By Mandar Kagade, Analyst, Bharti Institute of Public Policy, ISB

The recent report of the RBI committee to review governance of boards of banks (the P.J. Nayak Committee) recommends that non-executive directors at private-sector banks should be paid profit-based commissions so as to enable the private-sector banks to attract skilled professionals for their non-executive and independent directorial positions.

This is a welcome recommendation; but can be significantly improved upon. As the financial crisis taught us, financial firms are different from non-financials in that the last bearer of risk in the event of their failure is the taxpayer that funds their bailout.

It appears apposite that the RBI should prescribe remunerative tools that align the non-executive directors’ incentives to the banks’ creditors and taxpayers.

One such instrument, which aligns managerial incentives to the taxpayer/ uninsured creditor, is the contingent convertible bond (“CoCos”). Contingent capital instruments are subordinated uninsured long duration debt instruments that are either converted into equity capital or get written off (adding to equity capital) at prescribed triggers as the bank’s capital declines.

Since contingent capital privatises losses as the bank reaches the zone of insolvency and shores up the bank’s capital precisely at the point the bank needs it (but when it is likely very expensive to obtain on the capital markets), banking regulators across the world including the Basel Committee on banking supervision, have recognised it as a means to mitigate moral hazard and systemic risk emanating from bank failure. Recently, influential global banks in Europe too have adapted to contingent capital bonds for remunerating their executives.

These bonds get translated into cash awards for the bank executives, contingent upon the bank executives maintaining the core equity tier I capital of the bank concerned, above a certain prescribed threshold. Contingent capital bonds issued to bank executives align managerial incentives to conserving capital and therefore reducing risk; they are thus application of the contingent capital idea to executive remuneration.

In India, however, perhaps owing to path-dependence, ideas about compensating bank managers and directors in instruments deriving value from debt have received insufficient regulatory attention. However, in the absence of such aligning devices, the non-executive independent directors (and the bank executives generally) may not be incentivised to have regard of the uninsured bond-holder and taxpayer interests when they take decisions sitting as board member, ranging from asset creation, risk management to remuneration.

Paying them in cash induces sloth; remunerating in equity will make them risk-seeking. Regulators and uninsured bond-holders are outside the bank and therefore suffer from information asymmetry; as such, it may not be prudent to rely exclusively on those stakeholders to monitor and mitigate risk in the bank. It is therefore necessary that constituents inside the firm also have the appropriate incentives to monitor and mitigate risk.

Such incentives could be generated by mandating non-executive/ independent directors (and executives generally) of the bank be remunerated in debt-based instruments, especially, CoCos mentioned above. On the flip side, there is divergence of opinion about the accounting trigger; some policy papers and academics have argued in favour of market triggers, like moving average of the stock price for example, for the CoCo to convert into equity.

This is because, accounting-based triggers run the risk of being stale as they are only periodically disclosed. But the argument for making CoCos part of remuneration toolkit is not affected by the debate surrounding the nature of the trigger.

If CoCos issued to bank executives and directors have accounting trigger, they ought to have higher triggers than those issued to the investors, to align their interests strongly to the CoCo investors. Higher trigger for CoCos issued to Directors can in fact convey a leading signal for banking firms to recapitalize.

The RBI has already recognised contingent capital instruments as Additional Tier I instruments in its recently released Basel III Guidelines. The RBI should augment that apparatus by mandating key banking personnel and non-executive independent directors to be paid equally in contingent convertible bonds and equity-based pay so that they have explicit incentives to monitor and account for the creditors and taxpayers in the course of their management.

Such contingent convertible bonds should have high capital triggers on the breach whereof, the bonds convert into junior equity claims. The risk of default that such compensation structure carries will generate high powered incentives for the directors to manage the bank for risk-mitigation consistent with profit-seeking motives.

This article was first published in Business Today on July 31, 2014