Does Industry-Specific Expertise Improve Board Functioning? Evidence from Forced Bank CEO Turnovers
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Does Industry-Specific Expertise Improve Board Functioning?
Evidence from Forced Bank CEO Turnovers
Zhongdong Chen1
June, 2012
Abstract:
This study investigates whether independent directors’ expertise in the industry in which the
firm operates improves board functioning. In this study, board functioning is measured
through the lens of firm performance following a CEO turnover. Using a sample of 157
bank CEO turnovers at 202 banks from 1995 to 2009, I find that market responds more
positively to forced CEO turnover decisions when they are made by a more independent
board. I document that improvements in bank performance following a forced bank CEO
turnover are significantly positively related to independent financial expertise on the board.
In contrast, board independence improves post-turnover bank performance for the overall
sample. It does not particularly benefit forced turnovers of a bank CEO. This is likely
because that a properly functioning board is particularly important when a forced CEO
turnover becomes necessary, and industry-specific expertise greatly improves boards’
ability to monitor and advise management.
JEL classification: G21, G34, G38
Keywords: board advising, board structure, banking industry,
CEO turnover, financial expertise
1
University of Tennessee, Department of Finance, College of Business Administration, 427 Stokely Management
Center. Email: zchen12@utk.edu
I thank Harold Black, David Cicero, Phillip Daves, Ramon DeGennaro, Mike Ehrhardt, Larry Fauver, Deborah
Harrell, Jason Howell, Ulrike Malmendier, Usha Mittoo, Andy Puckett, Alvaro Taboada, John Wachowicz, James
Wansley, Tracie Woidtke, and seminar participants at the University of Tennessee and the 2011 FMA PhD
Consortium. I am especially grateful to my advisor, Alvaro Taboada, as well as to Andy Puckett, Ulrike
Malmendier, and Tracie Woidtke, for valuable discussion and suggestions.1. Introduction
The recent policy debate over corporate governance reform has sparked new
interests in board structure (Adams, Hermalin, and Weisbach, 2010). When exploring
how board structure impacts board effectiveness in monitoring and advising
management, previous studies largely focus on board independence (e.g., Weisbach,
1988; Denis and Denis, 1995), board size (e.g., Yermack, 1996; Coles, Daniel, and
Naveen, 2008), and directors’ individual knowledge that is not related to the industry
in which the firm operates (e.g., Agrawal and Chadha, 2005; Güner, Malmendier, and
Tate, 2008). Less attention has been paid to independent industry-specific expertise
on boards in previous literature. Fama (1980) and Fama and Jensen (1983)
acknowledge the importance of insider knowledge for board functioning and suggest
that it may be optimal to have insiders on boards (also see, e.g., Klein, 1998).
However, as noted in Williamson (1984), agency cost can be higher when
management has information advantages over the board of directors due to insider
knowledge (also see, e.g., Beasley, 1996). Independent industry-specific expertise on
boards, which potentially combines inside directors’ knowledge and independent
directors’ vigilance (e.g., Mace, 1986; Brickley, Coles, and Terry, 1994; Rosenstein
and Wyatt, 1997), may mitigate this issue. In this study, I examine whether
independent directors’ expertise in the industry in which the firm operates improves
board functioning by investigating bank performance following a forced CEO
turnover.
1I focus on the banking industry for three reasons. Most importantly, the
complexity of banks and the opacity of bank operations (e.g., Levine, 2004) make the
banking industry a unique platform to test the significance of directors’ industry-
specific expertise. Arguably, more so than in other industries, an independent bank
director needs a solid financial background to be able to monitor and advise the
management. Some extreme examples of the primary occupations of independent
bank directors in this study are dentists, professional volunteers, chiropractors, and
judges. It is reasonable to assume that without a financial background, independent
bank directors are less able to fulfill their monitoring and advising duty. Kroll,
Walters, and Wright (2008) suggest that independent expertise may be the key for a
board to function properly. Brickley and Zimmerman (2010) also emphasize directors’
occupational backgrounds over board independence. Second, financial expertise is
more readily observable than other types of industry expertise. The definition of a
financial expert in this study follows Güner et al. (2008) and Minton, Taillard, and
Williamson (2011). A director is classified as a financial expert if the director is (was)
employed by a financial organization (e.g., venture capital firm; consumer lending
company; mutual fund; hedge fund) or a banking regulator (e.g., the FRB; the FDIC).1
Last but not least, following the recent financial crisis, government regulators and
institutional investors are requiring banks to restructure their boards with more
1
This classification is more conservative than that used in Güner et al. (2008) and Minton et al. (2011).
Finance-related officers in non-financial firms and business professors (e.g., Finance and Accounting)
are also classified as financial experts in these two studies. I exclude these directors because they may
not necessarily have a strong understanding of bank operations. Furthermore, the two cited studies do
not consider directors with working experience with a banking regulator.
2independent directors that have financial expertise.2 However, our knowledge on the
relationship between independent directors’ financial expertise and bank performance
is quite limited.
Forced bank CEO turnovers make a unique set to test the impact of industry-
specific expertise on board functioning. Because, according to Mace (1986),
“directors serve as a source of advice and counsel… and act in crisis situations” when
a forced CEO turnover is necessary (also see Adams et al., 2010). Previous
governance studies suggest that board of directors plays a significant role in corporate
strategies. Therefore, a properly functioning board may be particularly important at
the point where a bank needs to oust its incumbent CEO. In this study, board
functioning is measured through the lens of post-turnover bank performance.
Consistent with previous literature, this study finds that in general, a forced bank CEO
turnover is preceded by a significant decline in bank performance. In the case of poor
performance, a troubled bank may be in greater needs of better monitoring and
advices from professionals. Conventional wisdom and previous literature suggest that
independent directors that have financial expertise may be better able to satisfy these
needs (e.g., Anderson and Reeb, 2003a, 2003b; Kor and Misanyi, 2008; Schmidt,
2008). Therefore, independent financial expertise should positively affect board
functioning and, ultimately, bank performance following a forced CEO turnover.
