Compensation in the banking sector has been another high profile issue post-crisis. It is now widely acknowledged that the flawed incentives framework underlying banks" compensation structures in the advanced countries fuelled the crisis. The performance-based compensation of bank executives is typically justified on the ground that banks need to acquire and retain talent. We now know, with the benefit of hindsight, that this argument overlooked the perverse incentives it would engender. Bank executives were motivated by short-term profits even if it compromised long term interests.
The Financial Stability Board (FSB) has since evolved a set of principles to govern compensation practices, and the Basel Committee has developed a methodology for assessing compliance with these principles. The proposed framework involves increasing the proportion of variable pay, aligning it with long-term value creation and instituting deferral and claw-back clauses to offset future losses caused by the executive.
In contrast to most other jurisdictions, the Reserve Bank has the power, in terms of the Banking Regulation Act, to regulate board compensation, including the pay and perquisites of the CEO of private sector banks. In evaluating compensation proposals for wholetime directors and CEOs of private sector banks, the Reserve Bank is guided by relevant factors such as the performance of the bank, compensation structures in the peer group, industry practice and regulatory concerns, if any. As regards bonus, in terms of the Reserve Bank guidelines issued in August 2003, bonus in respect of wholetime directors and CEOs has been capped at 25 per cent of their salary or at the level of bonus paid to other employees of the bank.
Post crisis, reflecting the spirit of the global initiative on compensation structures, we determined that there is a need for reform in India too. Accordingly, in July 2010, the Reserve Bank issued draft guidelines on 'Compensation of Whole Time Directors/Chief Executive Officers/Risk Takers and Control Staff", inviting public comments.
The draft guidelines proposed that banks should have a compensation policy, align compensation structures with prudent risk taking and institute a claw back mechanism. These guidelines were originally intended to be implemented with effect from 2011-12 but that schedule was deferred as the Basel Committee was in the process of finalising methodologies for alignment between risk, performance and remuneration. Meanwhile, the Reserve Bank carried out impact studies on select banks.
Taking into account the feedback received on the draft guidelines, the result of the impact studies and the final prescriptions issued in the matter by the Basel Committee in May 2011, the Reserve Bank is in the process of finalizing the guidelines relating to compensation. The guidelines are scheduled to be implemented from the financial year 2012-13, and banks have already been advised to start preparatory work in this regard.
Another relevant aspect is the compensation of non-executive directors on the board. There is a view, also articulated in the Government of India"s Corporate Governance Voluntary Guidelines 2009, that companies should have the option of giving a fixed contractual remuneration, not linked to profits, to non-executive directors. In the banking sector, non-executive directors are typically compensated through sitting fees, except non-executive chairmen who are paid a regular remuneration.
The question is whether non-executive directors of banks should also be paid a regular or a fixed contractual remuneration. This is probably a good concept, but difficult to implement in practice. Typically, in banks, the outcomes of risks taken become manifest after a long gap. While it is possible to align compensation of executives to the risks since they are long term employees, it is more problematic in the case of non-executive directors who serve for relatively shorter periods and have term limits. Furthermore, unlike wholetime executive directors, non-executive directors function collectively as a part of the board and committees of boards making it difficult to apportion responsibility on them individually. Notwithstanding these implementation issues, we need to debate on how to align the compensation of non-executive directors to the outcomes of corporate governance.