SPECIAL ARTICLE
Corporate Governance in Banks in India
Rekha Misra, Anwesha Das
While several committees have examined and
suggested ways to improve corporate governance in
banks in India, this study makes an attempt to prepare a
benchmark index for the board composition aspect of
corporate governance. A comparison between the
indices for public sector banks with private sector banks
reveals that differences in governance structures cannot
be explained fully in terms of ownership only. This is a
welcome feature, as with some efforts on the part of the
majority shareholder, corporate governance in all the
banks can be brought on par with the best-performing
bank, by ensuring greater compliance with corporate
governance benchmarks.
The views expressed in the article are personal and do not represent the
views of the authors’ institution.
Rekha Misra (rekhamisra@rbi.org.in) is the director and Anwesha Das
(ecowesha@yahoo.co.in) is a researcher at the Department of Economic
Policy and Research, Reserve Bank of India.
96
T
he link between efficiency and good corporate govern-
ance has been in focus in recent times. Good corporate
governance structures encourage companies to provide
accountability and set in place control systems. A fundamental
reason why corporate governance has moved onto the eco-
nomic and political agenda worldwide has been the rapid
growth in international capital markets. Effective corporate
governance enhances access to external financing by firms,
leading to greater investment, higher growth and employ-
ment. Investors look to place their funds where the standards
of disclosure, of timely and accurate financial reporting, and
of equal treatment of all shareholders are met. Good corporate
governance improves the credibility of firms, mitigates discord
between different stakeholders, reduces legal costs and imp-
roves management–labour relationships in the process.
India has a bank-based financial system and banks form the
fulcrum of the financial system. While banks finance firms,
they themselves need to be financed and have to attract inves-
tors. Given the predominance of banks and the significance of
good corporate governance practices in enhancing the credi-
bility of institutions, it is relevant to study corporate govern-
ance in banks in India. Against this backdrop, this study aims
to analyse corporate governance in the major public sector
banks (PSBs) and private sector banks (PVBs) in the country.
This analysis is based on the computation of a benchmark
index and the calculation of a corporate governance index on
the basis of this benchmark index. Accordingly, the study is
organised thus. The following section provides the genesis and
tenets of corporate governance. Existing literature on corpo-
rate governance is briefly discussed thereafter. Further, the
methodology for computing corporate governance index is dis-
cussed, following which are the details of index for PSBs and
PVBs along with the validation and concluding observations.
Genesis and Tenets of Corporate Governance
According to the Sarbanes-Oxley Act of 2002, corporate gov-
ernance is a framework of rules and practices by which a board
of directors ensures accountability, fairness and transparency
in a company’s relationship with all stakeholders. The genesis
of corporate governance can be traced to the East India Com-
pany which had a board known as Court of Directors and its
structure was very similar to the modern-day board of direc-
tors. Since its genesis, basic governance issues have been those
of power and accountability. The power structure in the corpo-
rate system, its exercise and the degree of accountability are
very crucial. The relationship between these three determines
the extent of agency problem in a modern corporation. Adam
JUly 13, 2019 vol lIV no 28 EPW Economic & Political Weekly

