… Key Issues for Central Banks Globally(II)
As noted in part I of this ‘governance of compensation series’, in this continuing piece (part II), I suggest four strategies that central banks and other financial sector regulators and supervisors should seek to have implemented at DFIs/FIs in the financial services industry during the COVID-19 era. These practical strategies will ensure that processes in the governance of compensation at DFIs/FIs[2] become transparent and are perceived to be fair during these difficult times.
Strategy # 1: The regulatory framework must enable and incentivize boards to play a proactive role in the governance of compensation at DFIs/FIs and prevent the compensation system from being in the grip of the CEO/senior management. First, the boards of DFIs/FIs can and must play a proactive role in establishing proper governance of remuneration and that is where the buck actually stops. It naturally follows that the board must also ensure that this compensation system is not primarily controlled by the chief executive officer and/or other members of the senior management team (CEO, CFO, etc.).
In cases where the compensation system has tended to be firmly in the grip of the CEO and/or senior management team, it seems prone to nontransparent actions, related-party transactions, and whimsical payouts to CEO/senior management, without sufficient rationale or justification. I see this strong grip of founder (as well as CEO and senior management) as a major cause for the U.S. subprime (2007/8), the 2010 Indian microfinance crisis in Andhra Pradesh (AP) and the 2018 IL&FS[3] crisis in India—as at these DFIs/FIs, the compensation decisions were laden with significant conflicts of interest and questionable from a legal as well as ethical standpoint.
Therefore, central banks and other financial sector regulators and supervisors must ask relevant questions as part of their day-to-day work and ensure course corrections in real time at various DFIs/FIs.
- Is the board of directors effectively taking overall responsibility for the DFI/FI compensation system, including participating directly in the design and operation of this system?
- Has the board ensured that the CEO and/or senior management team at the DFI/FI are not controlling the compensation system?
- Is the compensation policy aligned with the risk management framework of the DFI/FI?
- Has the board of directors at the DFI/FI approved and periodically reviewed the compensation policy?
- Has the board ensured that the compensation policy at the DFI/FI does not provide incentives for excessive risk taking and that it is also aligned with medium-/long-term operations?
Strategy # 2: The regulatory architecture should ensure that the boards of DFIs/FIs have members with requisite compensation experience and real independence, so that they can effectively participate in the regulation of compensation. It is crucial for the DFI/FI to have board members with relevant expertise in compensation and perhaps risk management. More importantly, these members must have complete independence in dealing with the (design and operation) of the compensation system. In a way, this is the fulcrum of a fair compensation system, where the board members not only have the requisite experience but are also able to use it in an independent and objective manner. This, in turn, implies that the boards of DFIs/FIs should not be filled with friends, relatives, and yes-men, as a former senior regulator, has argued.
Again, as evident from the U.S. subprime (2007/8) and the 2010 Indian microfinance crisis in AP, in a few cases, nominee directors and other independent directors seem to have been silenced and their independence compromised (on several occasions) in matters of compensation and remuneration. The same can be said to be true of the IL&FS case as has been pointed out in part I of this ‘governance of compensation’ series. This again has left a very poor impression of the financial services industry in the minds of the general public.
Here are some key questions in this regard for central banks and other financial sector regulators and supervisors:
- Is the board of the DFI/FI composed of independent, nonexecutive members, without any conflicts of interest?
- Does the board have sufficient expertise (in terms of members) to assess risk management issues related to compensation?
- Does the board have (members with) the skill and experience to reach an independent judgment on the compensation policy?
- Are the relatives of the CEO and/or senior management on the board of the DFI/FI? Are there close former associates and/or friends of the CEO/senior management, who are on the board of the DFI/FI?
- Can the appointment of these members to the board of the DFI/FI be justified in terms of their professional expertise? Or are these relatives/former associates/friends on the board primarily because of their (personal) relationship with the CEO/senior management?
