through structured questioners. Based

on this the following recommendations are being made.

Average board size of public sector banks stands at 13. From the empirical evidence

it is found that larger boards are resulting in more NPAs. Even primary data collected

from present and prospective board members indicates that smaller boards are

effective. Even Dr. A. S. Gangully report is of the view that larger boards may miss

the focus and hence more working director should be there in such cases. In view of

this and in order to make the boards of public sector banks more effective it is

recommended to prune down the board size.

The present level of executive directors in private sector banks is 3 per board. From

this study it is found that more number of executive directors leading to better profits.

Basel committee suggest that executive directors can be upto 75% of the elected

board, while Dr. A. S. Gangully committee is of the opinion that given the

complexity of board functioning more executive directors are preferred. In view of

this we suggest that strength of executive directors in private sector banks need to be

augmented further.

Most of the committees have talked about board independence and independent

directors on the board. But empirical evidence is not suggesting any meaning

correlation between quality of governance and presence of independent director on

board. Even respondents in our primary data collection also felt the same way.

However, we are of the opinion that contribution of Independent director on board

cannot be underestimated and the present level of in effectiveness need to be

understood from different dimensions. Keeping this in view, we would like to suggest

that board independence and role of independent directors as one of the governance

mechanisms need to be further strengthened and refined.

OECD principles and Dr.A.S. Gangully recommendations unanimously agree that

chairman of the board should be non executive. Non-executive chairmen are

expected to bring in better monitoring and more independence to the board

functioning. But in India, around 22% of private sector bank boards and 16% public

sector bank boards have non-executive chairman. Though we could not find a

significant empirical evidence to suggest non-executive chairmen lead to better

bank performance, we would like to suggest separation of leadership at board level,

theoretically, may result in better monitoring and better performance.

Majority of the reports including OECD Principles have not mentioned anything

about preferred shareholding pattern. Empirical evidence also not suggesting any

pattern significantly. But keeping the theoretical advantages and disadvantages of

concentrated shareholding in a competitive business environment we would like to

suggest a balance approach towards shareholding pattern.

Similarly, no mention was made about preferred Foreign Institutional Investment

(FIIs) and Domestic Institutional Investment (DIIs) by the above mentioned reports.

However, the little empirical evidence is suggesting that FIIs and DIIs having inverse

relationship with NPAs and perceived replacement value of private sector banks.

With this input we would like to suggest that the role of FIIs and DIIs in banking

sector need to be further strengthened so that these institutions can play a significant

role in governance of banking industry.

1

Chapter - 1

Introduction

1.1. Overview of Corporate Governance

Background

Issue of corporate governance gained prominence as one of the widely discussed

topics across the globe in recent times. This is not happening without reason. Gradual

dilution of values in society in general and business in particular and greed for easy

money have necessitated the relook into the governance practices of today’s business

corporations. Corporate Governance can be understood as the act of balancing

conflicting interests of different stakeholders.

In fact corporate governance is not new at all. But, it might not be that prominent

those days, may be, because the general business standards and ethics were high

comparatively. There were good number of entrepreneurs who were more prudent in

their business practices, more philanthropic and with environmental consciousness.

Liberalization, Privatization and Globalization (LPG), initiated by the government in

1991 resulted in growth of Indian economy at a much faster pace. Emergence of new

business sectors like IT and ITES etc., many fold growth in employment generation

and subsequent wealth creation marked the period.

Post LPG era added new dimensions to the Indian business environment. Few of them

to mention are integration of financial and product markets, increased shareholder

activism, benchmarking with international best practices and increased uncertainties

& business risks. With the surge of FII’s and companies raising funds abroad,

international investors started demanding better transparency in business accounting

and disclosure practices. White collar crimes coupled with misuse of technological

advancements further deteriorated the business standards.

Good governance practices are important to attract cheaper capital and provide long

term sustainability of the business. A lot of coarse and fine tuning is happening in the

corporate governance space these days across the world. India should not lag behind

in this direction, as we are in the phase of transition in integrating with global

markets.

2

Corporate Governance Meaning and Scope

There are various definitions given by different people to explain corporate

governance. It is very difficult for a single definition to explain corporate governance

completely. Hence, some of the definitions that are more prominent are given below

to enhance the understanding about corporate governance from different perspectives.

Mathiesen,1(2002) defined that corporate governance is a field in economics that

investigates how to secure/motivate efficient management of corporations by the use

of incentive mechanisms, such as contracts, organizational designs and legislation.

This is often limited to the question of improving financial performance, for example,

how the corporate owners can secure/motivate that the corporate managers will

deliver a competitive rate of return.

Sir Adrian Cadbury (2000) in 'Global Corporate Governance Forum', World Bank,

opined, "Corporate Governance is concerned with holding the balance between

economic and social goals and between individual and communal goals. The

corporate governance framework is there to encourage the efficient use of resources

and equally to require accountability for the stewardship of those resources. The aim

is to align as nearly as possible the interests of individuals, corporations and society".

Simon Deakin, Robert Monks described, corporate governance is about how

companies are directed and controlled. Good governance is an essential ingredient in

corporate success and sustainable economic growth. Research in governance requires

an interdisciplinary analysis, drawing above all on economics and law, and a close

understanding of modern business practice of the kind that comes from detailed

empirical studies in a range of national systems.

Sarah Teslik2 explained that corporate governance is what you do with something

after you acquire it. When people own property, they care for it: corporate governance

simply means caring for property in the corporate setting.

1 Colleced from the web site http://www.encycogov.com/WhatIsGorpGov.asp.2 Sarah Teslik was former Executive Director of the Council of Institutional Investors in UK.

3

Corporate governance describes all the influences affecting the institutional processes,

including those for appointing the controllers and/or regulators, involved in

organizing the production and sale of goods and services.

Corporate governance is about "the whole set of legal, cultural, and institutional

arrangements that determine what public corporations can do, who controls them,

how that control is exercised, and how the risks and return from the activities they

undertake are allocated."3

Corporate governance is the relationship among various participants [chief executive

officer, management, shareholders, and employees] in determining the direction and

performance of corporations"4

Corporate governance5 deals with the way suppliers of finance assure themselves of

getting a return on their investment.

Corporate governance6 is the way power is exercised over a corporate entity. All

corporate entities need to be governed as well as managed. The structure and

processes of the governing body, typically the board of directors in a joint stock

limited liability company, is central to corporate governance. The relationships

between the board and the shareholders, the auditors, the regulators and other

shareholders is also crucial to effective corporate governance, as is the linkage

between the board and top management.

Based on the seminal work of Berle and Means (1932), corporate governance can be

understood as a set of contracts that defines the relationships among the three

principal actors in the corporation: shareholders, who invest the money, stakeholders

who are being governed, and board of directors who direct and control the

corporation.

"Shareholder value is partly about efficiency. But there are serious issues of

distribution at stake - job security, income inequality, social welfare. There may be

many ways to organize an efficient firm."

3 As defined by Margaret Blair (1995), in the work ‘Ownership and Control: RethinkingCorporate Governance for the Twenty-first Century’.

4 Monks and Minow, Corporate Governance, 1995.5 Shleifer and Vishny, 19976 Explained by Bob Tricker, Pocket Director, 1998

4

The above definitions explain various dimensions of corporate governance. It

encompasses the interests of shareholders, employees, customers, Government,

society, environment etc.

In contemporary business corporations, the main external stakeholder groups are

shareholders, debt holders, trade creditors, suppliers, customers and communities

affected by the corporation's activities. Internal stakeholders are the board of directors,

executives, and other employees.

Much of the contemporary interest in corporate governance is concerned with

mitigation of the conflicts of interests between stakeholders. Ways of mitigating or

preventing these conflicts of interests include the processes, customs, policies, laws,

and institutions which have impact on the way a company is controlled. An important

theme of corporate governance is the nature and extent of accountability of people in

the business.

A related but separate thread of discussions focuses on the impact of a corporate

governance system on economic efficiency, with a strong emphasis on shareholders'

welfare. In large firms where there is a separation of ownership and management and

no controlling shareholder, the principal–agent issue arises between upper-

management (the "agent") which may have very different interests, and by definition

considerably more information, than shareholders (the "principals"). The danger arises

that rather than overseeing management on behalf of shareholders, the board of

directors may become insulated from shareholders and beholden to management. This

aspect is particularly present in contemporary public debates and developments in

regulatory policy.

There has been renewed interest in the corporate governance practices of modern

corporations, particularly in relation to accountability, since the high-profile collapses

of a number of large corporations during 2001-2002, most of which involved

accounting fraud. Corporate scandals of various forms have maintained public and

political interest in the regulation of corporate governance. In the U.S., these include

Enron Corporation and MCI Inc. (formerly WorldCom). Their demise is associated

with the U.S. federal government passing the Sarbanes-Oxley Act in 2002, intending

to restore public confidence in corporate governance. Comparable failures in

5

Australia (HIH, One.Tel) are associated with the eventual passage of the CLERP 9

reforms. Similar corporate failures in other countries stimulated increased regulatory

interest (e.g., Parmalat in Italy).

Corporate Governance Models

There are many different models of corporate governance around the world. These

differ according to the variety of capitalism in which they are embedded. The Anglo-

American "model" tends to emphasize the interests of shareholders. The coordinated

or multi-stakeholder model associated with Continental Europe and Japan also

recognizes the interests of workers, managers, suppliers, customers, and the

community.

Continental Europe

Some continental European countries, including Germany and the Netherlands,

require a two-tiered Board of Directors as a means of improving corporate

governance. In the two-tiered board, the Executive Board, made up of company

executives, generally runs day-to-day operations while the supervisory board, made

up entirely of non-executive directors who represent shareholders and employees,

hires and fires the members of the executive board, determines their compensation,

and reviews major business decisions. See also Aktiengesellschaft.

India

India's SEBI Committee on Corporate Governance defines corporate governance as

the "acceptance by management of the inalienable rights of shareholders as the true

owners of the corporation and of their own role as trustees on behalf of the

shareholders. It is about commitment to values, about ethical business conduct and

about making a distinction between personal & corporate funds in the management of

a company."[22] It has been suggested that the Indian approach is drawn from the

Gandhian principle of trusteeship and the Directive Principles of the Indian

Constitution, but this conceptualization of corporate objectives is also prevalent in

Anglo-American and most other jurisdictions.

United States, United Kingdom

The so-called "Anglo-American model" of corporate governance emphasizes the

interests of shareholders. It relies on a single-tiered Board of Directors that is

6

normally dominated by non-executive directors elected by shareholders. Because of

this, it is also known as "the unitary system").Within this system, many boards include

some executives from the company (who are ex officio members of the board). Non-

executive directors are expected to outnumber executive directors and hold key posts,

including audit and compensation committees. The United States and the United

Kingdom differ in one critical respect with regard to corporate governance: In the

United Kingdom, the CEO generally does not also serve as Chairman of the Board,

whereas in the US having the dual role is the norm, despite major misgivings

regarding the impact on corporate governance.

In the United States, corporations are directly governed by state laws, while the

exchange (offering and trading) of securities in corporations (including shares) is

governed by federal legislation. Many US states have adopted the Model Business

Corporation Act, but the dominant state law for publicly-traded corporations is

Delaware, which continues to be the place of incorporation for the majority of

publicly-traded corporations. Individual rules for corporations are based upon the

corporate charter and, less authoritatively, the corporate bylaws. Shareholders cannot

initiate changes in the corporate charter although they can initiate changes to the

corporate bylaws.

Regulation

Corporations are created as legal persons by the laws and regulations of a particular

jurisdiction. These may vary in many respects between countries, but a corporation's

legal person status is fundamental to all jurisdictions and is conferred by statute. This

allows the entity to hold property in its own right without reference to any particular

real person. It also results in the perpetual existence that characterizes the modern

corporation. The statutory granting of corporate existence may arise from general

purpose legislation (which is the general case) or from a statute to create a specific

corporation, which was the only method prior to the 19th century.

