How to tackle compensation of bankers

Financial Express, 25 June 2009

Financial regulators must take interest in how the incentives of bank managers are shaped by ownership, governance and compensation. But a mere focus on the level of compensation is giving in to the populist envy of the rich. RBI needs to come out with a policy document on ownership, governance and compensation, based on high quality economics and public discussion.

Backdrop: getting government out of wages has helped

Nickel costs $15,400 per tonne while Aluminium is at $1600 a tonne. Why should Nickel cost ten times more than Aluminium, even though they are a lot alike? Such questions are pretty pointless. Prices come out of supply and demand and have no other interpretation. A. M. Naik of L&T got paid Rs.8.4 crore in 2007-08 while Azim Premji of Wipro got Rs.1.31 crore. Interpersonal wage comparisons are as pointless as intermetal price comparisons.

When India became a socialist country, the government took it upon itself to control all kinds of prices, ranging from metals to labour. As a consequence, unethical firms found other ways of paying employees, which tilted the balance in favour of bad ethics. Lowered wages at the top reduced the incentives for young people to work hard and learn hard. Low wages pushed the brightest people out of the country. Inward migration of talent did not happen.

One of the most important reforms of the early 1990s was the removal of government involvement in wage setting. This fit into the larger theme of reforms refocusing government on the provision of public goods, and the removal of government interference in prices of the factors of production : land, labour, capital and enterprise. Deregulation of wages induced a sea change in the quality of the Indian workforce, based on stronger incentives in favour of hard work and education, a reduction in emigration, a reverse brain drain, and foreigners moving to India.

The compensation problem in banking

In this setting, debates about compensation in banking have resurfaced. With ordinary corporations, good corporate governance is about getting managers to maximise for the shareholders. This involves compensation packages containing shareholding, performance-linked bonuses and stock options.

In finance, in many situations, managers who think like shareholders can be pretty destructive. In banking, we have seen huge bonuses tied to short-term performance, without concern for risk. Excessive risk taking was consistent with bonus-maximisation. While such problems occur in other parts of finance also, they are particularly important in banking, given the toxic combination of opaque assets, high leverage and government guarantees. Many decisions taken by banks were good for shareholders and particularly for managers, but were value-destroying when viewed at the level of the bank as a whole or the economy at large.

If ownership, governance and compensation are unregulated, then regulators are left playing a game of cat and mouse trying to prevent CEOs from doing the things that they are incentivised towards doing. It makes sense for government to instead take interest in the ownership, governance and compensation structures so as to modify the incentives of top managers. It is better to give managers the incentive to do the right thing rather than giving them the incentive to do the wrong thing, and then trying to hem them in with regulations. Indeed, a greater focus on regulation of ownership, governance and compensation would make possible reduced direct regulation of the activities of banks.

Two principles need to be emphasised. First, the standard corporate governance ideas of aligning the interests of managers with that of shareholders should be dropped for banks. Second, regulators should think deeply about the incentive implications of ownership, governance and the structure of compensation. As an example, with banks, incentives should be linked to the total value of the firm and not just the value of the equity.

RBI and compensation of Indian bankers

In a report in Indian Express, P Vaidyanathan Iyer wrote that RBI has blocked the CEO compensation of ING Vysya Bank, Axis Bank and Development Credit Bank, on the grounds that the level of compensation was too high. RBI may be responding to concerns about compensation in banking that are now in vogue. However, going after the level of compensation is giving in to old Indian socialism, to the destructive politics of envy. What is important is not the level of compensation but the incentive structure that it engenders. RBI needs to shift from such blunt actions to bringing in sophisticated economics of the incentive implications of compensation.

Arbitrary letters to a few banks are an unhealthy way to run a regulatory system. RBI must go through the process of first using a top quality expert committee to think about these questions, then asking for public comments on a draft document, and then releasing the policy document. This policy statement must articulate a framework for thinking about the incentive implications of compensation in banking while meticulously staying away from the politics of envy. Fresh regulation of ownership, governance and compensation must be simultaneously accompanied by fresh deregulation of the activities of banks.

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