Strategy # 3: The regulatory framework must mandate the establishment of an accountable and independent board remuneration committee at each DFI/FI to oversee the design and implementation of the compensation system. While the previous two strategies articulated the role and responsibility of the board of directors, the key question that arises is how best the boards of DFIs/FIs can accomplish this in real time. All members of the board cannot spend their entire time on this, nor can individual members of the board work on this in an ad hoc manner.
In other words, there is a critical “how to” with regard to the discharge of the above roles and responsibilities by the DFI/FI board—that is, through the establishment of an appropriate independent remuneration committee[4] and defining its mandate. It is through such a committee that the board of directors can design, monitor, and review[5] the compensation system to ensure that it operates as intended. Therefore, it is critical that FIs have an accountable and independent board remuneration committee as an integral part of their governance structure and organization, to oversee the compensation system’s design and operation on behalf of the board of directors.
- The remuneration committee should be constituted in a way that enables it to exercise competent and independent judgment[6] on compensation policies/practices and the incentives created (at the DFI/FI) for managing risk, capital, liquidity, and customer satisfaction.
- In addition, the committee should carefully evaluate the practices by which compensation is paid for potential future revenues, whose timing and likelihood remain uncertain. This is a critical lesson from the 2007/8 U.S. subprime crisis, 2010 microfinance crisis in AP and the IL&FS (2018) crisis in the Indian financial sector. While doing so, the committee should demonstrate that its decisions are consistent with an assessment of the DFI’s/FI’s true financial condition and future prospects, including medium- and long-term risks.
- To this end, the remuneration committee must work closely with the DFI’s/FI’s risk committee in the evaluation of the incentives created by the compensation system.
- It should also ensure that the DFI’s/FI’s compensation policy is in compliance with global good practices and standards as well as the respective rules of the national regulatory authorities.
Here are some relevant questions for the central banks and other financial sector regulators and supervisors in this regard.
- Are there controls in place to regularly oversee the compliance of the compensation system? What are these and how sufficient are these controls? Is an accountable and independent board remuneration committee one of the key controls?
- In order that the DFI/FI board remuneration committee is able to operate independently of the senior executives, is it composed (at a minimum) of a majority of independent, nonexecutive (board) members without any conflicts of interest?[7]
- Does the DFI/FI board remuneration committee have (members with) the skill and experience to reach an independent judgment on the compensation policy?
- Do the terms of reference/charter of the board remuneration committee suggest that it has sufficient powers (mandate) to perform its functions in an accountable manner as well as independently?
- Is the board remuneration committee at the DFI/FI responsible for the preparation of recommendations to the board regarding compensation, including those having implications for risk and risk management?
- Has the board remuneration committee at the DFI/FI made recommendations to the board on the compensation to be paid to the highest paid employees, based on a predetermined materiality threshold? This is especially critical in systemically important and very large DFIs/FIs that can impact the stability of the financial ecosystem.
- Does the board remuneration committee at the DFI/FI have access to advice, either internal or external, that is independent of (such) advice provided to the senior management? What has been the process used for commissioning external advisers to advise the board on compensation policy? Do these advisers report directly to the board remuneration committee?
- Does the board remuneration committee at the DFI/FI have unfettered access to information and analysis from risk and control function personnel (e.g., risk management, finance, compliance, internal audit, and human resources)?
- Does the board remuneration committee at the DFI/FI engage appropriate control function personnel in its deliberations on compensation policy? Do control functions at the DFI/FI have input in the structure and determination of compensation?