Smith (1776–89) drew attention to the agency problem in The
Wealth of Nations. The agency problem is inherent in the rela-
tionship between the providers of capital and their agents who
put that capital to use, that is, between shareholders and
boards. The structure and composition of boards, the require-
ments for disclosure, and the balance of power between share-
holders and directors have a strong bearing on the resolution/
persistence of agency problem.
The independence of a board is a very important element for
the resolution of the agency problem. The board performs two
important functions, which are providing resources and moni-
toring. However, the desired characteristics of the outside
board members are different for a board focusing on monitor-
ing, compared to a board focusing on providing resources. It is
the non-affiliated outside directors—usually termed as inde-
pendent directors—who are expected to perform both the
monitoring role on behalf of the shareholders, as well as the
resourcing role for the firms. In the world of corporate govern-
ance, it is often observed that the number of independent/
outsider directors required by law is contingent on the
presence/absence of a promoter on the board. Where promot-
ers sit as chairpersons or managing directors on the boards of
the banks, insider control is further enhanced due to manage-
ment control by insiders. As the separation of decision-making
from shareholders to the board may yield results detrimental
to the shareholders, for the shareholders’ rights to hold, it
becomes important for shareholders to be able to appoint/
remove/have some representation on the board.
Promoters, when they also own a major stake in the firm,
have an incentive to monitor the management to increase their
share value and may help the minority shareholders. However,
the interests of minority shareholders need to be safeguarded,
where the interests of the controlling shareholders may over-
shadow their interests. Large shareholders have the voting
power necessary to safeguard the value of their investments.
Unlike small shareholders, they can easily accumulate their
votes together. They also incur lower costs of monitoring, as
they can pool their resources to span a large scale of their
investments. This is the basic premise of the “efficient moni-
toring hypothesis” propounded in literature (Fama and Jensen
1983; Jensen and Meckling 1976).
Firms with controlling shareholders face a two-level agency
problem: between controlling shareholders and management
and between minority shareholders and controlling share-
holders. The problem between controlling shareholders and
minority shareholders will be less severe if either outside inde-
pendent directors are abundantly present on the board, or the
management is independent from the controlling shareholders.
From the foregoing, it can be concluded that one of the most
important tenets of corporate governance is the composition
of the board and its effectiveness.
Effective Corporate Governance
The composition of the board is critical in determining its
effectiveness. E Fama (1980) posits that the presence of non-
executive directors on a board represents a means of monitoring
Economic & Political Weekly EPW JUly 13, 2019 vol lIV no 28
SPECIAL ARTICLE
the actions of the executive directors and ensures that the
interests of the executive directors are consistent with the int-
erests of the shareholders. The relationship between firm per-
formance and board independence varies depending on the
context in which the firm is operating. For instance, T Randøy
and J I Jenssen (2004) argue that firms in highly competitive
industries will already be “monitored” by the market and
therefore need fewer outside board members. Such companies
need stronger inside resource links.
Existing empirical studies show mixed results regarding the
relationship between firm performance and board indepen-
dence (for example, Dalton et al 1998; Dulewicz and Herbert
2004; Peng 2004; Weisbach and Hermalin 2003). Some schol-
ars argue that a supermajority of independent directors will
lead to worse performance (Bhagat and Black 1999). Firms
may strategically comply with the institutional demands for
more outside directors, while subtly limiting the independence
of the board. Various tactics may be employed to neutralise the
independence of members. For example, by appointing outside
directors who are demographically similar, and therefore
more sympathetic to chief executive officers (CEOs) (Westphal
and Zajac 1995). The CEOs may also appoint directors with an
experience on other passive boards (Zajac and Westphal
1996). Alternatively, CEOs may appoint individuals from
strategically irrelevant backgrounds to discourage effective
participation in strategic decision-making (Carpenter and
Westphal 2001).
Besides the composition of the board, the skill set of the
board members is equally important. A Hillman et al (2000)
discuss that there is a need to look at skills distinct from moni-
toring. A varied skill set is also important. B Boyd (1990)
argued that good governance is achieved when board mem-
bers are appointed for their expertise to help firms successfully
cope with environmental uncertainty. Researchers have also
focused on the impact of duality (CEO as the chairperson of the
board) on the effectiveness of the board. The results of res-
earch are ambiguous (Finegold et al 2007). There is a negative
relationship between duality and firm performance when the
board focuses on monitoring, and vice versa when the board
focuses on providing resources. From the foregoing, it is
evident that the researchers have focused on various aspects
of corporate governance, with relation to the composition of
board, role of independent directors, skill sets of board mem-
bers and also duality. However, the desirability or not of each
of these attributes depends on the environment in which the
institution functions.
Methodology and Rationale
Corporate governance in Indian banks has attracted attention
especially after the P J Nayak Committee (2014) which ana-
lysed the governance structure in Indian PSBs. PSBs account for
around 75% of the total assets of scheduled commercial banks
(SCBs) in India. However, in recent years, PSBs are losing their
share to PVBs. India has already moved towards a differen-
tiated banking regime. Now, licences for scheduled PVBs are
also freely available. With these developments, it is very
