Does the Board Structure Affect the Asset Quality of the Banks? Evidence from India

Abstract

The Office of the Comptroller of the Currency (OCC) argue that poor asset quality is an outcome of the failure of bank boards in effectively monitoring the management in terms of loan policies and compliance. The current study explores the influence of board structure (board size, board independence, CEO duality, financial expertise and board meeting) on asset quality of banks, using a sample of 36 scheduled commercial banks operating in India during the period from 2001 to 2014. After addressing the issue of endogeneity, the study finds that the proportions of independent directors and financial experts have significant positive impact on asset quality. It also concludes that board size, number of board meetings and CEO duality have no significant impact on asset quality.

Keywords

Board structure board size board independence CEO duality board meeting financial experts asset quality Indian banking

Introduction

The asset quality of banks remains a significant concern for the regulators, policymakers, investors and the public. Banks in general, and Indian banks in particular, are laden with a huge pile of non-performing assets over the years. The phenomenal rise in non-performing assets has invited the attention of regulators, policymakers and researchers around the world. A wide range of studies has sought to understand the underlying reasons for the poor asset quality of banks. However, most of the earlier studies focus only on the external factors ignoring the role of internal control mechanisms that enhance the asset quality of banks. Research on asset quality should necessarily focus on examining the roles of and the need for putting in place governance and regulatory mechanisms in preventing the deteriorating asset quality of banks. Though the primary reasons for the growth of poor asset quality are ascribed to domestic and global economic factors such as business cycles and global economic slowdown, internal factors of the bank such as inefficient management also contribute to the same.

A study conducted by Office of the Comptroller of the Currency (OCC) reports that poor asset quality is an outcome of board failures in effectively monitoring loan policies and compliance followed by the management and staff (Office of the Comptroller of the Currency, 1988). The OCC report further underlines that the failure of the bank board to effectively monitor the management in following loan policies, compliance procedures and early detection of problem loans are the ultimate causes for poor asset quality and bank failures. Macey and O’Hara (2003) argue that bank board is more important as a governance mechanism due to the fiduciary nature of banking business, and an effective board is likely to put a strong credit risk management system for the bank. That is the reason why regulators and policymakers around the world demand for stringent regulations in the formation of bank boards.

The Basel Committee on Banking Supervision (2006) argues that effective corporate governance practices are essential in achieving and maintaining public trust and confidence in the banking system. Among the different governing bodies, the board of directors plays an essential role in corporate governance and hence is considered as the lynchpin of corporate governance and also as the monitor of management in market economies. Jensen (1993) argues that the board of directors is critical in the effective internal control mechanism. The concerns related to corporate internal control systems begin with the board of directors. Being the pinnacle of internal control system, the board bears primary responsibility for the smooth functioning of the firm and also in monitoring and guiding management with fiduciary obligation to shareholders and depositors. Barth, Caprio and Levine (2004) argue that bank boards need to be more efficient in imposing effective control in the complex banking environment.

Though there are many studies on asset quality of the banks, only a few address the relationship between board structure and asset quality. This study explores this very aspect in order to find a new approach for corporate governance. Monitoring is the primary function of a board and the efficacy of monitoring relies upon the board structure, quality of discussions, time spent for discussions, and so on. Hence, the current study attempts to explore the impact of the characteristics of board structure such as number of directors (board size), board composition (number of independent directors), role of the chairperson and CEO (CEO duality), number of financial experts and number of meetings (board meetings) held about the asset quality of banks.

This study contributes to the existing literature in the several ways. First, it provides a new insight in the impact of board structure on asset quality. Despite the fact that the greater proportion of bad assets in a bank’s portfolio is expected to reduce the profitability of the bank, resulting in poor bank performance, many corporate governance studies ignore the importance of asset quality in bank performance and focus more on return on asset and Tobin’s q. When most of the earlier studies revolve around board structure and firm performance based on return on asset and Tobin’s q, this study attempts to examine the relationship between board structure and asset quality. Second, this study adds to corporate governance studies in the emerging economies, whereas most of the earlier studies focused on Europe, the US and other developed economies (Fama & Jensen, 1983; Hermalin and Weisbach, 1988). Third, this study contributes to the much underexplored literature on the board structure of banks (De Andres & Vallelado, 2008; Liang, Xu, & Jiraporn, 2013). Though the corporate governance practices of banks are similar to the non-banking firms, the highly leveraged, complex and opaque nature of banking as well as the fiduciary duties of banks makes corporate governance of banks different. Finally, this study adds to the board structure studies of banks in India, whereas earlier studies that took place in India focused mainly on non-financial firms (e.g., Garg, 2007; Jackling & Johl, 2009; Kumar & Singh, 2013).

