Limits to relative performance evaluation: evidence from bank executive turnover

Purpose - The paper aims to revisit the topic of relative performance evaluation (RPE) of top management using a large panel of community banks. Design/methodology/approach - The empirical tests for RPE utilized a two‐stage approach in a unique dataset of community banks executive turnover over a ten‐year period. This allowed the authors to better estimate the benchmark performance relative to which bank executives should be evaluated under RPE. Moreover, bank regulatory evaluations allowed the authors to control for the impact of poor governance. Findings - The paper shows that penalizing executives for poor performance arising from economic downturns is not necessarily inconsistent with the theory. The empirical results indicate that weak downturn‐linked performance is strongly related to increased executive turnover. Furthermore, this relationship is more pronounced in better‐governed banks, which are more likely to engage in value‐enhancing disciplinary actions. Research limitations/implications - The analysis suggests that executive dismissals during adverse economic conditions are not necessarily a result of bad luck; rather, the analysis implies that bad times are informative about management quality. Practical implications - The main practical implication is that both relative and absolute performance should be incorporated in the incentive structure of bank executives. Originality/value - The paper shows that the assumptions used in prior RPE studies may not be applicable to top executives which could explain the inconsistency between the theory and the empirical evidence. Further, the finding that better governed firms are more likely to penalize management for bad exogenously driven performance is unique and strengthens the case that disciplinary actions amid adverse economic times may not be due to bad luck.