In addition to the statutory laws of the relevant jurisdiction, corporations are subject to

common law in some countries, and various laws and regulations affecting business

practices. In most jurisdictions, corporations also have a constitution that provides

individual rules that govern the corporation and authorize or constrain its decision-

makers. This constitution is identified by a variety of terms; in English-speaking

7

jurisdictions, it is usually known as the Corporate Charter or the [Memorandum and]

Articles of Association. The capacity of shareholders to modify the constitution of

their corporation can vary substantially.

Codes and guidelines

Corporate governance principles and codes have been developed in different countries

and issued from stock exchanges, corporations, institutional investors, or associations

(institutes) of directors and managers with the support of governments and

international organizations. As a rule, compliance with these governance

recommendations is not mandated by law, although the codes linked to stock

exchange listing requirements may have a coercive effect. For example, companies

quoted on the London, Toronto and Australian Stock Exchanges formally need not

follow the recommendations of their respective codes. However, they must disclose

whether they follow the recommendations in those documents and, where not, they

should provide explanations concerning divergent practices. Such disclosure

requirements exert a significant pressure on listed companies for compliance.

One of the most influential guidelines has been the OECD Principles of Corporate

Governance—published in 1999 and revised in 2004. The OECD guidelines are often

referenced by countries developing local codes or guidelines. Building on the work of

the OECD, other international organizations, private sector associations and more

than 20 national corporate governance codes formed the United Nations

Intergovernmental Working Group of Experts on International Standards of

Accounting and Reporting (ISAR) to produce their Guidance on Good Practices in

Corporate Governance Disclosure. This internationally agreedbenchmark consists of

more than fifty distinct disclosure items across five broad categories:

Auditing

Board and management structure and process

Corporate responsibility and compliance

Financial transparency and information disclosure

Ownership structure and exercise of control rights

The investor-led organisation International Corporate Governance Network (ICGN)

was set up by individuals centered around the ten largest pension funds in the world

1995. The aim is to promote global corporate governance standards. The network is

8

led by investors that manage 18 trillion dollars and members are located in fifty

different countries. ICGN has developed a suite of global guidelines ranging from

shareholder rights to business ethics.

The World Business Council for Sustainable Development (WBCSD) has done work

on corporate governance, particularly on accountability and reporting, and in 2004

released Issue Management Tool: Strategic challenges for business in the use of

corporate responsibility codes, standards, and frameworks. This document offers

general information and a perspective from a business association/think-tank on a few

key codes, standards and frameworks relevant to the sustainability agenda.

In 2009, the International Finance Corporation and the UN Global Compact released a

report, Corporate Governance - the Foundation for Corporate Citizenship and

Sustainable Business, linking the environmental, social and governance

responsibilities of a company to its financial performance and long-term

sustainability.

Most codes are largely voluntary. An issue raised in the U.S. since the 2005 Disney

decision [30] is the degree to which companies manage their governance

responsibilities; in other words, do they merely try to supersede the legal threshold, or

should they create governance guidelines that ascend to the level of best practice. For

example, the guidelines issued by associations of directors, corporate managers and

individual companies tend to be wholly voluntary but such documents may have a

wider effect by prompting other companies to adopt similar practices.7

1.2 Evolution of Banking in India

Modern banking in India could be traced back to the establishment of Bank of Bengal

(Jan 2, 1809), the first joint-stock bank sponsored by Government of Bengal and

governed by the royal charter of the British India Government. It was followed by

establishment of Bank of Bombay (Apr 15, 1840) and Bank of Madras (Jul 1, 1843).

These three banks, known as the presidency banks, marked the beginning of the

limited liability and joint stock banking in India and were also vested with the right of

note issue.

7 http://en.wikipedia.org/wiki/Corporate_governance

9

In 1921, the three presidency banks were merged to form the Imperial Bank of India,

which had multiple roles and responsibilities and that functioned as a commercial

bank, a banker to the government and a banker’s bank. Following the establishment of

the Reserve Bank of India (RBI) in 1935, the central banking responsibilities that the

Imperial Bank of India was carrying out came to an end, leading it to become more of

a commercial bank. At the time of independence of India, the capital and reserves of

the Imperial Bank stood at Rs 118 mn, deposits at Rs 2751 mn and advances at Rs

723 mn and a network of 172 branches and 200 sub offices spread all over the

country.

In 1951, in the backdrop of central planning and the need to extend bank credit to the

rural areas, the Government constituted All India Rural Credit Survey Committee,

which recommended the creation of a state sponsored institution that will extend

banking services to the rural areas. Following this, by an act of parliament passed in

May 1955, State Bank of India was established in Jul, 1955. In 1959, State Bank of

India took over the eight former state-associated banks as its subsidiaries. To further

accelerate the credit to fl ow to the rural areas and the vital sections of the economy

such as agriculture, small scale industry etc., that are of national importance, Social

Control over banks was announced in 1967 and a National Credit Council was set up

in 1968 to assess the demand for credit by these sectors and determine resource

allocations. The decade of 1960s also witnessed significant consolidation in the Indian

banking industry with more than 500 banks functioning in the 1950s reduced to 89 by

1969.

For the Indian banking industry, Jul 19, 1969, was a landmark day, on which

nationalization of 14 major banks was announced that each had a minimum of Rs 500

mn and above of aggregate deposits. In 1980, eight more banks were nationalised. In

1976, the Regional Rural Banks Act came into being, that allowed the opening of

specialized regional rural banks to exclusively cater to the credit requirements in the

rural areas. These banks were set up jointly by the central government, commercial

banks and the respective local governments of the states in which these are located.

The period following nationalisation was characterized by rapid rise in banks business

and helped in increasing national savings. Savings rate in the country leapfrogged

10

from 10-12% in the two decades of 1950-70 to about 25 % post nationalisation

period. Aggregate deposits which registered annual growth in the range of 10% to

12% in the 1960s rose to over 20% in the 1980s. Growth of bank credit increased

from an average annual growth of 13% in the 1960s to about 19% in the 1970s and

1980s. Branch network expanded significantly leading to increase in the banking

coverage.

Indian banking, which experienced rapid growth following the nationalization, began

to face pressures on asset quality by the 1980s. Simultaneously, the banking world

everywhere was gearing up towards new prudential norms and operational standards

pertaining to capital adequacy, accounting and risk management, transparency and

disclosure etc. In the early 1990s, India embarked on an ambitious economic reform

programme in which the banking sector reforms formed a major part. The Committee

on Financial System (1991) more popularly known as the Narasimham Committee

prepared the blue print of the reforms. A few of the major aspects of reform included

(a) moving towards international norms in income recognition and provisioning and

other related aspects of accounting (b) liberalization of entry and exit norms leading

to the establishment of several New Private Sector Banks and entry of a number of

new Foreign Banks (c) freeing of deposit and lending rates (except the saving deposit

rate), (d) allowing Public Sector Banks access to public equity markets for raising

capital and diluting the government stake,(e) greater transparency and disclosure

standards in financial reporting (f) suitable adoption of Basel Accord on capital

adequacy (g) introduction of technology in banking operations etc. The reforms led to

major changes in the approach of the banks towards aspects such as competition,

profitability and productivity and the need and scope for harmonization of global

operational standards and adoption of best practices. Greater focus was given to

deriving efficiencies by improvement in performance and rationalization of resources

and greater reliance on technology including promoting in a big way computerization

of banking operations and introduction of electronic banking.

The reforms led to significant changes in the strength and sustainability of Indian

banking. In addition to significant growth in business, Indian banks experienced sharp

growth in profitability, greater emphasis on prudential norms with higher provisioning

levels, reduction in the non performing assets and surge in capital adequacy. All bank

11

groups witnessed sharp growth in performance and profitability. Indian banking

industry is preparing for smooth transition towards more intense competition arising

from further liberalization of banking sector that was envisaged in the year 2009 as a

part of the adherence to liberalization of the financial services industry.

Structure of the Banking Industry

According to the RBI definition, commercial banks which conduct the business of

banking in India and which (a) have paid up capital and reserves of an aggregate real

and exchangeable value of not less than Rs 0.5 mn and (b) satisfy the RBI that their

affairs are not being conducted in a manner detrimental to the interest of their

depositors, are eligible for inclusion in the Second Schedule to the Reserve Bank of

India Act, 1934, and when included are known as ‘Scheduled Commercial Banks’.

Scheduled Commercial Banks in India are categorized in five different groups

according to their ownership and/or nature of operation. These bank groups are (i)

State Bank of India and its associates, (ii) Nationalised Banks, (iii) Regional Rural

Banks, (iv) Foreign Banks and (v) Other Indian Scheduled Commercial Banks (in the

private sector). All Scheduled Banks comprise Schedule Commercial and Scheduled

Co-operative Banks. Scheduled Cooperative banks consist of Scheduled State Co-

operative Banks and Scheduled Urban Cooperative Banks.

Banking Industry at a Glance

As per the RBI report the number of scheduled commercial banks functioning in India

as on March 31st 2012 was 169, of which 82 were regional rural banks. There are

101261 bank offices spread across the country, of which 36 % are located in rural

areas, 26% in semi-urban areas, 20% in urban areas and the rest 19 % in the

metropolitan areas. The major bank groups (as defined by RBI) functioning during the

reference period of the report are State Bank of India and its associate banks,

nationalised banks and the IDBI Ltd, Old Private Sector Banks, New Private Sector

Banks and Foreign Banks8.

8http://www.rbi.org.in/scripts/annualpublications.aspx?head=statistical%20tables%20relating%20to%20banks%20of%20india

12

1.3. Corporate Governance in Indian Banking Industry

Banks are a critical component of the economy while providing financing for

commercial enterprises, basic financial services to a broad segment of the population

and access to payment systems. The importance of banks to national economies is

underscored by the fact that banking is, almost universally, a regulated industry and

that banks have access to government safety nets. It is of crucial importance therefore

that banks have strong corporate governance practices. Banks are also important

catalysts for economic reforms, including corporate governance practices. Because of

the systemic function of banks, the incorporation of corporate governance practices

in the assessment of credit risks pertaining to lending process will encourage the

corporate sector in turn to improve their internal corporate governance practices.

Importance of implementing modern corporate governance standards is conditioned

by the global tendency to consolidation in the banking sector and a need in further

capitalization.

1.4. Relevance of the study

Since the market control is not sufficient to ensure proper governance in banks, the

government does see reason in regulating and controlling the nature of activities, the

structure of bonds, the ownership pattern, capital adequacy norms, liquidity ratios, etc.

In the case of traditional manufacturing corporations, the issue has been that of

safeguarding and maximizing the shareholders’ value. In the case of banking, the risk

involved for depositors and the possibility of contagion assumes greater importance

than that of consumers of manufactured products. Further, the involvement of

government is discernibly higher in banks due to importance of stability of financial

system and the larger interests of the public. The RBI has made it clear that with the

abolition of minimum lending rates for co-operative banks, it will be incumbent on

these banks to make the interest rates charged by them transparent and known to all

customers. Banks have therefore been asked to publish the minimum and maximum

interest rates charged by them and display this information in every branch.

Disclosure and transparency are thus key pillars of a corporate governance framework

because they provide all the stakeholders with the information necessary to judge

whether their interests are being taken care of. Another area which requires focused

attention is greater transparency in the balance sheets of co-operative banks. The

commercial banks in India are now required to disclose accounting ratios relating to

13

operating profit, return on assets, business per employee, NPAs, etc. as also maturity

profile of loans, advances, investments, borrowings and deposits. At the initiative of

the RBI, a consultative group, aimed at strengthening corporate governance in banks,

headed by Dr. Ashok Ganguli was set up to review the supervisory role of Board of

banks. The recommendations include the role and responsibility of independent non-

executive directors, qualification and other eligibility criteria for appointment of non-

executive directors, training the directors and keeping them current with the latest

developments. Some of the important recommendations on the constitution of the

Board are to participate in the meetings of the board regularly and ensure that their

participation is effective & contributory, They must study the reports submitted to

them by the management team and enquire about follow up reports on definite time

schedule. They should be actively involved in the matter of formulation of general

policies, they should be familiar with the broad objectives of the bank, and the

policies laid down by the govt. and the changes in the various laws and legislations

time to time. They should be loyal to the bank and must remember that they should

not reveal any information relating to any constituent of the bank to anyone. In the

past, when banks considered the issue of how best to differentiate themselves from

their competition, Good Corporate Governance was undoubtedly not applied. Due to

the fallout from past corporate failures, more and more banks are looking at good

corporate governance from a new perspective. With Indian economic growth increase

and major stock Indices reaching record level, the time has come to position corporate

governance as a strategic force in Indian banks. Indian banks must drive growth and

profitability while continuing to focus on enhancing corporate governance practices.

