Chief executive officer pay, in general, is not regulated but the pay of bank CEOs is. With good reason. Banks are highly leveraged – it would be common to find a bank operating at a debt-to-equity ratio of 30:1 whereas a non-bank company operating at a debt to equity ratio of 2:1 would be thought highly risky.
When a firm operates at the sort of leverage that one finds in banking, managers have enormous incentives to take risky gambles. If the gambles work out and they have variable pay linked to performance, bankers will be hugely rewarded. If the gambles fail, shareholders and depositors will be left holding the can. Bank CEOs may lose their jobs but they can still walk away with enormous sums made in good times – unless their pay is properly structured.
That’s exactly what happened at global banks before the financial crisis of 2007-08.
- Richard Fuld, the CEO of Lehman Brothers, which failed in 2008, was paid $529 million between 2000 and 2007.
- James Cayne, CEO of Bear Stearns, received $87.5 million in cash and bonuses between 2000 and 2007, and cashed out $289 million in stock before his firm crashed.
- Charles Prince, who caused Citigroup billions of dollars in losses, was paid $34 million to leave.
- Merrill Lynch paid its departing CEO, Stanley O’Neal, $168 million.
It follows that in highly leveraged firms such as banks, variable pay linked to performance has the potential to create bank-level as well as systemic risk. It makes sense, therefore, to place limits on variable pay. Some amount of variable pay may be required to incentivise performance, although even this has come to be debated of late among academics. But over-sized incentives are not healthy. Following the crisis, European Union regulators set fixed to variable pay at banks at 1:1. They said this could rise to 1:2 with shareholder approval.
Secondly, since risks in banking show up over time, variable pay must be paid out over time, not at one go.
Thirdly, not all variable pay must be in cash; some of it must be in the form of shares so that CEOs pay the price for decisions that impact the stock price adversely over time.
Somewhat belatedly—it’s over a decade since the financial crisis—the RBI has moved to put these principles into practice. It released a discussion paper late February that seeks to incorporate these principles. These principles apply to private and foreign banks. Public sector banks still operate within stringent government guidelines.
Also Read: RBI Proposes Revamp Of Bank CEO Compensation
Plugging A Big Hole
The big change is that RBI’s definition of CEO pay now includes stock options. Earlier, the RBI used to approve fixed pay for private bank CEOs based on a range of parameters including size. Variable pay was limited to 70 percent of fixed pay but did not include stock options.
This was not just a lacuna; it was something of a joke. It meant that there were no limits at all on variable pay, contrary to the healthy principles that emerged at the EU and elsewhere consequent to the global financial crisis.
CEOs at private banks, and also executives down the line, made a significant multiple of their cash pay in the form of shares.
The discussion paper now proposes variable pay at 200 percent of fixed pay. The RBI leaves a whole range of perquisites out of the definition of fixed pay. It’s not clear why. After all, it’s the cost to a company that should matter when it comes to setting pay. The RBI also stipulates that at least 50 percent of the total compensation should be variable and 50 percent of the variable should be in forms other than cash. Very roughly, a minimum of about 25 percent of total compensation would be in the form of shares.
The RBI also says that at least 60 percent of the total variable pay and 50 per cent of the cash component should be deferred. However, it does not specify the period of deferral.
It would be prudent to suggest a deferral period of at least five years, which could be extended to ten years over time.
The discussion paper proposes mandatory malus, or penalties, in instances where there is divergence in non-performing assets beyond a threshold- that is, NPAs are under-provided for in violation of RBI guidelines. It also proposes clawback of variable pay taking into account statutory and regulatory stipulations.
These proposals constitute a step forward in addressing systemic risk arising from executive pay. They allow incentives for performance. At the same time, by subjecting CEO pay to reasonable caps, they seek to ensure that these incentives do not result in perverse outcomes, by rewarding excessive risk-taking. The effectiveness of these proposals will depend a great deal on disclosure and close supervision on the part of RBI.
It is in the realm of disclosure that the discussion paper really scores. It prescribes a whole range of qualitative as well as quantitative disclosures that would take disclosures on CEO pay at banks to a different level altogether. The qualitative disclosures include a description of how the incentives take into account various risks and how exactly performance is measured.
These are among the weakest points in disclosure today. Go through a bank’s annual report and you will have no clue how the board approved a particular figure for variable pay or a certain number of stock options.
Performance measurement is described in annual reports in the most abstract terms. There is also no disclosure on total pay in a given year including the value of shares encashed.
This where supervision comes in. The RBI must insist that the disclosures be such that investors and analysts can tell why the CEO is being a certain amount in a given year, compared to a given amount last year. This means that the entire set of performance measures and performance against these measures should be spelt out in the annual report. In the absence of such disclosure, it has been something of a mystery why many private banks have increased variable to their CEOs in the face of rising NPAs and falling return on equity.
While the RBI’s proposals are about CEO pay at private banks, they have the potential to have a much wider impact. If implemented vigorously, the RBI’s new proposals could get nominations and remuneration committees of boards—and boards as a whole—to take their jobs more seriously than they have done so far. By better linking pay to performance, it could result in tighter monitoring of CEO performance, and thus usher in a sea-change in governance at private banks.
TT Ram Mohan is professor of finance and economics at IIM Ahmedabad.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.
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