The RBI has taken the rather unusual step of asking three private banks?Axis Bank, Development Credit Bank and ING Vysya Bank?to cut back their proposed CEO salaries. While it is well within its statutory powers arising from the Banking Regulation Act in doing so, this raises a few interesting questions that may have implications for the banking sector in India and beyond. First, should government agencies interfere in the setting of executive compensation in private companies at all? Second, does such interference in a specific sector make it less competitive and open the door for regulatory arbitrage? Finally, what benchmarks and criteria should drive the norms in this matter, or should this be left to the discretion of the regulator?
Textbook economics will tell us that executive compensation is a contract between employers (shareholders acting through their representatives, the board) and employees, suggesting little role for government interference. However, as the ongoing crisis has clearly demonstrated, the reality is far more complex and executives have successfully ratcheted their pay with little connection to performance and without necessarily the consent of shareholders. This is particularly true of the financial sector, and specifically in the US, but it has a lesson for everyone.
Besides when things get out of control, the government has little choice but to bail large players out to avert the collateral damage to the economy. So, yes, large companies, and definitely banks, with huge external linkages, are doubtless areas of government lookout. In fact the regulators have an obligation to taxpayers to take what in their judgment is preventive action, if only to protect the economy and the public purse.
Would RBI?s clampdown on CEO pay hurt the competitiveness of the banking industry? Does this promote regulatory arbitrage within the financial sector as well as between the financial sector and other parts of corporate India? Would an across-the-board norm affecting all Indian companies be a better way of dealing with it? The boundaries for industries are rather arbitrary and there is no doubt that firms compete for CEOs. To the extent that RBI?s stance affects only banks, it may have implications about tilting the playing field. But probably these fears are exaggerated. CEO candidates for top companies usually have industry lock-in in terms of experience and expertise. Finally, given RBI?s responsibility as the apex banking sector regulator, one can hardly fault it for preventing what, in its judgment, was a violation of appropriate norms. If uneven playing ground is a serious issue, it is for other regulators to follow suit and collectively lay down appropriate norms in this matter.
So, in principle, the RBI action can be easily defended. But was the decision to ask these three specific banks to revise their CEO salary the right one? This, unfortunately, is a question that is next to impossible to answer. The reason: it is up to RBI?s discretion rather than any transparent norms to decide what compensation range is Ok for what bank.
Given that all three banks had new leaders, one would assume that each probably hiked its existing CEO compensation considerably and that raised eyebrows at the regulator, particularly after the AIG bonus furore in the US. Given the fact that these promised pay packages probably mattered significantly in finding the new chiefs, it now creates avoidable discontent for many involved. All this could have been avoided if the RBI had laid down transparent norms in this matter.
The absence of such norms is probably because of the rarity of such action. However, going forward, it would help all if RBI developed and communicated such norms. Naturally they would have to accommodate all existing bank CEOs and provide for future growth. Probably the criteria that the RBI employed linked CEO pay to bank size, CEO pay at peer banks and to the salary of the outgoing CEO. Guidelines with indicative pay caps connected to all these variables can easily be developed and communicated to the banks, so that both the bank and the would-be CEO know whether the offer on the table is realistic or not.
Furthermore, other regulators with similar authority over their charges should also do likewise, to avoid regulatory uncertainty elsewhere.
Of course, evidence shows high CEO pay is not necessary and certainly not sufficient for superior performance. But given the widespread perception of the competitive advantage of having a star CEO and the pressures of competition, all can gain from some regulatory intervention here.
?The author teaches finance at the Indian School of Business, Hyderabad