Independent financial expertise may improve the functioning of a bank board
through several channels. Independent financial experts may be better able to locate a
2
“Help Wanted: Bank Boards Seeking Competent Directors”, Stephen Gandel, TIME, May 20, 2009.
3superior successor CEO, which, according to the Improvement Management
Hypothesis (e.g., Weisbach, 1988; Fredrickson, Hambrick, and Baumrin, 1988; Denis
and Denis, 1995), leads to improved ex-post bank performance. As noted in Walsh
and Seward (1990) and others, boards constantly face the difficult task of attributing
poor performance to exogenous negative performance shocks or CEO quality (also
see, e.g., Jenter and Kanaan, 2010). Directors with financial expertise may be better
able to select a superior successor CEO because their expertise may facilitate the
identification of exogenous performance shocks when assessing the quality of
incumbent CEO and candidates. Furthermore, as mentioned earlier, with a financial
background, independent bank directors may be better able to monitor and advise
management. This may be especially important for banks that need to replace their
incumbent CEOs.
In this study, I investigate the relationship between independent financial
expertise and the functioning of a bank board with a sample of 157 bank CEO
turnovers, including voluntary and forced turnovers. I find a higher rate of forced
bank CEO turnovers during periods of financial turmoil, consistent with Jenter and
Kanaan (2010). In an event study examining cumulative abnormal stock returns
(CARs) around the announcements of a bank CEO turnover, I find that market
response to forced CEO turnovers is significantly positive while the response to
voluntary CEO turnovers is statistically and economically insignificant. I further find
that the positive market response is driven by forced turnover decisions made by a
more independent board. The evidence indicates that the market recognizes the
4significant role of board independence in a CEO firing decision and believes that a
more independent board is likely to help improve the status quo. In contrast,
independent financial expertise does not have a similar impact on the market response
toward forced bank CEO turnovers.
In an examination of post-turnover bank performance, I find that forced CEO
turnover and outsider succession significantly improve bank performance. After the
interactive effects between forced CEO turnover and board structure are controlled in
a Heckman two-step model, forced CEO turnover becomes negatively correlated,
although not significantly, with improvements in post-turnover bank performance. I
document that improvements in bank performance following a forced CEO turnover
are driven by banks with more independent financial experts on their boards. In
contrast with the market belief, board independence does not particularly benefit
forced CEO turnovers in terms of ex-post performance. Moreover, for the overall
sample, board independence is positively correlated with improvements in
performance and independent financial expertise tends to be negatively correlated
with such improvements, consistent with the findings in Huson et al. (2004) and
Minton et al. (2011), respectively. The evidence suggests that independent financial
expertise improves the functioning of a bank board in the period following a forced
CEO turnover. It is likely because that a bank board with more independent financial
expertise is better able to monitor and advise the management in that critical period.
These findings are not driven by mean reverting or risk-taking behavior. The results
5are robust to different specifications of board independence and alternative measures
of risk-taking and governance quality.
The findings add to the growing literature suggesting the importance of directors’
expertise in board functioning. As noted in Carpenter and Westphal (2001) and others,
to advance the knowledge on the effectiveness of board functioning, governance
research may need to go beyond a focus on board independence to directors’ relevant
expertise. The evidence of a positive correlation between independent financial
expertise and ex-post bank performance following a forced CEO turnover is new.
This study also adds to the literature on the relationship between forced CEO turnover
and ex-post firm performance. Previous literature tends to attribute improved
performance following a forced CEO turnover to “improved management”. The new
evidence suggests that the performance consequence of a forced CEO turnover may
partly depend on boards’ effectiveness in monitoring and advising management in the
post-turnover period. Finally, this study has implications for policy issues as
government regulators and institutional investors are requiring banks to restructure
their boards with more independent directors that have a financial background.
The reminder of the paper is organized as follows. In section 2, I discuss related
literature and provide some background information on regulatory requirements on
bank board structure. In section 3, I describe the data. Sections 4, 5, and 6 are
dedicated to reporting the empirical results. I present robustness tests in section 7,
and concluding remarks in section 8.
62. Related literature and background information
2.1. Directors’ expertise
Rosenstein and Wyatt (1990) examine stock market reaction to the
announcement of the appointment of an independent director. They find that a
director’s occupation does not impact abnormal stock returns around announcements.
They argue that independent directors of any occupation are equally valuable. The
evidence in Shivdasani and Yermack (1999) is supportive of this argument. However,
recent studies suggest that independent directors with industry-specific expertise may
be comparatively more valuable in some circumstances. Anderson and Reeb (2003a,
2003b) find better performance at US firms with founding-family ownership. This is
likely because that, as suggested in Anderson and Reeb (2004), families may place
independent directors with industry-specific expertise on the board for performance
related reasons. This indicates that founding families recognize the value of
independent industry-specific expertise on a board. Kor and Misangyi (2008) find
evidence that independent industry-specific expertise can, to some extent, offset the
lack of industry experience by top management. However, Minton et al. (2011) find
different results. Their evidence from the banking industry shows that independent
financial expertise on a bank board is positively correlated with poor stock
performance and risk-taking during the recent financial crisis, and the correlation is
7stronger among large commercial banks. They argue that it is because financial
experts may encourage bank management to exploit the “too big to fail” effect.
Previous studies have shown the importance of independent directors’ expertise
in corporate governance. Eng and Mak (2003) argue that independent expertise on a
board and corporate disclosure are substitutes, suggesting the important role of
independent expertise in corporate control. Gul and Leung (2004) find consistent
evidence. They also find that CEO/chairman duality limits corporate disclosure and
independent expertise on a board weakens such negative association.
2.2. Determinants of post-turnover performance
The turnover literature suggests that, in general, forced CEO turnover leads to
improved ex-post performance because of improved management (e.g., Denis and
Denis, 1995; Weisbach, 1988; Fredrickson et al., 1988). Huson et al. (2004)
specifically point out that the magnitude of improvement in performance is positively
correlated with board independence. Successor origin also impacts post-turnover
performance. For instance, Khurana and Nohria (2000) find that following a forced
CEO turnover, an insider succession leads to statistically and economically
insignificant performance changes while an outsider succession leads to better
performance. In line with this notion, Adams and Mansi (2009) find evidence that
successor origin is correlated with the change in firm value. Huson et al. (2004)
document a positive correlation between outsider succession and expected change in
8subsequent performance. As a result, Borokhovich et al. (1996) find that abnormal
stock returns around forced CEO turnover announcements are significantly positive
for outsider successions but significantly negative for insider successions.
