Will banks get their remuneration policy right?

The Reserve Bank of India (RBI) put out a discussion paper on compensation practices in banks. Although this would have been in the works for a while, I have no doubt that media reports on the amount of its CEO’s bonus that ICICI Bank proposes to claw back — despite there being no confirmation on the exact figure — hastened the publication of this report. For far too long, under its current guidelines, the RBI has signed off on a bank CEO salary, ignoring ESOPs, which have become the largest component of any bankers pay packet (Exhibit 1). RBI, belatedly many will argue, is correcting this anomaly, and using this opportunity to review its current guidelines. 

While this discussion concentrates on CEO compensation, the paper also focuses on compensation for those in risk, control and compliance functions.

Compensation for bank CEOs (and senior personnel) came under public scrutiny after the 2007 financial crisis. The crisis was characterised by excessive risk taking by banks which, among other factors, was attributed to compensation and flawed incentive structures that prioritised deal flows over better credit calls. The massive bail-outs of financial institutions and unconventional monetary and fiscal policies to prevent a possible collapse of the world financial system was accompanied by a public outcry to curb bankers pay. In 2009, the Financial Stability Board (FSB) in the UK came out with a set of nine principles that called for financial institutions to have a remuneration designed by a remuneration committee that works closely with risk management and focuses on the long term and liquidity. It mooted aligning compensation of the ‘risk’ and ‘compliance’ teams with their functional goals. It propagated a greater alignment of pay and performance with a substantial portion as variable, including ESOPs, and a large portion of the variable pay itself being deferred. 

The Basel Committee on Banking Supervision supplemented its own report on performance and risk alignment that banks should consider while developing their methodologies, and supervisors, when reviewing and assessing banks’ compensation practices. It was, in its own words, “technical and not prescriptive”. Although the US Federal Reserve voiced its differences with the FSB report, RBI echoed its proposals, and suggested “formulation of suitable compensation policy by banks, constitution of a Remuneration Committee, alignment of compensation with prudent risk taking, capping of variable compensation as a percentage of fixed pay, deferral of part of variable compensation, incorporation of malus/clawback clause, adequate disclosure norms and supervisory oversight”.

The current discussion paper gives a more granular guidance to compensation and expects 50 per cent of the salary should be non-cash variable pay (earlier no limit) and the aggregate variable pay should be capped at 200 per cent of fixed and should include ESOPs (earlier variable pay was capped at 70 per cent but excluded ESOPs). Variable pay will have a compulsory deferred mechanism and a new provision regarding clawback in case of divergence in NPA/provisioning beyond a prescribed threshold (new suggestion).

Given the pay cap on the ESOPs, will private banks be able to attract and retain talent? This question is not new. It is being asked since 2016 when the Supreme Court expanded the definition of public servants under the Prevention of Corruption Act, to include private bankers. My answer is yes. People join a profession and strive to reach the top. Sure, a handful do leave for some adjacencies, but they are hired in these for their banking knowledge and skills. And with IRDA and Sebi exercising oversight over their respective markets, you should expect more such notices across the financial sector. Bankers, on average are better paid — more on this later, and banking will continue to attract talented beginners and I don’t see this changing. 

Given how hierarchical banking is, and with overall remuneration levels being linked to fixed pay, I do expect the fixed component to move up across the board. This should help make compensation more balanced throughout the banks. And this helps bring to fore the most basic of questions: What amount of compensation is appropriate? In FY18, 36 per cent of private bank CEOs earned above Rs 10 crore — just 19 per cent of CEOs of the BSE 500 companies cross this threshold. In contrast, private sector bank CEO pay averages at 66 times the median employees, lower than 88 times for the BSE 500 and less than half for the construction sector at 144 times. These two matrices, while giving different answers, point to the fact that salaries in banking are, on average, higher than other sectors.   

Given the end-objective of curbing excessive risk-taking, the Remuneration Committee should also explore issuing restrictions on the exercise of stock options — restricting executives from exercising options for two to three years from their last day at work. A supplementary benefit is that this gets the CEO to focus on succession planning, the most important of all decisions. 

The suggestions will no doubt receive some push-back from those arguing that you need to run horses for courses. Critics already chafe that government cannot fix compensation through such interventions — it will only make things worse. Look no further than recent regulations that have restricted the tenure of the CEO of a Market Infrastructure Institutions to two terms, with a ‘fresh search’ at the end of the first term. An unintended consequence is that the remuneration committee cannot hold out more than a five-year term for potential candidates, narrowing the field. But by focusing on pay, the regulator is signalling where its priorities lie.

The author is with Institutional Investor Advisory Services. Twitter: @amittandon_in