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SPECIAL ARTICLE
important to analyse the corporate governance in SCBs in
India and also whether there is any difference in the corporate
governance of PSBs and PVBs.
As is evident from the discussion earlier, board composition,
its independence and effectiveness are the most important
parameters of corporate governance. This study aims to ana-
lyse corporate governance in Indian banks on the basis of
these parameters. The methodology adopted for preparation
of the benchmark index is a combination of the legal require-
ments, along with guidance available in literature for variables
where legal requirements are not spelt out. The constituents
which determine the effectiveness of the board are: indepen-
dence of the board, the qualification/diversity of the board,
presence of promoters in the board, evaluation and duality, that
is, whether the chairperson and managing director are one
or separate.
The product markets in which PSBs and PVBs operate differ
in their competitiveness. The former (playing dominantly in
the infrastructure and utilities segment) is an oligopolistic
market. The latter operates in more generic and hence more
competitive markets. Requirements to make corporate govern-
ance effective should vary accordingly between these two
bank groups. The benchmark index has been calculated sepa-
rately for PSBs and PVBs. The article endeavours to measure
the quality of corporate governance by a distance to frontier
approach. As mentioned before, corporate governance in PSBs
and PVBs in India are practised according to certain laws. The
underlying assumption is that the provisions laid down by
laws have certain merit to them.
The legal guidelines have been customised to suit the indig-
enous evolution of the structure and functions of the banking
system in India. For instance, the Banking Acquisition Act,
2005 that carries corporate governance guidelines for the
PSBs, posits that the board be representative of all its stake-
holder groups, along with outsider directors with auditing
experience. This goes with the egalitarian outlook that is a
part and parcel of the aims and objectives of the PSBs. Similarly,
the detailed guidelines on the number of independent direc-
tors that the Companies Act, 2013 spells out for the PVBs are a
cautionary move to protect the bank and its dispersed share-
holders from the promoters, who, according to economic theory,
would be guided by self-interest rather than shareholders’ wel-
fare. In the case of PSBs, the listing agreements of the Securities
and Exchange Board of India (SEBI) that are prepared for the
purpose of ensuring sound corporate governance of listed
companies, come only second to the Banking Companies (Ac-
quisition and Transfer of Undertakings) Act (BCA), 2005 and the
Nationalised Banks (Management and Miscellaneous Provisions)
Scheme, 1970, State Bank of India (SBI) Act, 1955 and the
guidelines issued by the Reserve Bank of India (RBI) in this regard.
Having set the existing legal framework to be the bench-
mark form of corporate governance to be followed, both in
form and in principle, we proceed to capture how far our
banks stand from this frontier. To calculate the corporate gov-
ernance index for PSBs, we have considered seven major PSBs
accounting for around two-thirds of the total assets of PSBs.
98
The PVBs which form the sample for this study account for
around three-fourths of the total assets of PVBs. All figures are
as of March 2015.
Public Sector Banks
The attributes that make for an effective board of a PSB are
outlined below. The maximum score allocated to each attri-
bute is 10.
Size of the board: One strand of thought in literature is that it
takes more compromises for a larger board to reach consensus,
even though decisions of larger boards may be less extreme,
leading to less variable corporate performance (Lipton and
Lorsch 1992). M Jensen (1993) even puts a specific limit on
board size with his finding that firms with a board size greater
than seven or eight members function inefficiently. He attri-
butes it to the ease it offers to CEOs who want to control and
manipulate the board. Boards can be large based on the res-
ource dependency theory. However, with a very large board
size, the advisory function is weakened because of poor com-
munication and decision-making. On the other hand, propo-
nents supporting a larger board size argue that with a large
board, the firm has a larger pool of expertise which helps
improve strategic decision-making (Pearce and Zahra 1992).
The board size of PSBs follows from law. As per the BCA, the
central government shall, in consultation with the RBI, consti-
tute the first board of directors of a corresponding new bank,
consisting of not more than seven persons. The board size
thereafter would be nine members. Of these, not more than
four whole-time directors are to be appointed by the central
government after consultation with the RBI. One director
would be from among those employees who are workers under
the clause(s) of Section 2 of the Industrial Disputes Act, 1947
(14 of 1947), to be nominated by the central government in
such a manner as may be specified in a scheme made under
this section.
One director, from among the employees who are not work-
ers under the clause(s) of Section 2 of the Industrial Disputes
Act, 1947 (14 of 1947), is to be nominated by the central govern-
ment after consultation with the RBI. The act also specifies the
number of directors to be elected by the shareholders,
depending on the capital issued under clause (c) of sub-section
(2B) of Section 3: (i) one director if it is not more than 16% of
the total paid-up capital (PUC); (ii) two directors if it is more
than 16% but not more than 32% of the total PUC and
(iii) three directors if it is more than 32% of the total PUC, to be
elected by the shareholders, other than the central govern-
ment, from amongst themselves.
The BCA allows for a board size of 11.1 This is after taking the
upper limit of the number of whole-time executive directors
allowed and the medium range of PUC issued that year (more
than 16% but not more than 32% of the total PUC).2 The range
dictates the number of shareholder directors required to be
included in the board and the highest range is that of more
than 32%. In the index construction, the PSBs are penalised if
they fall short of the board size that they are required to
JUly 13, 2019 vol lIV no 28 EPW Economic & Political Weekly