Indian government has mandating corporate governance reforms at banks, can create

the necessary infrastructure to ensure the continued flow of investment into the

region. Expanding global and regional banks, such as State Bank of India, Bank of

Baroda, Bank of India, Punjab National Bank, ICICI Bank, HDFC Bank, Standard

Chartered, HSBC, Citibank and others along with major investments by large

institutional investor, are enhancing corporate governance practices, increasing

competitiveness and permanently changing the competitive landscape of Indian

banking environment. Due to rapidly changing banking environment, Indian banks

must continue to implement strong corporate governance practices. They must now

approach corporate governance as a competitive differentiator in an environment of

14

strong foreign entrants and growing regional competitors. To the extent that banks

have systemic implications, Corporate Governance in the banks is of critical

importance.9

9 http://www.abhinavjournal.com/images/Commerce_&_Management/Apr12/5.pdf

15

Chapter-2

Review of recommendations by expert bodies

2.1. Board Composition

Board composition is one of the widely discussed and deliberated issues of corporate

governance across the globe. Notable areas covered are levels of board governance,

types of board leadership, quality of board independence and strength of executive

representation in the board. Recommendations by OECD, A.S. Ganguly committee

and Basel committee on banking supervision in these areas are discussed below.

(a) OECD Guidelines

The board should be able to exercise objective independent judgment on corporate

affairs. In order to exercise its duties of monitoring managerial performance,

preventing conflicts of interest and balancing competing demands on the corporation,

it is essential that the board is able to exercise objective judgment. In the first instance

this will mean independence and objectivity with respect to management with

important implications for the composition and structure of the board. Board

independence in these circumstances usually requires that a sufficient number of

board members will need to be independent of management.

In a number of countries with single tier board systems, the objectivity of the board

and its independence from management may be strengthened by the separation of the

role of chief executive and chairman, or, if these roles are combined, by designating a

lead non-executive director to convene or chair sessions of the outside directors.

Separation of the two posts may be regarded as good practice, as it can help to

achieve an appropriate balance of power, increase accountability and improve the

board’s capacity for decision making independent of management. The designation of

a lead director is also regarded as a good practice a dominant shareholder has

considerable powers to appoint the board and the management. However, in this case,

the board still has a fiduciary responsibility to the company and to all shareholders

including minority shareholders.

The variety of board structures, ownership patterns and practices in different countries

will thus require different approaches to the issue of board objectivity. In many

instances objectivity requires that a sufficient number of board members not be

16

employed by the company or its affiliates and not be closely related to the company or

its management through significant economic, family or other ties. In defining

independent members of the board, some national principles of corporate governance

have specified quite detailed presumptions for non-independence which are frequently

reflected in listing requirements. While establishing necessary conditions, such

‘negative’ criteria defining when an individual is not regarded as independent can

usefully be complemented by ‘positive’ examples of qualities that will increase the

probability of effective independence. Independent board members can contribute

significantly to the decision-making of the board. They can bring an objective view to

the evaluation of the performance of the board and management. In addition, they can

play an important role in areas where the interests of management, the company and

its shareholders may diverge such as executive remuneration, succession planning,

changes of corporate control, take-over defenses, large acquisitions and the audit

function. In order for them to play this key role, it is desirable that boards declare who

they consider to be independent and the criterion for this judgment.

1. Boards should consider assigning a sufficient number of non-executive board

members capable of exercising independent judgment to tasks where there is a

potential for conflict of interest. Examples of such key responsibilities are ensuring

the integrity of financial and non-financial reporting, the review of related party

transactions, nomination of board members and key executives, and board

remuneration. While the responsibility for financial reporting, remuneration and

nomination are frequently those of the board as a whole, independent non-executive

board members can provide additional assurance to market participants that their

interests are defended. The board may also consider establishing specific committees

to consider questions where there is a potential for conflict of interest. These

committees may require a minimum number or be composed entirely of non-

executive members. In some countries, shareholders have direct responsibility for

nominating and electing non-executive directors to specialized functions.

2. When committees of the board are established, their mandate, composition and

working procedures should be well defined and disclosed by the board. While the use

of committees may improve the work of the board they may also raise questions about

the collective responsibility of the board and of individual board members. In order to

17

evaluate the merits of board committees it is therefore important that the market

receives a full and clear picture of their purpose, duties and composition. Such

information is particularly important in the increasing number of jurisdictions where

boards are establishing independent audit committees with powers to oversee the

relationship with the external auditor and to act in many cases independently. Other

such committees include those dealing with nomination and compensation. The

accountability of the rest of the board and the board as a whole should be clear.

Disclosure should not extend to committees set up to deal with, for example,

confidential commercial transactions.

3. Board members should be able to commit themselves effectively to their

responsibilities. Service on too many boards can interfere with the performance of

board members. Companies may wish to consider whether multiple board

memberships by the same person are compatible with effective board performance

and disclose the information to shareholders. Some countries have limited the number

of board positions that can be held. Specific limitations may be less important than

ensuring that members of the board enjoy legitimacy and confidence in the eyes of

shareholders. Achieving legitimacy would also be facilitated by the publication of

attendance records for individual board members (e.g. whether they have missed a

significant number of meetings) and any other work undertaken on behalf of the board

and the associated remuneration. In order to improve board practices and the

performance of its members, an increasing number of jurisdictions are now

encouraging companies to engage in board training and voluntary self-evaluation that

meets the needs of the individual company. This might include that board members

acquire appropriate skills upon appointment, and thereafter remain abreast of relevant

new laws, regulations, and changing commercial risks through in-house training and

external courses. 10

(b) Dr. A. S. Ganguly Report

The Group examined the structure and the composition of the Boards of banks. It is

noted that composition of the Boards of banks is more regulation-based rather than

need-based. The Board of Directors of a bank is required to have representation from

specific sectors like agriculture and rural economy, co-operation, SSI, law, etc., The

10www.oecd.org/dataoecd/32/18/31557724.pdf

18

Group is of the view that in the context of banking becoming more complex and

competitive, the composition of the Board should be left to the business needs of

banks. Composition of the Board (by way of representation of various sectors) should

be so as to reflect the business strategy and its vision for the future. The Group is of

the view that in the present context when banking is becoming more complex and

knowledge-based, there is an urgent need for making the Boards of banks more

contemporarily professional, by inducting technical and specially qualified personnel.

The earlier requirement of ensuring representation on the Boards of banks for areas

like agricultural sector, law, co-operation, small-scale industry, etc. which were

relevant in the immediate post-nationalization era, in the Group's view, have now to

be supplemented by other emerging priorities. The Group feels that instead of

attempting to wholly change sectoral representation, efforts should be aimed at

bringing about a blend of ‘historical skills’ set (that is, regulation-based representation

of sectors like agriculture, SSI, co-operation, etc.) and the ‘new skills’ set (that is,

need-based representation of skills such as, marketing, technology and systems, risk

management, strategic planning, treasury operations, credit recovery, etc.).11

It was recognized that agriculture still contributes a significant share of GDP and

representation to agriculture and SSI, etc., sectors have to be continued. With

increased de-regulation and the structural changes that have taken place in the

economy and in the banking sector, the Group is of the view that the Boards of banks

should have representation with candidates having good practical exposure in the

areas of Finance, Information Technology and Human Resources Development.

The independent / non-executive directors in any organization have a constructive role

to play both on-and-off-the Board because of their knowledge and professional

objectivity. Within the existing legal framework, the Group is of the view that the

independent / non-executive directors must play a more pro-active role by exercising

their independence of judgment, practical experience, specialized knowledge, etc. to

the deliberations of the Board. The independent / non-executive directors have a

prominent role in introducing and sustaining a pro-active governance framework in

banks and financial institutions. The independent / non-executive directors, according

to the Group, should provide constructive inputs regarding the business strategy,

11 kannanpersonal.com/corpgovern/ganguly/report1.html

19

performance of the bank, etc. They should act as the catalyst for focused discussions

on issues brought to the Board and subjects of critical importance to the bank during

the meetings of the Board. These directors, being independent, are expected to be free

from any organizational affiliation and should seek all information which are relevant

to monitor the performance of the bank, the overall risk profile of its credit and

investment portfolios, cases of over-exposure to one or a particular group of

borrowers or entities related / associated with the promoter directors, etc. According

to the Group, the independent / non-executive directors should raise in the meetings of

the Board, critical questions relating to Business strategy, including loans and

recovery policy, Housekeeping and internal control system, Record of exposure to

various sectors / industries by way of both, Credit and investments, Risk management

systems, Internal audit, Accounting policy Senior management development, Other

aspects of the functioning of the bank, and Investor relations.

The independent / non - executive directors need to ensure that the vital issues raised

by them are addressed by the bank to the full satisfaction of the Board. While

making the above recommendations, the Group is guided by the fact that good

corporate governance in banks will be sustained by a knowledgeable, skilful and well

informed Board of Directors with a correct blend of expertise / professionalism,

independence and involvement.

In the case of private sector banks where promoter directors may act in concert, the

independent / non-executive directors should provide effective checks and balances

ensuring that the bank does not build up exposures to entities connected with the

promoters or their associates. They should also seek through the Board, all

information relating to critical areas like connected lending, investments, exposure to

entities / associates related to the promoters/ large shareholders. The independent /

non-executive 16 directors should provide effective checks and balances, particularly,

in widely held and closely controlled banking organizations.

The Group notes that the statutes governing public sector banks vest powers with the

Central Government to appoint whole-time directors as also majority of the

independent / non-executive directors. The Boards of public sector banks (barring

State Bank of India) comprise presently, two whole-time directors (one Chairman &

Managing Director and one Executive Director). Considering the fact that banking is

20

becoming more complex, the Group is of the view that one more whole-time director

should be appointed on the Boards of large-sized nationalized banks, who could

provide undivided attention to critical areas like risk management systems, human

resource management, etc.

The eligibility criteria normally followed for nomination of independent directors to

the Boards of public sector banks are the following:

The candidate should normally be a graduate (which can be relaxed while selecting

directors for the categories of farmers, depositors, artisans, etc.)

He / she would be between 35 and 65 years of age.

He / she should not be a Member of Parliament /Member of Legislative

Assembly/Member of Legislative Council. The Group is of the view that the above

criteria needs to be revised in view of challenges facing the banking sector.

Presently, the due diligence is done, to a limited extent, by the Reserve Bank of India

for the candidates considered for independent / non- executive directorship in public

sector banks. The due diligence by RBI is, however, confined to verifying whether

the names forwarded by the Government of India figure in the Defaulters' List or not.

This due diligence process does not assess either the ability, professional qualification

or the technical competence of the candidates being considered for directorship to

fulfil the fiduciary responsibilities expected of them. In the case of independent / non-

executive directors of private sector banks, since they are appointed by the Board, the

due diligence exercise is not done by RBI. Such directors are appointed by the Board

keeping in view the requirement of giving representation to the specified sectors, as

enshrined in the Banking Regulation Act, 1949. The Group recommends that the

criteria followed by the Government of India for nominating directors to the Boards

of public sector banks and the due diligence followed for them should be made

applicable to independent / non-executive directors of other banks as well.

The Group is of the view that due diligence of the directors of all banks - be they in

public sector or private sector should be done in regard to their suitability for the post

by way of qualifications and technical expertise. The Group strongly feels that

involvement of Nomination Committee of the Board in such an exercise should be

seriously considered as a formal process. The final decision in respect of appointment

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of independent / non-executive directors should be that of the Board with the

Nomination.

