India’s central bank, the Reserve Bank of India (RBI), has made it clear to Indian banks that they may have faced the global financial crisis without a single casualty, but their top management officials could find traces of it in their paychecks. The RBI plans to scrutinize whether they are earning more than they deserve, adjusting their compensation packages for all types of risk. In draft guidelines on senior management compensation released in early July, the RBI said it wanted to save Indian banking from the “flawed incentive compensation practices” that contributed to the global financial crisis. “Perverse incentives amplified the excessive risk taking,” it stated.

The RBI’s latest move extends its control over compensation to senior management at private banks and foreign banks; it has exercised that control over public sector banks since 1969. India’s public sector banks held 76% of total bank deposits of US$860 billion (at Rs. 46 to a dollar) as of March 2009, according to RBI statistics.The RBI wants bank managements to recast internal processes involving their recruitment and risk management committees to weigh all types of risks and shape compensation packages to reflect “risk outcomes,” or measuring how well their risk gambits paid off. It also wants them to split compensation into fixed and variable components, introduce so-called “claw back” provisions that deny senior management a part of their compensation if they took ill-advised risks, and do away with guaranteed bonuses, among other measures.

Routine Supervision vs. Compensation Caps

Compensation controls won’t do the job as well as existing tools, according to Wharton professor of investment banking Krishna Ramaswamy. “If you want to curb excessive risk taking and excessive leverage, a direct approach to [monitoring] risks frequently would be more effective than a cap on salaries,” he says. “You can use your existing tools of prudential regulation.” He feels if a bank’s portfolio gets lopsided in certain ways that increase risks, the regulator could monitor that more frequently with periodic checks. This would be more accurate than indirect compensation controls, and contain the damage more effectively. “I don’t quite see what putting caps on salaries would do to curb their risk-taking appetite,” he says.

The RBI, however, feels compensation is at the center stage of the regulatory reforms currently sweeping the global financial system, and explains why that is the case in its draft guidelines. “Employees were too often rewarded for increasing the short-term profit without adequate recognition of the risks the employees’ activities posed to the organizations,” the RBI says. That situation ultimately “severely threatened the global financial system.”

The RBI had in place guidelines to fix the compensation of bank CEOs, and the latest move is to expand that to cover other senior management positions, says Alpana Killawala, chief general manager of the RBI’s department of communication. “We have also refined [those guidelines] given the experience of the global financial crisis,” she adds.

The RBI has framed its compensation guidelines to be consistent with the standards laid out two years ago by the Financial Stability Board, an international body of banking regulators based in Basel, Switzerland. The RBI has asked banks to send their responses to the draft guidelines by July 31, and wants the new compensation guidelines to take effect by the year-end.

The regulator clearly wants to prevent runaway growth in the pay packages of top bank executives. It recently turned down a proposal by Federal Bank in Kerala state “to offer a salary of Rs. 10 crore (US$220,000) and a generous dose of stock options” to recruit a top banker, according to a report in newspaper The Economic Times. By contrast, O. P. Bhatt, chairman of India’s largest bank, the State Bank of India, received Rs. 2.65 million (US$58,000) as compensation in the year ended March 31, 2009, according to a bank statement.

Ashvin Parekh, partner-national leader of global financial services at accounting and consulting firm Ernst & Young, points out that foreign banks operating in India would not find the latest changes disorienting because the regulators in their home countries would have introduced similar changes. He feels the RBI’s move is “in keeping with the global trend” and that it is well advised. “The conflict between greed and fear has never been as sharp as it is today,” he says. “The industry will always approach the opportunity with greed while the regulator will approach it with fear because he wants stability in the system.”

Sankar De, executive director, Centre for Analytical Finance at the Indian School of Business (ISB) in Hyderabad, doesn’t see the need for any controversy. Bringing private and foreign banks into the regulatory compensation ambit should “not cause turmoil … because this has been the status quo, the norm [that applied hitherto to public sector banks],” he says. The big question for bank regulators is to ascertain if a specific risk is commensurate with rewards, he adds. “It is a misconception that higher risk projects are also poorer projects; many high-risk ventures also have the potential of generating attractive returns.”

Partha Mohanram, associate professor of accounting at the Rothman School of Business at the University of Toronto and a visiting professor at the ISB doesn’t begrudge bank managers their compensation packages. “If shareholders want to pay a CEO US$50 million even if the guy doesn’t deserve it, it is the shareholders’ business,” he says. “What you need is extremely good disclosure.” He supports recent laws in the U.S. on “Say on Pay,” where shareholders have a voice in determining CEO compensation. “Even if it is not binding, it is embarrassing for a company if the shareholders pass a resolution saying the CEO should not be paid more than X and the CEO gets paid 2X,” he adds.

Rajesh Chakrabarti, assistant professor of finance at the ISB, says that while he wouldn’t advocate “excessive micromanagement” of bank salaries by the RBI, “it is understandable that the central bank may have an interest in maintaining parity in pay [across] the system.”

