By Kagade, Mandar.,Verma, Aadhar. |May 09, 2015
The compensation practices, especially of the large financial institutions, are often held as one of the important factors which contributed to the recent global financial crisis. These perverse incentives amplified the risk taking that threatened the global financial system. Financial regulators around the world, including India, moved to enact prescriptions aimed at increasing shareholder oversight of executive pay.
Set against this background, the article makes two novel proposals focusing on the Indian context: firstly, it nudges the regulators to prescribe creditor-centric compensation rules at banks. The RBI has hitherto focused on pay-reforms that will promote incentive alignment between executives and shareholders in the aftermath of financial crisis. We argue that such reforms are likely to promote more risk-taking among bank executives rather than less. On the other hand, creditor-centric approach to pay reform will ensure “skin in the game” for the bank executives and promote conservative management. And secondly, we argue that the RBI ought to mandate banks to pay a substantial portion of the managerial compensation in contingent capital bonds. We argue that the design of these bonds have advantages over “inside debt” (deferred and retirement pay) and can significantly motivate the executives to “think like creditors” thereby enable avoidance of taxpayer-funded bailouts.