maintain by law and by their ownership pattern. The penalty
is allotted such that for every two members that the board falls
short of the score reduces by one.
Composition of the board: Board independence should be
higher for PSBs than PVBs for greater focus on the monitoring
function. Large shareholders typically enjoy substantial repre-
sentation on the board either directly or indirectly. By virtue of
this representation, they are able to affect their desired level of
monitoring. They are helped in this process by access to better
quality of information and the management. Minority share-
holders have less influence on the decisions of the board when
compared to large shareholders. This is why, in the case of
majority shareholder-owned PSBs, the presence of an outside
monitor benefits the minority shareholders.
In India, Section 149(6) of the Companies Act, 2013 defines
an independent director to mean a director other than a man-
aging director or a whole-time director or a nominee director
who conforms to the criteria mentioned therein. The amended
Clause 49 of the Listing Agreement defines an independent
director to mean a non-executive director, other than a nomi-
nee director, who possesses certain criteria, which have been
elaborated in the agreement and which are mostly similar to
those laid down under the act and the rules. PSBs are corpora-
tions established under the Nationalised Banks (Management
and Miscellaneous) Scheme, 1970. The Companies Act, 2013
does not apply to them.3
PSBs often deem the shareholder directors and nominee
directors as independent directors. For instance, where super-
seding laws clash with Clause 49 regulations, as per the for-
mer, PSB boards keep shareholder directors and nominee
directors on their board and qualify them as independent
directors. However, in the light of the agency problem (majority–
minority shareholder) faced by PSBs, and given the ambiguity
regarding the true independence of directors nominated by
the majority shareholders, only shareholder directors are con-
sidered independent directors in the context of PSBs.4 The law
stipulates the number of shareholder directors to be held on
the board of a PSB based on the extent of non-promoter share-
holding in the PSB.
Following from above, the next attribute is whether the
number of shareholder directors are in tandem with the level
of paid-up capital issued at the time. If a PSB falls short of the
level of minority shareholder representation that the law finds
appropriate for protecting the majority–minority agency prob-
lem, then the bank is penalised such that we subtract from the
maximum score of 10, an amount that is calculated by apply-
ing the fraction of required shareholder directors missing
among total shareholder directors required, to the total score
of 10.5 One measure of the effectiveness of corporate govern-
ance in PSBs is the extent to which the minority shareholders
are able to influence important corporate decisions. Of these
decisions, the minority shareholders have no say as to the ap-
pointment and removal of majority of board members for most
listed PSBs. Minority shareholders have representation on the
board and are privy to the board’s decisions. But given their
Economic & Political Weekly EPW JUly 13, 2019 vol lIV no 28
SPECIAL ARTICLE
minority status, they are not in a position to resist any decision
with their votes and methods. For example, cumulative voting
can bring outside block-holders and dispersed shareholders
together to counter the majority shareholders in any decision,
is not practised in India.
Presence of insider directors: While minority shareholder
directors are outsider directors, the boards of PSBs are domi-
nated more by insider directors, including executive directors,
employee representatives, and the nominee directors (who are
considered as insider directors by SEBI’s Clause 49 for state-
owned enterprises [SoE s]). The stewardship theory of corpo-
rate governance suggests that more insider directors can guide
a firm better through strong inside resource links when the
markets for the firm’s products are highly competitive. The
PSBs face competition in offering some of their banking servi-
ces and products from their private sector counterparts. Also,
SoEs have to be accountable for how all their stakeholders fare
and from that end, the law requires representation of emplo-
yees at various levels on the board of the banks.
The scoring is done as follows: the nominee directors are
counted out because they are a constant for all banks. The
number of insider directors are then calculated as a percent-
age of the total number of directors. The optimum percentage
is arrived at by taking one worker, one non-worker employee
director and three whole-time executive directors.6 While the
law allows at the most four whole-time/executive directors,
considering that they are all appointees of the controlling
shareholder, the majority–minority agency problem will be
more balanced if a bank instead of having all the four, leaves
enough room for representative directors of other stakehold-
ers. Keeping the stewardship theory in mind, we believe three,
including the CEO, to be an optimum number. If the percent-
age thus calculated for each of the banks goes above this opti-
mum percentage, and so does the optimum share of executive
director group of insiders, the score is cut by two points. That
is, if any one of the percentages is broached, the score gets cut
by one point. In addition, for each type of employee repre-
sentatives missing from the board, the score gets reduced by
one point.
Presence of duality: For PSBs, the shareholding pattern is
such that majority shareholders have controlling rights, leav-
ing the minority shareholders with not much ability to effec-
tively monitor instances where the interests of the controlling
shareholder are aligned with the interests of the management
but misaligned with their interests. Thus, there is a need to
shield the board from the management, who are at present, in
essence, appointees of the controlling shareholder, to enable
such monitoring. This is the rationale behind not wanting the
CEO to be the chairperson of the board of directors.7 Literature
also finds a negative relationship between duality and firm
performance when a major function of the board is monitoring
(Finkelstein and D’Aveni 1994; Rashid 2010). Accordingly, the
presence of duality is penalised with a score cut of 50%.8 The
score gets cut by 100% only for banks which follow the more
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SPECIAL ARTICLE
dispersed-shareholder-oriented Companies Act, 2013 for the
