RBI revamps pay of bank CEOs, directors to reflect performance

Come FY2020, private sector banks, foreign banks operating under the Wholly Owned Subsidiary (WOS) Model and foreign banks operating in India may be required to incorporate malus (financial penalty)/ clawback (taking back already disbursed money) clauses in deferred compensation in the event of negative contributions of the bank in any year, give joining/sign-on bonus only in the form of Employee Stock Option Plan (ESOP), and make disclosure on remuneration in annual financial statements.

The aforementioned clauses have been incorporated in the Reserve Bank of India’s proposed Guidelines for Compensation of Whole Time Directors/Chief Executive Officers/Material Risk Takers and Control Function Staff, etc.

Private sector banks, include local area banks, small finance banks and payments banks.

As per the guidelines — which have been put together to ensure effective governance of compensation — alignment of the compensation with prudent risk-taking and effective supervisory oversight and stakeholder engagement in compensation, banks are required to put in place appropriate modalities to incorporate malus/clawback mechanisms in respect of variable pay, taking into account the relevant statutory and regulatory stipulations as applicable.

In their compensation policies, banks have to identify a representative set of situations which require them to invoke these clauses which may be applicable on entire variable pay. When setting criteria for the application of the malus and clawback clauses, banks should also set a period during which they can be applied, covering at least deferral and retention periods.

The RBI said wherever the assessed divergence in bank’s asset classification or provisioning from the RBI norms exceeds the prescribed threshold for public disclosure, the bank shall not pay the unvested portion of the variable compensation for the assessment year under ‘malus’ clause. Further, in such situations, no proposal for increase in variable pay (for the assessment year) can be entertained.

Joining bonus: only ESOPs

Emphasising that guaranteed bonuses are not consistent with sound risk management or the ‘pay for performance’ principles and should not be part of compensation plan, the draft guidelines state that the joining/sign-on bonus should only occur in the context of hiring new staff and be limited to the first year.

Further, joining/sign-on bonus should be in the form of ESOPs (employee stock option plans) only, since payments in cash upfront would create perverse incentives. In addition, banks should not grant severance pay other than accrued benefits (gratuity, pension, etc.) except in cases where it is mandatory under any statute.

Computing pay

According to the guidelines, banks are required to ensure that the fixed portion of compensation is reasonable, taking into account all relevant factors including adherence to statutory requirements and industry practice.

For the purpose of computing fixed pay, all the fixed items of compensation, excluding the perquisites, will be treated as part of it.

The variable pay can be in cash or stock-linked instruments or a mix of both. There should be proper balance between the cash and stock/share-linked components in the variable pay.

Except where compensation by way of share-linked instruments is not permitted by law/regulations, a minimum of 50 per cent of the variable pay should be via non-cash compensation, such as ESOPs or share linked instruments, etc.

Banks have to ensure that there is a proper balance between fixed pay and variable pay. The total variable pay should be limited to a maximum of 200 per cent of the fixed pay (for the relative period). Within this ceiling, at higher levels of responsibility, the proportion of variable pay should be higher. The deterioration in the financial performance of the bank should generally lead to a contraction in the total amount of variable compensation paid.

In the event that an executive is barred by statute or regulation from grant of share-linked instruments, his/her variable pay will be capped at 100 per cent of the fixed pay, but will not be less than 50 per cent of the fixed pay.

For senior executives, including whole-time directors (WTDs), and other employees who are Material Risk Takers (MRTs), deferral arrangements (which should be a minimum of three years) must invariably exist for the variable pay, regardless of the quantum of pay. For such executives of the bank, a minimum of 60 per cent of the total variable pay must invariably be under deferral arrangements. Of this, at least 50 per cent of the cash component should also be deferred.

RBI said Banks cannot permit employees to insure or hedge their compensation structure to offset the risk alignment effects embedded in their compensation arrangement. To enforce the same, banks should establish appropriate compliance arrangements.

As per the guidelines, members of staff engaged in financial and risk control should be compensated in a manner that is independent of the business areas they oversee and commensurate with their key role in the bank. Effective independence and appropriate authority of such staff are necessary to preserve the integrity of financial and risk management’s influence on incentive compensation.

“Back office and risk control employees play a key role in ensuring the integrity of risk measures. If their own compensation is significantly affected by short-term measures, their independence will be compromised. If their compensation is too low, the quality of such employees may be insufficient for their tasks and their authority may be undermined. The mix of fixed and variable compensation for control function personnel should be weighted in favour of fixed compensation,” RBI said.

For the other categories of staff, banks may devise appropriate compensation structure. However, in doing so, banks may adopt principles similar to the principles enunciated for WTD/CEO as appropriate. The banks are expected to identify their Material Risk Takers, whose actions have a material impact on the risk exposure of the bank.

The central bank observed that banks’ compensation policies will also be subject to supervisory oversight including review under Basel framework. Deficiencies observed in this regard would have the effect of increasing the risk profile of the bank with attendant consequences, including a requirement of additional capital if the deficiencies are very significant.

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