Wednesday, May 27, 2015

Designing Executive Compensation for Banks and Financial Institutions

When it comes to banks and financial institutions, there are additional corporate governance requirements apart from those applicable to other types of companies. This is because the operation of banks and financial institutions affect the interests of a constituency other than shareholders, namely deposit holders and other creditors. Hence, executive compensation practices need to take these special issues into account.

In this regard, a recent article in the Economic & Political Weekly (EPW) titled Contingent Convertibles and Bankers' Pay by Mandar Kagade and Aadhaar Verma is instructive. The abstract is as follows:

The compensation practices at large financial institutions are often held as one of the important factors which contributed to the 2007/2008 global financial crisis. Regulators around the world, including India, have therefore moved to enact prescriptions aimed at increasing shareholder oversight of executive pay. Set against this background, the paper makes two novel proposals focusing on the Indian context. First, it nudges the regulators to prescribe creditor-centric compensation rules at banks. The Reserve Bank of India has hitherto focused on pay reforms that will promote incentive alignment between executives and shareholders. This paper argues that such reforms are likely to promote more rather than less risk-taking among bank executives. Second, it argues that the RBI ought to mandate banks to pay a substantial portion of the managerial compensation in contingent capital bonds. The design of these bonds can significantly motivate executives to "think like creditors" and thereby enable avoidance of taxpayer-funded bailouts.

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