A new study by ISB’s Prasanna Tantri finds that, unlike their predecessors, newly appointed bank CEOs are less likely to continue lending to debt-saddled firms.

In times of an economic crisis, the decisions made in a bank’s executive boardroom can determine whether the crisis worsens, or recovery begins. A new study by ISB faculty Prasanna Tantri examines how the career incentives of bank CEOs affect lending during a crisis.

Zombie lending — the practice of providing credit to firms that do not have sufficient income to repay their debts — keeps unproductive firms afloat. While previous research has linked this to regulatory forbearance, an economic policy that temporarily eases banking rules during crises, this study argues that it is not just a structural issue. Instead, CEO’s decisions also play a role, influencing which firms receive credit during a crisis.

Why new CEOs cut the ties old ones hold on to

The study builds on a well-documented pattern – profit-driven CEOs lend to low-quality firms when the economy is stable. However, when an unexpected crisis hits, these firms struggle more than regular borrowers.

To contain the fallout, the central bank steps in with a regulatory forbearance policy, easing lending restrictions. The researcher argues that the response of new and old CEOs to this policy, and their consequent lending behaviours, differs.

Old CEOs face reputational risk if pre-crisis loans default. They use forbearance to restructure bad loans or issue new loans to zombie firms. This keeps the financial statements healthier, effectively delaying losses and protecting their legacy.

In contrast, newly appointed CEOs do not benefit from postponing provisions on bad loans, as defaults will eventually materialise under their tenure. They are more likely to cut off credit to insolvent borrowers as it risks damaging their performance records.

An experiment in CEO turnover

The study examined the role of CEO turnover by focusing on 27 Indian government-controlled banks during the 2008 Global Financial Crisis (GFC) when the Reserve Bank of India (RBI) implemented a forbearance policy. Among these banks, 11 saw a CEO change during the crisis.

The researcher took advantage of India’s strictly enforced age-based retirement rule to isolate the role of CEO incentives. “India was an ideal setting to study CEO turnover since government-controlled bank CEOs retire based on age, not performance. This allowed me to assess the impact of performance on CEO change without concerns of reverse causality,” said Professor Tantri.

By analysing six quarters of lending data (Q4 2007-08 to Q1 2009-10) from the Ministry of Corporate Affairs, Centre for Monitoring Indian Economy, and hand collected records of CEO turnover, the study asked: Are banks with CEO turnover less likely to issue new loans or restructure existing loans for low-quality firms?

The researcher found:

1. After a CEO change, low-quality borrowers are 28.9% less likely to get loans than before and 29.6% less likely to have their loans restructured.
2. They are also 62.6% less likely to get loans than regular borrowers and 143.8% less likely to have their loans restructured than regular borrowers.

Cleaning vs. covering

To further validate the findings, the author examined what happened after the crisis.

In 2015, RBI ended forbearance and ordered an Asset Quality Review (AQR), an exercise conducted to assess the scale of bad loans in the banking industry. The study found that banks which retained the same CEO during the crisis were far more likely to have hidden bad loans than those that saw a leadership change.

The review exposed attempts to disguise non-performing loans through restructuring and evergreening, which refers to the practice of extending new loans to borrowers who are unable to repay their existing loans, allowing them to roll over their debt.

However, this raised a counterargument: What if old CEOs were not hiding bad loans, but genuinely helping temporarily cash-strapped borrowers?

To evaluate this theory, the researcher analysed how firms that borrowed during the crisis fared in terms of investment growth. If old CEOs were helping temporarily cash-strapped but viable businesses, those firms should have bounced back and invested productively after receiving loans.

However, the study found that firms that borrowed from banks with new CEOs during the crisis experienced a 1% higher investment growth than firms that borrowed from banks where the CEO remained unchanged.

While the difference is small, it was found to be statistically significant, suggesting that banks with new CEOs allocated capital more efficiently. These firms also showed stronger profit growth post-crisis.

Are CEO incentives the only factor?

The study conducted several other tests to rule out other explanations. First, it checked whether banks with CEO turnover had different lending patterns before the

crisis. Finding no significant differences confirmed that the changes observed were due to CEO turnover, not pre-existing trends.

A similar pattern emerged when the study analysed CEO turnover during the COVID-19 crisis, which also saw a forbearance policy. The findings remained consistent.

Finally, the study explored whether old CEOs offset risk by charging higher interest rates. It found no difference—loans to zombie firms had the same interest rates, regardless of whether the bank had a new or old CEO. This suggests that old CEOs were not properly pricing risk but were instead avoiding recognising losses.

Author: ISB Editorial Team