The Reserve Bank of India had constituted an Expert Committee to Review Governance of Boards of Banks in India.The Committee was chaired by Shri P. J. Nayak, former Chairman and CEO of Axis Bank; the other members were Shri S. Raman, Whole Time Member, Securities & Exchange Board of India, Smt. Shubhalakshmi Panse, Chairperson & Managing Director, Allahabad Bank, Shri Pratip Kar, former Executive Director, Securities & Exchange Board of India, Shri Joydeep Sengupta, Director, McKinsey & Company, Shri Harsh Vardhan, Partner, Bain & Company India Pvt. Ltd., Shri Somasekhar Sundaresan, Partner, J. Sagar Associates, and Shri Krishnamurthy Subramanian, Assistant Professor, Indian School of Business.
Overview of the Report and List of Recommendations
1. The financial position of public sector banks is fragile, partly masked by regulatory forbearance. Forbearance delays, but does not extinguish, the recognition of this fragility. Capital is significantly eroded with the proportion of stressed assets rising rapidly. The Report projects, under different scenarios, the capital requirements till March 2018 in order that provisions are prudent, there is adequate balance sheet growth to support the needs of the economy, and capital is in line with the more demanding requirements of Basel 3.
2. It is unclear that the boards of most of these banks have the required sense of purpose, in terms of their focus on business strategy and risk management, in being able to provide oversight to steer the banks through their present difficult position. The boards are disempowered, and the selection process for directors is increasingly compromised. Board governance is consequently weak.
3. The onus of remedying this situation through radical reform lies primarily with the Central Government. In the absence of such reform, or if reform is piecemeal and non-substantive, it is unlikely that there will be material improvement in the governance of these banks. This could impede the Government's objective of fiscal consolidation. The fiscal cost of inadequate reform will therefore be steep.
4. The high leverage that banks operate under makes banking a riskier commercial activity than most non-financial businesses. Unless banks are extremely well run and with a strong focus on financial returns, they tend to falter. The Central Government is a good example of a bank shareholder which has suffered deeply negative returns over decades. It is therefore in the Government's own interest to provide clarity in the objectives set for bank boards, and to thereby improve governance and management.
5. The Report proposes that the Government distances itself from several bank governance functions which it presently discharges. For this purpose it recommends that the Bank Nationalisation Acts of 1970 and 1980, together with the SBI Act and the SBI (Subsidiary Banks) Act, be repealed, all banks be incorporated under the Companies Act, and a Bank Investment Company (BIC) be constituted to which the Government transfers its holdings in banks. The Government's powers in relation to the governance of banks should also be transferred to BIC.
6. The process of board appointments, including appointments of whole-time directors, needs to be professionalised and a three-phase process is envisaged. In the first phase, until BIC becomes operational, a Bank Boards Bureau (BBB) comprising former senior bankers should advise on all board appointments, including those of Chairmen and Executive Directors. In the second phase this function would be undertaken by BIC, which would also actively strive to professionalise bank boards. In the third phase BIC would move several of its powers to the bank boards. The duration of this three-phase transition is expected to be between two and three years.
7. Governance difficulties in public sector banks arise from several externally imposed constraints. These include dual regulation, by the Finance Ministry in addition to RBI; board constitution, wherein it is difficult to categorise any director as independent; significant and widening compensation differences with private sector banks, leading to the erosion of specialist skills; external vigilance enforcement though the CVC and CBI; and limited applicability of the RTI Act. A more level playing field with private sector banks is desirable.
8. If the Government stake in these banks were to reduce to less than 50 per cent, together with certain other executive measures taken, all these external constraints would disappear. This would be a beneficial trade-off for the Government because it would continue to be the dominant shareholder and, without its control in banks diminishing, it would create the conditions for its banks to compete more successfully. It is a fundamental irony that presently the Government disadvantages the very banks it has invested in.
9. The Report proposes the need for wide-ranging human resource policy changes. These would encompass getting younger people into top management, for which a demographic opportunity has now arisen, and which would thereby lead to longer tenures; and succession planning. There is also a need to envision afresh the process of countering corruption through a redesign of the existing process of vigilance enforcement. The Report argues that present modalities are damaging and erode the ability of the banks to compete strategically, besides being only weakly effective in combating corruption.
10. Governance issues in private sector banks originate from an altogether different set of concerns. There are issues which arise from ownership constraints stipulated by RBI, which could misalign the interests of shareholders with those of the management. In several other jurisdictions, these constraints are less rigid. Rigidity keeps out certain kinds of investors and thereby reduces the pool of capital that banks could otherwise attract. When individual shareholdings are small, investors also tend to be more disengaged. Allowing larger block shareholders generally enhances governance.
