Does Independent Industry Expertise Improve Board Effectiveness? Evidence From Bank CEO Turnovers

DOIhttp://doi.org/10.1111/irfi.12236
Published date01 September 2020
AuthorZhongdong Chen
Date01 September 2020
Does Independent Industry
Expertise Improve Board
Effectiveness? Evidence From
Bank CEO Turnovers
ZHONGDONG CHEN
Department of Finance, College of Business Administration, University of Northern
Iowa, Cedar Falls, Iowa
ABSTRACT
This study explores the impact of independent bank directorsnancial
industry expertise on board effectiveness by investigating bank CEO turn-
overs and post-turnover bank performance. Empirical results nd such exper-
tise increases the probability of forced CEO turnover and the probability of
outsider succession. It improves bank performance and reduces bank risk-
taking following a forced CEO turnover. This is likely because industry-
specic expertise enhances boardsability to locate a superior successor CEO
and to monitor and advise the new management. Market reaction to bank
CEO turnover announcements tends to agree with this view.
JEL Codes: G21; G34; G38
Accepted: 23 August 2018
I. INTRODUCTION
The recent debate over corporate governance reform has sparked new interest
in board structure (Adams et al. 2010). The existing literature on board structure
largely focuses on board independence, board size, CEO-chairman duality, stag-
gered board, and board committees. Less attention has been paid to indepen-
dent directorsexpertise in the industry in which the rm operates, which may
help lower their cost to obtain and process information and therefore, reduce
information asymmetry and improve board effectiveness in monitoring and
advising management (Kroll et al. 2008; Brickley and Zimmerman 2010; Pozen
2010). Recent empirical studies nd results consistent with this view (Dass
et al. 2014; Denis et al. 2015; Von Meyerinck et al. 2016). Specically, Wang
et al. (2015) nd that such expertise increases the sensitivity of CEO turnover
to poor rm performance.
Forced CEO turnovers make a unique set to test the effectiveness of board
functioning. Given that independent directors typically spend only a limited
amount of time with the organization(Judge and Dobbins 1995) but are likely
© 2018 International Review of Finance Ltd. 2018
International Review of Finance, 20:3, 2020: pp. 665699
DOI: 10.1111/ir.12236
to act in crisis situations(Mace 1986), an effective board may be particularly
important when a rm needs to oust its CEO and adjust its strategies (Parrino
1997). Specically, effective boards should be able to not only replace poorly
performing CEOs (Weisbach 1988), but also identify and attract superior
replacement CEOs (Denis and Denis 1995) and provide advice and counsel
(Mace 1986; Adams et al. 2010). If independent industry expertise improves
board effectiveness and increases the sensitivity of CEO turnover to poor rm
performance (Wang et al. 2015), ex-post rm performance should signicantly
improve, relative to voluntary turnovers. Otherwise, the increased sensitivity of
CEO turnover to poor rm performance might be attributable to other factors
such as scapegoating (Jenter and Kanaan 2015). For instance, independent
directors with prior experience in the rms industry may be socially connected
with professionals in the industry. To avoid social embarrassment and maintain
professional reputation, these directors might be more inclined to blame poor
performance on their CEOs, leading to an increased sensitivity of CEO turnover
to poor rm performance. If this were the case, independent industry expertise
would not have a positive impact on CEO turnover decisions or subsequent
rm performance. This study aims to ll this gap in the literature and tests
these two competing hypotheses by examining the relationship between inde-
pendent industry expertise on board and rm performance following a forced
CEO turnover.