Post-turnover performance may be related to board size. Hermalin and
Weisbach (2003) argue that board size is negatively related to firm performance. This
is likely because of inefficiency and the free-rider problem associated with large
boards (e.g., Jensen, 1993). However, Coles, Daniel, and Naveen (2008) suggest that
very small and very large boards can both be optimal, depending on firm complexity.
In line with this argument, Adams and Mehran (2008) find that Tobin’s Q is
increasing in bank board size, given that banks are comparatively large and complex.
Moreover, Pathan (2009) argues that small boards and more powerful boards tend to
restrain bank risk-taking.
A staggered board deters takeover and thus hinders market discipline (e.g.,
Bebchuk, Coates, and Subramanian, 2002), resulting in less managerial effort.
Consistent with this, Bebchuk and Cohen (2005) find a lower Tobin’s Q at firms with
a staggered board. Faleye (2007) further suggests that a staggered board decreases the
probability of forced CEO turnover at underperforming firms. Mahoney and
Mahoney (1993) and Faleye (2007) both find a negative market reaction to the
announcement of the adoption of a classified board. Therefore, a staggered board
may be negatively associated with post-turnover improvements in firm performance.
9An independent board is believed to be associated with better governance quality.
Beasley (1996) suggests that firms committing financial statement fraud tend to have
a significantly lower percentage of independent directors. Core, Holthausen, and
Larcker (1999) find that firms with a weak board are more likely to overcompensate
their CEOs. Although in general board independence does not significantly impact
long term firm performance (e.g., Hermalin and Weisbach, 1988; Klein, 1998; Bhagat
and Black, 2002), it is positively correlated with firm performance following a CEO
turnover (e.g., Huson et al., 2004).
According to Yermack (2004), with all incentives accounted for, a $1,000
increase in firm value increases the wealth of a Fortune 500 firm director by 11 cents.
A one standard deviation change in firm performance implies a change of about
$285,000 in the director’s wealth. Thus a well-motivated independent director has a
good reason to monitor management. In line with this reasoning, studies have shown
that the percentage of equity-based compensation and ownership by independent
directors are positively correlated with a higher probability of forced CEO turnover at
underperforming firms (e.g., Perry, 1999; Brickley, Lease, and Smith, 1988).
However, a higher percentage of equity-based compensation as well as a greater
ownership by independent bank directors may encourage excess risk-taking,
maximizing the value of under-priced deposit insurance. The impact of these
incentives on bank performance following a forced CEO turnover is not clear.
10Woidtke (2002) argues that institutional investors are likely to monitor
management, although the value effect of institutional monitoring depends on the
objectives of the institutions. Therefore, institutional ownership may be positively
correlated with improvements in performance following a forced bank CEO turnover.
2.3. Regulatory requirements on bank board structure
Recent efforts by government regulators to increase bank board independence
can be traced back to the Financial Institutions Reform Recovery and Enforcement
Act of 1989 (FIRREA) and the Federal Deposit Insurance Corporation Improvement
Act of 1991 (FDICIA). The Sarbanes-Oxley Act of 2002 (SOX) also emphasizes
board independence but it applies only to public financial institutions. The Federal
Deposit Insurance Corporation (FDIC) issued the “Pocket Guide for Directors” (the
guide) to non-public banks following the passage of SOX. The guide, which
emphasizes “the need for a strong and independent board of directors”, encourages
practices quite similar to, or even identical to those in SOX. The Federal Reserve
Board (FRB), the Office of Thrift Supervision (OTS) 3 , and the Office of the
Comptroller of the Currency (OCC) also issued similar guidance to non-public banks
which they supervised. Banks listed on the NYSE, AMEX, and NASDAQ are
required by the exchanges to have a board that is comprised of a majority of
independent directors.
3
On July 21, 2011, the OTS became part of the OCC.
11At the same time, the definition of “independence” has become stricter in the last
decade. The Amendments to the Housing Act on July 30, 2008 specifies that “an
individual is not eligible to be an independent bank director if the individual serves as
an officer, employee, or director of any member of the bank, or of any recipient of
loans from the bank”. The three stock exchanges also adopted stricter definition of
“independent director” since 2002.
Previously, regulations largely focused on board independence. Although FDIC
implemented new requirements on independent directors’ financial expertise
following the banking crisis in the 1990s, they are applied only to bank audit
committees. Until recently, little attention was paid to the occupational background
of independent directors at banks. Following the recent crisis, government regulators
and institutional investors are requiring banks to restructure their boards with more
independent directors that have financial expertise.
3. Data and summary statistics
In this study, I explore the relation between independent financial expertise and
post-turnover bank performance using a sample of CEO turnovers at US banks in the
1995-2009 period.4 To indentify changes in CEO position, I start with all firms in
Standard & Poor’s Execucomp database with an SIC code between 6000 and 6300
from January 1st, 1995 to December 31st, 2009. Of these 295 firms, I exclude non-
4
I start with the year 1995 because board information prior to 1994 is not available in the Edgar filing
database.
