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RBI adopts FSB Principles for Sound Compensation Practices

15 tips for Banks to respond to new guidelines on compensation of WTDs, CEOs, MRTs and Control Staff

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By Shai Ganu , Arvind Usretay and Deepika Raj | January 15, 2020

In this article, Willis Towers Watson’s Executive Compensation and Corporate Governance practice has summarised the key action items for Indian banks to adhere to with respect to the latest guidelines issued by Reserve Bank of India.

On 4 November 2019, the Reserve Bank of India (RBI) issued guidelines for all private sector and foreign banks, on compensation of Whole Time Directors (WTD), Chief Executive Officers (CEO), Material Risk Takers (MRT) and Control Function Staff. Aligned with Financial Stability Board’s principles for sound compensation practices, the guidelines are intended to enhance compensation governance and discourage excessive risk taking. With effect from performance periods commencing on or after 1 April 2020, the new standards will place a greater focus on Board oversight of remuneration outcomes, risk-reward alignment, share-linked instruments, deferral of variable compensation, and malus and clawback provisions.

Given recent identification of large non-performing assets and demand from shareholders and investors for stronger governance, compensation of senior executives (especially WTDs, CEOs, MRTs) is at the center stage of these regulatory reforms. The guidelines apply to private sector banks, including Local Area Banks, Small Finance Banks and Payments Banks, along with the Foreign banks operating in India either through a branch or a wholly owned subsidiary structure.

In this article, Willis Towers Watson’s Executive Compensation and Corporate Governance practice has summarised the key action items for Indian banks to adhere to:

Checklist of action items for Banks to follow:

  1. Establish a NRC: RBI asks all banks to establish a nomination and remuneration committee (NRC) comprising of three or more non-executive directors (NEDs), with at least 50% of the members being independent and at least one of the member should be part of the risk management committee. The NRC is also expected to ensure that the Cost / Income ratio and Capital Adequacy requirements are factored into the compensation structure.
  2. Adopt a formal compensation policy: The policy should cover the bank’s philosophy on all aspects of the compensation structure, including fixed pay, incentives, KPIs, and other remuneration elements covering at least WTDs, CEOs, MRTs, and control function staff (but ideally covering all employees).
  3. Identify Material Risk Takers (MRTs): While WTDs and CEO are already defined in various regulations, RBI guidelines include definitions for MRTs, covering qualitative criteria (e.g. roles that may have authority to take significant risk positions), and quantitative criteria (e.g. above a certain threshold, or among the 0.3% highest paid staff, or roles where whole remuneration may be higher than lowest paid senior management personnel).
  4. Calculate complete fixed pay: Fixed pay should include all fixed allowances, perquisites, as well as reimbursable perquisites so long as there is a monetary ceiling on these reimbursements.
  5. Review mix between fixed and variable pay: The guidelines specify the maximum amount of variable pay (cash bonuses and share-linked instruments) as a percentage of total compensation:
    • At minimum, variable pay should be at least 1x times of fixed pay (except for Control Function staff).
    • At maximum, variable pay should be capped at 3x times fixed pay for those with highest levels of responsibility.
    • If an executive is barred by regulation/ statute to receive grant of share linked instruments, variable pay will be capped at 150% of fixed pay.
  6. Review mix between cash and share-linked instruments: The guideline emphasises a greater focus on share-linked instruments (unless grant of equity linked variable pay is not allowed):
    • If variable pay is up to 200% of fixed pay, then at least 50% of the variable pay must be in the form of share-linked.
    • If variable pay is between 200% and 300% of fixed pay, then at least 67% of the variable pay must be in the form of share-linked (i.e. non-cash).
  7. Make variable pay truly variable: If the Bank experiences deterioration of financial performance, it should directly lead to a lower variable pay payment; including, if appropriate zero bonus.
  8. Implement deferrals: At least 60% of total variable pay must be deferred, and at least 50% of cash-based variable pay must be deferred (excluding cases where cash based variable pay is less than INR 25 Lacs).
  9. Deferral should be for at least 3 years, or more. Vesting of such deferred variable pay can either be cliff vesting (total amount vesting in lump sum after 3 years), or on a pro-rata basis over the full deferral term (i.e. not front loaded. So, for a three-year deferral, vesting will be one-third each year; whereas for four-year deferral will be quarter each year).