The remainder of the article is structured as follows: the section that follows presents a review of literature and indicates the research gap; the data and methodology are explained in the section that follows; empirical results are discussed next and the last section provides the summary and conclusion of the study.

Review of Literature

Related Literature on Board Structure and Financial Distress

Simpson and Gleason (1999) report lower financial distress when the CEO holds the position of both chairperson and CEO. However, our study finds no significant relationship between board structure characteristics and financial distress. Lin and Zhang (2009) report that state-owned banks are less effective and have worst asset quality than other banks. Berger, Hasan and Zhou (2009) conclude that minority foreign ownership is associated with significantly higher asset quality. García-Herrero, Gavilá and Santabárbara (2009) report that low profitability is the outcome of poor asset quality and weak corporate governance among Chinese banks. Grove, Patelli, Victoravich and Xu (2011) examine the role of corporate governance in the performance of banks during the 2007–2008 financial crisis and find that corporate governance explains more about financial performance than asset quality. Lai and Choi (2014) examine the impact of corporate governance of banks on bank performance and find no significant relationship between corporate governance and asset quality.

Board Size

One of the important issues discussed in the finance and economic literature is about the board size and its role in alleviating agency issues. Yet, the financial press or academic research does not provide any conclusive evidence on the relationship between board size and firm performance. Dalton, Daily, Johnson and Ellstrand (1999) report that a large board contributes to the firm’s performance. Adams and Mehran (2012) argue that a large board is important for complex banking environment and the board members contribute to bank performance. De Andres and Vallelado (2008) argue that the board size is related to the director’s ability to monitor and advice management and having a large board is likely to result in better monitoring and advisory functions, and create more value for the bank. Using a sample of top Indian companies, Jackling and Johl (2009) report that large boards are more beneficial to Indian companies due to certain specific nature of Indian corporate culture. Salim, Arjomandi and Seufert (2016), using a sample of Australian banks between 1999 and 2013, suggest that large boards bring insights into the decision and supervisory processes and improve bank efficiency. Another argument that comes to the fore in the above-mentioned studies is that inclusion of more directors on a board benefits the monitoring and advisory functions and improves the governance and returns of banks. However, Lipton and Lorch (1992), Jensen (1993), Yermack (1996), Barnhart and Rosenstein (1998), Hermalin and Weisbach (1988) and Liang et al. (2013) report a negative association between board size and firm performance. Likewise, James and Joseph (2015) find no significant relationship between board size and bank performance. Raheja (2005) reports that the ‘optimal board size and composition are the function of directors and firm characteristics’.

Board Independence

Though a large group of researchers argue that independent directors are better monitors of the board since they are ‘independent’ (defined as the directors ‘not having any relationship with firm’) in decision-making, existing literature does not have a consensus on this view. Fama and Jensen (1983) argue that directors from outside are better monitors of managers as their reputation as experts in decision control is at stake. Baysinger and Butler (1985) report that firms with a higher proportion of independent directors show superior performance. Hermalin and Weisbach (1988) argue that outside directors are more likely to join the board of a firm when its performance is poor, leading to the inference that additional guidance improves the firm’s performance. Rosenstein and Wyatt (1990) examine the wealth effect on the nomination of outside directors and their study reports that appointment of outside directors are accompanied by significant positive excess returns. Using a sample of top Indian companies, Jackling and Johl (2009) report that appointment of outside directors is associated with positive financial performance. Francis, Hasan and Wu (2012), using buy-and-hold return, report that a board with strong independent directors shows a positive and significant relationship with firm performance. Liang et al. (2013), using a sample of 50 large Chinese banks, report that a larger presence of independent directors have a significant impact on both bank performance and asset quality. However, Yermack (1996), Hermalin and Weisbach (1988), Adams and Mehran (2012), James and Joseph (2015) and Salim et al. (2016) find no significant relationship between independent directors and bank performance.