12lending firms with SIC codes 6172 (Finance Lessors), 6099 (Functions Rel to Dep
Bkg, Nec), 6282 (Investment Advice), 6163 (Loan Brokers), 6200 (Security &
Commodity Brokers), and 6211 (Security Brokers & Dealers). I also exclude the
three federal credit agencies (Freddie Mac, Fannie Mae, and Sallie Mae) because they
have important differences compared with other financial institutions due to their
unique role as quasi-government entities.5 I manually check the remaining firms and
exclude those firms (e.g., American Express, Mellon Financial Corp, State Street
Corporation, Finova Group, and Financial Federal Corporation) whose primary
service is not making loans (e.g., wire transferring and investment advice). This
yields a final raw sample of 202 firms, including 150 commercial banks, one finance
services company, five mortgage bankers, 33 federal-chartered savings institutions
and 13 non-federal-chartered savings institutions. Following Fahlenbrach and Stulz
(2011), I define the lending firms from this sample as banks. The sample has a mean
age of 23 years (median age of 24 years), and is potentially biased toward large banks
because Execucomp tends to cover larger firms, as shown by the market capitalization
in panel A of Table 1.6 The silver lining from this basis is that those banks represent
the bulk of the market value of all banks in the US and their CEO firing decisions
have a significant impact on the industry and its “aggregate wealth” (Huson et al.,
2004).
5
For example, Sallie Mae functioned as a government-sponsored enterprise until its privatization
process was finished in 2004 and even after that point it was still widely regarded as quasi-government
backed. However, the main results do not change after I include CEO turnovers at these three
institutions.
6
Market capitalization is averaged across the 1995-2009 period for each bank.
13[Insert Table 1]
After I identify CEO changes at the 202 sample banks through the Execucomp
database, I search for banks’ announcements and related news on their top
management changes through LexisNexis and Factiva. For the purpose of this study,
I exclude CEO turnovers that are directly related to M&A activities. I also exclude
turnovers of interim/acting CEOs that serve less than one year. Of the 160 bank CEO
turnovers generated by the above selection process, I further exclude the three CEO
turnovers that are preceded by M&A activities in the seven-quarter pre-turnover
period. This yields a cleaner sample allowing me to focus on performance changes
that are caused only by turnovers. Together with information provided by
Execucomp, I am able to obtain turnover announcement date and effective date, CEO
age and tenure at turnover for all 157 turnovers. As shown in panel A of Table 1, the
median outgoing bank CEO is 62 years old and has served as a CEO for 9 years.
Quarterly data on bank total assets, operating income, and capital assets ratio from
1993 to 2011 are either obtained from Bank Regulatory database, COMPUSTAT or
manually collected from Form 10-Q, Form 10-K, or Form 8-K.
Information on board structure in the turnover year is obtained from the bank’s
proxy statement (Form 14A) immediately before the turnover announcement through
SEC’s Edgar filing database. Board information for ten turnovers is set to missing
either because the proxy statements are not found in the Edgar database (e.g., Hanmi
Financial Corp, 1999), or because the proxy statements do not provide enough
14information (e.g., the primary occupation of the directors is not reported by Bancwest
Corp in 2004). Data are available for 147 turnovers, as reported in panel A of Table 1.
Following the literature (e.g., Huson et al., 2004), I classify a director as an insider if
the director is, or was employed by the bank, its subsidiary, or an affiliated
organization. Other directors are classified as outside directors. I go through each
outside director’s detailed information reported in the proxy statement and classify an
outside director as “grey” if the director (1) is employed by one of the following firms:
consulting/advisory firm, investment bank, law firm, insurance company; or (2) has
significant business relationship with the bank; or (3) is related to an officer of the
bank (e.g., Huson et al., 2001). Other outside directors are classified as independent
directors. In panel A of Table 1, a median bank board has 13 directors, of which
66.67% (81.67%) are independent (outside) directors. This percentage of independent
directors (the number of independent directors/board size) is very close to those
reported in Adams and Mehran (2003) and Booth, Cornett, and Tehranian (2002). A
median independent bank director has served on the board for 11 years.
As previously mentioned, a director is classified as a financial expert if the
director is (was) employed by a financial organization (e.g., venture capital firm;
consumer lending company; mutual fund; hedge fund) or a banking regulator (e.g.,
the FRB; the FDIC). I find that other director occupations include, but are not limited
to, attorneys, dentists, realtors, professional volunteer, professors, surgeons, farmers,
dairy farmers, chiropractors, judges, and executive officers of industrial firms. While
the percentage of independent director is high (median=66.67%), the median (mean)
15percentage of independent financial experts (the number of independent financial
experts on a board/board size) is only 9.09% (11.93%). The correlation coefficient
between the percentages of independent directors and independent financial experts is
0.2115 (p-value=0.01).
Director compensation information in the turnover year for the 147 bank CEO
turnovers is obtained either from the Execucomp database or from bank filings. I
calculate the percentage of director equity-based compensation (EBC) using the year-
end stock price in the prior year for stock grants and I use the modified Black-Scholes
option valuation model for option grants (e.g., Guay, 1999; Core and Guay, 2002).
As reported in panel A of Table 1, the median percentage of equity-based
compensation for directors is 52.34%. CEO/chairman duality and ownership structure
are found in the proxy statement immediately before a turnover announcement.7 I
exclude ownership by institutions affiliated with the bank, such as a subsidiary bank
or employee stock ownership plan trust, because these institutions are not likely to
monitor bank management (e.g., Adams and Mehran, 2003). The median ownerships
by CEO and his or her immediate family, independent directors as a group, and
institutional investors are 0.82%, 0.81%, 5.61%, respectively.
Following the turnover literature (e.g., Huson et al., 2001), I classify a turnover
as forced if: (1) the announcement mentions strategy or opinion differences between
the CEO and the board; or (2) related news uses words such as “ousted, fired, or
forced out”; or (3) the CEO is under the age of 60 and he (or she) is leaving for
7
Out of the 147 outgoing CEOs, 104 (70.75%) are also board chairmen.
16reasons other than death, health issues, or reposition; or (4) the retiring CEO is under
the age of 60 and does not announce his (or her) intention to retire at least 6 months
prior to the effective turnover date. All other turnovers are classified as voluntary.