Committee presenting its recommendations highlighting both positive and negative

aspects of each recommended candidate, for consideration of the Board. While the

desirable international practice of the Board members being nominated by the

Nomination Committee from a list of qualified, experienced professionals would

require amendments to the banking laws, he Group recommends that the Government

while nominating directors on the Boards of public sector banks should be guided by

certain broad "fit and proper" norms for the directors. The Group recommends the

criteria suggested by the BIS to consider 'fit and proper" for bank directors:

Competence of the individual directors as assessed in terms of formal qualifications,

previous experience and track record.

Integrity of the candidates.

For assessing integrity and suitability, the features like criminal records, financial

position, civil actions undertaken to pursue personal debts, refusal of admission to, or

expulsion from professional bodies, sanctions applied by regulators or similar bodies,

and previous questionable usiness practices, etc. should be considered. (“Supervision

of Financial Conglomerates", 1998, BCBS). The Group recommends that these

criteria should also be made applicable to nomination of independent directors of

private sector banks.

The Group recommends that a pool of professional and talented people should be

built up for consideration of nomination as independent / non- executive directors to

the Board of banks and financial institutions. The list of such eligible directors should

be assembled by RBI from independent sources after proper due diligence and such a

list should be put on the RBI’ s website for access by all concerned. The Group is of

the view that appointment / nomination of independent / non-executive directors to

the Boards of banks (both public sector and private sector) should be from this list.

Any deviation from this procedure by any bank, according to the Group, should be

with the prior approval of RBI. RBI may also establish procedures for regularly

updating the list through additions and deletions from time to time.

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The Group examined the structure and the composition of the Boards of banks. It is

noted that composition of the Boards of banks is more regulation-based rather than

need-based. As noted in paragraph 2.2 above, as per the regulation applicable to

banks, the Board of Directors of a bank is required to have representation from

specific sectors like agriculture and rural economy, co-operation, SSI, law, etc., The

Group is of the view that in the context of banking becoming more complex and

competitive, the composition of the Board should be left to the business needs of

banks. Composition of the Board (by way of representation of various sectors) should

be so as to reflect the business strategy and its vision for the future. Criteria followed

by the GOI for nominating directors of Public Sector Banks - to be followed for other

banks also. The Govt. while nominating directors on the board of Public Sector Banks

should be guided by certain broad ‘ Fit and proper’ norms like: Competence of the

individual directors- assessed in terms of formal qualifications, previous experience &

track record – Integrity. These criteria-also applicable for independent directors of

private sector banks. A pool of professional and talented people to be built up, by

exercising their Independence of judgment, practical experience, specialized

knowledge etc.

(c) Basel Committee on Banking Supervision (Basel-III)

Encourage effective representation of independent non-executive directors, including

those representing minority interests.

Minority shareholders as a class are facilitated to contest. (through the use of proxy).

At least one independent director representing institutional equity interest of financial

institution. (A director nominated as a director under section 182 and 183 not be

taken as independent directors).

Executive directors not more than75% of the elected directors.

Voluntary Provision: The directors to give consent that they are aware of their duties

and powers. Appointment etc. of Chief Executive to be determined by the board.

Investment policy of modaraba institution to be approved and reported in annual

report. Significant issues to be placed for decision by the board of directors (i.e.

annual business plan, budgets, joint ventures etc.). Orientation courses for directors.

23

CFO has to be a professional accountant (or) Graduate with 5 yrs. experience in

handling financial affairs in a listed company (or) a bank.

CS has to be a Professional accountant; (or) Member of a recognized body of

corporate/chartered secretaries (or) Lawyer (or) A Graduate with 5 yrs. experience of

handling corporate affairs.

Independent directors:

Board should have adequate number of independent directors.

Independence = ability to exercise objective judgment.

Helpful if not members of bank management especially important in certain areas.

Ensuring integrity of reporting.

Review of related-party transactions.

Nomination of board members and key executives.

Board and key executive compensation.

Two-tier boards

Some countries adopt a two-tier board of directors (e.g. management board and

supervisory board.

Basel Committee recognises that both one-tier and two-tier boards may be

appropriate.

Two-tier boards may be structured differently across jurisdictions, so no specific

guidance.

Whichever structure is used, principles of sound corporate governance should be in

place.

The board should apply high ethical standards. It should take into account the interests

of stakeholders. The board has a key role in setting the ethical tone of a company, not

only by its own actions, but also in appointing and overseeing key executives and

consequently the management in general. High ethical standards are in the long term

interests of the company as a means to make it credible and trustworthy, not only in

day-to-day operations but also with respect to longer term commitments. To make the

objectives of the board clear and operational, many companies have found it useful to

develop company codes of conduct based on, inter alia, professional standards and

sometimes broader codes of behavior. The latter might include a voluntary

commitment by the company (including its subsidiaries) to comply with the OECD

24

Guidelines for Multinational Enterprises which reflect all four principles contained in

the ILO Declaration on Fundamental Labor Rights. Company-wide codes serve as a

standard for conduct by both the board and key executives, setting the framework for

the exercise of judgment in dealing with varying and often conflicting constituencies.

At a minimum, the ethical code should set clear limits on the pursuit of private

interests, including dealings in the shares of the company. An overall framework for

ethical conduct goes beyond compliance with the law, which should always be a

fundamental requirement.12

2.2 Board Compensation:

(a) OECD Principles

Guidelines on Corporate Governance for OECD countries insist that shareholders

should be able to make their views known on the remuneration policy for board

members and key executives. The equity component of compensation schemes for

board members and employees should be subject to shareholder approval. In

particular, it is important for shareholders to know the specific link between

remuneration and company performance when they assess the capability of the board

and the qualities they should seek in nominees for the board. 13

All stakeholders to be informed about remuneration policy for members of the board

and key executives, and information about board members, including their

qualifications, the selection process, other company directorships and whether they

are regarded as independent by the board.

Investors require information on individual board members and key executives in

order to evaluate their experience and qualifications and assess any potential conflicts

of interest that might affect their judgment. For board members, the information

should include their qualifications, share ownership in the company, membership of

other boards and whether they are considered by the board to be an independent

member. It is important to disclose membership of other boards not only because it is

an indication of experience and possible time pressures facing a member of the board,

but also because it may reveal potential conflicts of interest and makes transparent the

degree to which there are inter-locking boards. Information about board and

12http://rbidocs.rbi.org.in/rbiadmin/scripts/PublicationReportDetails.aspx?FromDate=04/05/02&SECID=7&SUBSECID=1813 www.oecd.org/dataoecd/32/18/31557724.pdf

25

executive remuneration is also of concern to shareholders. Of particular interest is the

link between remuneration and company performance.

It is considered good practice in an increasing number of countries that remuneration

policy and employment contracts for board members and key executives be handled

by a special committee of the board comprising either wholly or a majority of

independent directors. There are also calls for a remuneration committee that excludes

executives that serve on each other’s remuneration committees, which could lead to

conflicts of interest.14

(b) Dr.A. S. Ganguly Report

The Group is of the view that the existing level of remuneration paid (by way of

sitting fees, etc.) to directors of banks and financial institutions is grossly inadequate,

by contemporary standards, to attract qualified professional people to their Boards,

and expect them to discharge their duties as per the mutually agreed covenants. A few

of the banks / FIs have modified their compensation plans to include a base salary,

performance bonus and options to their directors. In order to get quality professional

people, the level of remuneration payable to the directors should be commensurate

with the time required to be devoted to the bank's work and also to signal the

appropriateness of remuneration to the quality of inputs expected from a member.

The remuneration of the directors may also include the form of stock option.

(c) Basel recommendations have not mentioned about board remuneration.

2.3 Board Committees:

(a) OECD Principles

OECD Principle VI.E.1: Boards should consider assigning a sufficient number of non-

executive directors capable of exercising independent judgment to tasks where there

is a potential for conflict of interest. Examples of such key responsibilities are

ensuring the integrity of financial and non-financial reporting, the review of related

party transactions, nomination of directors and key executives, and board

remuneration.

Annotation to OECD Principle VI.E.1:

14 Oecd Principles of Corporate Governancehttp://Acts.Oecd.Org/Instruments/Showinstrumentview.Aspx?Instrumentid=151&Lang=En&Book=False

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While the responsibility for financial reporting, remuneration and nomination are

frequently those of the board as a whole, independent non-executive board members

can provide additional assurance to market participants that their interests are

defended. The board may also consider establishing specific committees to consider

questions where there is a potential for conflict of interest. These committees may

require a minimum number or be composed entirely of non-executive members. In

some countries, shareholders have direct responsibility for nominating and electing

non-executive directors to specialized functions.

OECD Principle VI.E.2: When committees of the board are established, their

mandate, composition and working procedures should be well defined and disclosed

by the board.

Annotation to OECD Principle VI.E.2:

While the use of committees may improve the work of the board they may also raise

questions about the collective responsibility of the board and of individual board

members. In order to evaluate the merits of board committees it is therefore important

that the market receives a full and clear picture of their purpose, duties and

composition. Such information is particularly important in the increasing number of

jurisdictions where boards are establishing independent audit committees with powers

to oversee the relationship with the external auditor and to act in many cases

independently. Other such committees include those dealing with nomination and

compensation. The accountability of the rest of the board and the board as a whole

should be clear. Disclosure should not extend to committees set up to deal with, for

example, confidential commercial transactions.15

(b) Dr.A. S. Ganguly Report

(1) Supervisory Committee

An issue raised during the deliberations of the Group was whether an additional tier

by way of Supervisory Board could be considered for banks, a practice which is

followed by banks in Germany. The Supervisory Boards of banks in Germany mainly

function as "Executive Committees" of the Board. The public sector banks in India

15 Oecd Principles Of Corporate Governancehttp://Acts.Oecd.Org/Instruments/Showinstrumentview.Aspx?Instrumentid=151&Lang=En&Book=False

27

have constituted "Executive Committee" or "Management Committee” which meet

more frequently than the full Board do. The Group is of the view that instead of

creating another tier by way of a Supervisory Board, there could be a Supervisory

Committee of the Board in all banks - be they public or private sector, which will

work on collective trust and at the same time, without diluting the overall

responsibility of the Board. The role and responsibilities of the Supervisory

Committee of the Board could include monitoring of the exposures (both credit and

investment) by the banks, review of the adequacy of the risk management process and

up gradation thereof, internal control systems and ensuring compliance with the

statutory / regulatory framework.

(2) Audit Committee of the Board

The Group notes that banks have set up as required in terms of the RBI guidelines,

independent Audit Committees. The Audit Committee comprises a majority of the

independent / non-executive directors with the Executive Director of the bank as one

of the members. The Group notes that a Chartered Accountant, wherever available on

the board, is a member of the Audit Committee.

The international best practice in this regard is to constitute Audit Committees with

only independent / non-executive directors. As regards the composition of the Audit

Committee, the Basel Committee has suggested that in order to ensure its

independence, the Audit Committee of the Board should be constituted with external

Board members who have banking or financial expertise. (cf Enhancing Corporate

Governance for Banking Organisations, Basel, September 1999). The Group is of the

view that ideally the Audit Committee should be constituted with independent / non-

executive directors and the Executive Director should only be a permanent invitee.

However, keeping in view that the present circumstances, the existing arrangements

where the Executive Director is one of the members may continue; and may include

the Executive Director and official directors i.e., nominee of Government of India and

RBI in respect of public sector banks.

The Group is of view that the Chairman of Audit Committee need not be confined to

the Chartered accountant profession but can be a person with knowledge of

‘finance’ or 'banking' so as to provide directions and guidance to the Audit Committee

28

since the Committee not only looks at accounting role but also the overall

management audit etc. of the bank.