appointment of their board members. This is because a non-
dual set-up may bring more positive change in the functioning
of the board of these banks.
Diversity of the board: The need for the monitoring function
also dictates a certain kind of qualification to dominate the
board’s expertise spectrum. Keeping this in mind, the board
has been scored based on the presence of a sufficient number
of outside directors with financial expertise. However, it is not
to be overlooked that banks, even under the state mandate,
need to cater to financial needs across a certain cross section
of the economy. Thus, comprehending the need for minimum
variation in the field of expertise of outside directors, while
acknowledging the importance of having outside directors
who are qualified in financial accounting, such directors
should form at least one half of all outside directors. The score
cut here follows the same logic as with the shareholder direc-
tor numbers on the board.
There are, however, some bank-specific calls that deviate
from theory in non-systematic ways. There are banks with no
outsider directors at all but with single chartered accountants
who are nominated by the controller shareholder and there
are banks where the financial expertise is at or above the
desired level, but the board lacks other variations in expertise.
Since the absence of outsider directors is already penalised in
the shareholder director section, the former group of banks
are penalised based on how many more financial experts
should have been present even if nominated, such that some
semblance of the monitoring function can be pursued. The
latter group of banks only get a score cut of one because of the
lack of other expertise on the board.
Evaluation of board: A consultative report prepared by the
Deloitte Group (2014: 3) lists the performance goals of a board
and defines board evaluation as follows:
The Board performs three major roles in a company—sets the strate-
gic direction of the company, monitors the management and provides
support and advice. Board evaluation typically examines these roles
and the entailing responsibilities. Board evaluation is an annual exer-
cise by choice or by regulatory prescription.
Before SEBI amended its Clause 49 in 2014, board evaluation
was not a binding requirement for listed companies in India.
As per the Deloitte Group (2014), in companies that had been
pursuing the practice of board evaluation, despite it not being
part of the law, evaluation was usually led by the chairperson.
As per the Companies Act, 2013, with effect from 1 October
2014, it is now mandatory for every listed company to have a
formal annual performance evaluation of their board, its com-
mittees and individual directors. The act does not lay down
the exact methodology of evaluation. The revised Clause 49
attempts that to some extent. Both however relegate the evalu-
ation function to the Nomination and Remuneration Committee
(NRC). For the sake of objectivity, it is believed that evaluation
should be facilitated by external experts rather than internal
ones. The law does not refrain the NRC from incorporating
100
external experts. The independent directors in effect act as the
external experts and such a committee should ideally be com-
prised of only such directors.
The Companies Act, 2013 provides a code for independent
directors to follow in the process of board evaluation. It has
been summarised by the Deloitte Group (2014: 8) as follows:
The independent directors are required to hold at least one meeting in
a year, without the attendance of non-independent directors and mem-
bers of the management where they are required to review the per-
formance of the non-independent directors and the Board as whole;
and also review the performance of the Chairperson of the company,
taking into account the views of the executive and non-executive di-
rectors … The performance evaluation of the independent directors
would have to be done by the entire Board excluding the director to be
evaluated and the continuance or extension of the independent direc-
tor would be determined by the performance evaluation report.
The Companies Act further requires companies to disclose
the steps followed in board evaluation.
With respect to PSBs, the Government of India has pre-
scribed board evaluation only to the extent that incentives for
the whole-time directors of PSBs can be decided upon.9 Given
that the legal framework that can shape an effective mecha-
nism for board evaluation is still evolving, more standard
measures practised globally were looked at for constructing
the benchmark. In this context, it is important that a clear
methodology for conducting the evaluation is spelled out
(i) to evaluate all individual directors as well as the whole
board, (ii) to have a defined technique of evaluation such as
peer review, validation of individual level observations with
board level observations, (iii) to define a way of collecting in-
formation—questionnaires, interviews, etc. Qualitative inputs
are richer and individual interviews may form a part of it.
Some of the popular methods adopted internationally quanti-
fy them with the help of questionnaires using a rating scale for
responses, (iv) to have a designated committee, preferably of
independent experts, to carry out the evaluation, and (v) to
disclose the results of the evaluation and take it to a logical
conclusion. Each of these five attributes carries two points and
a bank’s score is deducted according to the number of attrib-
utes of the benchmark evaluation method that it fails to meet.
Once the scores are thus computed, the board composition
attributes are summed up to form an aggregate score. All
attributes are given equal weights. This is to avoid random
judgments on one attribute with respect to others. Techniques
like principal components analysis are often employed to
derive weights of attributes. These require a large data set.
Since we in this article make an attempt to cull out informa-
tion on some dimensions of governance that are not readily
available in the usual databases used in literature, we do not at
this stage have that expanse of data.
But it should be noted that the literature also widely uses
unweighted indices for index construction (Cooke 1989; Hos-
sain and Hammami 2009). The board composition index (BCI)
for each bank is then calculated as its score as a percentage of
the maximum score. If some single bank had been taken as a
benchmark model and its score taken as the maximum score
for the calculation of the index, then changes in the governance
JUly 13, 2019 vol lIV no 28 EPW Economic & Political Weekly