Panel B of Table 1 reports the frequency of bank CEO turnovers over the 1995-2009
period. Of all the 157 bank CEO turnovers identified in this study, 65 are classified as
forced turnovers and 92 are classified as voluntary turnovers. The average annual
turnover rate (the annual number of turnovers/the annual number of banks) is 7.04%,
similar to that reported in Hubbard and Palia (1995) (6%, a sample of 116 banks) over
the three years before the introduction of interstate bank regulation.8 The average
annual forced turnover rate (41.40%) is higher than that reported in Taylor (2010)
(21.3%, financial firms, 1970-2007) and that in Huson et al. (2004) (16%, a sample of
firms across industries over 1971-1994). This is because the sample period in this
study covers two crises (the 1998 LTCM/Asian financial crisis and the recent 2007-
2009 crisis) and one recession (2000-2002) 9, in which the frequency of forced CEO
turnover spiked. The rate of forced bank CEO turnover (the number of forced bank
CEO turnovers/then number of bank CEO turnovers) in panel B of Table 1 is
consistent with Jenter and Kanaan (2010) where they find that CEOs are more likely
to be fired during periods of industry turmoil.
A succession is labeled an insider succession if the successor holds, or held a
position in the bank, its subsidiaries or affiliates for more than a year (e.g., Huson et
8
Hubbard and Palia (1995) find a cumulative turnover rate of 18.1% in the three years before interstate
banking legislation. I divide this percentage by three to find the approximate annual turnover rates.
9
CRSP value-weighted NYSE/AMEX/NASDAQ Index dropped 37.55% during 2000-2002.
17al., 2001). All other successions are labeled an outsider succession.10 Out of the 157
successions, 34 are classified as outsider successions and 123 are classified as insider
successions. Panel B of Table 1 reports that 33.85% (13.04%) of the outgoing CEOs
are replaced by an outside successor following a forced (voluntary) turnover, lower
(higher) than the 49.6% (9.9%) reported in Parrino (1997) (a sample of firms across
industries over 1970-1989). This indicates that outsider succession is more likely
following a forced turnover than following a voluntary turnover. It should be noted
that when an insider officer is promoted to the CEO position he (or she) usually
leaves his (or her) current position. I find that out of the 123 inside successors in the
sample, 50 are currently COOs and 12 are currently CFOs. I also find that some
banks replace their CEOs and other top executive officer(s) at the same time.11 This
means that other top management changes (e.g., CFO; COO) are likely to take place
around CEO turnovers, which may also influence a bank’s stock price and post-
turnover performance (e.g., Mian, 2001). However, it is nearly impossible to
disentangle these effects.
4. Market reaction to bank CEO turnover announcements
10
I do not differentiate between outside successors from other banks and those from other industries
(see Parrino, 1997). Of the 34 outside successors, only three come immediately from another industry.
However, they all have a banking background.
11
For example, Fremont General Corp. announced on Monday, November 12, 2007 that its CEO,
Louis J. Rampino, and COO, Wayne R. Bailey had resigned, which is classified as a forced CEO
turnover in this study. http://articles.latimes.com/2007/nov/13/business/fi-fremont13
18There have been many empirical studies examining the impact of CEO turnover
announcements on stock price. In general, these studies find an insignificant reaction
across their overall samples but significantly positive market reaction for forced
turnovers (see Furtado and Karan (1990) for a summary of market reaction studies).
In this section, I examine the impact of turnover type (forced vs. voluntary) and board
structure (i.e., board independence; independent financial experts) on stock price
around bank CEO turnover announcements, using a sample of 157 bank CEO
turnovers as described in the prior section. I do not test the difference between insider
succession and outsider succession because many banks, especially those that oust
their CEOs, have not selected a successor at the time of announcement, which
significantly reduces the sample size.
Panel A of Table 2 presents the results of an event study centered on the turnover
announcement day (day 0). I report cumulative abnormal returns (CARs) for various
windows including [0], [-1, 0], [0, +1] and [-1, +1]. The reported CARs are returns
adjusted by a four factor model that includes the market risk premium (the spread
between CRSP value-weighted market return and risk-free rate), SMB (the return
spread between portfolios of small and big capitalization stocks), HML (the return
spread between portfolios of high and low book-to-market stocks), and a momentum
factor. The market model parameters are estimated with daily returns over the 150-
trading-day period 30 days before a turnover announcement (see, e.g., Ellis, 2010).
To be included in this event study, a bank’s stock must trade around the
announcement day. I go through related news and bank filings around turnover
19announcements and exclude observations that may be biased by significant
contemporary events. Appendix A cites several examples of excluded observations. I
report the results for the remaining 138 CEO turnover announcements in panel A of
Table 2.
[Insert Table 2]
Panel A of Table 2 shows that, for the overall sample, average market reaction is
positive but not significant on the announcement day. Market reaction to forced
turnovers is positive over four event windows. CARs on the day of forced turnover
announcement are statistically (at the 5% level) and economically significant (1.74%).
CARs for voluntary turnovers are statistically and economically insignificant. The
spread between market reactions to forced turnovers and voluntary turnovers on the
announcement day is statistically (at the 1% level) and economically (2.07%)
significant.
To examine whether board structure impacts CARs around CEO turnover
announcements, I estimate OLS model (1) and report the results in panel B of Table 2.
Pairwise correlations between independent variables are reported in Table 3.
[Insert Table 3]
= + + + (1)
where CARs are abnormal stock returns around bank CEO turnover
announcements. Forced is a forced turnover indicator that is equal to 1 if a turnover
20is classified as forced and 0 otherwise. Governance Variables include board size, a
staggered board indicator that is equal to 1 if the directors are classified and 0
otherwise, independent director tenure, the percentage of director equity-based
compensation (% Director EBC), ownership by independent directors as a group,
ownership by institutional investors, ownership by outgoing CEO and his or her
immediate family, outgoing CEO tenure, a CEO/chairman duality indicator that is
equal to 1 if there is duality and 0 otherwise, the percentage of independent directors (%
ID), and the percentage of independent financial experts (% IFE). I control for bank
size, proxied by the natural logarithm of market capitalization (Lsize). To see whether
board independence and independent financial expertise are particularly important for
the decisions of a forced CEO turnover, I include two interaction terms (ITS): one is
between the forced turnover indicator and board independence (% ID*Forced), the
other is between the forced turnover indicator and the percentage of independent
financial experts on a board (% IFE*Forced).