However, bringing parity or consistency in how banks fix compensation packages for their senior executives could prove counterproductive, according to Krishnamurthy Subramanian, assistant professor of finance at the ISB. “Regulations, typically, have a ‘one-size-fits-all’ approach … [and that] will essentially curb risk-taking a lot more in those banks that have the ability to take good risks,” he warns. However, he points out that according to recent academic research, banks in the U.S. whose holding companies had “good risk management functions did not suffer as badly in the crisis.”

Rajrishi Singhal, head of policy and research at Dhanalaxmi Bank, a fast-growing private bank, sees that differently. “In the past, we have seen some of the largest systemic risks emanate from [India’s] public sector banks, thereby necessitating recapitalizations in tens of thousands of crores, despite compensation controls,” he says. “These risks, including those emerging from nonperforming assets, eroded their capital base, and this occurred despite salary caps and regulation.”

In fact, compensation caps could drive away good talent, says Ramaswamy. He feels the regulator’s move “has the disincentive of putting off bright people who would otherwise come to the banking system, to go somewhere else.” Mohanram says he isn’t sure if that is entirely a bad outcome.”The same so-called talent was responsible for the mess that some of the banking sector was in,” he points out. “So if you have slightly less ‘talent,’ you might end up with a more stable banking system with less ‘innovation.'” Some of that innovation, which led to “excessive off-balance sheet items [and] excessive securitization,” is best avoided, according to him. “If you reduce the incentives for risk-taking through the mechanism of caps on compensation, I don’t see anything bad in that,” he adds.

Parekh, too, warns that with the latest moves, “[Indian] banking will not attract the top talent and skills as it used to around three years ago.” He says that already in recent years, many senior banking executives have moved away to become independent financial advisors or intermediaries.

Innovation in financial products could also take a direct hit, according to some observers. “When [banks move] from a growth mode to a survival mode, innovations are bound to come down for at least a little while,” says Parekh. However, he sees an innovative spirit returning in about a year or so, once the new order settles down. ISB’s Subramanian agrees that innovation will get impacted. “If you want to motivate employees to innovate, you have to be tolerant of failure,” he says. “In any sector, the innovative employees do get paid the highest. So if you want to attract the best talent, you have to pay them the best.”

Innovation at Risk?

Mohanram says he is “very skeptical” of attempts to portray compensation controls as hurting innovation. “Sometimes it is risk-taking, and in many of these cases the banks know they almost entirely bear the upside of the risk, and that the downside is covered by the fact that they are a regulated institution and some kind of tax payer-funded mechanism like FDIC [the Federal Deposit Insurance Corp. in the U.S.] is going to be a backstop for them.”

Mohanram also says that if the compensation controls do hurt innovation, the Indian banking industry may not be necessarily worse off. “It is quite possible that the sophistication and innovations of the derivatives markets might lag a little bit in India, but people have not convinced me that those things are tremendously important and add a lot of value,” he says. De says he “cannot champion unfettered flexibility because you are dealing with deposits and savings of small investors.” Chakrabarti, however, is hopeful. He says public sector banks, where top management compensation packages have for long been regulated, “have innovated very strongly at a fraction of top executive pay.”

Almost all commentators agree that the RBI has steered India’s banking sector away from a series of global financial downturns, including the Asian contagion of the late 1990s and the latest meltdown triggered by the housing slump in the U.S. It has not been taken in by broker-dealers from the U.S. and elsewhere who may have offered the RBI triple-A rated high-yield securities with attractive interest rates against its impressive foreign exchange reserves (US$251 billion as of June 25), says Ramaswamy. “If they had taken [that option] like some European countries have done, that would have placed them in a very awkward situation. They too could have gone the way of Iceland and others.”

Mohanram recalls that the RBI has resisted pressure over the years from U.S.-based banks “to allow off-balance sheet financing, to reduce the stringency of requirements [and] to loosen up mortgage markets.” The previous RBI governor, Y.V. Reddy, had been accused of “stifling innovation, being behind the times [and not] keeping up with Joneses, but history has proved all those detractors wrong,” Mohanram says. “He has been — for want of a better word — proved to be almost clairvoyant.”

Singhal of Dhanalaxmi Bank agrees that India’s banking regulator has come out smelling good in the recent economic crisis. “The RBI had seen the writing on the wall and put in place risk mitigation measures — such as higher provisioning for riskier asset classes like real estate — much before other [banking regulators],” he says. “It also began increasing interest rates before the crisis unfolded elsewhere. Those took out the sting from the asset bubble that was building up. Those were very prescient on the RBI’s part.”

Singhal, however, points out, “The RBI also took the market development agenda off the table, along with all its risk mitigation moves. As a consequence, two important elements of the financial markets suffered — efficient price discovery and enhancing the reach and scope of financial intermediation.”

Not everybody is sure the latest moves are in fact required at all. “The restrictions that are already in place in the banking system in India naturally prevent the excessive risk taking which happened in other countries,” Mohanram says. “[Also], the sophistication of instruments which are allowed is constrained compared to what is allowed in the U.S. capital markets. Even if there is intent to take risk, the ability to take that risk is not there in the Indian context. In that sense, you might say [a compensation cap] is unnecessary. But I fail to see how it is harmful.”

The RBI wants to prepare for activities it may permit banks to undertake in the future, says Killawala. “We are installing the fire extinguishers before any fires break out.”