(3) Nomination Committee

As already discussed in the paragraph 4.8, the Group is of the view that it is desirable

to have a Nomination Committee for appointing independent / non-executive directors

of banks that should scrutinize the nominations received for nomination of

independent / non-executive directors with reference to their qualifications,

experience and other criteria proposed above. The Group recognizes that in the case

of public sector banks, the nomination committees may be of no immediate relevance,

since the independent / non-executive directors (except shareholder nominees in the

case of banks which have issued capital to the public) are appointed by the Central

Government. The Group is of the view that in the context of a number of public

sector banks issuing capital to the public, a Nomination Committee of the Board may

be formed for nomination of directors representing shareholders.

(4) Shareholders Redressal Committee

Since banks are increasingly accessing capital market, there is a need for an effective

machinery for redressal of investor grievances in banks. The Group notes that as of

now, the matters relating to investor complaints, etc. are looked after by the line staff.

With a view to building up credibility among the investor class, the Group

recommends that a Committee of the Board may be set up to look into the grievances

of investors and share holders, with the Company Secretary as a nodal point.

(5) Risk Management Committee

The Group notes that in pursuance of the Guidelines issued by the Reserve Bank of

India, every banking organization is required to set up Risk Management Committees

(for management of both credit risk and market risk) with Board level representation

to manage effectively the risk profile of the bank. The management of risk particularly

arising from over exposure to interconnected entities came to the fore in the recent

past in respect of a few banks. The Group, therefore, recommends that the formation

and operationalisation of the Risk Management Committees should be speeded up and

their role further strengthened.16

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(c) Basel recommendations have not given much emphasis to board committees.

2.4. Share Holding Pattern

(a) OECD Principles

The Rights of Shareholders and Key Ownership Functions The corporate governance

framework should protect and facilitate the exercise of shareholders’ rights.

Basic shareholder rights should include the right to: 1) secure methods of ownership

registration; 2) convey or transfer shares; 3) obtain relevant and material information

on the corporation on a timely and regular basis; 4) participate and vote in general

shareholder meetings; 5) elect and remove members of the board; and 6) share in the

profits of the corporation.

Shareholders should have the right to participate in, and to be sufficiently informed

on, decisions concerning fundamental corporate changes such as: 1) amendments to

the statutes, or articles of incorporation or similar governing documents of the

company; 2) the authorization of additional shares; and 3) extraordinary transactions,

including the transfer of all or substantially all assets, that in effect result in the sale of

the company.

Shareholders should have the opportunity to participate effectively and vote in general

shareholder meetings and should be informed of the rules, including voting

procedures that govern general shareholder meetings:

1. Shareholders should be furnished with sufficient and timely information concerning

the date, location and agenda of general meetings, as well as full and timely

information regarding the issues to be decided at the meeting.

2. Shareholders should have the opportunity to ask questions to the board, including

questions relating to the annual external audit, to place items on the agenda of general

meetings, and to propose resolutions, subject to reasonable limitations.

3. Effective shareholder participation in key corporate governance decisions, such as

the nomination and election of board members, should be facilitated. Shareholders

should be able to make their views known on the remuneration policy for board

members and key executives. The equity component of compensation schemes for

board members and employees should be subject to shareholder approval.

30

4. Shareholders should be able to vote in person or in absentia, and equal effect should

be given to votes whether cast in person or in absentia. Capital structures and

arrangements that enable certain shareholders to obtain a degree of control

disproportionate to their equity ownership should be disclosed. Markets for corporate

control should be allowed to function in an efficient and transparent manner. The rules

and procedures governing the acquisition of corporate control in the capital markets,

and extraordinary transactions such as mergers, and sales of substantial portions of

corporate assets, should be clearly articulated and disclosed so that investors

understand their rights and recourse. Transactions should occur at transparent prices

and under fair conditions that protect the rights of all shareholders according to their

class.

Anti-take-over devices should not be used to shield management and the board from

accountability.

The exercise of ownership rights by all shareholders, including institutional investors,

should be facilitated.

1. Institutional investors acting in a fiduciary capacity should disclose their overall

corporate governance and voting policies with respect to their investments, including

the procedures that they have in place for deciding on the use of their voting rights.

2. Institutional investors acting in a fiduciary capacity should disclose how they

manage material conflicts of interest that may affect the exercise of key ownership

rights regarding their investments.

Shareholders, including institutional shareholders, should be allowed to consult with

each other on issues concerning their basic shareholder rights as defined in the

Principles, subject to exceptions to prevent abuse. OECD report talked about

shareholder rights and obligations. But, it has not mentioned about the preferred

shareholding pattern17.

(b) A.S. Ganguly Committee and Basel Recommendations did not mention about the

shareholder related aspects of corporate governance.

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2.5. Risk Management

(a) OECD Principles

Risks can be classified in many different ways and the exact balance will vary over

time and between companies. Moreover, each category is often correlated with others

(i.e. they are not independent). For financial companies, strategic, market,

reputational, compliance, operational and credit risks are all important and for several

of them (operational, credit and market) measurement is normal although sometimes

potentially misleading. The banking sector has some quite specific risks that are of

key significance for regulators. Unlike non-financial companies, banks especially are

involved in maturity transformation (i.e. borrow short, lend long) which means that

liquidity risks are crucial. The financial crisis has exposed gaps in risk management in

this area with a number of firms relying on marketability of securities for liquidity

needs, which with all trying to sell at the same time led to market failure. Closely

associated with liquidity risk is reputational risk which has only been effectively kept

under control during the crisis through widespread deposit and borrowing guarantees.

At the time of the revision of the Principles in 2004 internal controls were an

important current theme but risk management issues were nevertheless emerging and

were partially taken into account. Disclosure of foreseeable risk factors had always

been a part of the Principles but the 2004 revision extended responsibility to the

board. Principle VI.D.1 recommends that “the board should fulfil certain key

functions including reviewing and guiding corporate strategy, major plans of action,

risk policy…” while VI.D.7 defines a key function to include “Ensuring the integrity

of the corporation’s accounting and reporting systems …and that appropriate systems

of control are in place, in particular systems of risk management, financial and

operational control”. The annotations to principle VI.D.1 note that risk policy

(sometimes termed risk appetite) is closely related to strategy and “will involve

specifying the types and degree of risk that a company is willing to accept in pursuit

of its goals. It is thus a crucial guideline for management that must manage risks to

meet the company’s desired risk profile”. Although the Principles make risk

management an oversight duty of the board, the internal management issues

highlighted during the financial crisis receive less explicit treatment.

32

Principle VI.D.2 lists a function of the board to be “monitoring the effectiveness of

the company’s management practices and making changes as needed”. The

annotations are easily overlooked but are highly relevant: monitoring of governance

by the board also includes continuous review of the internal structure of the company

to ensure that there are clear lines of accountability for management throughout the

organisation. This more internal management aspect of the Principles might not have

received the attention it deserves in Codes and in practice. The annotations to

Principle VI.D.7 note that “ensuring the integrity of the essential reporting and

monitoring systems will require the board to set and enforce Clear lines of

responsibility and accountability throughout the organization. The board will also

need to ensure that there is appropriate oversight by senior management”. Principle

V.A.6 calls for disclosure of material information on foreseeable risk factors and the

annotations go on to note that “disclosure about the system for monitoring and

managing risk is increasingly regarded as good practice”. However, this latter aspect

is vague and might even be better related to evolving international or domestic risk

management standards similar to the treatment in financial reporting, principle, V.B.

With respect to Principle V.A.6, research about the major economies of the OECD

suggests that the readability of risk disclosures is difficult or very difficult and that

there is generally no consistent global set of generally accepted risk management

accounting principles and additional guidance available for risk disclosures in the

annual report (van Manen, 2009). The Financial Stability Forum (2008) has been

concerned about disclosure and encouraged “financial institutions to make robust risk

disclosures using the leading disclosure practices … at the time of their upcoming

mid-year 2008 reports”. Leading disclosure practices were first enunciated by the

Senior Supervisors Group in early 2008.

The audit committee should discuss the listed company's major financial risk

exposures and the steps management has taken to monitor and control such exposures.

The audit committee is not required to be the sole body responsible for risk

assessment and management, but, as stated above, the committee must discuss

guidelines and policies to govern the process by which risk assessment and

management is undertaken. Many companies, particularly financial companies,

manage and assess their risk through mechanisms other than the audit committee. The

33

processes these companies have in place should be reviewed in a general manner by

the audit committee, but they need not be replaced by the audit committee.”

Key findings of report commissioned by the OECD (Anderson, 2009) are as follows.

• Effective risk management is a key element of good corporate governance in

financial and non-financial companies. Risk management failures in financial

companies can have important implications for systemic risk. However, failures in

non-financial companies can also involve major externalities and social costs.

Nevertheless, national risk standards are still in a very high level form and may not

give good guidance to companies, investors and stakeholders.

• Risk management is integral to corporate strategy not just in companies avoiding

losses but also in being able to seize new opportunities. However, excessive emphasis

appears to have been given to financial risk and internal controls for the purpose of

corporate reporting and to the board’s responsibilities via the audit committee. This

orientation is much too ex-post. Linking risk management to strategy is more forward

oriented and also introduces an important role for stress testing.

• The financial crisis shows that risk management needs to be an enterprise-wide

undertaking and not just practiced in particular product/market lines. Indeed, with the

current level of outsourcing, the economic borders of the firm might be wider than its

legal form.

• The board bears primary responsibility for strategy and for associated risk

management. However, good risk management must be practiced throughout the

organization and be a part of the way it does business. Boards must therefore monitor

the structure of the company and its culture and also ensure a reliable and relevant

flow of information (the assurance perspective) to the board about the implementation

of its strategy and the associated risks.

• Particularly in financial institutions, a separate channel of risk reporting to the

board such as via a chief risk officer is warranted in the same way as internal audit

reports separately to the audit committee and not just to the CEO. It is not clear that

risk management belongs to the duties of the audit committee, although it should

inform itself about risk management in the company.

34

• Reflecting the lack of adequate standards, disclosure of foreseeable risks is often

poor and can be mechanical and boiler plate in nature (e.g. a list of umpteen possible

risks). More important is adequate disclosure about the mechanisms of risk

management and the risk management culture.

• Remuneration and incentive systems have important implications for risk taking and

therefore need to be monitored and perhaps even influenced by the risk management

system.18

(b) Dr.A. S. Ganguly Report

There is no recommendation as such by the Ganguly committee on risk management

in banks, except recommending Risk Management Guidelines issued by the Reserve

Bank of India in October 1999.

(c) Basel-III Report

The adequacy of the documentation of the risk management system and process;

• The organisation of the risk control unit;

• The integration of counterparty credit risk measures into daily risk

Management;

• The approval process for counterparty credit risk models used in the calculation of

counterparty credit risk used by front office and back office personnel;

• The validation of any significant change in the risk measurement

Process;

• The scope of counterparty credit risks captured by the risk

Measurement model;

• The integrity of the management information system;

• The accuracy and completeness of position data;

• The verification of the consistency, timeliness and reliability of data sources used to

run internal models, including the independence of such data sources;

• The accuracy and appropriateness of volatility and correlation assumptions;

• The accuracy of valuation and risk transformation calculations; and

• The verification of the model’s accuracy as described below in

paragraphs

18 Corporate Governance and the Financial Crisis - Organisation for ...www.oecd.org/dataoecd/3/10/43056196.pdf

35

The on-going validation of counterparty credit risk models, including back testing,

must be reviewed periodically by a level of management with sufficient authority to

decide the course of action that will be taken to address weaknesses in the models.

Banks must document the process for initial and on-going validation of their IMM

model to a level of detail that would enable a third party to recreate the analysis.

Banks must also document the calculation of the risk measures generated by the

models to a level of detail that would allow a third party to re-create the risk

measures. This documentation must set out the frequency with which back testing

analysis and any other on-going validation will be conducted, how the validation is

conducted with respect to data flows and portfolios and the analyses that are used.

Banks must define criteria with which to assess their EPE models and the models that

input into the calculation of EPE and have a written policy in place that describes the

process by which unacceptable performance will be determined and remedied.