Panel B of Table 2 suggests that without controlling for the interactive effects
between board structure and the forced turnover indicator, CARs for forced turnovers
are significantly higher (at the 1% level over [0], [-1, 0], and [0, +1]) than those for
voluntary turnovers. In contrast with previous studies, board independence (the
percentage of independent directors) is not correlated with market reaction. The
percentage of independent financial experts is also not correlated with CARs.
Institutional ownership is significantly negatively correlated with CARs over the four
event windows.
21When the two interaction terms are included in the regressions, panel B of Table
2 shows that the interaction term, % ID*Forced, is positively correlated with CARs,
significant at the 1% level in all estimates. In contrast, the interaction term, %
IFE*Forced, is not correlated with CARs.12 More importantly, the forced turnover
indicator becomes significantly (at least at the 5% level in three estimates and at the
10% level on day 0) negatively correlated with CARs once the two interaction terms
are included. This is consistent with the view that forced CEO turnovers reveal
negative insider information. The F-test reported in panel B of Table 2 strongly
rejects the null hypothesis that the coefficients of Forced, %ID*Forced, and %
IFE*Forced are jointly zero.
The evidence indicates that forced CEO turnovers tend to receive positive market
reaction and it is driven by turnover decisions made by a more independent board. It
is likely because that the market understands the pivotal role of board independence
in corporate governance. One explanation is that a more independent board is better
able to filter out exogenous negative performance shocks from CEO quality and is
therefore less likely to scapegoat. Another explanation is that a more independent
board may be better able to locate a superior successor, leading to truly improved
management. The evidence in Borokhovich, Brunarski, Donahue, and Harman
(2006) is consistent with this explanation as they find a positive correlation between
12
One concern is that this may be driven by the significant correlation between % ID and % IFE. I
drop %ID*Forced in unreported tests and find similar results.
22board independence and market reaction to exogenous CEO turnovers (i.e.,
executive deaths), which involves the assessment of the quality of successor CEOs.
5. Performance changes around bank CEO turnovers
It has been well documented in the turnover literature that firm performance
improves following a forced CEO turnover (e.g., Denis and Denis, 1995; Huson et al.,
2004). However, this result may not hold for banks due to the unique nature of their
business and the heavy regulations they face, along with their different governance
mechanisms (e.g., Brickley and James, 1987; Adams and Mehran, 2002; Adams and
Mehran, 2003; Becher, Campbell, and Frye, 2005). Direct evidence from the banking
industry is limited to date. Hence it is necessary to examine the changes in bank
performance around bank CEO turnovers within the framework of this study.
Specifically, I examine bank performance over the seven-quarter pre- and post-
turnover periods. Four measures of performance are employed: unadjusted and
industry-adjusted return on assets, abnormal stock performance, and Tobin’s Q. I do
not choose a period of three years as in previous studies (e.g., Huson et al., 2004), and
admittedly, the selection of a seven-quarter period is arbitrage. This is because 60
(38.22%) successor CEOs in the sample survive less than three years. The sample
can be further reduced when considering the tenure of the outgoing CEOs. In contrast,
only 24 (15.29%) successor CEOs survive less than seven quarters. Arguably, a
period of seven quarters is long enough to test the impact of bank CEO turnover on
23subsequent bank performance. In contrast with previous studies where annual
accounting data are used, I use quarterly data, which according to Huson et al. (2001)
“would provide a more precise measure of the information available to internal
monitors when the succession is announced”. It should be noted that quarterly
accounting data have disadvantages. 13 First of all, quarterly data are unaudited.
However, quarterly data (e.g., call report) are also used by banking regulators to
perform off-site examination of banks (e.g., Cole and Gunther, 1998; Hirtle and
Lopez, 1999), suggesting their inherent value. Besides, examinations by bank
regulators add credibility to quarterly data. Second, quarterly data may be seasonal
and changes over the seven-quarter pre- and post-turnover periods may partially
capture this seasonality. I utilize industry-adjusted data in the empirical tests to
alleviate this issue.
To obtain a clean sample, I extensively check bank announcements and news
reports and exclude banks that announce M&A activity in seven quarters following a
CEO turnover announcement. Banks with M&A activities in the pre-turnover period
are already excluded from the sample as described in previous section. From the
remaining turnovers, I exclude CEO turnovers where the outgoing CEO or the
successor CEO has held the CEO position for less than seven quarters, either because
the CEO leaves his or her position or because the bank does not survive in the seven-
quarter post-turnover period. This selection process results in a sample of 119 bank
13
In robustness tests, I find similar results with annual accounting data.
24CEO turnovers, including 46 forced turnovers (13 of these CEOs are succeeded by an
outsider) and 73 voluntary turnovers (11 of these CEOs are succeeded by an outsider).
5.1. Changes in return on assets around CEO turnovers
In this section, I compare changes in return on assets (ROA = net income/the
book value of total assets, see, e.g., Anderson and Reeb, 2003a; Adams and Mehran,
2008) across turnover types (forced vs. voluntary) and successor origins (outsider vs.
insider) in the seven-fiscal-quarter pre- and post-turnover periods.
[Insert Figs. 1 and 2]
Figs. 1 and 2 plot sample banks’ average industry-adjusted ROA over the period
from seven quarters before to seven quarters after CEO turnovers.14 Industry median
ROA is calculated from a pool of banks covered by COMPUSTAT from 1993 to 2011
(around 600 banks are included in each year). The upper graph in Fig. 1 compares
industry-adjusted ROA between outsider and insider successions. It shows that banks
experiencing worse performance tend to select an outside successor and their
performance improves afterward. Insider succession does not display a similar
pattern. The lower graph in Fig. 1 compares industry-adjusted ROA between forced
and voluntary turnovers. Banks that constantly experience worse performance tend to
fire their CEOs and their performance improves thereafter. In Fig. 2, the sample
banks are divided into two groups: voluntary turnovers and forced turnovers. The
14
I find a similar pattern with unadjusted ROA.
25upper graph in Fig. 2 indicates that within the voluntary turnover group, banks
experiencing worse and more volatile performance tend to select an outside successor.