mechanism of a bank over time would only be captured in as
far as its deviation from this model bank changed over time.
The index constructed as above takes care of this and the
evolution of the quality of governance of a bank is measured
simply on its own merit.
Components of index of effectiveness of board: Based on
the benchmarks outlined above and on the data available in
the annual reports and other sources like the Prowess data-
base and banks’ websites, the composite index for the effec-
tiveness of the board for each of the banks was constructed
(Table 1).
From the above it is evident that there is wide variation in
the composite corporate governance index even within the
PSBs, with a difference of almost 30 points between the high-
est and the lowest ranked bank. This result proves that even
with similar ownership structure, the corporate governance
index may vary sharply within a group, as the determinants of
corporate governance go beyond plain ownership.
Private Sector Banks
Size of the board: The Companies Act, 2013, under which the
PVBs operate, allows for a maximum board size of 15. The PVBs
in India follow the profitable segments of the market. They are
not shielded from the vagaries of the market by implicit guar-
antees. Thus, for PVBs, markets act as an effective external
monitor. The board of directors in PVBs should then strive to
fulfil the resource dependency theory of corporate governance
stated above, wherein, despite the possibility of problems in
Table 1: Board reaching a consensus, some space needs
Composition Index for to be made on the board for a variety of
Public Sector Banks
external experts. Following from this, the
Bank BCI
1 72.8
benchmark size is set, not at the maxi-
2 78.3 mum that the law deems fit, but at the
3 81.7 median board size for our group of banks,
4 78.3 keeping faith in the guidance provided by
5 51.7 the market. If a bank lies within the
6 68.3 benchmark, they get a full score at this
7 65.0 point for this attribute.10 If they overshoot
Source: Author’s
calculations based on
it, their score gets cut by the extent that
various bank attributes. they overshoot the benchmark.
Presence of independent directors: The markets may well
be an external monitor for the PVBs, but they may not be able
to detect fast enough the differential benefits accruing to the
board. The law takes care of this by providing for internal
monitoring. For PVBs, the law prescribes the requirement of
independent directors, depending on the extent of influence
the insiders and promoters exert on the board. The presence of
an executive or promoter chairperson warranties that one-half
of the board be comprised of independent directors, as op-
posed to one-third of the board which is required otherwise. If
the PVBs meet these criteria, they get a full score. All PVBs meet
these criteria. However, they tend to overshoot this bench-
mark. As cautioned in literature above, for PVBs that operate in
Economic & Political Weekly EPW JUly 13, 2019 vol lIV no 28
SPECIAL ARTICLE
fairly competitive markets, this may result in the resource
dependency theory overshadowing the stewardship theory of
having some insider guidance. Thus, going over and above the
number proposed by law is considered negative. The banks get
a score cut by the number by which they exceed the bench-
mark in this regard.
Direct ownership of promoters: The next measure is the level
of direct ownership of promoters in the banks. The SEBI guide-
lines require the holding of the direct promoter to be at least
20%. A certain amount of direct stake by the promoters is found
to bring about an alignment in the interests of controlling share-
holders with outside shareholders.11 The scores assigned are as
per the extent the direct ownership of promoters exceeds or falls
short of SEBI’s designated benchmark.12 Among the set of banks,
the one that exceeds by the maximum amount gets a conserva-
tive score of nine (allowing for the fact that enough may not be
enough when it comes to translating to actual benefits), and the
score gets cut by one as the exceeding amount falls in steps.
Stockholding by independent directors: The provisions of
Sections 197 and 198 of the Companies Act, 2013 state that an
independent director shall not be entitled to any stock option
and may receive remuneration by the way of fee provided
under sub-section (5) of Section 197, reimbursement of exp-
enses for participation in the board and other meetings and
profit related commission, as may be approved by the mem-
bers. Stockholding by independent directors can only be effec-
tive (in terms of aligning their interests with that of the dis-
persed/minority shareholders), insofar as the insider directors
do not hold stocks in the firm. The PVBs get a full score if this
criterion is met. If a given number of independent directors are
found to hold stocks at the same time as the insider directors
hold stocks too, then they are scored based on the fraction of
independent directors who do not own stocks and are expect-
ed to offer an opinion truly independent of any concerns of
material gains.
Presence of nominee director: Large investors enjoy some
advantages over dispersed shareholders in protecting the
overall interests of all shareholders, when they can become a
part of the board of directors. They are in a stronger position
to use the proxy mechanism to discipline inefficient manage-
ment (Dodd and Warner 1983). For non-financial firms, the
exercise of the “voice” option by outside block-holders is typi-
cally exercised in India by a covenant that allows banks as
creditors to be represented on the board of its debtor company
via a nominee director. Following from this, PVBs get a full
score if they have such nominee directors present on their
board and zero otherwise.
Presence of duality: The duality of the chairperson of the
board as CEO is scored in a manner similar to the PSBs.
Diversity of the board: There is a need for diversity of exter-
nal experts on the board of PVBs from the perspective of
101
SPECIAL ARTICLE
Figure 1: Score versus Index of Net Profit Figure 3: Score versus Stock Volatility
100 500 100

