Where Angels Prey

Where Angels Prey is a novel by Ramesh S Arunachalam. Please refer to www.whereangelsprey.com for more information

Thursday, November 25, 2010

The Governance of Remuneration in Indian MFIs: Lessons from The Indian Experience

Ramesh S Arunachalam
Rural Finance Practitioner

As we move through the current crisis in Indian micro-finance, there are several important lessons for me and the first of these relate to Governance in Indian MFIs and I articulate the same in a series of posts, for readability and also segregating the key issues. The first post is on the governance of remuneration and here is some food for thought and I am sure this applies to other countries and their micro-finance contexts as well…

Some of the compensation practices that I have come across in Indian micro-finance include the following: Irrational and unusually high compensation of senior management, founder/other directors and much of this seems to be similar to that observed in financial services companies during the sub-prime and global financial crisis. Further, adhoc bonuses, pay raises (followed by sudden termination), the grant of shares when options have been sanctioned, the non-transparent pricing of options, provision of (huge) loans to enable founders and board members to buy their own company shares are some of the key compensation/remuneration issues in Indian micro-finance. Much of this practice is observable during the last 4/5 years, although the seeds were sown much earlier.

While the above provides a brief summary of the various existing practices, here are the lessons that I learnt from the Indian micro-finance experience:

Lack of Arms Length Decisions and Negotiations: The governance of remuneration and incentive systems seems to have (apparently) failed in some Indian MFIs because decisions and negotiations (carried out) have not been at arm’s length. Conflicts of interest at various levels have aided such improper decision-making and negotiation and much of this is applicable to remuneration and incentive systems for a range of senior management personnel and not just the CEO or Managing Director or Chairman of the Board. There are several examples from the Indian micro-finance context but I have decided to refrain from naming organisations and people because of the sensitivities involved…

Inordinate Level of Influence of Senior Management in Establishing Remuneration Schemes: In the several cases that I have personally seen, senior management generally appears to have far too much influence over the level and conditions (including measures) set for performance based remuneration. On the other hand, boards are often unable to or sometimes, even incapable of exercising objective, independent judgement. Here again, there are serious conflicts of interest, which certainly exacerbate this whole issue – in fact, this has been one of the most important reasons for inaction by the board against inappropriate remuneration proposals of senior management in MFIs

Medium and Long Terms Risks are Not Taken Into Account: In some cases that I have closely observed, the relationship between performance and remuneration is rather tenuous and sometimes, even difficult to establish, especially, given the nature of micro-finance operations. A very critical aspect here is that medium as well as long term risks and possibility of adversarial political action are rarely factored into the whole process – something that should have been done, given the nature of micro-finance and given what has happened in Andhra Pradesh recently

Complicated and Opaque Remuneration Schemes: Some of the MFI remuneration schemes are fairly complicated and also opaque in terms of shrouding actual conditions in the operation of scheme and the consequences. What I am saying is that these (operational conditions and terms) are perhaps not clear and obvious to the naked eye of an unassuming observer. These conditions also tend to encourage excessive and mindless (growth and) risk taking…

Mere Disclosure is Not Transparency: While transparency (in some cases) may exist in terms of disclosure, several MFIs couch the main characteristics of their performance related remuneration programs in verbose technical language and thereby make it very difficult for comprehension to the normal reader. Very rarely do we get information on the following: a) The total cost of the remuneration program to the MFI; b) The specific performance criteria and measures along with their conceptual and operational definitions; and c) The manner in which remuneration has been adjusted for relevant risks – especially, medium and long term risks as well as risk of political action (which is so relevant today). Without question, MFIs will surely need to have remuneration and incentive systems that focus and encourage at least on the medium term, if not long-term performance. This, in turn, means that MFIs must choose to reward their senior management after some actual performance has been realised and that has not usually been the case – a good example is a recent high front loaded one-time bonus paid to a senior management executive of a large MFI

Overall, remuneration does not seem to have been established through an explicit governance process where the roles and responsibilities of all stakeholders involved, including committee members, consultants, risk managers and others, are clearly defined and separated (without conflict of interest). The roles given to non-executive independent board members in the process - although they may seem somewhat appropriate - again appears to be laden with serious conflicts of interest. And finally, while remuneration policies are sometimes submitted to the annual meeting and subject to shareholder approval, much of this seems to be a routine matter, with minimal (informed) discussion…because of aspects mentioned earlier…

Therefore, given the above, in my opinion, a key question that stakeholders always need to ask is whether the compensation approaches being pursued are indeed consistent with the institutions (MFIs) ethical values of creating value for clients and its objectives, strategy and control environment as well as that of the overall industry? This aspect on compensation is nicely summarized by Mr Jan Postmus in his paper {Cited from Arunachalam, Ramesh S (2010)} and reproduced in Box below:

“The second lesson from the financial crisis deals with the huge bonuses that fuelled the crisis. The Dutch book ‘de Prooi’ (‘the Pray’)[ii] concludes that the excessive remunerations in the banking and financial sector failed. Especially the investment bankers took too many risks in their hunt for excessive bonuses. One of the main and important conclusions of this book is that banks need to become reliable, sound and maybe a bit ‘dull’ again with the core focus on the client and share value becomes as stable as an ‘government bond with a little extra’. This lesson is utmost valid for the microfinance sector where the clients consist of mainly illiterate clients.[iii] The MFI needs to be responsible for its clients in the first place and not for its investors. Both the MFI and the investors in microfinance need to be fully aware of the fact that the client always stays central. High expectations from investors about returns on their equity investment by creating increased share value for personal gains (which is happening frequently nowadays) needs to banned from the microfinance sector. We need to make sure that greed and excessive self enrichment, which is the root cause of the financial crisis, does not get a hold on microfinance. We know by now that this will become the downfall of the microfinance sector. If banks now want to become reliable, stable and ‘dull’ again and return to conventional banking, why should microfinance want to continue to measure itself with the investment bankers in the capital markets? Microfinance is not about creating personal gains rooted in greed. An MFI needs to be focused on creating maximum value for its clients. That is the raison d’ ĂȘtre of an MFI.”

To summarise, “Compensation…is one factor among many that contributed to the financial crisis that began in 2007. Official action to address unsound compensation systems must therefore be embedded in the broader financial regulatory reform program, built around a substantially stronger and more resilient global capital and liquidity framework. Action …must be speedy, determined and coherent. Urgency is particularly important to prevent a return to the compensation practices that contributed to the crisis.”[iv] I hope that the RBI sub-committee focuses on this aspect as part of its Micro-finance regulatory exercise…

[i] Jan, Postmus (2010), “Micro-finance at Cross Roads”, Unpublished Working Paper
[ii] De Prooi (‘the Prey’), about the rise and fall of ABN AMRO, a fascinating book written by J.Smit, 2008, recently translated in English
[iii] Jan Postmus, Lessons for Microfinance (based on ‘the Prey’), 2009 at http://www.microfinance.nl/en-GB/Content.aspx?type=news&id=196
[iv] Quoted from BIS paper on Compensation and Corporate Governance, 2010

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