Remuneration is not the sole decider of management behaviour at banks

Ever since the global financial crisis threw up instances of untrammelled risk-taking by top executives in big banks which put the entire financial system at risk, regulators have been grappling with executive compensation structures that remove such perverse incentives for risk-taking. The Reserve Bank of India’s guidelines last week, specifying how private sector banks in India must design the compensation packages of their CEOs, whole-time directors and material risk-takers, are part of this effort. The latest set of rules represents a fleshing out of RBI’s broader guidelines set in 2012.

Not content with asking bank boards to structure pay packages of their senior executives to align them with risk outcomes, the RBI has now gone ahead to specify how exactly these packages must be structured. While the earlier requirement was merely for a variable component to top management pay, the RBI now requires that at least 50 per cent of the compensation package be variable. From capping variable pay at 70 per cent of fixed pay, the RBI has expanded the limit to 300 per cent. But the catch is that variable pay must now include ESOPs, which may pose knotty problems of valuation from year to year. The most material change though is the stipulation that at least 60 per cent of an executive’s variable pay must be deferred for three years. Banks will be required to compulsorily claw back this deferred pay, in the event of ‘negative’ business performance or significant divergence of its reported NPAs from RBI-assessed numbers. While the intent behind such tweaks is praiseworthy, the concern is whether the RBI is straying too far from principles-based regulation to a rule-based approach that micro-manages banks’ commercial decisions. Private sector banks in any case need the RBI’s explicit approval for the remuneration packages of their CEOs and whole-time directors, making it quite easy for the RBI to vet their proposals for alignment with fair-pay principles. It is also a moot point if pay structures are such a big determinant of top management behaviour or sound governance at banks as the RBI is making them out to be. Top managers’ skin-in-the-game and the independence of bank boards may be far bigger deterrents to undue risk-taking and need greater attention.

The other elephant in the room is that while the RBI is subjecting private sector banks to such elaborate rules, it is essentially powerless to impose its writ on PSBs (public sector banks) that make up over two-thirds of the Indian banking system. In contrast to private sector banks, the key risk-takers at PSBs earn very low monetary compensation that is completely out of sync with market realities, while enjoying outsized perks irrespective of performance. This pay structure, taken with the extremely short tenures of PSB top executives, is a recipe for lack of accountability and even outright corruption. If the RBI is serious about reforming bank incentives, it must prevail on the Centre to loosen its grip on top management appointments at PSBs and pay performance-linked compensation.

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