80 400 80

60 300 60 Board composition index

per cent

per cent
Board composition index Volatility (14 February–15 December)
40 200 40
Profit index (RHS) Volatility (14 February–15 March)

20 100 20

0 0 0
1 2 3 4 5 6 7
Bank 1 2 3 4 5 6 7
Source: Data from RBI and author’s calculations. Source: Bombay Stock Exchange and author’s calculations.

Figure 2: Score versus RoA Calculated Figure 4: Score versus Closing Stock Price
100 0.80 100 400
Board composition index
RoA calculated (RHS)
80 80
0.60 300

60 60

per cent

per cent
per cent

per cent

0.40 200
40 40
Board composition index Closing price of share
0.20 as on March 2015 (RHS) 100
20 20

0 0.00 0 0
1 2 3 4 5 6 7 1 2 3 4 5 6 7
Bank Bank
Source: Same as Figure 1. Source: Same as Figure 3.

resource dependency theory. The directors on the board are Figure 5: Score versus Stock Volatility
counted on the basis of the number of different qualifications 78 30
Table 2: Board Composition and the experience that they possess. Board composition index
Index for Private Sector Banks 76 25
This number is then taken as a share
Bank BCI
1 70.4
of the size of the board of the bank 74 20
2 75.0 and the maximum of such a share Volatility (14 February–15 December) (RHS)
per cent

per cent
72 15
3 75.0 that is observed in the set of PVBs is
4 76.3 taken as the benchmark value. The 70 10
5 72.0 score is cut by one for each drop in
68 5
Source: Same as Table 1. rank in the share. Volatility (14 February–15 March) (RHS)
66 0
Board evaluation: Board evaluation mechanism is scored fol- 1 2 3 4 5
Bank
lowing the same guidelines as set for the PSBs. Based on the Source: RBI and author’s calculations.
methodology outlined above, the BCI of PVBs is given in Table 2.
As can be seen from Table 2, there is a variation in the attri- confidence in the banks. Stock price is one such indicator—
bute scores for the PVBs but the range is narrow, with the dif- both in level (closing share price as of 31 March 2015) and its
ference between the highest and the lowest score being 5.9, steadiness (as measured by volatility of the stock returns for
which is much lower than the difference observed across the over the past year and continuing forward into December
PSBs. It may be noted here that the PSBs are scored on six 2015). The index should also be a predictor of the banks’ per-
attributes and PVBs are scored on eight attributes. Since these formance given in terms of variability in return on assets (RoA)
attributes differ between PSBs and PVBs, the scores of PSBs can- and net profit across the banks at end-March 2015. The latter is
not be compared with the scores of PVBs. But another observa- expressed as a profit index with the base being taken as the net
tion that follows is that the mean deviation from the maximum profit of the bank with the lowest score.13
score/benchmark is less for the PSBs (16.9) than the PVBs (21.8). Tobin’s Q is a common ratio used in literature to indicate
investors’ confidence in firm performance and corporate
Validation of the Score governance indices are often validated against it. It is
The importance of corporate governance lies in the eyes of the calculated as the market value and liabilities’ book value
investors. The validation of the scores hence is in its movement divided by the assets’ book value. In the particular case of
parallel to the movement in the indicators of investors’ PSBs, the market value may not provide all the information
102 JUly 13, 2019 vol lIV no 28 EPW Economic & Political Weekly
 SPECIAL ARTICLE

Figure 6: Score versus RoA Figure 8: Score versus Closing Share

78 1.8 78 1,400

76 1,200
76
1.7
RoA (RHS) 1,000
74 74
Board composition index 1.6 Board composition index 800
per cent

per cent
72 72
Closing share price (RHS) 600
1.5
70
70
400
68 1.4
68 200
66
1.3 66 0
1 2 3 4 5 1 2 3 4 5
Bank Source: Same as Figure 7.
Source: Same as Figure 5.

Figure 7: Score versus Profit Index

least 10% more for a better-governed firm (Khanna and
77 120
Zyla 2017).
76 To validate the corporate governance index of the banks, an
75
100 attempt was made to analyse how closely the index tracks the
74
Board composition index profitability, RoA, stock price and stock volatility. As can be
80
73 seen from the Figures 1–5 (p 102) and Figures 6–8, the index
72 60 tracks the various indicators and the direction is according to a
71 priori expectations. While Figures 1–4 are for PSBs, Figures 5–8
Profit index (RHS) 40
70 are for PVBs.
69 20 The PSBs and PVBs exhibit distinct features due to the differ-
68 ence in their legislative acts, ownership, business plan, product
0 mix and competition. Hence, the article focuses on evaluating
67
1 2 3 4 5
them distinctly and does not compare governance between
Source: Bombay Stock Exchange and author’s calculations.
both groups. In addition to these differences, each attribute of
Table 3: Board Composition Index versus Validation Metric the corporate governance
BCI versus Validation Metric Sign Expected for PSBs Sign Expected for PVBs index has both qualitative
Index versus index of net profit Co-movement is expected since For operating in a competitive and quantitative aspects. If
PSBs operate in oligopolistic markets environment, profitability indicators
where profitability indicates performance. are expected to move negative to index. one does a purely time se-
(They face competition from PVBs on some ries analysis based on qua-
products but they also enjoy size, scale and ntifiable attributes, then it
government guarantee benefits which make
them a separate class where the market is may not track the corpo-
dominated by few big banks.) rate governance attributes
Index versus RoA calculated Co-movement is expected because of same Same expectation and reasoning as above. in the true sense, as quali-
reason as above. tative aspects would not
Index versus closing stock price
31 March 2015 Co-movement Co-movement
be accounted for. Thus, the
Index versus stock volatility Expected inverse relation observed Inverse relationship composite score would
but mild in nature. not capture the unique
Source: Author’s analysis. features of each group.
about investors’ confidence in the stock because of the large To overcome this problem, the index has been worked out
and varying degrees of government stock ownership in these using both qualitative as well as quantitative attributes of cor-
banks. Tobin’s Q is thus not being considered by us while vali- porate governance. As both qualitative and quantitative as-
dating the index. Table 3 summarises how our BCI is expected pects have been considered while computing the index, it cap-
to move with relation to these validation metrics. When the tures the group-specific and institution-specific features more
actual movement shows any kind of deviation from the ex- accurately. This is borne out by the fact that the bank-specific
pected trend, it is mentioned in the table. composite index for both PSBs and PVBs tracks their profitabil-
As mentioned earlier, sound governance practices are ity, share price and share price volatility closely. The banks
expected to contribute to higher earnings and greater profit- with higher composite index have a higher profitability, higher
ability. Greater corporate governance creates higher firm share price and lower share price volatility and vice versa.
valuation and results in higher and stable price in the stock
market. A survey by the International Finance Corporation Conclusions
shows that investors will pay more for emerging market Corporate governance in banks has come to the forefront in re-
companies with good governance. More than half of the cent times. A few committees have examined this and have sug-
investors surveyed said that they would be willing to pay at gested ways to improve the same. There have been sporadic
Economic & Political Weekly EPW JUly 13, 2019 vol lIV no 28 103
SPECIAL ARTICLE