This study employs a sample of 173 bank CEO turnovers from 1995 to 2010,
including 70 forced turnovers and 103 voluntary turnovers. This study focuses
on the banking industry for three reasons. First, information asymmetry is argu-
ably more of an issue in the banking industry due to complexity of banks and
opacity of bank operations (e.g., Furne 2001; Levine 2004). Industry-specic
expertise may be therefore particularly important for independent bank direc-
tors to have, in order to monitor and advise management. Second, nancial
industry expertise is more readily observable than other types of industry exper-
tise. In this study, independent nancial industry expertise is measured by the
ratio between the number of independent directors that are nancial industry
experts and the number of directors on a bank board. The denition of nan-
cial industry expert in this study follows Güner et al. (2008), Minton
et al. (2014), and Wang et al. (2015). A director is classied as a nancial indus-
try expert if the director is (was) employed by a nancial organization
(e.g., venture capital rm; consumer lending company; investment company;
mutual fund; bank) or a banking regulator. Last but not least, blamed for the
recent nancial crisis (e.g., Kirkpatrick 2009; Adams 2011), governance mecha-
nisms in the banking industry have received growing attention since then
(e.g., Adams 2012). In line with such concerns, government regulators and
institutional investors are requiring banks to restructure their boards with more
independent directors that have nancial industry expertise.
1
However, our
1Help Wanted: Bank Boards Seeking Competent Directors, Stephen Gandel, TIME, May
20, 2009. Although FDIC implemented requirements on independent directorsnancial
© 2018 International Review of Finance Ltd. 2018666
International Review of Finance
knowledge on the impact of such expertise on the effectiveness of bank board
is quite limited.
While previous studies on bank CEO turnovers tend to focus on the proba-
bility of forced CEO turnover (e.g., Webb 2008; Palvia 2011), this study investi-
gates the relationship between bank performance following a CEO turnover
and board structure with a focus on independent directorsnancial industry
expertise. A Heckman two-step model shows that poor bank performance and
independent nancial industry expertise increase the probability of forced CEO
turnover. Although forced CEO turnovers lead to improved bank performance,
the improvements are likely driven by forced CEO turnover decisions made by
bank boards with more independent nancial industry experts (IFIEs). Further-
more, consistent with Minton et al. (2014), IFIEs tend to encourage risk-taking
in general, but they are negatively correlated with risk-taking following a forced
CEO turnover. This is likely because in the crisis situation where performance
has been poor and a bank needs to replace its CEO, it is more important for the
bank to decrease risk-taking and restore its stability. Independent directors with
nancial industry expertise may be better able to monitor and advise successor
CEOs in such efforts. These ndings are robust to alternative denition of board
independence, the use of annual accounting data and alternative measures of
risk-taking. Moreover, the improvements in ex-post performance are not likely
driven by window dressing or mean reversion.
To explore the mechanisms through which independent nancial industry
expertise impacts post-turnover bank performance, this study examines the
relationship between such expertise and the selection of successor CEOs. The
previous CEO turnover literature suggests that outside successor CEOs tend to
be superior in certain aspects (e.g., Parrino 1997), and they are better able to
improve rm performance and enhance rm value (e.g., Khurana and Nohria
2000; Huson et al. 2004; Adams and Mansi 2009). Given their familiarity with
the industry, IFIEs might be better able to identify and attract an outside succes-
sor CEO. This study tests this hypothesis and nds that IFIEs are positively
related to the selection of an outside successor CEO, regardless of the nature of
a bank CEO turnover.
In an event study examining cumulative abnormal stock returns around the
announcements of a bank CEO turnover, this study nds market reactions that
are consistent with the above empirical ndings. Although forced CEO turn-
overs in general tend to receive a more positive market reaction relative to vol-
untary CEO turnovers, it is driven by forced turnover decisions made by a bank
board with more IFIEs. The evidence indicates that the market recognizes the
signicant role of industry experts in a CEO ring decision and believes that
they are likely to help improve the status quo.
These ndings add to the growing literature suggesting the importance of
directorsindustry-specic expertise to board functioning. The documented
industry expertise following the banking crisis in the 1990s, they are applied only to bank
audit committees.
© 2018 International Review of Finance Ltd. 2018 667
Independent Industry Expertise & CEO Turnovers

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