Banks must define how representative counterparty portfolios are constructed for the

purposes of validating an EPE model and its risk measures when validating EPE

models and its risk measures that produce forecast distributions, validation must

assess more than a single statistic of the model distribution.

As part of the initial and on-going validation of an IMM model and its risk easures,

the following requirements must be met:

A bank must carry out back testing using historical data on movements in market risk

factors prior to supervisory approval. Back testing must consider a number of distinct

prediction time horizons out to at least one year, over a range of various start

(initialization) dates and covering a wide range of market conditions.

Banks must back test the performance of their EPE model and the model’s relevant

risk measures as well as the market risk factor predictions that support EPE. For

collateralized trades, the prediction time horizons considered must include those

reflecting typical margin periods of risk applied in collateralized/margined trading,

and must include long time horizons of at least 1 year.

• The pricing models used to calculate counterparty credit risk exposure for a given

scenario of future shocks to market risk factors must be tested as part of the initial and

on-going model validation process. These pricing models may be different from those

36

used to calculate Market Risk over a short horizon. Pricing models for options must

account for the nonlinearity of option value with respect to market risk factors.

• An EPE model must capture transaction specific information in order to aggregate

exposures at the level of the netting set. Banks must verify that transactions are

assigned to the appropriate netting set within the model.

• Static, historical back testing on representative counterparty portfolios must be a part

of the validation process. At regular intervals as directed by its supervisor, a bank

must conduct such back testing on a number of representative counterparty portfolios.

The representative portfolios must be chosen based on their sensitivity to the material

risk factors and correlations to which the bank is exposed. In addition, IMM banks

need to conduct back testing that is designed to test the key assumptions of the EPE

model and the relevant risk measures, e.g. the modelled relationship between tenors of

the same risk factor, and the modelled relationships between risk factors.

• Significant differences between realized exposures and the forecast distribution

could indicate a problem with the model or the underlying data that the supervisor

would require the bank to correct. Under such circumstances, supervisors may require

additional capital to be held while the problem is being solved.

• The performance of EPE models and its risk measures must be subject to good back

testing practice. The back testing programme must be capable of identifying poor

performance in an EPE model’s risk measures.

Banks must validate their EPE models and all relevant risk measures out to time

horizons commensurate with the maturity of trades covered by the IMM waiver.

• The pricing models used to calculate counterparty exposure must be regularly tested

against appropriate independent benchmarks as part of the on-going model validation

process.

• The on-going validation of a bank’s EPE model and the relevant risk measures

include an assessment of recent performance.

• The frequency with which the parameters of an EPE model are updated needs to be

assessed as part of the validation process.

37

• Under the IMM, a measure that is more conservative than the metric used to

calculate regulatory EAD for every counterparty, may be used in place of alpha times

Effective EPE with the prior approval of the supervisor. The degree of relative

conservatism will be assessed upon initial supervisory approval and at the regular

supervisory reviews of the EPE models. The bank must validate the conservatism

regularly.

• The on-going assessment of model performance needs to cover all counterparties for

which the models are used.

• The validation of IMM models must assess whether or not the bank level and netting

set exposure calculations of EPE are appropriate.

The bank must have an independent risk control unit that is responsible for the design

and implementation of the bank’s counterparty credit risk management system. The

unit should produce and analyze daily reports on the output of the bank’s risk

measurement model, including an evaluation of the relationship between measures of

counterparty credit exposure and trading limits. The unit must be independent from

the business trading units and should report directly to senior management of the

bank.

Addressing reliance on external credit ratings and minimizing cliff effects 1.

Standardized inferred rating treatment for long-term exposures 118. Para. 99 of the

Basel II text would be modified as follows:

Note: A revised version of the rules text has been published in June 2011.

http://www.bis.org/publ/bcbs189.htm

• In circumstances where the borrower has a specific assessment for an issued debt –

but the bank’s claim is not an investment in this particular debt – a high quality credit

assessment (one which maps into a risk weight lower than that which applies to an

unrated claim) on that specific debt may only be applied to the bank’s unassessed

claim if this claim ranks pari passu or senior to the claim with an assessment in all

respects. If not, the credit assessment cannot be used and the unassessed claim will

receive the risk weight for unrated claims.

38

In circumstances where the borrower has an issuer assessment, this assessment

typically applies to senior unsecured claims on that issuer. Consequently, only senior

claims on that.

39

Chapter-3

Research Methodology

3.1. Objectives of the study

The study on “Priority areas for Reforms of corporate governance in Indian Banking

Sector” is expected to achieve the following objectives.

1. To understand the influence of shareholding pattern, board structure on bank

performance.

2. To understand the perspectives of different expert bodies on various corporate

governance issues.

3. To suggest reforms in the area of corporate governance in Indian Banking Sector

3.2. Methodology

In order to achieve the above objectives, the following methodology is adopted.

It is proposed to collect primary data about various governance parameters and their

influence on bank performance, by using a structured questionnaire, from different

board level and next level employees of various private and public sector banks.

Simultaneously, data from secondary sources is proposed to be collected from sample

banks on various dependent and independent variables as detailed below.

Independent variables are identified under the categories shareholding pattern &

board of directors. Similarly dependent variables that can explain banks performance

are also identified. List of these variables are given below.

Table: 3.1

List of Variables

S.No Variable Type Units

1 Profitability Dependent %2 Market Performance Dependent %3 Tobin's Q Value Dependent Value4 Z-Score Dependent Value

5 Return on Equity Dependent %

6 NPA Ratio Dependent %

7 Government Independent Numbers

8 Promoter group Independent Numbers

9 Foreign Institutional ownership (FII) Independent Numbers

10 Domestic Institutional Investors (DII) Independent Numbers

40

11 Private Corporate Bodies Independent Numbers

12 Others (other shareholders) Independent Numbers

13 Independent Directors Independent Numbers14 Executive Directors Independent Numbers15 Board Leadership Independent 1 or 016 Board Size Independent Numbers

Values of these variables are collected from various secondary sources like Bank

Annual Reports, National Stock Exchange (NSE), Indian Bank’s Association (IBA)

and Reserve Bank of India (RBI), Websites.

To understand the banks performance parameters like Profitability, Market

Performance, Tobin's Q Value, Z-Score, Return on Equity and NPA Ratio are used.

3.2.1. Variables Description

Banks profitability is understood through Net profit margin. It is the percentage of

revenue remaining after all operating expenses, interest, taxes and preferred stock

dividends (but not common stock dividends) have been deducted from a company's

total revenue. Net Profit margin= (Total Revenue – Total Expenses)*100/Total

Revenue.

Market Performance of bank is arrived by calculating market return on shares. Market

performance= (Market Price period ‘t’ – Market Price period ‘t-1’)*100/Market Price

period ‘t-1’.

Z-Score is a statistical measurement of a score's relationship to the mean in a group of

scores. Z-score of 0 means the score is the same as the mean. Z-score can also be

positive or negative, indicating whether it is above or below the mean and by how

many standard deviations.

Z-score of bank is calculated from return on shares, capital, total asset, and standard

deviation of 3 years return on assets. Z-Score=Return on Asset+(Capital/Total

Assets)/Standard Deviation of 3years return on assets.

Tobin’s Q value is calculated by dividing market value of the capital by replacement

value of the total assets. Tobin’s Q= No of Shares*Market Price/Total Assets. For

example, a low Q (between 0 and 1) means that the cost to replace a firm's assets is

greater than the value of its stock. This implies that the stock is undervalued.

Conversely, a high Q (greater than 1) implies that a firm's stock is more expensive

41

than the replacement cost of its assets, which implies that the stock is overvalued.

This measure of stock valuation is the driving factor behind investment decisions in

Tobin's model.

Return on Equity is derived by adding dividend to Capital appreciation and then

divided by previous year’s equity price.

NPA is a classification used by financial institutions that refer to loans that are in

jeopardy of default. Once the borrower has failed to make interest or principal

payments for 90 days the loan is considered to be a non-performing asset. NPA ratio is

calculated by dividing Net NPA’s by Total Assets.

3.2.2. Sample

As per the information available on Indian Bankers Association website

(http://www.iba.org.in/kbp/PublicSecBanks1_23_07_12.xls,

http://www.iba.org.in/kbp/PrivateSecBanks_03_08_12.xls ) there are about 27 public

sector banks and 20 private sector banks are operating in India). For collecting

secondary data we have considered 12 public sector banks and 9 private sector banks.

Data for all the variables of all sample banks are collected for the period of three years

(2008-09, 2009-10 and 2010-11).

Primary data about various governance parameters and their influence on bank

performance have been collected from different board level and next level employees

of various private and public sector banks.

3.2.3. Statistical Tools

Suitable statistical tools like correlation, stepwise regression, etc will be used.

Stepwise regression is designed to find the most parsimonious set of predictors that

are most effective in predicting the dependent variable.

Variables are added to the regression equation one at a time, using the statistical

criterion of maximizing the R² of the included variables.

The process of adding more variables stops when all of the available variables have

been included or when it is not possible to make a statistically significant

improvement in R² using any of the variables not yet included.

42

Since variables will not be added to the regression equation unless they make a

statistically significant addition to the analysis, all of the independent variables

selected for inclusion will have a statistically significant relationship to the dependent

variable.

Each time SPSS includes or removes a variable from the analysis, SPSS considers it a

new step or model, i.e. there will be one model and result for each variable included

in the analysis.

SPSS provides a table of variables included in the analysis and a table of variables

excluded from the analysis. It is possible that none of the variables will be included.

It is possible that all of the variables will be included.

The order of entry of the variables can be used as a measure of relative importance.

Once a variable is included, its interpretation in stepwise regression is the same as it

would be using other methods for including regression variables.

43

Chapter – 4

Data Collection and Analysis

Data on 6 dependent variables and 10 independent variables of 12 public sector banks

and 9 private sector banks that are listed in National Stock Exchange (NSE), India.

The data for the above variables are collected for the financial years 2008-09, 2009-10

& 2010-11. It has come to a total of 1008 observations.

Descriptive Statistics

Profitability of Public sector banks for three years period, on average, is hovering at

11.36% with a minimum of 4.99% and maximum of 17.18%. Whereas the private

sector banks average profitability stands at 12.41% with a minimum of 5.29% and

maximum of 17.20%.

Average market performance of public sector banks for the three years period, in

terms of return on investment in stock, stands at 45.73% with a range of -66.25% to

331.03%. Whereas private sector banks average performance is at 64.21% with a

range of -70.37% to 429.91%.

Average Tobin’s Q value of public sector banks for the three years period is 0.08 with

a range of 0.00 to 0.79. At the same time private sector banks average value stands at

0.17 with a range of 0.00 to 0.47.

Average Z-score value of public sector banks for the three years period stands at 7.87

with a range of 0.74 to 27.80. At the same time private sector banks average value

stands at 13.12 with a range of 1.70 to 53.50.

Public sector banks three years average return on equity is at 50.58% with a minimum

of -62.92% & maximum of 337.50%. Private sector banks average return stands at

70.08% with a range of -61.23% to 435.51%.

Three year average NPA ratio of public sector banks figured at 0.96% with a

minimum of 0.17% & maximum of 2.52%. While private sector banks average stands

at 0.76% with a range of 0.03% to 2.39%.

The maximum number of independent directors in the sample public sector banks is at

11 while some of the public sector banks are does not have independent directors at

44

all. On the other hand all the private sector banks have independent directors on their

boards with a minimum of 4 and maximum of 12 directors per bank.

On average it appears that around 24.60% of the board members are executives in

public sector banks with a minimum of 3 to a maximum of 5 per board. Whereas for

private sector the average is 19.57 with a minimum of 1 to a maximum of 4 per board.

It is found that in 10 out of 12 public sector banks chairman is executive also, while in

private sector 7 out of 9 banks have executive chairman.

Average Board size in public sector banks is at 12.56 with a minimum of 9 and

maximum of 18 directors per bank. Where as in private sector banks the average

board size is 11.9 with a minimum of 8 and maximum of 19 directors per board.

On the whole, government holding in the public sector banks is hovering at 62.5%

with a span of 53% to 69.47%. Similarly promoter holding in private banks stands at

21.7% with span of 19.54% to 45.57%.

