Impact of CEO Turnover in Indian Banks
In this week's blog, we explore the impact of exogenous CEO turnover in Indian banks. You can read the paper which is the inspiration for this blog here.
When a new CEO joins a bank he faces a lot of challenges due to the opaque nature of the bank's operation and to reduce his risk capacity more loan provisions are issued for future delinquencies and bank lending is reduced.
According to Financial Times, "In the space of seven months in 2015, a trio of the world’s biggest banks — Barclays, Deutsche Bank, and Credit Suisse — all brought new leaders on board. These ‘new brooms’ face similar challenges in cleaning up their businesses: cutting costs, reshaping their investment banks, and dealing with a legacy of legal and regulatory transgressions."
The reason why CEO turnovers in banks are more important than other non-financial organizations is that any changes in a bank's structure or operation can cause impacts on another part of the economy. The other reasons are banking operations are opaque and the incoming CEO also faces information asymmetry.
In the paper, the researchers opted for those turnovers which were due to exogenous reasons. This is due to a few reasons such as that endogenous turnover may be due to industry or company-wide performance or forced retirements may be disguised as voluntary.
The existing theory has 3 different predictions about the impact of CEO turnovers.
Big Bath Hypothesis: It states that the incoming CEO will resort to window dressing of accounts to improve the performance of the bank and make the investors believe in him. This is done by making the transition quarter look bad deliberately and in the next quarter due to the lower base these adjustments can enable the CEO to show higher profits.
Truth Telling Hypothesis: This says that the incoming CEO will put everything in front of the investors and will give a true picture of the bank. This may also include the incoming CEO may reduce the evergreen loans issued by the previous CEO.
Personal Risk Management Hypothesis: It states that the incoming CEO will increase loan provisions and reduce lending to risky propositions to reduce the risk of the bank on his watch.
The paper concludes with the following findings.
The incoming CEO, increase provisions for bad loans (also referred to as LLP provisions) by 8.5% in the first quarter he is in charge. However, there was no change to be found in the last quarter of the outgoing CEO.
The volume of loans is reduced by 7.04% during the transition year. Though this decrease is not attributed to the incoming CEO terminating the evergreen loans issued by the outgoing CEO.
The 3-day cumulative abnormal return around the announcement of the results by the CEO equals -1.7% (which is statistically significant). Although the previous studies conducted, have the opinion that the stock market reacts positively when the truth is revealed. However, the evidence is inconsistent with the truth-telling hypothesis.
In the last year of the outgoing CEO, there was no evidence of any changes compared to the changes made under the incoming CEO. This is in line with the outgoing CEO facing no information asymmetry compared to the incoming CEO.
A bank plays an important role in any economy as it acts as a catalyst for various economic activities and the CEO is the one heading the bank, forming the policies, implementing them, and thus it is of utmost importance to understand the impact of any transition taking place in such institutions. Agency-related problems in the banking world have gained importance especially after the 2008 financial crisis due to the CEO taking a hefty amount of risks for his gains.
On that note, we come to the end of this week's quick explanation of one of the financial papers.