CEO Duality

Two theories exist in the field of finance to explain why some firms have chosen to conflate the roles of CEO and chairperson while others have chosen to separate them. Agency theory argues that CEO duality (referring to the system where the CEO also holds the position of the board chairperson) hinder the board’s ability to monitor management. Contrary to the agency theory, stewardship theory argues that because of a single command authority, CEO duality is good. Given the two major theories, empirical research does not provide any conclusive evidence. Fama and Jensen (1983) and Jensen (1993) argue that CEO duality may hinder board’s ability to monitor management and thereby increase the agency cost. Rechner and Dalton (1991) report that firms with separate CEO and chairperson consistently outperform firms with combined titles. Pi and Timme (1993) investigate the principal–agent conflict and document negative relationship between CEO duality and accounting performance measures in banking industry. Brickley, Coles and Jarrell (1997) argue that separation has potential costs and that potential benefits and costs of separation are larger than the benefits for most of the large firms. Peng, Zhang and Li (2007) offer a strong support for stewardship theory and relatively little support for agency theory. Chen, Lin and Yi (2008) find no improvement in firm performance when firms convert from dual to non-dual CEO structure. They argue that CEO duality is endogenously and optimally determined due to firm characteristic and ownership structure. Yang and Zhao (2014) argue that duality firms outperform non-duality firms and CEO duality saves the benefits of information costs and swift decision-making.

Financial Experts

The 2007 financial crisis has shed enough light on the importance of having financial experts on board. Many banks and financial institutions came under the scanner for excessive risk taking without having financial experts on board (Kirkpatrick, 2009). The assumption is that financial expertise of the director can enhance the understanding of complex business environment and financial statements and can lead to better monitoring. Güner, Malmendier and Tate (2008) report that financial expertise of the director influences corporate performance and external funding of firms but not necessarily benefit the shareholders’ interest. Minton, Taillard and Williamson (2011) find that the director’s financial expertise is associated more with risk taking firms and is rewarded by higher market value before any crisis strikes and subsequently lower performance during the crisis. Gray and Nowland (2015) argue that shareholders benefit due to the diversity in expertise of the board, especially when the board has members with expertise in accountancy, banking and law. However, Liang et al. (2013) find no significant impact on bank performance and asset quality in China when the board has more financial experts.

Board Meeting

Board of directors, as an internal control mechanism, is charged with the responsibility of monitoring and advising the management and this monitoring is performed through the board meetings. Hence, the frequency of board meetings and directors’ attendance signal the quality of an effective board. Lipton and Lorsch (1992) argue that board should meet at least bimonthly and more number of meetings are likely to improve firm performance. De Andres and Vallelado (2008), using a sample of large international commercial banks, report that bank performance has a significant positive relation with the number of board meetings conducted. Jackling and Johl (2009), using a sample of top Indian companies, find that an increased frequency of board meetings does not result in improved firm performance. Liang et al. (2013) find that the number of board meetings has positive impact on both bank performance and asset quality. Salim et al. (2016), using a sample of Australian banks, report that the number of committee meetings has significant and positive correlation with efficiency, suggesting that the higher the number of meetings, the better the bank’s performance. However, Jensen (1993) and Vafeas (1999) argue that poor firm performance demands close monitoring, which results in increased frequency of board meetings.

Data, Variables and Methodology

Sample

Our sample comprises of 42 scheduled commercial banks operating in India during the period from 2001 to 2014. The sample includes 26 government owned public sector banks and 16 private sector banks. The year 2001 is considered as a suitable starting point since the mandatory disclosure of corporate governance was implemented in the year 2000 and by 2001 all listed firms complied with disclosure norms. The original sample of 42 banks was reduced to 36 banks since key variables for six banks were either not available or missing. The final panel data was built with 504 bank-year observations. Financial variables were mainly collected from the database of Centre for Monitoring Indian Economy (CMIE). The data was cross verified with the information available in annual financial statements of the sample banks to confirm the accuracy. The board variables were collected from individual bank’s corporate governance reports. The study explored 504 bank-year corporate governance reports to obtain board information.