The lower graph in Fig. 2 suggests that among banks that fire their CEOs, those
experiencing a sharp decrease in industry-adjusted ROA tend to choose a successor
from the outside talent pool, and their performance improves in the post-turnover
period. Insider successions following a forced turnover do not show a similar pattern.
[Insert Table 4]
In Table 4, I report average changes in unadjusted and industry-adjusted ROA in
the pre-turnover (Quarter -1 minus Quarter -7) and post-turnover (Quarter 7 minus
Quarter 1) periods. Panel A indicates that unadjusted ROA declines (at the 10% level)
prior to a forced bank CEO turnover and recovers significantly (at the 1% level) in the
post-turnover period. Unadjusted ROA does not drop significantly prior to a
voluntary bank CEO turnover, but deteriorates in the post-turnover period (at the 1%
level). When comparing between forced and voluntary turnovers (column 1 minus
column 2), banks experiencing worse performance (-2.22%, marginally significant at
the 10% level) tend to oust their CEOs, leading to a more significant improvement
(3.82%, significant at the 1% level). Panel A of Table 4 also indicates that the
selection of an outside successor is likely motivated by poor performance in the pre-
turnover period, compared with insider successions (column 3 minus column 4,
significant at the 1% level). Outside successors tend to outperform inside successors
26in the post-turnover period, although not significantly. Industry-adjusted ROA in
panel A of Table 4 tells a similar story.
When grouping turnovers by turnover type and successor origin, panel B of
Table 4 suggests that banks with a significant decline (at the 5% level) in unadjusted
ROA tend to fire their CEOs and employ an outside successor (column 7). In contrast,
forced turnovers without a significant decrease in unadjusted ROA tend to be
succeeded by an insider (column 5). Consistent with the literature, forced bank CEO
turnover leads to a significant (at the 5% level) improvement in unadjusted ROA
regardless of successor origin (columns 5 and 7). Furthermore, outsider successions
following a forced turnover lead to a more significant improvement than those
following a voluntary turnover (column 7 minus column 8, marginally significant at
the 1% level). As a matter of fact, outsider successions following a voluntary
turnover are characterized by a decline in unadjusted ROA (column 8). When
examining industry-adjusted ROA in panel B of Table 4, I find similar results.
5.2. Abnormal stock performance around CEO turnovers
In this section I examine banks’ long-run abnormal stock performance around
CEO turnovers with a sample of 119 bank CEO turnovers as described in previous
section. Table 5 reports average abnormal stock returns over the following six
window periods around the announcement quarter (quarter 0): [-Q7, -Q1], [-Q4, -Q1],
[-Q1], [+Q1], [+Q1, +Q4], [+Q1, +Q7]. Stock returns are adjusted by a four factor
27model that includes the market risk premium (the spread between CRSP value-
weighted market return and risk-free rate), SMB (the return spread between portfolios
of small and big capitalization stocks), HML (the return spread between portfolios of
high and low book-to-market stocks), and a momentum factor. The market model
parameters are estimated with data over the 24-month period seven quarters before the
turnover announcement quarter.
[Insert Table 5]
Panel A of Table 5 suggests that banks showing a sharp decrease in pre-turnover
abnormal stock performance, especially during the [-Q4, -Q1] and [-Q1] (significant
at the 5% level and 1% level, respectively) windows, tend to oust their CEOs. Their
abnormal stock performance improves in the post-turnover period as abnormal returns
are not significantly negative any more (column 1). In contrast, following a voluntary
CEO turnover, abnormal stock returns are significantly negative (at least at the 5%
level) over all post-turnover windows (column 2). Column 3 shows that insider
successions are followed by a significant decline in abnormal stock returns. Column
4 indicates that banks with significantly negative (at the 1% level over [-Q4, -Q1] and
[-Q1]) abnormal stock returns prior to a turnover tend to recruit an outside successor.
When comparing outsider succession with insider succession, I find that the former
significantly outperforms the latter over the [+Q1, +Q4] (at the 5% level) and [+Q1,
+Q7] (at the 10% level) windows.
28As reported in panel B of Table 5, I find that insider successions following a
voluntary CEO turnover lead to significantly negative abnormal stock returns in the
post-turnover period (column 6). Abnormal stock performance continues to plunge
following a forced turnover if the successor comes from inside of the bank, especially
over the [+Q1, +Q4] window (significant at the 5% level, column 5). Among banks
that fire their CEOs, those that select an outside successor have experienced a
significant decline (at least at the 1% level) in abnormal stock performance in the pre-
turnover windows (column 7), and they significantly outperform banks that hire from
inside the firm (column 5 minus column 7). Ultimately, outsider successions
following a forced turnover significantly outperform those following a voluntary
turnover over the [+Q1, +Q4] and [+Q1, +Q7] windows.
5.3. Changes in Tobin’s Q around CEO turnovers
In this section, I examine changes in firm value (measured by Tobin’s Q) in the
seven-fiscal-quarter pre- and post-turnover periods with a sample of 119 turnovers as
described in previous section. Following Adams and Mehran (2008) and others,
Tobin’s Q is defined as the ratio of a bank’s market value to the book value of total
assets. A bank’s market value is calculated as the market value of equity plus the
book value of total assets minus the book value of equity.
[Insert Figs. 3 and 4]
29Figs. 3 and 4 plot sample banks’ average Tobin’s Q over the 15-quarter period
centered on the turnover quarter. When comparing insider and outsider successions,
the upper graph in Fig. 3 shows that outsider succession is preceded by a decrease in
Tobin’s Q and followed by a significant increase in Tobin’s Q. In contrast, insider
succession leads to a decline in firm value. The lower graph in Fig. 3 indicates that
voluntary turnover is followed by a decrease in Tobin’s Q. Banks that oust their
CEOs have a lower and declining firm value in the pre-turnover period. Their firm
value stops decreasing in the post-turnover period, but remains low relative to banks
with a voluntary turnover.
Within the group of voluntary turnovers (upper graph in Fig. 4), Tobin’s Q
declines following an insider succession and increases following an outsider
succession. Outsider succession has a higher Tobin’s Q in both pre- and post-
turnover periods. Among firms that complete forced turnovers (lower graph in Fig. 4),
those that have a lower and declining Tobin’s Q tend to choose an outside successor
and their Tobin’s Q increases in the post-turnover period. Insider successions
following a forced turnover do not lead to a similar improvement.
