CEO pay can transform banks

Compensation structures can be designed to make risk management a core part of Indian banks' strategic decision making and planning processes

When, in February 2019, the Reserve Bank of India (RBI) published a discussion paper on proposed compensation guidelines for senior management and material risk-takers in Indian banks, the debate was focused on how this would constrain CEO compensation. What may not have received due attention was how such a proposal, if implemented appropriately, can transform Indian banking. 

It can make risk management a core part of a bank’s strategic decision-making and planning process, as opposed to the peripheral position it now occupies. Risk-related projections in some cases tend to come out as an after-thought to assess the growth planning exercise.

Previously, in 2012, the RBI had issued compensation guidelines for senior management. These ticked all the boxes and suggested alignment of compensation with prudent risk-taking, capping of variable compensation, deferring a part of variable compensation, incorporation of a claw-back clause, adequate disclosure norms and supervisory oversight. However, given limited implementation guidelines and specificity, the guidelines’ benefit to the stake-holders remains uncertain.

The current proposal provides for more detailed quantitative requirements than its 2012 avatar. For instance, it has capped variable pay at 200 per cent of fixed pay. ESOPs are included in variable pay. It proposes application of the claw-back clause in case of divergence in NPA/provisioning.

The proposal, if implemented, will trigger board discussions on how top management salaries need to be adjusted to comply. The crux of the RBI’s focus is that senior management compensation outcomes should be aligned to risk outcomes, and all types of risk and payout schedules should be sensitive to the time horizon of the risk. This has been the regulatory aspiration since 2012.

However, a fixed ratio of fixed to variable compensation, or defining a narrow activity that can trigger the claw-back clause, may not limit meeting the regulatory aspiration to the full extent. Instead of transforming risk management, it may morph into a compliance requirement. Some improvement to risk reporting is expected to the extent the NPA divergence is addressed. An opportunity to fundamentally strengthen risk management in Indian banking will be lost.

The RBI’s proposal is inspired by the Financial Stability Board's (FSB) Principles for Sound Compensation Practices and their Implementation Standards (Principles and Standards, P&S), 2011. Quite a few G20 countries have adopted them. They provide rich benchmarks for effective implementation. 

Risk outcome-based compensation requires that compensation policies should be structured before-hand. Compensation is a priori mapped to a range of strategic and financial outcomes, so that senior management focuses on long-term sustainability in its planning process. After the performance period the variable compensation is determined by the outcomes vis-à-vis the initial target, and not just by asset growth, accounting profit or stock performance, as is the case currently.

This requires the RBI to guide banks on the following:

Risk assessment statement (RAS): Banking regulators in Canada, Singapore and Europe expect a clear linkage between the RAS and senior management compensation. Several regulators require the RAS to be well-articulated and quantified. It should be granular so that it can be cascaded to appropriate levels within the bank. Indian banks often have RASs that are aspirational or have not percolated down to the business unit level for policymaking. Compensation philosophies try to ensure that decision-makers adopt growth strategies that are aligned with their stated risk appetite.

The experience of several countries has been that quantifiable and granular risk appetite statements tend to drive banks’ strategy and planning, and risk-based compensation guidelines led to more meaningful adoption with desirable results.

Broaden the claw-back clause: Most major international banks have provisions for claw-backs for incidents such as ignorance, willful neglect or violations of risk norms by employees. For certain adverse events claw-back could apply for seven years. The US requires the largest firms to defer up to 60 per cent of incentive compensation for senior executives for four years. 

Enhance disclosure levels: The RBI should enhance the disclosure level in general to best in class for G20 countries. Basel expects quantitative disclosures about banks’ compensation policies, details of the structure and also measures of outcomes from such policies. Disclosures to markets are expected to state the amount of outstanding deferred remuneration exposed to risk-adjusted-performance or actual adverse risk events.  

Global best practices require the RBI to do more of certain things and less of others. The quantum of compensation and the ratio of fixed to variable may be left to the board. At any rate, more elbow room may be given. On the other hand, risk targets and metrics and the mapping of risk outcomes with compensation levels need to be owned by the board and suitably disclosed. Certain regulators favour testing the procedures to assess the efficacy of compensation frameworks, and to establish whether the outcomes are consistent with the regulator’s expectations.

The RBI must broaden the focus on improving the risk management capability of Indian banks by making it core to strategic decision making. Executive compensation plays a critical role here. But guidelines should not focus on narrow compensation ratios alone, or else banks will remain compliant while seeing no improvement in their risk capabilities.    

The writer is visiting faculty of finance at IIM Calcutta, and a consultant