Corporate governance in banks: boards, rules and lessons from failures

When a bank fails, the post-mortem almost always finds a governance failure before a financial one: a board that did not ask questions, a dominant chief executive, a risk function that was overruled, or loans to connected parties that nobody reported. That is why the RBI has spent much of the last decade tightening governance rules, and why Paper III asks about them. Good answers connect theory (the agency problem) with Indian rules and real cases.

What corporate governance means

The Cadbury Committee (UK, 1992) gave the classic definition: corporate governance is the system by which companies are directed and controlled. It covers the relationships between the board, management, shareholders and other stakeholders, and the structures through which objectives are set and performance is monitored.

The OECD Principles of Corporate Governance (first issued in 1999 and revised since) stress shareholder rights, equitable treatment, the role of stakeholders, disclosure and transparency, and board responsibilities. The four values most answers cite are accountability, transparency, fairness and responsibility.

The theory behind it

• Agency theory: shareholders (principals) hire managers (agents), whose interests may differ. Managers may prefer empire-building, perks or short-term results. Governance aligns them through boards, audits, disclosure and pay design.
• Stakeholder theory: a company answers to employees, customers, creditors and society, not only shareholders.

In India, a common problem is not only owners versus managers but controlling promoters versus minority shareholders, which is why related-party rules matter so much.

Why banks need stricter governance

• Other people's money: most of a bank's funding comes from depositors, who cannot monitor the bank themselves.
• High leverage: shareholders gain from risk-taking while depositors and the deposit insurer bear much of the downside.
• Opacity: loan quality is hard for outsiders to judge, so problems can be hidden for years.
• Contagion: one bank's failure can shake confidence in others and in the payment system.

So bank governance must protect depositors and financial stability, not just maximise shareholder value, and the regulator takes a direct interest in who sits on the board.

Committees that shaped Indian governance

The Bank Boards Bureau (2016) advised on top appointments in public sector banks. It was replaced in 2022 by the Financial Services Institutions Bureau (FSIB).

Legal rules on bank boards

The Banking Regulation Act, 1949 has specific provisions:

• Section 10A: at least 51% of the directors of a banking company must have special knowledge or practical experience in fields such as accountancy, agriculture and rural economy, banking, cooperation, economics, finance, law and small-scale industry.
• Section 10B: a banking company must be managed by a whole-time chair or managing director.
• Section 20: restricts loans to directors and firms in which they are interested.
• Section 35B: appointment or reappointment of the chief executive of a private bank needs RBI approval.
• Section 36AA: the RBI can remove a chair, director or chief executive.

The Companies Act, 2013 applies too: at least one-third of a listed company's board must be independent directors (Section 149), with audit (Section 177) and nomination and remuneration (Section 178) committees. SEBI's LODR Regulations, 2015 add listing obligations.

Worked example: Section 10A

A bank's board has 11 directors. How many must meet the Section 10A expertise test?

1. 51% of 11 = 5.61.
2. The number must be a whole number and at least 51%, so round up to 6.
3. If only 5 qualify, the bank must reconstitute the board.

The RBI's 2021 governance directions

In April 2021 the RBI issued governance directions for private sector banks and foreign banks' wholly owned subsidiaries. The main points:

• Chair: the board's chair should be an independent director.
• Chief executive tenure: an MD & CEO or whole-time director can serve at most 15 years (with a break before any reappointment) and must retire at 70.
• Non-executive directors: up to 8 continuous years, and an upper age limit of 75.
• Board committees: the Audit Committee, Risk Management Committee and Nomination and Remuneration Committee, with non-executive or independent directors in control; the chief executive cannot be a member of the audit or nomination and remuneration committees.
• Assurance functions: the chief risk officer, chief compliance officer and head of internal audit must be independent and have direct access to the board.

Separately, the RBI's compensation guidelines tie variable pay to risk and allow malus (cancelling unvested pay) and clawback (recovering paid amounts) if performance turns out to be illusory.

CSR under the Companies Act

Section 135 of the Companies Act, 2013 requires companies with net worth of ₹500 crore or more, or turnover of ₹1,000 crore or more, or net profit of ₹5 crore or more, to spend at least 2% of average net profits of the three immediately preceding financial years on CSR activities listed in Schedule VII.

Worked example: CSR spend

A company's net profits for the last three years are ₹90 crore, ₹110 crore and ₹130 crore.

1. Average = (90 + 110 + 130) ÷ 3 = 330 ÷ 3 = ₹110 crore.
2. Minimum CSR spend = 2% of 110 = ₹2.2 crore.
3. Unspent amounts must be transferred to specified funds within set timelines, so CSR is effectively mandatory.

Lessons from Indian failures

Model answer outline (15 marks)

Question: "Good governance is the first line of defence against bank failures." Discuss.

1. Introduction: Cadbury definition; banks' special features.
2. Why governance matters more in banks: depositors' money, leverage, opacity, contagion.
3. Elements: competent, independent board; committees; independent assurance functions; risk-sensitive pay.
4. Indian framework: BR Act Sections 10A, 10B, 35B and 36AA; Companies Act; RBI 2021 directions; FSIB for public sector banks.
5. Failures: PMC Bank, Yes Bank, IL&FS.
6. Limits: governance cannot replace capital and supervision; culture is hard to regulate.
7. Conclusion: governance is the first line; supervision and capital are the backstops.

Short model answer (10 marks)

Question: What is the agency problem, and how does corporate governance address it in banks?

The agency problem arises when one party (the principal) hires another (the agent) to act on its behalf, and the agent's interests differ. In companies, shareholders are principals and managers are agents. Managers may pursue size, short-term profits or personal benefits rather than long-term value.

In banks the problem is sharper. Depositors are also principals, but they are dispersed and cannot monitor the bank. Shareholders of a highly leveraged bank may even favour risky lending, since gains accrue to them while losses fall heavily on depositors and the insurer.

Governance tackles this in several ways. Independent, competent boards oversee management. Audit and risk committees scrutinise accounts and exposures. Independent risk, compliance and audit functions report directly to the board. Pay is linked to long-term, risk-adjusted performance, with malus and clawback. Disclosure lets markets judge the bank, and the RBI's fit-and-proper tests, approval of chief executives and power to remove managers act for depositors who cannot act for themselves.

Practice questions

1. Which committee defined corporate governance as "the system by which companies are directed and controlled"?
   • The Cadbury Committee (UK, 1992).
2. Which section of the BR Act requires 51% of directors to have special knowledge?
   • Section 10A.
3. What is the maximum tenure of an MD & CEO of a private bank under the 2021 directions?
   • 15 years.
4. Average net profit of the last three years is ₹75 crore. What is the minimum CSR spend?
   • ₹1.5 crore.
5. Which body replaced the Bank Boards Bureau in 2022?
   • The Financial Services Institutions Bureau (FSIB).
6. Which SEBI committee's report led to Clause 49?
   • The Kumar Mangalam Birla Committee.

What to do next

• Learn the committee table in date order with one contribution each.
• List the BR Act sections on boards (10A, 10B, 20, 35B, 36AA) from memory.
• Read the risk management guide for the three lines of defence.
• Then read the banking regulation guide and the ethics guide.