FIIs investment in public sector banks stands at 13.52% with a range of 4.59% to

23%. While in private sector it is at 44.81 with a range of 27.74% to 66.47%.

Domestic institution investors share in public sector banks stands at 12.7% with a

range of 5% to 18.68%. But, in private sector it is 13.38% with a range of 5.12% to

24.1%.

Whereas corporate bodies invested on average around 2.4% in public sector banks

and 5.7% in private sector banks.

Primary Data Analysis

A structured questionnaire was circulated among present and prospective board

members of Indian Banking Industry and we have received 42 responses. The analysis

of responses is as follows.

Around 62% respondents favored external regulation to voluntary self regulation by

banking sector for better governance. Around 58% of the respondents would like to

see more executive directors on Indian bank boards. At the same time they are of the

opinion relatively smaller boards can deliver better. Around 43% respondents felt the

need for a robust mechanism for board performance evaluation. Public sector banks

scored better in terms of corporate governance as opinioned by the respondents. At the

45

same time the respondents felt that checking the borrower companies governance

practices is not practicable. In consistence with their view 61% of the respondents feel

that privatization of bank not necessarily improve the bank governance.

Regression Analysis

The data is analyzed by using stepwise regression procedure to know which

independent variable is important to predict the dependent variable and found that two

models are seem to have a good relevance for predicting percentage of profitability of

private sector banks.

Profitability Prediction

The data collected represents in to the following two models while predicting the

influence of independent variables on profitability of the private sector banks.

Model 1: y (Profitability) = Constant + β1* (x1)

Model 2: y (Profitability) = Constant + β1 * (x1) + β2 * (x2)Table 4.1

Profitability - Variables Entered/Removeda

BANK Model Variables Entered VariablesRemoved

Method

PRIVATEBANK

1 Executive DirectorsValue

. Stepwise (Criteria: Probability-of-F-to-enter <= .050, Probability-of-F-to-remove >= .100).

2 DomesticInstitutionalInvestors (DII)No.Of Shares

. Stepwise (Criteria: Probability-of-F-to-enter <= .050, Probability-of-F-to-remove >= .100).

a. Dependent Variable: Profitability %

Table 4.2

Profitability - Model Summary

BANK Mode

l

R R Square Adjusted R

Square

Std. Error of the

Estimate

PRIVATE BANK 1 .620a .384 .360 11.467853

2 .709b .503 .462 10.511939a. Predictors: (Constant), Executive Directors Valueb. Predictors: (Constant), Executive Directors Value, Domestic Institutional Investors (DII) No.Of Shares

46

Table 4.3

Profitability - ANOVAa

BANK Model Sum ofSquares

df Mean Square F Sig.

PRIVATE BANK

1 Regression 2052.258 1 2052.258 15.605 .001b

Residual 3287.791 25 131.512Total 5340.049 26

2 Regression 2688.029 2 1344.014 12.163 .000c

Residual 2652.020 24 110.501Total 5340.049 26

a. Dependent Variable: Profitability %b. Predictors: (Constant), Executive Directors Valuec. Predictors: (Constant), Executive Directors Value, Domestic Institutional Investors (DII) No.Of Shares

Table 4.4

Profitability - Coefficientsa

BANK Model UnstandardizedCoefficients

StandardizedCoefficients

B Std. Error Beta t Sig.PRIVATEBANK

1 (Constant) -7.330 4.532 -1.617 .118ExecutiveDirectorsValue

7.156 1.812 .620 3.950 .001*

2 (Constant) -6.908 4.158 -1.661 .110ExecutiveDirectorsValue

9.049 1.838 .784 4.922 .000*

DomesticInstitutionalInvestors(DII) No.OfShares

-6.326E

-008

.000 -.382 -2.399 .025*

* Significant

Table 4.5

Profitability - Excluded Variablesa

BANK

Model Beta In t Sig.Partial

Correlation

PRIVATEBANK

1 Independent Directors Value -.043b -.258 .799 -.053Board Size Value -.095b -.536 .597 -.109Government No.Of Shares .040b .246 .808 .050Foreign Institutional ownership (FII)No.Of Shares

-.214b -1.244 .226 -.246

Domestic Institutional Investors (DII)No.Of Shares

-.382b -2.399 .025 -.440

Private Corporate Bodies No.Of Shares -.014b -.086 .932 -.017Others No.Of Shares -.307b -2.015 .055 -.380

2 Independent Directors Value .136c .819 .421 .168Board Size Value .050c .287 .777 .060Government No.Of Shares .039c .263 .795 .055Foreign Institutional ownership (FII)No.Of Shares

.406c 1.361 .187 .273

Private Corporate Bodies No.Of Shares .065c .426 .674 .088Others No.Of Shares -.138c -.718 .480 -.148

a. Dependent Variable: Profitability %b. Predictors in the Model: (Constant), Executive Directors Valuec. Predictors in the Model: (Constant), Executive Directors Value, Domestic Institutional Investors (DII) No.Of Shares

47

We have got R2 Value of 0.384 with 0.001siginificance in model-1 and R2 value of

0.503 at 0.00 significance with Model-2.

It appears that for model-1 for predicting profitability, executive director value is

significant whereas under the second model both executive director’s value and

domestic institutional investors are significant in predicting profitability of private

sector banks.

Regression fit to predict the percentage profitability in private sector banks, as

per Model-1 = -7.330 + 7.156 (EDv), Whereas EDv= Executive Director

value.

Regression fit to predict the profitability in private sector banks, as

per Model-2 = -6.908+ 9.049 (EDv) – 0.00000006326 (DII) whereas EDv =

Executive Director value & DII = Domestic Institutional Investors.

Other variable considered in this study seems to have no influence on profitability of

private sector banks.

Risk Perception

The data is analyzed by using stepwise regression procedure to know which

independent variable is important to predict the dependent variable and found that the

model is seem to have a good relevance for predicting Risk perception of public

sector banks.

The data collected represents in to the following model while predicting the influence

of independent variables on Risk Perception of the public sector banks.

Model: y (Risk Perception) = Constant + β1* (x1)

Table 4.6

Risk Perception - Variables Entered/Removeda

BANK Model

VariablesEntered

VariablesRemoved

Method

PUBLICBANK

1 GovernmentNo.OfShares

. Stepwise (Criteria: Probability-of-F-to-enter <=.050, Probability-of-F-to-remove >= .100).

a. Dependent Variable: Z-Score

48

Table 4.7

Risk Perception - Model SummaryBANK M

odel

R R Square Adjusted R Square Std.Errorof the

Estimate

PUBLICBANK

1 .605a .366 .340 4.877108

a. Predictors: (Constant), Government No.Of Shares

Table 4.8

Risk Perception - ANOVAa

BANK Model Sum ofSquares

df Mean Square F Sig.

PUBLICBANK

1 Regression 342.604 1 342.604 14.403

.001b

Residual 594.655 25 23.786Total 937.259 26

a. Dependent Variable: Z-Scoreb. Predictors: (Constant), Government No.Of Shares

Table 4.9

Risk Perception - Coefficientsa

BANK Model UnstandardizedCoefficients

Standardized

Coefficients

B Std. Error Beta t Sig.

PUBLICBANK

1 (Constant) 17.936 2.609 6.874 .000

GovernmentNo.OfShares

-3.260E-

008

.000 -.605 -3.795 .001

Table 4.10

Risk Perception - Excluded Variablesa

BANK Model CollinearityStatisticsTolerance

PUBLIC BANK 1 Independent Directors Value .832b

Executive Directors Value .990b

Board Size Value .985b

Foreign Institutional ownership (FII) No.OfShares

.969b

Domestic Institutional Investors (DII) No.OfShares

.590b

Private Corporate Bodies No.Of Shares .698b

Others No.Of Shares .539b

a. Dependent Variable: Z-Scoreb. Predictors in the Model: (Constant), Government No.Of Shares

49

We have got R2 Value of 0.366 with 0.001siginificance in this model.

It appears that using this model for predicting z-score of public sector banks, the

quantum of government ownership value is significant. Whereas for private sector

banks it is not significant.

Regression fit to predict the Z-score value in public sector banks, as per

Model = 17.936 - 0.0000000326 (Government Shares)

Other variable considered in this study seems to have no influence on Z-score of

public sector banks as these variables got excluded in stepwise regression.

Non-Performing Assets (NPAs):

The data is analyzed by using stepwise regression procedure to know which

independent variable is important to predict the dependent variable and found that

four models are seem to have a good relevance for predicting percentage of NPAs of

public and private sector banks.

The data collected represents in to the following two models while predicting the

influence of independent variables on NPAs of the public and private sector.

Public Sector:

Model 1: y (NPAs) = Constant + β1* (x1)

Private Sector:

Model 1: y (NPAs) = Constant + β1 * (x1)

Model 2: y (NPAs) = Constant + β1 * (x1) + β2 * (x2)

Model 3: y (NPAs) = Constant + β1 * (x1) + β2 * (x2) + β3 * (x3)

Table 4.11

NPA Ratio - Variables Entered/Removeda

BANK Model VariablesEntered

VariablesRemoved

Method

PUBLIC BANK 1 Board Size Value . Stepwise (Criteria:Probability-of-F-to-enter<= .050, Probability-of-F-to-remove >= .100).

PRIVATE BANK 1 Promoter No.ofShares

. Stepwise (Criteria:Probability-of-F-to-enter<= .050, Probability-of-F-to-remove >= .100).

50

2 Others No.OfShares

. Stepwise (Criteria:Probability-of-F-to-enter<= .050, Probability-of-F-to-remove >= .100).

3 ForeignInstitutionalownership(FII) No.OfShares

. Stepwise (Criteria:Probability-of-F-to-enter<= .050, Probability-of-F-to-remove >= .100).

a. Dependent Variable: NPA Ratio %

Table 4.11

NPA Ratio -Model SummaryBANK Mode

lR R Square Adjusted R

SquareStd. Error of the Estimate

PUBLICBANK

1 .464a .215 .184 .473632

PRIVATEBANK

1 1.000b 1.000 1.000 .6582832 1.000c 1.000 1.000 .5618433 1.000d 1.000 1.000 .523752

a. Predictors: (Constant), Board Size Valueb. Predictors: (Constant), Promoter No.of Sharesc. Predictors: (Constant), Promoter No.of Shares, Others No.Of Sharesd. Predictors: (Constant), Promoter No.of Shares, Others No.Of Shares, Foreign Institutionalownership (FII) No.Of Shares

Table 4.12

NPA Ratio -ANOVAa

BANK Model Sum ofSquares

df Mean Square F

PUBLICBANK

1 Regression 1.540 1 1.540 6.866Residual 5.608 25 .224

Total 7.148 26PRIVATE

BANK1 Regression 91833.918 1 91833.918 211922.

821Residual 10.833 25 .433

Total 91844.751 262 Regression 91837.175 2 45918.588 145465.

164Residual 7.576 24 .316

Total 91844.751 263 Regression 91838.442 3 30612.814 111596.

880Residual 6.309 23 .274Total 91844.751 26

51

Table 4.13

NPA Ratio -ANOVAa

BANK Model Sig.PUBLIC BANK 1 Regression .015

ResidualTotal

PRIVATE BANK 1 Regression .000Residual

Total2 Regression .000

ResidualTotal

3 Regression .000Residual

Total

a. Dependent Variable: NPA Ratio %b. Predictors: (Constant), Board Size Valuec. Predictors: (Constant), Promoter No.of Sharesd. Predictors: (Constant), Promoter No.of Shares, Others No.Of Sharese. Predictors: (Constant), Promoter No.of Shares, Others No.Of Shares, Foreign Institutional ownership (FII) No.OfShares

Table 4.14

NPA Ratio - Coefficientsa

BANK Model UnstandardizedCoefficients

Standardized

CoefficientsB Std.

ErrorBeta t Sig.

