In today’s Finshots, we see whether the Reserve Bank of India’s regulations to curb a bank executive's compensation are leading to unintended consequences.

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The Story

A recent report by Mint says that the RBI has been poking its nose into how the leaders at banks are being compensated.

Apparently, the banking regulator recently asked IDFC First Bank to cut the pay of one of its top executives by 30%. And similar things are happening at Catholic Syrian Bank and IndusInd Bank too. Even in the case of banking giant HDFC Bank, the RBI approved the CEO’s performance pay for FY22 only a year later.

And this interference might be making some executives leave banking for greener pastures.

So, why on earth is the RBI getting involved in such trivial matters, you ask?

Well, the root of this issue can probably be traced back to the 2008 global financial crisis. As the Financial Stability Forum said back then:

“compensation practices at large financial institutions are one factor among many that contributed to the financial crisis that began in 2007. High short-term profits led to generous bonus payments to employees without adequate regard for the longer-term risks they imposed on their firms. These perverse incentives amplified the excessive risk-taking that severely threatened the global financial system and left firms with fewer resources to absorb losses as risks materialized. The lack of attention to risk also contributed to the large, in some cases extreme absolute level of compensation in the industry.”

Simply put, everyone was worried that bank execs seemed to be chasing short-term gains for themselves and ignored the risk. On purpose.

And most research papers we pored through revealed similar results. They point out how corporate governance issues come to the fore when the entire focus is on short-term profits. That execs sidelines the ones who caution about risk as they strive for higher payouts.

So with the consensus pointing to compensation being a factor, global bank forums jumped in. They began to issue guidelines on what the best practices for CEO compensation in banks should look like.

Now even though it didn’t first appear that Indian banks were cut from the same cloth as its foreign counterparts, things changed quickly. The RBI initiated a cleanup in the mid-2010s and the skeletons tumbled out of the closet. Indian bankers had indeed been quite trigger-happy and lent money out to lots of dubious enterprises. And a huge chunk of them had turned into bad debt.

It wasn’t a good look.

So in 2019, the RBI enacted its own rules.

They decided to keep a watch on the total remuneration paid to bankers. They wanted 50% of the pay to be linked to performance. So only if the bank hit certain targets, would either a cash bonus be paid or equity shares be issued.

But wait — how do you decide what’s a ‘good’ performance in this case?

If it’s simply higher revenues and profits, it could be achieved by selling loans that are in vogue at that time. And that could come at a higher risk. And since risks typically materialize only a few years down the road, investors will ignore it too. They might bid up the stock price. And that means the stock options that the exec receives for good performance will rise in value too. Even though the banks probably took risky bets to achieve the desired growth.

So the RBI included something else too. It told banks to include clawback clauses. This meant that past bonuses given to the CEO could be taken back if some decision they made turned sour later.

Kind of like what happened to Ms Chanda Kochhar, the former CEO of ICICI Bank.

Remember the case where she was hauled up for sanctioning loans to Videocon Industries which went bankrupt? The problem here was that Videocon seemingly had ties to her husband’s business too. So that raised eyebrows.

Eventually, she was booted out and ICICI Bank said it would claw back whatever performance-linked component it had paid out during her tenure. By some estimates, this would’ve amounted to a whopping ₹350 crores.

So yeah, these RBI rules meant that all banks would have to include such clauses in contracts just to ensure that the execs don’t get too cavalier. And that they don’t think that they can wash their hands off any misdeeds they’ve done in the past.

But there could be unintended consequences of such over-regulation too.

The banking industry might lose valuable talent. Mint claims that bankers are jittery already. We’re not saying it just for the sake of it, but something similar played out in Israel a few years ago. The country passed a law that capped compensation in places such as banks in 2016. It was enacted because bad loans from lending to business tycoons were in the billions and people didn’t think it was fair that the execs behind it got paid exorbitant sums of money.

And then, one headline in the Times of Israel claimed: “CEOs fleeing Israeli banks in quest for higher salaries, less regulation”.

That’s because the CEOs of 3 of the country’s top five banks all quit within a span of half a year.

And it wasn’t just banks that the regulation clamped down on but even insurance companies. So execs began to resign from insurance companies and moved into industries like construction which were poles apart.

Could something like that happen in India too?

We don’t know yet. It could, especially if you consider that bank CEOs are being held even more accountable for things that could go wrong. There’s an increased level of personal responsibility at play here and maybe execs will feel they’re not being compensated enough for that risk.

We’ll have to wait and see if there's an exodus of senior banker exits in the industry now.

Until then…

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Update: We have edited the story to exclude the name of a senior banking executive who was mentioned earlier.