  10. Introduce malus and clawback provisions: Banks are required to put in place appropriate modalities to incorporate malus and clawback mechanisms:
    • A malus arrangement permits the bank to prevent vesting of all or part of the amount of a deferred remuneration. Malus arrangement does not reverse vesting after it has already occurred.
    • A clawback, on the other hand, is a contractual agreement between the employee and the bank in which the employee agrees to return previously paid or vested remuneration to the bank under certain circumstances.
    • Banks may exercise clawback and/or malus provisions in cases of material risk issues, financial misstatements, malfeasance, fraud, criminality etc.
    • Additionally, wherever the assessed divergence in bank’s provisioning for Non-Performing Assets (NPAs) or asset classification exceeds the prescribed threshold for public disclosure, the bank shall not pay the unvested portion of the variable compensation for the assessment year under ‘malus’ clause. Also, RBI will not approve any proposal for increase in variable pay (for the assessment year) for the executives of the company in such cases.
  11. No guaranteed bonuses: RBI discourages guaranteed bonuses in compensation arrangements. If at all, banks may offer a one-time sign-on bonus when hiring senior executives, only in their first year of service, and only in form of share-linked instruments. Sign-on or joining bonuses should not count as fixed pay, nor variable pay.
  12. No severance payments: Banks should not grant any severance pay, other than accrued benefits, unless otherwise mandated by law.
  13. Prohibit hedging: Banks shall not allow executives to insure or hedge their compensation structures to offset for the deliberate risk-reward alignment intended from such programmes.
  14. De-leverage compensation for control staff: Given control function staff play a key role in ensuring integrity of risk management, their own compensation should not be materially influenced by short-term performance outcomes. Majority of the compensation for control staff should be in form of fixed pay; and the variable pay components should be subject to clawback and malus provisions.
  15. Disclose compensation outcomes: Banks will need to make annual compensation disclosures for each pay element, WTD, CEO, MRTs, both for current and prior financial year, including reasons for changes. RBI has published a very comprehensive table with all the expected disclosures.
  16. Obtain regulatory approval: Any gaps in the compensation arrangements for WTDs, CEO, MRTs, Control Function staff may cause increase in risk profile of the bank, with consequences including requirement of additional capital if deficiencies are significant.

Way ahead

Considering the revised guidelines being effective from April 2020 cycle, Banks need to relook at their executive compensation policy and stock-based compensation plans for their WTDs, CEOs and MRTs.

  • Boards and NRC need to be closely involved in the formulation or review of the compensation policy as well as implementation of these compensation policies in the Bank. NRC must review the current variable pay process and setup regular review processes to ensure quick mitigation of gaps/ deficiencies in the process.
  • The guidelines define a structured governance and pay design framework for banks, with an aim of ensuring prudent risk taking and mitigating high risks for short term gains. The design framework is aligned to this aim through a balance of fixed vs. variable and cash vs. non-cash variable pay elements. Banks will need to adopt their pay structure, incentive plans and rewards programmes and processes accordingly to align to the guidelines.
  • The RBI guideline has defined clear rules around the pay mix of these critical employees at Banks. This is aimed to promote a higher ‘pay for performance’ culture by introducing a healthy mix of variable pay in the compensation, however it may restrict the design of pay structure in various circumstances. Banks will need to be more innovative in terms of incentive plan design to ensure that their reward programmes are uniquely aligned to their organisation context and business goals.

Willis Towers Watson recognises that aligning pay with performance and business strategy is a journey, and each company will have a different way to address these issues over time. We also see a need for boards to maintain their strategic and oversight perspectives while working with their management teams to ask the right questions and to develop ways to monitor progress.

Careful attention will need to be given in designing appropriate executive compensation arrangements that comply with RBI guidelines, align with interests of shareholders and broader stakeholders, and yet at the same time are able to attract, retain, and motivate high-calibre management talent.

Authors

Managing Director – Rewards Business Leader – Asia Pacific; and Talent & Rewards Business Leader – ASEAN & South Asia
Willis Towers Watson

Arvind Usretay
Director – Rewards

Consultant - Rewards, India
Willis Towers Watson

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