Description of the Variables

Variables for this study are classified into three broad categories: performance/dependent variables, board/independent variables and control variables (see Table 1). Control variables are used to control the potential effects on performance.

Performance Variable

Asset quality: Asset quality is an important indicator of bank performance; it reflects the credit quality with respect to bank’s lending practices. Non-performing assets (NPA) is one of the generally accepted measures of bank’s asset quality. NPA is measured as the ratio of non-performing loans (bad loans) over the total loans and advances as a measure of asset quality. Liang et al. (2013) and Pi and Timme (1993) used NPA as one of the measures of asset quality.

Board Structure Variables

Board size: Board size refers to the number of board of directors in the bank during an accounting year. The size of the board signals the strength of the board in effectively monitoring the asset quality of the banks. The number of board directors can change during a particular year due to end of tenure, death, resignation of existing directors or addition of new directors. Hence, the board size has been determined on the basis of the number of directors who have attended board meetings during the tenure.

Board independence: Board independence is defined as the percentage of independent directors on board. Those directors who hold less than five directorship are considered as independent directors.

CEO duality: CEO duality refers to one person holding the two key positions of chairperson of the board and CEO of the firm. The study uses a dummy variable, wherein the combined role is given the dummy value of 0 and the split role is given the dummy value of 1.

Board meetings: Board meetings are defined as the number of board meetings held during a financial year. The number of board meetings held over a year indicates how much the board is concerned about the functioning of the bank.

Financial Experts: The variable of financial experts represent the number of financial experts on the board. Financial experts are the ones who have in-depth knowledge of banking, finance and economics. The study calculates financial experts as the percentage of financial experts over the board size.

Control Variables

Similar to what has been reported in previous studies (Adams and Mehran, 2008; Aebi, Sabato, & Schmid, 2012; Barnhart and Rosenstein, 1998; Liang et al., 2013; Pi and Timme, 1993; Yermack, 1996), our study also verifies the effect of control variables such as potential effect of bank size, loan size and capital size on bank performance.

Bank size: We used natural log of total assets as a measure of bank size to control its effect on bank performance. Bank size is measured as total assets that may influence the performance of banks (Adams and Mehran, 2008; Aebi et al., 2012; De Andres & Vallelado, 2008; Liang et al., 2013).

Loan size: We used the natural log of total loans as a measure of loan size. Many previous studies (Adams and Mehran, 2008; Aebi et al., 2012; De Andres & Vallelado, 2008; Liang et al., 2013; Pi and Timme, 1993) have used total loans to control the impact of loan size on bank performance.

Capital size: Most of the regulators across the world consider capital as the key measure of financial position of banks. Moreover, previous studies (Aebi et al., 2012; De Andres & Vallelado, 2008; Liang et al., 2013; Yermack, 1996) also control for the impact of capital on bank performance. Our study uses natural log of total capital as the third measure of control variable as it accounts for the bank’s financial strength.

Table 1.

Variables Description

Nature of variables	Name of variables	Description of variables
Panel-A Dependent variables	Non-performing assets	Ratio of non-performing loans to the total loans
Panel-B Independent variables	Board size	Total number of directors serving on the board
	Board independence	The percentage of independent directors on the board
	CEO duality	Dummy variable 0 if dual and 1 otherwise
	Board meeting	The number of board meetings held during the financial year
	Financial experts	The percentage of financial experts in the board
Panel-C Control variables	Bank size	Natural log of total assets
Panel-C Control variables	Loan size	Total loan over total assets
	Capital size	Natural log of total capital

Source: Authors.

Note: The table presents description of variables. Panel-A presents description of dependent variable, Panel-B independent variable and Panel-C control variables.