attempts to analyse corporate governance in banks. However,
preparing a composite benchmark index incorporating the
legal requirements, as well as the best practices available in lit-
erature, has not been attempted so far. This study makes an at-
tempt to prepare such a benchmark index, and studies board
composition. It is observed that the legal nuances of govern-
ance of banks in India align with literature to a large extent,
and corporate governance in banks in India can go a long way
simply by adopting the laws in form and substance. Two inter-
esting facts which emerge from the analysis are that firstly, the
mean deviation from the respective benchmarks is lower for the
PSBs than the PVBs, implying higher legal compliance for the
former. Second, the variation in the composite scores is higher
for PSBs as compared with PVBs. Thus, even among banks with a
uniform ownership structure, there are banks with wide variations
in their governance structure and differences in governance
structures cannot be explained fully in terms of ownership only.
This has important implications at the current juncture when
banks have to meet the enhanced capital requirements under
Basel III. The study shows that a higher BCI corresponds to
higher RoA and share prices and lower share price volatility. Ac-
cordingly, an improvement in BCI should imply increasing suc-
cess in efforts by the banks to raise capital from the market to
meet higher capital requirements. It will also reduce the
dependence on the owner for additional capital. As PSBs acc-
ount for around 75% of the total assets of the banking sector,
this should reduce the pressure on fiscal expenditures con-
siderably. The setting up of the bank board bureau is thus a
step in the right direction, and similar initiatives can lend
higher efficiency and vibrancy to Indian banking space.

Notes
1 The State Bank of India (SBI) is governed by
the SBI Act and the board size stipulated therein
is 14.
2 The average non-promoter shareholding for
PSBs stood at about 30% at end-March 2015.
3 IDBI Bank has “independent” directors apart
from the government nominee director. These
directors are elected by the shareholders. The
SBI Act, 1955 governs the same for SBI and
there is no concept of independent directors in
that act.
4 In PSBs, the concentration of promoter owner-
ship is high and the promoter nominates major-
ity of the directors on the board and the con-
trolling shareholders have direct and indirect
representation on the board. This leaves the
predominant agency problem to be one of
majority-minority problem.
5 For instance, if three such directors are req-
uired and the bank is short of meeting the req-
uirement by one, the score is calculated as:
10-((1/3)*10).
6 A separate optimum share for executive direc-
tors is also calculated with similar logic.
7 Both the P J Nayak Committee and Indrad-
hanush have proposed this measure of non-
duality. However, the former adds that this
should be adopted when there is an arrange-
ment by which the members of the board are
appointed by a Bank Investment Company that
is granted some autonomy from the govern-
ment. This is in line with the thinking that non-
duality might not bring the necessary change if
the controller serves as the chair.
8 This study is a snapshot of the corporate gov-
ernance of banks as at end March 2015. Some
banks like IDBI have gone on to propose non-
duality after this.
9 Notification No F No20/1/2005-BOI dated
9 March 2007.
10 If the board falls too short of the benchmark, it
will fail some other crucial attribute for an eff-
ective board as well and will get a score cut at
that attribute. This is how interactions of dif-
ferent attributes are factored in the measure.
11 Support for a piece-wise linear relationship be-
tween alignment or convergence of interests
between insiders and outside shareholders out-
weighs the negative entrenchment effects of
insiders once the promoter ownership crosses a
threshold of around 25% found in both Sarkar
and Sarkar (2000), and Kumar (2008). Selarka
(2005), and Pant and Pattanayak (2007) find a
quadratic and cubic relationship respectively,
which supports the basic finding that the
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