Blind Spots and Bailouts: Rethinking Risk in Bank Boardrooms

In March 2020, government-owned lender State Bank of India along with a host of other Indian banks intervened to rescue embattled private bank Yes Bank after banking regulator Reserve Bank of India (RBI) decided to replace its board citing governance issues (1).  

Yes Bank represents the most notable instance of an Indian bank's downfall making headlines due to its board overlooking governance issues, but few others also made headlines in the last few years.  

Privately-held Lakshmi Vilas Bank collapsed due to flawed corporate lending and mismanagement of funds, highlighted by a failed INR 7.2 billion loan to ex-Ranbaxy Laboratories Limited promoters (2). The RBI imposed a moratorium in November 2020 (3), capping withdrawals, and subsequently merged the bank with DBS Singapore's India operation after lifting the moratorium (4).

The 2018 global financial crisis raised doubts about the effectiveness of board oversight in banks and financial firms. There have been several media reports and discussions that pointed out bank boards’ turning a blind eye to assessing risks.  

Silicon Valley Bank's (SVB) failure was highlighted during a speech by an European Central Bank supervisory board member, emphasising the critical need for proper board oversight, adequate banking and risk management expertise within the board, and the establishment of appropriate incentives to guide strategy and risk mitigation (5).

In March 2023, venture capital-favourite and lender to the tech community, SVB, collapsed with the immediate trigger being a panic run on the bank deposits fuelled by the bank’s announcement that it needed to raise USD 2.25 billion to shore up its balance sheet (6). The U.S. Federal Reserve attributed the collapse to mismanagement, with its senior leadership unable to handle fundamental interest rate and liquidity risks. The Reserve also blamed its board of directors for failing to oversee the senior management or ensure their accountability (7).  

“In today’s environment, backward-looking indicators of risk might be misleading,” Elizabeth McCaul, Member of the Supervisory Board of the ECB, said in April 2023 (8). “It is therefore more important than ever for boards to be vigilant. Boards need to take a proactive approach to identifying emerging risks and trends, assessing potential impacts on the bank, and taking appropriate actions to mitigate them.”

This situation underscores the necessity for academics and policymakers to examine and grasp the inner workings of bank boards’ closely. Previous academic studies have focused on the impact of board structure on governance within banks. Despite the critical role of board oversight emphasised in policy reports analysing the global financial crisis, there exists no academic research investigating board conduct within banks.

To understand this better, Indian School of Business’ Prasanna Tantri, Associate Professor, Finance, and his co-authors accessed a set of confidential Indian banks board meeting minutes, in their study ‘Board Conduct in Banks’.

The study revealed that regulatory and compliance issues dominated board meetings, followed by business strategy, with risk issues being less prominent. It was also seen that most issues were not deliberated in detail, indicating a tendency towards superficial treatment.  

The analysis shows a positive correlation between the focus on risk issues and positive financial outcomes, such as higher returns on assets and equity, and a lower proportion of non-performing assets.

Boards: Banks versus Industries

Why are bank boards subject to such higher scrutiny versus non-financial firms? Especially in India, banking is a heavily-regulated industry, often subjected to tougher norms than their counterparts in the west.  

Banks are the lynchpin of the Indian financial ecosystem contributing over 50% of the total financial flows into the economy. The sector consists of state-owned public sector banks, privately-held banks as well as non-banking financial companies (NBFCs), and foreign banks - all of them regulated by the RBI.  

In non-financial companies, boards primarily owe duties to shareholders, while bondholders rely on covenants for protection. Governance in banks presents greater complexity due to their critical economic role and business nature, highlighting three major distinctions from industrial firms.  

Firstly, banks have a capital structure heavily reliant on debt, with depositors as key stakeholders. Secondly, banks engage a wider range of stakeholders, including regulators and deposit insurance authorities, due to their potential systemic impact, leading to varied risk preferences among stakeholders. Thirdly, the banking business is characterised by its opacity and complexity, making risk assessment and management oversight challenging and necessitating regulatory involvement.

Public sector banks are guided by specific laws that outline governance structures and director selection, including government and RBI representatives, alongside qualified professionals and employee representatives. Conversely, private-sector banks follow corporate laws, including a mix of executive and independent directors, and align with global best practices for leadership appointments.

Board responsibilities within these banks are comprehensive, covering risk management, cultural development, governance, and strategic implementation, under the oversight of the RBI's stringent risk governance framework.  

Bank governance is influenced by the interplay of a debt-dominated capital structure, diverse stakeholders, and the intricate nature of banking operations. This complexity requires a more expansive duty of care from bank boards compared to their counterparts in industrial firms, encompassing fiduciary responsibilities to depositors, other debt holders, regulators, and equity claimants.

Behind Closed Doors

Prof Tantri’s research utilised minutes from bank board meetings, sourced from a committee established by the RBI in January 2014 to assess governance practices within Indian banks' boards.  

The committee, in February 2014, asked 24 public sector and 17 private Indian banks for the minutes of their most recent board meetings. Since the targeted banks had not held board meetings for 3Q13 at the time of the request, such banks were instructed to send 2Q13 minutes.  

17 public sector and 12 private banks provided the final data considered for this research representing 70% by market capitalisation and 65% by total revenues of the Indian banking industry.

Prof Tantri used this information to examine the distribution of topics such as strategy, risk, financial reporting, compliance, and human resources discussed in bank board meetings and their relationship to bank performance.  

The ISB team also investigated whether discussions are thorough or merely superficial "box-ticking," thus identifying patterns.

The depth of deliberation offers insights into board dynamics, particularly whether members actively question assumptions and decisions. Board members discussing and debating is a positive sign as it indicates collective decision-making, countering the risk of executive “group-think.”