11. In order to permit certain kinds of investors to take larger stakes, it is proposed that a category of Authorised Bank Investors (ABIs) be created, comprising all diversified funds which are discretionally managed by fund managers and which are deemed fit and proper. It is proposed that an ABI be permitted a 20 per cent equity stake without regulatory approval, or 15 per cent if it also has a seat on the bank board. All other financial investors should be permitted upto 10 per cent.
12. The shareholding permitted to promoters of banks is also tightly structured at present. Under the 2013 RBI guidelines, while such investors could begin with large stakes in banks, after some years they would need to reduce their stake and eventually can own no more than 15 per cent. The Report proposes increasing the continual stake ceiling to 25 per cent. It also proposes that for distressed banks, private equity funds - including sovereign wealth funds - be permitted to take a controlling stake of upto 40 per cent.
13. The Report also proposes that the principle of proportionate voting rights should constitute part of the regulatory bedrock that fosters good governance.
14. It is also necessary for boards to be vigilant about the quality of the loan asset portfolios as these sensitively affect the integrity of financial reporting. In private sector banks senior management is incentivised on the basis of bank profitability, and the compensation paid out - through stock options - is in substantial measure contingent on the stock price of the bank. There is a potential incentive to evergreen assets in order that provisions do not make a dent in profitability.
15. With RBI also having moved away from detailed to risk-based supervision, the annual financial inspections investigate the asset quality reporting accuracy of banks less rigorously. It appears desirable therefore that RBI conducts random and detailed checks on asset quality in these banks.
16. Wherever significant evergreening in a bank is detected by RBI, it is recommended that penalties be levied through cancellations of unvested stock options and claw-back of monetary bonuses on officers concerned and on all whole-time directors, and that the Chairman of the audit committee be asked to step down from the board.
17. Boards should also define for third-party products what constitutes proper selling practices. Products need to be matched with customer demographics, customer income and wealth, and customer risk-appetite.
18. Profit-based commissions for non-executive directors should be permitted in, but not before, Phase 3 of the transition process described in Observation 6 above.
19. Old private sector banks typically began as community banks, although some have attempted to outgrow their historical origins and imitate the new private sector banks, bringing in diversified boards and broadbasing senior management. However, many other banks have management styles where the community hold remains intact, either tacit or explicit. The designation of a 'promoter director' then develops, who controls shareholder voting, the board and the employees. The CEO thereby becomes disempowered. RBI should attempt to diversify boards in banks where independence is not visible, by mandating prior RBI approval for directors in such banks. RBI should also mandate a separation between board oversight and executive autonomy.
20. The Report also proposes details of legislation needed in order to implement its Recommendations.
To view the full report click here
Overview of the Report and List of Recommendations
1. The financial position of public sector banks is fragile, partly masked by regulatory forbearance. Forbearance delays, but does not extinguish, the recognition of this fragility. Capital is significantly eroded with the proportion of stressed assets rising rapidly. The Report projects, under different scenarios, the capital requirements till March 2018 in order that provisions are prudent, there is adequate balance sheet growth to support the needs of the economy, and capital is in line with the more demanding requirements of Basel 3.
2. It is unclear that the boards of most of these banks have the required sense of purpose, in terms of their focus on business strategy and risk management, in being able to provide oversight to steer the banks through their present difficult position. The boards are disempowered, and the selection process for directors is increasingly compromised. Board governance is consequently weak.
3. The onus of remedying this situation through radical reform lies primarily with the Central Government. In the absence of such reform, or if reform is piecemeal and non-substantive, it is unlikely that there will be material improvement in the governance of these banks. This could impede the Government's objective of fiscal consolidation. The fiscal cost of inadequate reform will therefore be steep.
4. The high leverage that banks operate under makes banking a riskier commercial activity than most non-financial businesses. Unless banks are extremely well run and with a strong focus on financial returns, they tend to falter. The Central Government is a good example of a bank shareholder which has suffered deeply negative returns over decades. It is therefore in the Government's own interest to provide clarity in the objectives set for bank boards, and to thereby improve governance and management.
5. The Report proposes that the Government distances itself from several bank governance functions which it presently discharges. For this purpose it recommends that the Bank Nationalisation Acts of 1970 and 1980, together with the SBI Act and the SBI (Subsidiary Banks) Act, be repealed, all banks be incorporated under the Companies Act, and a Bank Investment Company (BIC) be constituted to which the Government transfers its holdings in banks. The Government's powers in relation to the governance of banks should also be transferred to BIC.
6. The process of board appointments, including appointments of whole-time directors, needs to be professionalised and a three-phase process is envisaged. In the first phase, until BIC becomes operational, a Bank Boards Bureau (BBB) comprising former senior bankers should advise on all board appointments, including those of Chairmen and Executive Directors. In the second phase this function would be undertaken by BIC, which would also actively strive to professionalise bank boards. In the third phase BIC would move several of its powers to the bank boards. The duration of this three-phase transition is expected to be between two and three years.