[Insert Table 6]
I report average percentage change in Tobin’s Q in the seven-quarter pre- and
post-turnover periods in Table 6.15 Panel A of Table 6 suggests that forced turnovers
and outsider successions are both preceded by a significant decrease in Tobin’s Q
15
I find similar results in empirical tests using the level change in Tobin’s Q.
30(columns 1 and 4). Panel B of Table 6 further indicates that with banks experiencing
a significant decline in Tobin’s Q tend to oust their CEOs and select an outside
successor.
6. Determinants of post-turnover bank performance
Previous results have showed that in general, forced bank CEO turnovers are
preceded by a decline in performance and that turnover type and successor origin do
impact post-turnover bank performance. Forced turnovers significantly increase bank
performance in the seven-quarter post-turnover period, especially forced turnovers
followed by the succession of an outside CEO. In this section, I systematically
examine the determinants of post-turnover bank performance. I am particularly
interested in the relationship between board structure and bank performance following
a forced CEO turnover. Following Huson et al. (2004), I use a two-step model
developed in Heckman (1979) 16 to deal with the selectivity issue because some
successors in the sample do not survive until the end of the seven-quarter post-
turnover period. To obtain consistent regression results, in the first step I use probit
model (2) to estimate the probability of survival and the inverse Mill’s ratio (IML):
= + + + (2)
where Survivor is a binary variable that takes a value of 1 if a successor holds the
CEO position for seven quarters and 0 otherwise. Out is an outsider succession
16
See Huson et al. (2004) for a discussion of this two-step Heckman model.
31indicator that is 1 if a succession is labeled an outsider succession and 0 otherwise.
Other variables are defined as in model (1). I report results for probit model (2) in
column 1 of Table 7.
[Insert Table 7]
In the second step, I estimate OLS model (3) with the IML added as an
independent variable. The IML is supposed to capture the omitted variables in OLS
regressions where data are censored (e.g., Heckman, 1979). Regression results for
OLS model (3) are presented in Table 7.
= + + + + + + (3)
where PC is performance change over the seven-quarter post-turnover period,
including changes in unadjusted and industry-adjusted ROA, abnormal stock
performance, and the percentage change in Tobin’s Q. I control for the change in
bank risk-taking in the post-turnover period. Following Laeven and Levine (2009), I
use the natural logarithm of the z-score to proxy bank risk-taking. Since the z-score is
defined as “the inverse of the probability of insolvency” (Laeven and Levine, 2009), it
is a proper measure of bank risk-taking. A positive change in z-score (LZC) implies a
decrease in bank risk-taking. Following the literature, the z-score is calculated as a
bank’s average return on assets (ROA) plus capital assets ratio (CAR) divided by the
standard deviation of return on assets (σ(ROA)), or mathematically, z =
(ROA+CAR)/σ(ROA). Other variables are defined as in probit model (2).
32There are studies suggesting that CEO/chairman duality jeopardizes board
independence by increasing CEO power over the board (e.g., Palvia, 2011; Goyal and
Park, 2002; Adams, Almerda, and Ferreira, 2005). These studies take the view that
duality entrenches CEOs and decreases firm performance (e.g., Dalton and Rechner,
1991). I do not include a CEO/chairman duality indicator for successor CEOs in OLS
model (3) for the following reasons. First, there also are studies suggesting that
duality is merely a “natural result of succession process” and thus has no systematic
impact on firm performance (e.g., Brickley, Jeffrey, and Gregg, 1997; Adams et al.,
2005). Second, Zajac and Westphal (1996) argue that the power of a board is decided
by its tenure relative to that of the CEO. It is reasonable to assume that duality alone
will not significantly increase the power of a successor CEO over the board since the
former is new to the CEO position. Ultimately, it is difficult to test the impact of
duality on ex-post performance because of the temporary separation of CEO and
chairman following a CEO turnover. Typically, an outgoing CEO will remain on the
board as the chairman for several months (or even several quarters) before the
successor CEO takes over the chair position. 17 However, the main results do not
change after I add a CEO/chairman duality indicator for outgoing CEOs in the
Heckman two-step model.
17
For instance, AmSouth Bancorporation announced on December 21, 1995 that current CEO John W.
Woods would be succeeded in January 1996 by C. Dowd Ritter, president and COO of the bank. Mr.
Woods would continue as the chairman of the board, an additional role to be assumed by Mr. Ritter in
August 1996. http://www.highbeam.com/doc/1G1-17931956.html
33Results in Table 7 (columns 2, 4, 6, and 8) indicate that without controlling for
the interactive effects between forced CEO turnover and board structure, forced CEO
turnover significantly (at the 1% level) increases unadjusted and industry-adjusted
ROA. The magnitude is economically significant. On average, forced turnover
increases unadjusted (industry-adjusted) ROA by 3.471% (3.18%). Outsider
succession leads to a 3.68% (3.27%) improvement in ex-post bank performance
(significant at the 5% level) when performance is measured by unadjusted (industry-
adjusted) ROA. It also improves abnormal stock performance significantly. The
change in bank risk-taking over the seven-quarter post-turnover period is negatively
correlated with performance changes, significant at least at the 10% level in three
estimates. The stagger board indicator and independent directors’ ownership are
negatively related to improvements in bank performance. The percentage of
independent directors is significantly related to improvements in ROA following a
bank CEO turnover, consistent with Huson et al. (2004). Bank size is negatively
related to ex-post improvements in ROA. Consistent with Minton et al. (2011),
independent financial experts are negatively correlated with abnormal stock
performance and the change in Tobin’s Q.
So far I have confirmed that forced turnover of a bank CEO improves ex-post
bank performance. Next I investigate whether board structure impacts board
functioning, which ultimately impacts ex-post improvements in bank performance.
As discussed previously, a properly functioning board can be particularly important
when a forced CEO turnover becomes necessary. Independent financial expertise is
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