Strategy # 4: The regulatory framework must mandate that DFI/FI board remuneration committees ensure an annual external compensation review. Last but not least, the remuneration committee should facilitate an annual compensation review at the DFI/FI and get it done externally. This review should be independent of any CEO/senior management interference and it should be submitted to the remuneration committee, board of directors, and regulator/supervisor. It should also be disclosed to the public. This review should, among other things, assess (legal) compliances with the applicable rules and standards promulgated by the relevant regulatory authorities. An example from one of the MFIs at the heart of the 2010 Indian microfinance crisis in AP is documented well in The Economic Times article (by John Samuel Raja D and M Rajshekhar), which notes that Share Microfin’s Managing Director’s salary was well beyond the limit stipulated by the Companies Act.[8]
Some relevant questions in this regard for the central banks and other financial sector regulators and supervisors include the following:
- Is there an external annual compensation review at the DFI/FI?
- What is the process for conducting the annual compensation review? Is it an objective and fair process without (any) conflicts of interest?
- Does the annual compensation review assess the compensation policy’s compliance with global principles/standards in the financial services industry, as well as standards (if any) promulgated by the (national) regulators/supervisors?
- Does this include ensuring that all material compensation plans/programs (including those for executives and employees, whose actions have a material impact on the risk exposure of the DFI/FI), are covered?
- Does this include assessing the appropriateness of the compensation plans/programs relative to organizational goals, objectives, and risk profile of the DFI/FI?
Irrational and ad hoc compensation practices (at some FIs) have been a major factor that appears to have contributed (in significant measure) to the U.S. subprime (2007/8), the 2010 Indian microfinance crisis in AP, and also the 2018 crisis in the Indian financial sector—i.e., the IL&FS case.
Therefore, given the lessons from these past crisis situations and given the stress that the financial sector is currently undergoing (and likely to face in the future) because of COVID-19, it is imperative that central banks and financial services regulators worldwide be always on the lookout and take suitable proactive action to address the issue of (such) unsound compensation systems that may crop up from time to time at DFIs/FIs. The importance of this task—ensuring the proper governance of compensation—should not be underestimated, as I see this as one of the most important causes leading to these past crisis situations. Only the good governance of compensation can keep future crisis situations at bay and ensure the presence of a stable, inclusive, accountable and world-class financial sector worldwide, so very vital for double digit growth in many economies, especially because of the deep devastation caused by COVID-19.
[1] RAMESH SRIVATSAVA ARUNACHALAM, a board member of the Financial Inclusion Advocacy Centre (FIAC), Ghana and UK, is author of 14 critically acclaimed books. Ramesh also provides strategic advice on a wide variety of Financial Sector, Financial Inclusion and Economic Development issues. He has worked in over 314 assignments with multi-laterals, governments, private sector, Banks, NBFCs, DFIs, regulators, supervisors, MFIs and other stakeholders in 31 countries across 5 continents and 640 districts of India during the last 31 years. He can be contacted at [email protected] and +919962815615.
[2] DFI = Development Finance Institution. FI = Financial Institution. Types of FIs are: Commercial and Investment Banks, NBFIs, Cooperatives, Credit Unions and the like.
[3] IL&FS = Infrastructure Leasing and Financial Services Limited.
[4] Sometimes the board may have people with requisite skills and experience and also independence. They, however, need to be appointed to the DFI/FI compensation committee and there are cases, where this has not happened, as the CEO/senior management have desired otherwise.
[5] Two issues are relevant here. One is that the compensation system will need to have controls to ensure compliance and, in some ways, the committee itself is the main control available. Thus, the committee will have to also review the practical operation of the compensation system regularly for compliance with design policies and procedures. Compensation outcomes, risk measurements, and risk outcomes should also be regularly reviewed for consistency on intentions.
[6] See BIS paper on ‘Compensation and Corporate Governance’, 2010.
[7] Ibid.
[8] See ‘Share Microfin MD takes home 7.4 crore, more than double HDFC Bank MD’s salary’ by John Samuel Raja D and M Rajshekhar, The Economic Times, February 1, 2011,
https://economictimes.indiatimes.com/jobs/share-microfin-md-takes-home-7-4-cr-more-than-double-hdfc-bank-mds-salary/articleshow/7401434.cms — last accessed on August 3, 2020.