7. Governance difficulties in public sector banks arise from several externally imposed constraints. These include dual regulation, by the Finance Ministry in addition to RBI; board constitution, wherein it is difficult to categorise any director as independent; significant and widening compensation differences with private sector banks, leading to the erosion of specialist skills; external vigilance enforcement though the CVC and CBI; and limited applicability of the RTI Act. A more level playing field with private sector banks is desirable.
8. If the Government stake in these banks were to reduce to less than 50 per cent, together with certain other executive measures taken, all these external constraints would disappear. This would be a beneficial trade-off for the Government because it would continue to be the dominant shareholder and, without its control in banks diminishing, it would create the conditions for its banks to compete more successfully. It is a fundamental irony that presently the Government disadvantages the very banks it has invested in.
9. The Report proposes the need for wide-ranging human resource policy changes. These would encompass getting younger people into top management, for which a demographic opportunity has now arisen, and which would thereby lead to longer tenures; and succession planning. There is also a need to envision afresh the process of countering corruption through a redesign of the existing process of vigilance enforcement. The Report argues that present modalities are damaging and erode the ability of the banks to compete strategically, besides being only weakly effective in combating corruption.
10. Governance issues in private sector banks originate from an altogether different set of concerns. There are issues which arise from ownership constraints stipulated by RBI, which could misalign the interests of shareholders with those of the management. In several other jurisdictions, these constraints are less rigid. Rigidity keeps out certain kinds of investors and thereby reduces the pool of capital that banks could otherwise attract. When individual shareholdings are small, investors also tend to be more disengaged. Allowing larger block shareholders generally enhances governance.
11. In order to permit certain kinds of investors to take larger stakes, it is proposed that a category of Authorised Bank Investors (ABIs) be created, comprising all diversified funds which are discretionally managed by fund managers and which are deemed fit and proper. It is proposed that an ABI be permitted a 20 per cent equity stake without regulatory approval, or 15 per cent if it also has a seat on the bank board. All other financial investors should be permitted upto 10 per cent.
RBI appointed panel, headed by Mr. P J Nayak, has recommended radical reforms for Indian banks. Read this report at http://t.co/ERzewJjTh5
— Canara Bank (@canarabanktweet) May 14, 2014
12. The shareholding permitted to promoters of banks is also tightly structured at present. Under the 2013 RBI guidelines, while such investors could begin with large stakes in banks, after some years they would need to reduce their stake and eventually can own no more than 15 per cent. The Report proposes increasing the continual stake ceiling to 25 per cent. It also proposes that for distressed banks, private equity funds - including sovereign wealth funds - be permitted to take a controlling stake of upto 40 per cent.
13. The Report also proposes that the principle of proportionate voting rights should constitute part of the regulatory bedrock that fosters good governance.
14. It is also necessary for boards to be vigilant about the quality of the loan asset portfolios as these sensitively affect the integrity of financial reporting. In private sector banks senior management is incentivised on the basis of bank profitability, and the compensation paid out - through stock options - is in substantial measure contingent on the stock price of the bank. There is a potential incentive to evergreen assets in order that provisions do not make a dent in profitability.
15. With RBI also having moved away from detailed to risk-based supervision, the annual financial inspections investigate the asset quality reporting accuracy of banks less rigorously. It appears desirable therefore that RBI conducts random and detailed checks on asset quality in these banks.
16. Wherever significant evergreening in a bank is detected by RBI, it is recommended that penalties be levied through cancellations of unvested stock options and claw-back of monetary bonuses on officers concerned and on all whole-time directors, and that the Chairman of the audit committee be asked to step down from the board.
17. Boards should also define for third-party products what constitutes proper selling practices. Products need to be matched with customer demographics, customer income and wealth, and customer risk-appetite.
18. Profit-based commissions for non-executive directors should be permitted in, but not before, Phase 3 of the transition process described in Observation 6 above.
19. Old private sector banks typically began as community banks, although some have attempted to outgrow their historical origins and imitate the new private sector banks, bringing in diversified boards and broadbasing senior management. However, many other banks have management styles where the community hold remains intact, either tacit or explicit. The designation of a 'promoter director' then develops, who controls shareholder voting, the board and the employees. The CEO thereby becomes disempowered. RBI should attempt to diversify boards in banks where independence is not visible, by mandating prior RBI approval for directors in such banks. RBI should also mandate a separation between board oversight and executive autonomy.
20. The Report also proposes details of legislation needed in order to implement its Recommendations.
To view the full report click here
