We need more financial innovation in India and not less. It is now well recognised in economic literature that innovation involves risk-taking. Furthermore, recent research points out that motivating innovation requires an environment where failure is tolerated. In fact, some of my own research highlights that laws and regulations that exhibit tolerance to failure can be quite instrumental in motivating innovation in the economy. This ?tolerance to failure? aspect of innovation applies to innovation in financial markets as well. Thus, given the fact that financial sector innovation in India considerably lags behind those in the developed markets, the recommendations of the Financial Stability Board for curbing excessive risk-taking applies more pertinently to the developed markets. Mimicking these recommendations in India would hurt us more than benefit us.

I now turn to the question, is executive compensation the most potent tool to curb excessive risk-taking? In this connection, it is quite pertinent to point out that, even in the context of developed markets, the quality of the risk management function within a bank/financial institution can be quite instrumental in ensuring the optimal level of risk-taking. In fact, based on its discussions with the largest financial institutions, the Senior Supervisors Group (SSG) concluded in a report in 2008 that a strong and independent risk management function distinguished well-managed institutions that fared well during the crisis from the poorly managed ones that experienced disaster. (The SSG is a group of supervisory agencies from France, Germany, Switzerland, the UK and the US.) The Group also noted that in the well-managed institutions, there was a robust dialogue between their senior management team and business segments regarding organisation-wide risks. In particular, the SSG report highlights specific weaknesses in risk management practices that contributed to heavy losses at institutions that performed poorly during the crisis: (i) excessive reliance on external credit rating agencies; (ii) backward-looking measures of risk as well as failure to conduct forward-looking stress tests; (iii) failure to identify correlation risk; and (iv) underestimation of liquidity risk. The SSG report specifically highlights that institutions with strong risk management functions identified risks and started taking corrective actions as early as in 2006, when it was easier to offload holdings of mortgage-backed securities and CDOs, and was relatively cheaper to hedge risks.

Recent research by Andrew Ellul of Indiana University and Vijay Yerramilli of University of Houston finds evidence that is consistent with the conclusions arrived at by the SSG. The authors find that bank holding companies with stronger risk management structures were more judicious in their risk-taking. Such bank holding companies had lower exposure to mortgage-backed securities and trading assets, and were less active in trading off-balance sheet derivative securities before and during the crisis. Moreover, bank holding companies with better risk management functions were more profitable, fared better in terms of stock return performance and had lower downside risks during the crisis years.

The authors find a strong risk management function to be correlated with the following features of the bank/financial institution?s organisational structure. First, such banks/financial institutions certainly had a designated chief risk officer. Second, the designated chief risk officer was a company executive who could understand and evaluate the company?s risk profile (not an outsider). Third, the chief risk officer was among the top five company officials in terms of compensation. Fourth, the board committee designated with overseeing and managing risk had at least one director with significant banking experience. Fifth, in the well-managed institutions, this committee of the board was quite active and met quite frequently together. Sixth, the executive risk management committee, which is usually the asset liability management committee, reported directly to the board?s risk management committee rather than to the CEO.

This piece of research suggests that strengthening the risk management function in the bank/financial institution can have a first-order effect on risk-taking by the bank/financial institution. Since attractive compensation attracts the best talent that is crucial to innovation, strengthening the risk management function does not have the detrimental effects that curbing executive compensation will have. Apart from the fact that curbing executive compensation may not be the most potent tool to curb excessive risk-taking, we must not overlook the fact that the current focus in the developed countries on curbing executive compensation in the financial sector stems at least partly from the fact that such a measure is politically expedient. Should we mimic the potential mistakes being made in the developed countries in the same way as an inept student copies the incorrect answers of a ?once upon a time bright student? who has lost his sharpness? Instead, we should attempt to be the street-smart student that exploits the opportunity to leapfrog this ?once upon a time bright student? by coming up with better answers.

Regulatory restraints on bank compensation will reduce flexibility in hiring top talent and discourage current and future generations of top talent to prefer careers in banking. Furthermore, if the developed markets resort to a knee-jerk reaction and curb executive compensation while we in India resist the temptation to do so, we would be able to attract away the best talent in the financial sector from the developed markets into India. Since innovation finally is driven by the quality of human capital, this could be the opportunity that we need to grab to leapfrog the developed markets.

(Concluded)

The author teaches finance at the Indian School of Business, Hyderabad