State-Owned Banks Lose Investor Trust Over Accounting Tactics: IIM-I Study

Indore (Madhya Pradesh): A study by the Indian Institute of Management-Indore has revealed that government-owned banks in India use discretionary loan loss provisions (LLPs) for income smoothing, but investors perceive this practice negatively, interpreting it as a sign of poor governance rather than financial prudence.

This results in a lower market valuation for these banks compared to their private counterparts. The study highlighted the need for governance reforms,  including depoliticizing key appointments, strengthening audit processes and ensuring greater managerial autonomy, to restore investor confidence and enhance the credibility of public sector banks.

Drawing on a dataset of Indian firms from 2011 to 2023, the research, conducted by Prof Kousik Guhathakurta provided evidence that banks with majority government ownership systematically engaged in earnings management using discretionary LLPs.

While income smoothing can reduce earnings volatility and potentially signal financial stability, the study revealed that investors viewed such behaviour with skepticism when undertaken by government--controlled institutions.

“The managerial insights from the study revealed a dual tension that senior leadership in state-owned banks must navigate. On the one hand, they are required to demonstrate financial discipline by complying with mandated dividend payouts, even in volatile periods such as the Covid -19 pandemic.

“On the other hand, they operate under the weight of public expectations and political influence, where managerial autonomy is often limited by appointment procedures and fixed tenures set by the government. This results in short-term performance strategies that lack long-term market signalling value,” said Prof Guhathakurta.

From an industry standpoint, the research uncovered that the discretionary components of LLPs, typically used by banks to indicate foresight on credit risk, failed to convince investors when exercised by government banks. Instead of interpreting these adjustments as prudent or forward-looking, investors were more likely to see them as indicators of poor governance or opportunistic behaviour.

This led to a discounting of these provisions in the banks’ stock valuations. The negative valuation effect was statistically significant and persistent across different model specifications, market conditions, and during crisis periods such as the pandemic.

Moreover, banks controlling government ownership also reported higher non-performing assets and lower capital adequacy ratios, which further eroded investor confidence.

The study found that such banks tended to provision more but were less effective in signalling resilience. In contrast, private banks, although also using LLPs for smoothing purposes, were not penalized by the market to the same degree. This contrast underscored the critical role that perceived governance quality played in shaping market reactions.

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The implications of these findings are far-reaching for both policymakers and banking leaders. As the Indian financial system undergoes regulatory reforms and aims to attract greater private investment, the study calls attention to the need to strengthen governance structures in public sector banks.

It recommends insulating key managerial appointments from political influence and enhancing the role of independent audit committees to bolster oversight and transparency. Without such institutional mechanisms, discretionary accounting tools like LLPs risk becoming red flags instead of informative signals.

Furthermore, there is a need to enhance internal and statutory audit procedures. It is also essential to evaluate the appointment process for key management personnel, as governmental interests presently sway it.

The creation of an independent organization to manage nominations may enhance the integrity of the appointment process. This approach would prioritize qualifications and technical expertise, steering clear of political influences. These reforms aim to enhance management independence and tackle issues related to possible conflicts of interest arising from the government’s dual function as both a regulator and a shareholder.