Empirical Methodology

\begin{matrix} N P A_{i t} = α + β_{1} B s i z e_{i t} + β ​_{2} B i n d e p e n d e n c e_{i t} + \\ β_{3} C E O D u a l i t y_{i t} + β ​_{4} M e e t i n g_{i t} + \\ β ​_{5} F x p e r t_{i t} + γ c o n t r o l var i a b l e s_{i, t} + ε_{i, t} \end{matrix}

where β parameters capture the potential impacts of various board characteristics on asset quality, that is, β is k × 1 vector of parameters to be estimated on explanatory variables and i,t are 1 × k vector of observations on explanatory variables.

where i = 1……N, that is, from bank 1 to bank 36

where t = 1…….T, that is, the values of the years from 2001 to 2014.

Empirical Results

Descriptive Statistics

Table 2 reports the descriptive statistic for the dependent, independent and control variables. The average NPA reported for the sample is 2.26 per cent and maximum NPA reported is 18.3 per cent, which means that NPA level still remains higher. Panel B presents the descriptive statistic for board structure variables such as board size, independent director, CEO duality, number of meetings and number of financial experts. The average board size for the sample is 11, which is smaller compared to boards in developed countries. For instance, in the US, the average board size is 18 and, in China, it is 13. On average, bank boards in India have 63.66 per cent independent directors on board. This means that all the banks comply with the listing agreement of Securities Exchange Board of India, which specifies that minimum one-third of the board should be independent when the chairperson of the board is non-executive and 50 per cent in the case of an executive chairperson. Total 34 per cent of banks in India have separate chair-person and CEO and in 66 per cent, they are one person. The average number of board meetings held during the accounting year is 12. On average, 57.62 per cent of the directors in the board have expertise in the field of finance, accounting and economics. Panel C presents the results of the descriptive statistic for control variables. The mean value of total assets shows 13.08 (log). The average loan size shows 0.72 per cent of the total assets. The average size of bank capital is 7.68 (log).

Table 2.

Descriptive Statistics

Variables	No	Mean	Median	STD	Min	Max
Dependent variables: Panel-A
Non-performing assets	504	2.26	1.30	2.59	0.40	18.37
Independent variables: Panel-B
Board size	504	11.10	11.00	1.75	6.00	17.00
Board independence	504	63.66	63.64	14.79	27.27	92.31
CEO duality	504	1.34	1.00	0.48	1.00	2.00
Board meeting	504	11.90	12.00	4.11	4.00	26.00
Financial experts	504	57.62	55.56	14.88	25.00	92.31
Control variables: Panel-C
Bank size	504	13.08	13.15	1.36	9.41	16.70
Loan size	504	0.72	0.58	0.59	6.18	9.07
Capital size	504	7.68	8.04	1.23	4.09	10.73

Source: Authors.

Note: The table presents the descriptive statistics of mean, median, standard deviation, minimum and maximum for dependent, independent and control variables.

Table 3.

Cross Correlation Matrix

	Asset	Board size	Capital	CEO	Financial experts	Board independence	Loan	Meeting
Asset	1.00
Board size	0.35	1.00
Capital	0.70	0.15	1.00
CEO	–0.06	0.14	–0.24	1.00
Financial experts	–0.11	–0.21	0.00	0.24	1.00
Board independence	–0.13	–0.02	–0.15	0.18	0.09	1.00
Loan	–0.09	0.06	–0.02	–0.03	0.13	–0.01	1.00
Meeting	–0.16	–0.14	–0.22	–0.52	–0.25	0.02	0.14	1.00

Source: Authors.

Note: The table presents results of correlation matrix for dependent, independent and control variables.

Multicollinearity

Table 3 presents the correlation matrix for all the variables. The results show that there is no much correlation among variables and that most of the values are within the acceptable range of 0.35 to –0.24. However, the correlation between capital and asset is 0.70, which indicates that the capital is linked to the firm size. The correlation between the number of board meetings and CEO duality is –0.52. Overall, the result of correlation matrix confirms the absence of multicollinearity among the variables.