PUBLICBANK

1 (Constant) 2.441 .572 4.269 .000Board SizeValue

-.117 .045 -.464 -2.620 .015*

PRIVATEBANK

1 (Constant) .786 .129 6.089 .000Promoter No.ofShares

3.348E-006

.000 1.000 460.351 .000*

2 (Constant) .412 .160 2.569 .017Promoter No.ofShares

3.348E-006

.000 1.000 539.333 .000*

Others No.Of

Shares

2.443E-

009

.000 .006 3.212 .004*

3 (Constant) .562 .165 3.407 .002Promoter No.ofShares

3.348E-006

.000 1.000 578.067 .000*

Others No.OfShares

4.531E-009

.000 .011 3.767 .001*

ForeignInstitutionalownership(FII) No.OfShares

-2.995E-009

.000 -.006 -2.149 .042*

*Significant

52

Table 4.15

a. Dependent Variable: NPA Ratio %

NPA Ratio - Excluded Variablesa

BANK Model Beta In t Sig. PartialCorrelatio

n

PUBLIC

BANK

1 Independent Directors Value .233b 1.288 .210 .254Executive Directors Value -.058b -.319 .752 -.065Government No.Of Shares .194b 1.094 .285 .218Foreign Institutionalownership (FII) No.OfShares

.096b .498 .623 .101

Domestic InstitutionalInvestors (DII) No.Of Shares

-.003b -.014 .989 -.003

Private Corporate BodiesNo.Of Shares

.062b .337 .739 .069

Others No.Of Shares .187b .990 .332 .198

PRIVATE

BANK

1 Independent Directors Value .003c 1.254 .222 .248Executive Directors Value .002c .767 .451 .155Foreign Institutionalownership (FII) No.OfShares

.003c 1.218 .235 .241

Domestic InstitutionalInvestors (DII) No.Of Shares

.003c 1.390 .177 .273

Private Corporate BodiesNo.Of Shares

-.001c -.354 .727 -.072

Others No.Of Shares .006c 3.212 .004 .548Board Size Value .002c 1.117 .275 .222

2 Independent Directors Value -.001d -.576 .570 -.119Executive Directors Value .000d .149 .883 .031Foreign Institutionalownership (FII) No.OfShares

-.006d -2.149 .042 -.409

Domestic InstitutionalInvestors (DII) No.Of Shares

-.002d -.665 .513 -.137

Public Sector

We have got R2 Value of 0.215 with 0.015 significance using this model.

It appears that for predicting NPAs of public sector banks board size is significant

whereas all other parameters are insignificant.

Regression fit to predict the value of NPA of public sector banks

=2.441 - 0.117 (Board Size).

Private Sector

With Model-1 we have got R2 value of 1.000 with 0.000 significance.

With Model-2 we have got R2 value of 1.000 with 0.000 significance.

With Model-3 we have got R2 value of 1.000 with 0.000 significance.

53

It appears that for predicting NPAs of private sector banks government shares, other

shareholding and Foreign Institutional Investors are significant whereas all other

parameters are insignificant

Regression fit to predict the value of NPA of private sector banks as per

Model-1 = 0.786 + 0.000003348 (Promoter No.of Shares)

Regression fit to predict the value of NPA of private sector banks as per

Model-2 = 0.412 + 0.000003348 (Promoter No.of Shares) + 0.000000002443 (Other

Shares).

Regression fit to predict the value of NPA of private sector banks as per

Model-3 = 0.562 + 0.000003348 (Promoter No.of Shares) + 0.000000004531 (Other

Shares) – 0.000000002995 (FIIs)

TOBIN’s Q:

The data is analyzed by using stepwise regression procedure to know which

independent variable is important to predict the dependent variable and found that

four models are seem to have a good relevance for predicting the Tobin’s Q value of

private sector banks.

The data collected represents in to the following two models while predicting the

influence of independent variables on Tobin’s Q value of the private sector banks.

Model 1: y (Tobin’s Q) = Constant + β1* (x1)

Table 4.16

TOBIN’s Q -Variables Entered/Removeda

Mode

l

Variables

Entered

Variables

Removed

Method

1 Promoter groupNo.Of Shares

. Stepwise (Criteria: Probability-of-F-to-enter <= .050,Probability-of-F-to-remove >= .100).

2 DomesticInstitutionalInvestors (DII)No.Of Shares

. Stepwise (Criteria: Probability-of-F-to-enter <= .050,Probability-of-F-to-remove >= .100).

a. Dependent Variable: Tobin's Q Value

54

Table 4.17

TOBIN’s Q - Model SummaryModel R R

SquareAdjusted R

Square

Std. Error of the Estimate

1 .555a .308 .295 .0932452 .606b .368 .343 .089985

a. Predictors: (Constant), Promoter group No.Of Sharesb. Predictors: (Constant), Promoter group No.Of Shares , Domestic Institutional Investors(DII) No.Of Shares

Table 4.18

TOBIN’s Q - ANOVAa

Model Sum ofSquares

df Mean Square F Sig.

1 Regression .201 1 .201 23.128

.000b

Residual .452 52 .009Total .653 53

2 Regression .240 2 .120 14.835

.000c

Residual .413 51 .008Total .653 53

a. Dependent Variable: Tobin's Q Valueb. Predictors: (Constant), Promoter group No.Of Sharesc. Predictors: (Constant), Promoter group No.Of Shares , Domestic Institutional Investors(DII) No.Of Shares

Table 4.19

TOBIN’s Q - Coefficientsa

ModelUnstandardized

CoefficientsStandardizedCoefficients t Sig.

B Std. Error Beta1 (Constant) .075 .015 4.940 .000

Promotergroup No.OfShares

6.964E-010

.000 .555 4.809 .000

2 (Constant) .095 .017 5.501 .000Promotergroup No.OfShares

9.542E-010

.000 .760 5.231 .000

DomesticInstitutionalInvestors(DII) No.OfShares

-5.556E-010

.000 -.320 -2.199 .032

We have got R2 Value of 0.308 with 0.000 significance for model-1 and R2 value of

0.368 with 0.000 significance for model-2.

It appears that for predicting Tobin’s Q value of banks promoter group of shares and

DIIs are significant whereas all other parameters are insignificant.

Regression fit to predict the value of Tobin’s Q of banks as per for

55

Model-1 = 0.075 + 0.0000000006964 (Promoter Group Shares).

Regression fit to predict the value of Tobin’s Q of banks as per for

Model-2 = 0.095 + 0.0000000009542 (Promoter Group Shares) – 0.0000000005556(DIIs).

56

Chapter – 5

Empirical Findings & Recommendations

Empirical Findings

Board and Bank Performance:

From the empirical evidence it is found that various board parameters like

Independent Directors (IDs), Leadership Duality do not have any influence on various

bank performance metrics like profitability, market performance of the stock, return

on equity, risk-return perception, non performing assets etc. Whereas, the board size

seem to influence the NPAs in public sector banks while executive directors leverage

profitability in private sector banks.

NPAs in Public sector banks = 2.441 - 0.117 (Board Size). This means if board size is

more then it results in more NPAs in public sector banks and whereas this influence is

not found with private sector banks.

Profitability of private sector banks = -6.908+9.049(EDv)–0.00000006326 (DII). This

means more executive directors on the board and less of domestic institutional

investment results in more profitability of private sector banks.

Shareholding Pattern and Bank Performance:

From the empirical evidence it is found that ownership structure of private sector

banks have better influence on bank performance than that of public sector banks.

In private sector banks, NPAs, Tobin’s Q value and Profitability are seemed to

dependent on different aspects of shareholding like Govt. holding, FIIs and

shareholding in Others category are influencing. The NPAs of private sector banks =

0.562 + 0.000003348 (Govt. No. of shares) + 0.000000004531 (Other Shares) –

0.000000002995 (FIIs). This means more government and others category holding

and less of FII holding in the private banks resulting in more NPAs.

Promoters and DIIs seem to influence Tobins Q value of private banks. This value can

be predicted by the following equation.

Tobins Q value = 0.095+0.0000000009542(Promoter Group Shares) –

57

0.0000000005556 (DIIs). This indicates that more promoter holding and less of

domestic institutional investment in private banks will improve their Tobins Q value.

But for public sector banks Z score seem to get influenced by quantum govt. holding

as indicated by the following equation. Z score = 17.936 - 0.0000000326

(Government Shares). This means lesser the government holding more the Z score for

the public sector banks.

From the following equation we can understand that for private banks profitability is a

function of quantum of domestic institutional investment. Profitability = -6.908+

9.049 (EDv) – 0.00000006326 (DII). This means that lesser the domestic investment

more the profitability for private sector banks.

Recommendations

Though outcomes of good corporate governance remains same irrespective of nature

of business, type of ownership, quality of management, business/legal regulations,

and political environment, but the means to achieve this good governance differs a lot

based on the factors mentioned above. Some of the parameters that may influence

corporate governance include ownership structure, board philosophy, industry

segment, maturity of business, management process, level of competition,

international business participation, and size of the company.

Lot of effort is being put both nationally and internationally in understanding and

suggesting good practices that can improve governance of banking sector. In India

also several initiatives have been taken up in understanding nuances of banking sector

governance.

The research team at IPE made an attempt to understand the linkages between

ownership, governance and performance of banking sector in India. In this pursuit,

the team gathered recommendations of few important reports like OECD principles,

Dr. A. S. Ganguly Committee report and Basel recommendations on ownership

structure and governance mechanisms of banking industry. In addition to this, data on

various parameters coming under the category of ownership, governance and

performance of banks was collected. Over and above, views of present and

prospective board members of Indian banking sector on issues related to corporate

governance in banking industry were collected through structured questioners. Based

on this the following recommendations are being made.

58

1. Average board size of public sector banks stands at 13. From the empirical

evidence it is found that larger boards are resulting in more NPAs. Even primary

data collected from present and prospective board members indicates that smaller

boards are effective. Even Dr. A. S. Gangully report is of the view that larger

boards may miss the focus and hence more working director should be there in

such cases. In view of this and in order to make the boards of public sector banks

more effective it is recommended to prune down the board size.

2. The present level of executive directors in private sector banks is 3 per board.

From this study it is found that more number of executive directors leading to

better profits. Basel committee suggest that executive directors can be upto 75%

of the elected board, while Dr. A. S. Gangully committee is of the opinion that

given the complexity of board functioning more executive directors are preferred.

In view of this we suggest that strength of executive directors in private sector

banks need to be augmented further.

3. Most of the committees have talked about board independence and independent

directors on the board. But empirical evidence is not suggesting any meaning

correlation between quality of governance and presence of independent director

on board. Even respondents in our primary data collection also felt the same way.

However, we are of the opinion that contribution of Independent director on

board cannot be underestimated and the present level of in effectiveness need to

be understood from different dimensions. Keeping this in view, we would like to

suggest that board independence and role of independent directors as one of the

governance mechanisms need to be further strengthened and refined.

4. OECD principles and Dr.A.S. Gangully recommendations unanimously agree that

chairman of the board should be non executive. Non-executive chairmen are

expected to bring in better monitoring and more independence to the board

functioning. But in India, around 22% of private sector bank boards and 16%

public sector bank boards have non-executive chairman. Though we could not

find a significant empirical evidence to suggest non-executive chairmen lead to

better bank performance, we would like to suggest separation of leadership at

board level, theoretically, may result in better monitoring and better performance.

59

5. Majority of the reports including OECD Principles have not mentioned anything

about preferred shareholding pattern. Empirical evidence also not suggesting any

pattern significantly. But keeping the theoretical advantages and disadvantages of

concentrated shareholding in a competitive business environment we would like

to suggest a balance approach towards shareholding pattern.

6. Similarly, no mention was made about preferred Foreign Institutional Investment

(FIIs) and Domestic Institutional Investment (DIIs) by the above mentioned

reports. However, the little empirical evidence is suggesting that FIIs and DIIs

having inverse relationship with NPAs and perceived replacement value of

private sector banks. With this input we would like to suggest that the role of FIIs

and DIIs in banking sector need to be further strengthened so that these

institutions can play a significant role in governance of banking industry.