“Groupthink is slow to recognise changes in the weather; it cannot visualise the storm ahead to see the risks which strike at the heart of its business model,” ECB member McCaul noted in her 2023 speech (9). “For banks to safely navigate these dangers, we need independent directors to be thinking about how they can facilitate boardroom discussions that fully reflect the diverse perspectives around the table.” 

The 2009 Walker report criticised failed bank boards for not sufficiently questioning executives on key matters, often settling for procedural compliance over substantive engagement (10). This lack of scrutiny can manifest as hesitance in tackling complex topics, avoiding probing questions, or agreeing with dominant opinions to maintain harmony, pointing to a board's potential ineffectiveness in critically engaging with management issues.

Boardroom Balance: Strategy vs. Risk

The RBI, in a guidance note titled “Management of Operational Risk,” stated, “The Board of Directors is primarily responsible for ensuring effective management of the operational risks in banks. The bank's Board of Directors has the ultimate responsibility for ensuring that the senior management establishes and maintains an adequate and effective system of internal controls (11).”

An indicator of a bank board's regard for risk is the prominence it receives in meeting discussions and its position on the agenda.

Prof Tantri’s research showed that bank boards tabled a significantly higher number of overall issues, averaging 50 per meeting, compared with 8.5 tabled in industrial companies. The bank board discussions with regulation and compliance accounted for 40.88% of the total issues, closely followed by business strategy at 30.63%. Despite the importance of risk management, it constituted a mere 10.31% of the conversation. Statistical analysis reinforced the observation that regulation, compliance, and business strategy significantly overshadow risk discussions.

Further examination into the consistency of these findings across different parameters revealed that the variety of issues discussed remains stable, regardless of bank ownership, size, or performance metrics.  

In board meetings, the portion of discussions centred on risk issues has a notable correlation with all measures of bank performance.  

A 1998 study published in Organizational Dynamics showed a positive correlation between the frequency of corporate board meetings and enhanced internal governance, which supports performance by lowering agency costs and risk-taking (12).

Further, research from 2003 (13) and 2011 (14) highlights that banks, due to their complex operations, necessitate more regular board meetings compared to non-financial companies. Additionally, a 2013 study indicates that the frequency of these meetings is beneficial not only for banking performance but also for the quality of bank assets, contributing to a notable decrease in banking risk (15).

Prof Tantri’s research highlighted that focus on risk in board discussions aligned positively with increases in return on assets and return on equity and inversely with the ratio of non-performing assets to advances. Topics such as business strategy, regulation, compliance, and financial reporting did not demonstrate a direct link to bank performance.

The data showed that topics such as business strategy and regulation received more attention, while risk, financial reporting, and human resources are less frequently explored in depth. This trend persisted across banks of various ownership models and sizes, indicating a widespread need for boards to engage more thoroughly with risk management topics during their meetings.

Investigating the factors influencing the low incidence of risk topic discussions revealed no direct link to the banks' existing risk profiles or specific characteristics, pointing to a generally uniform approach to risk deliberation. This lack of variation suggested a potential gap in boards' responsiveness to the evolving risk landscape.

The study also delved into how board structure impacted discussion focus. Boards with members having prior experience or those from the private sector tend to allocate more attention to risk issues. In contrast, larger boards or those with older members tend to devote less attention to human resources topics.  

Eyes Wide Open

In 2023, five banks with total assets of USD 548.705 billion failed in the United States including SVB, First Republic Bank and New York-based Signature Bank (16). March 2023 also witnessed the almost-collapse of global banking behemoth Credit Suisse which was ultimately acquired by UBS Group – a relationship orchestrated by the Swiss government (17).  

One of the factors contributing to the collapse was, “a poor risk culture, as well as ineffective senior management and board oversight,” according to a 2023 report by Bank for International Settlement (18).

“We see [the board] as our eyes and ears at the table... Challenge is not something that is just for the sake of challenge,” ECB member McCaul said in her 2023 speech. “Around the board table we need the right level of expertise and intellectual discourse for such challenge to be effective.”

The European Central Bank noted that despite recent progress, internal governance and risk management remain areas of concern, with the 2022 Supervisory Review and Evaluation Process (SREP), showing that 73% of institutions received a score of 3 for internal governance, which suggests a widespread need for enhancement in these areas (19).

The 2022 SREP for European banks showed that almost half of the supervised banks faced at least one action related to their management body.  

The primary reasons for this inadequate oversight typically stemmed from flaws in the essential operations and makeup of boards and their committees. Problems arise from infrequent meetings, vague mandates, inadequate reporting lines to independent control functions, and ineffective communication between the board and its committees or with the heads of internal control.  

Prof Tantri's research showed that risk issues in Indian banks received 10% of board attention, with compliance and regulation dominating the discussion at 41%, and business strategy at 31%, thus he concluded that bank boards invested less in risk-related issues and more in compliance matters.

Board characteristics, such as prior experience and board size, influenced the focus of discussions, particularly regarding risk and financial reporting issues. The study also explored the implications of these findings through a model of multi-tasking by boards, suggesting that boards under-invested in risk mitigation compared to optimal levels, especially under high regulatory pressure. This tendency led to an overemphasis on compliance and regulatory issues, potentially affecting firm value negatively.

Overall, the study provided new insights into the conduct of bank boards, supporting concerns about boards focusing excessively on compliance at the expense of strategy and risk. It complemented existing research on board structure and governance, indicating a need for a balanced approach to risk, strategy, and compliance in board deliberations.  

As echoed by the ECB reports, this issue is not unique to the Indian context, as similar concerns had been raised in reports from other countries, suggesting a widespread challenge in board governance in the banking sector.