Regression Results

Based on Hausman test results, fixed effect model is used to explain the results. Table 4 presents the results. The Hausman test shows the value of 56.712 with a degree of freedom of 8 and a probability value of 0.000, which is less than the significant level of 5 per cent. Thus, the fixed effect model is the most appropriate model to explain the results. The final result of the study is explained using fixed effect model presented in Table 4. The adjusted R-square value is higher and the F-value stands at 18.24, which means that the model is significant (5%) for explaining the results. In the fixed effect model, asset quality can be explained by board structure to the extent of 67.59 per cent.

Table 4.

Regression Results: Fixed Effect

Variable	Results
Intercept	–4.1886 (1.5315)
Board structure (Board variables)
Board size	0.0159 (2.2799)
Board independence	–0.0121** (–1.9729)
CEO	–0.3657 (–1.2632)
Financial experts	–0.0147** (–2.2581)
Meeting	0.0283 (1.1170)
Bank characteristics (Control variables)
Asset	0.6952*** (3.6273)
Capital	–0.4323*** (–3.0277)
Loan	0.2868*** (2.9448)
Number of observations	504
Adjusted R-squared	0.6759
F-statistic	18.2429
Prob. (F-statistic)	0.0000
Hausman test	Test Statistics	df	Significance
	56.7112	8	0.000

Source: Authors.

Note: The table reports the results of OLS regression on NPA as dependent variables and board structure as independent variables. The t-statistics values are in parenthesis.

Dependent variable: Non-performing assets

* Statistical significance at10% level, ** at 5% level and *** at1% level.

As reported by Hermalin and Weisbach (1988), corporate governance research is likely to be influenced by endogeneity. Nevertheless, we take measures to control the potential endogeneity by using generalized method of moments (GMM) in the following section. Analysing the board structure constituent reveals that board size is insignificant. Regarding the percentage of independent directors, the results show that independent directors are significant at 5 per cent level. However, result for CEO duality shows that CEO duality is insignificant at any level (10%). The number of board meetings is also insignificant at any level (10%). The results regarding the percentage of financial experts show that financial experts are significant at 5 per cent level.

The empirical results exhibit that board size is not associated with asset quality. So, increasing the board size does not improve the asset quality, which is consistent with Liang et al. (2013). The result supports the argument that board size does not matter in improving the asset quality of the bank. The possible explanation for this insignificant relationship of NPA with board size is that a large board is inefficient in governance and has detrimental effects on bank performance. This may be due to the problems associated with decision-making, coordination and communication. Another possible reason may be that the more the number of the directors, the more is the chance of pressure on management to give loans and advances to the firms and individuals connected with the directors. Moreover, there will be less pressure on repaying such loans and that could result in higher NPAs.

Regarding the percentage of independent directors, the result shows that banks with higher proportion of independent directors have superior asset quality, which is consistent with previous studies (De Andres & Vallelado, 2008; Liang et al., 2013). Getting more independent directors on the board is accompanied by lower NPAs. The result supports the argument that independent directors reduce the conflict of interest between shareholders and insiders, and increase the efficiency of monitoring and supervision. Another argument that can be attributed to this positive relationship is the independent monitoring by independent directors. Since independent directors are not connected with the bank, they can easily detect the deteriorating asset quality and advice the management to take corrective measures. Independent directors can thus act as a watchdog on asset quality of the banks.

The regression results of CEO duality and asset quality show that banks with separate roles of chairperson and CEO do not exhibit superior asset quality as compared to the banks with dual role, which is consistent with Liang et al. (2013). The results show insignificant impact on NPA when the bank has separate chairperson and CEO. A possible explanation for this insignificant relationship may be the trade-off between potential benefit and cost associated with separation of the roles.

The study finds significant positive relationship between percentage of financial experts on the board and asset quality, which is consistent with previous studies (De Andres & Vallelado, 2008; Kirkpatrick, 2009; Liang et al., 2013). The result supports the argument that since financial experts are good in accounting, finance and banking, and their expertise helps the financial institution in crafting good loan policies, they in turn help to improve asset quality and to increase the financial performance. The results suggest that banks and financial institutions need to appoint more financial experts on their board because they reward the financial institutions through their knowledge and expertise.

