Making bankers pay for failed gambles

The RBI should adopt some of the bold and far-reaching proposals made by a British parliamentary panel for making banks and boards accountable

Updated - June 13, 2016 02:10 pm IST

Published - July 12, 2013 12:20 am IST

edit article banking reform 120713

edit article banking reform 120713

The financial sector in the West imploded in 2007, causing a downturn in the world economy from which it is yet to recover. How to prevent >recurrent banking crises has been uppermost in the minds of policymakers ever since. Progress has been painfully slow and there is a sense also that the reforms implemented thus far do not go far enough.

It has been left to the United Kingdom’s Parliamentary Commission on Banking Standards to grasp the nettle. Its two-volume report contains some of the boldest and most far-reaching proposals made so far. The RBI would do well to embrace some of these proposals as part of India’s ongoing reforms in the banking sector.

The report breaks new ground in several respects. One, it proposes a mechanism by which individual bankers can be held liable for negligence or serious lapses. Two, it makes several recommendations for improving the functioning of boards of directors of banks. Three, it moves further on tightening incentives for bankers than the proposals currently on the table. Four, it puts the onus on regulators to respond quickly to perceptions of serious inadequacies in standards or culture at any bank.

Lack of accountability

Several large banks collapsed or were on the verge of collapse in the financial crisis and had to be bailed out by taxpayers. Top managers at the banks lost their jobs but exited in a golden parachute, with hefty severance payments or pensions. The public in the West is outraged that hardly any banker has gone to jail or otherwise been held accountable.

The U.K. Commission attempts to tackle this issue head on. It proposes a Senior Persons regime which will ensure that “the key responsibilities within banks are assigned to specific individuals who are aware of those responsibilities and have formally accepted them.” By thus assigning responsibilities in clear terms to specific individuals, the report lays the ground for enforcement action in the event of serious problems. Those at the top will find it difficult hereafter to disclaim responsibility for actions that result in serious harm to the bank.

The Commission wants regulators to review the responsibilities to Senior Persons from time to time and ask for responsibilities to be redistributed within the bank where, for instance, a bank undergoes rapid expansion. It asks that Senior Persons relinquishing office prepare a handover certificate outlining how they have exercised their responsibilities and indicating areas that their successors should be aware of. These are sound management practices that banks should have instituted on their own; that they have to be now told to do so is a reflection on how banks have been run.

The Commission also proposes a Licensing Regime for a wider set of people than those covered by the Senior Persons regime. The broader regime would cover almost anybody whose actions could harm the bank, its reputation or its customers. All persons covered by the Licensing Regime would be subject to a set of Banking Standards Rules. These Rules would “encapsulate expectations of behaviour.” The Commission believes that the Senior Persons regime and the Licensing Regime together should enable regulators to hold individual bankers to account.

Bank boards were found to be ineffective in the years leading up to the financial crisis. The Commission makes wide-ranging recommendations to improve the functioning of boards. It notes that shareholders own too small a piece of banks to have the incentives to seriously monitor management. They also tend to be focussed on short-term performance of banks. It is the boards, therefore, that must bear the primary responsibility for oversight of banks.

The financial crisis highlighted serious flaws in bank boards: overly dominant CEOs; weak Chairmen who tended to become cheerleaders for CEOs; lack of expertise amongst independent directors; and a failure on the part of independent directors to challenge the executive. The Commission raises the issue of whether the Nominations Committee, which selects independent directors, should be headed by the Chairman or by a Senior Independent Director. Boards tend to be self-selecting and self-perpetuating. The Commission would like banks above a certain size to advertise the position of independent director.

These are useful suggestions but they do not go far enough. Independent directors cannot exercise independence as long as they are all chosen by the management. (The Nominations Committee typically rubber-stamps the choices of the CEO or the controlling shareholder). Other stakeholders — institutional shareholders, retail shareholders, employees — must have a say in the appointment of independent directors.

The Commission recommends that the Senior Independent Director be asked to make an annual assessment of the performance of the Chairman. It wants him to explain to regulators how he has satisfied himself that the Chairman has fulfilled his role. Board members will be covered by the Senior Persons regime. An independent director or the Chairman must assume specific responsibility for the firm’s whistle-blowing regime. Regulators themselves must go through whistleblower reports both to be aware about concerns being reported and to ensure that whistleblowers are being treated fairly.

The Commission might have gone further. We need a review of the performance of every independent director, not just that of the Chairman. Such a review can be done by peers on the board. Regulators must go through the minutes of board meetings and judge whether discussions are properly minuted and any meaningful discussions are taking place in the first instance.

The financial crisis highlighted how executive pay can become a source of systemic risk. Managers can take huge risks knowing that if their gambles work out, they stand to be hugely rewarded; if their gambles fail, it is the taxpayer who bleeds. Moreover, managers can easily show short-term performance and walk away with rewards whereas the risks reveal themselves over a longer period.

The Commission proposes several reforms to address the issue of performance incentives in banking. One, the creation of a separate set of regulatory accounts for determining remuneration, both at the company level and at the level of business units. Two, the rejection of the use of narrow measures such as return on equity for setting remuneration. Three, bank remuneration committees must disclose the measures used to determine remuneration (something that is sadly missing in annual reports of companies). Four, a significant part of variable remuneration should be deferred — and for up to 10 years.

One advantage with deferring compensation over a long period is that it allows remuneration to be recouped where required. The Commission would also like the regulator to explore the possibility of recovering remuneration already paid in cases where individuals are subject to enforcement action. It also recommends legislation to ensure that, where banks receive taxpayer support, all deferred compensation and unvested pensions are cancelled.

In the realm of regulation, the Commission’s innovation is the proposed creation of what it terms ‘special measures’ for regulators to deal with banks that are seen to be wanting in standards or culture. The Commission would like the regulators’ concerns on this account to be authenticated by an independent auditor. Once this happens, the regulators should have the powers to secure a commitment from the bank that it will take the necessary rectification measures and subject itself to intense monitoring.

The Commission also wants the U.K. to have a leverage ratio — the ratio of equity to assets — higher than the 3 per cent proposed under international norms. It wants the appropriate regulatory authority, not the U.K. government, to set the leverage norm. Finally, it proposes a number of measures to make the regulators themselves accountable to parliament.

Word of caution

Banks are apt to use their lobbying power with politicians to dilute regulations or regulatory actions. The Commission exhorts the Governor of the Bank of England to warn parliament or the public when this happens. Mervyn King, who has just stepped down as Governor, has already heeded this piece of advice.

Several commissions have gone into the financial crisis and proposed reforms. These relate mostly to issues of capital, scope and size in banking. It has taken a parliamentary commission to look into the inner workings of banks and focus resolutely on the accountability of bankers and bank boards. The Commission’s report goes to show that banking reform is too important to be left to regulators and bankers and that parliament, as the representative of the wider interests of society at large, has a great deal to contribute.

The RBI should consider taking many of these proposals on board. >Indian banking has been dominated thus far by public sector banks, which are intrinsically risk averse and more amenable to direction by government and the regulator. This has made for a certain stability in Indian banking.

The situation is changing. The role of the private sector has grown and will grow further in the years to come, especially with a new set of players due to be given bank licences. Bankers’ accountability, incentives, the role of boards, culture and standards in banking — all these issues will loom larger than before. It is wise to put in place measures that will ensure that stability in Indian banking is not undermined by the quest for greater efficiency.

(The author is a professor at IIM, Ahmedabad.

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