Contrary to the general assumption, our study does not find any significant relationship between number of board meeting and asset quality, which is consistent with Jackling and Johl (2009). This result challenges the general understanding that more board meetings are associated with close monitoring and increased supervision. This insignificant relationship may be due to the reason that boards do not spend enough time discussing the means to recover the loans as the directors themselves are responsible for the loans and advances to firms and individuals they are connected with. Hence, any number of meetings coupled with small pressure on repayment will not improve the asset quality of banks.

Endogeneity Using Generalized Methods of Moments

One of the key issues in corporate governance research is the effect of endogeneity of board as observed by Hermalin and Weisbach (1988). Therefore, when endogeneity exists, ordinary least squares (OLS) results are biased and inconsistent. The study assumes that the board structure of banks in India is not likely to suffer from endogeneity since the boards are constituted based on ‘fit and proper criteria’ and are also approved by the Reserve Bank of India. However, the study addresses the endogeneity issue by using GMM as have been the case with previous studies (De Andres & Vallelado, 2008; Liang et al., 2013). Due to space constraints, the GMM results are presented in Annexure 1. The results show that board independence and financial experts are positively related to asset quality, while board size and CEO duality is insignificant. Moreover, J statistic value is insignificant (29.265) at 10 per cent. Hence, the study concludes that earlier results are valid and the board is likely to be free of endogeneity.

Conclusions

The concern about increasing NPA has made the bank regulators to frame stringent norms and regulations regarding loan policies and recovery mechanisms. However, most of these regulations are meant for the credit officers and borrowers and ignore the role of directors, one of the key arms of corporate governance in monitoring and advising management in the design and implementation of corporate strategies. This article explores the importance of board structure characteristics such as board size, board independence, CEO duality, financial expertise and board meetings, and examines their influence on the asset quality of banks.

After controlling the problem of endogeneity, we study the impact of board structure on asset quality using a sample of 36 scheduled commercial banks operating in India during the period from 2001 to 2014. The study uses three models of panel regression, namely pooled panel, random effect and fixed effect model, to test the empirical results. The findings give new insights to the regulators and the shareholders regarding the role of board structure in improving the asset quality of banks. The findings also indicate that appointment of more independent directors on the board is likely to strengthen the internal control system, thereby improving the asset quality. Independent directors of a small board are likely to pursue their interest and make the risk management policies aligned to their interests, whereas a board with more independent directors would be capable of unbiased monitoring that would protect the interests of the shareholders and investors. The result that the board with more financial experts will increase the asset quality of the banks shows that shareholders should choose directors with knowledge in finance and accounting.

It was found that inducting more directors on board has less significance, which means that the regulators should limit the size of the board. Merely appointing more directors to the board will yield no results other than incurring cost to the bank. The findings of the study also do not support the argument that frequent board meetings signal better monitoring of NPAs. Effectiveness of the meeting depends on how much time is being spent on discussing and recovering problematic loans. Finally, the results indicate that separating the role of the chairperson and the CEO does not improve the asset quality.

The findings of the study have important policy implications in the area of corporate governance in general and banks in particular. An efficient board is likely to frame effective loan policies. The results lead to the conclusion that to make the bank board efficient, regulators and shareholders may induct more independent directors and financial experts on the board. Consequently, bank boards with more independent directors and financial experts may monitor the management in following loan policies and compliances and lead to an early detection of problematic loans. The study also suggests that regulators should make problematic loans and their recovery one of the mandatory agenda of bank board meetings.

Footnotes

Appendix

Annexure 1.

Generalized Method of Moments (GMM)

Variable	Coefficient	Prob.
NPA	0.9248	0.0000
Board structure (Board variables)
Board size	–0.3285	0.0000
Independent director	0.1058	0.0000
CEO	1.5997	0.0002
Financial experts	–0.0175	0.0193
Meeting	–0.1245	0.0130
Bank characteristics (Control variables)
Asset	0.9536	0.0004
Capital	0.2094	0.5667
Loan	–0.1118	0.3939
J-statistic	25.9091
Prob. (J-statistic)	0.5236

Source: Authors.

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