Where Angels Prey

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

Sunday, November 28, 2010

Improving The Governance of Compensation in MFIs: Four Practical Strategies Based On The Indian Experience…

Ramesh S Arunachalam
Rural Finance Practitioner

There has been so much of controversy regarding the governance of compensation in MFIs, especially during the last few months. I had posted my observations - a few days ago - with regard to remuneration issues at various MFIs in India. In this post, I try and look at how the governance of compensation at MFIs can (perhaps) be improved in practice…This is something that we stakeholders (bankers, investors, technical support personnel, raters and others including MFI associations and regulators perhaps) - in the Indian micro-finance industry - could look towards achieving…in our own little ways…as part of our work with MFIs. Here are some practical things that we could try and implement on the ground…to ensure that the process in governance of compensation at MFIs becomes transparent and is perceived to be fair…

1.   Boards Must Play Proactive Role in Governance of Compensation at MFIs and Compensation System Must Not Be In Grip Of The CEO/Senior Management: First, boards of MFIs can and must play a proactive role in establishing proper governance of remuneration and that is where the buck actually stops…It naturally follows that the board must also ensure that this compensation system is not primarily controlled by the chief executive officer and/or other members of the senior management team (chief operating officer, chief finance officer etc).

In fact, the above has been a major problem with some of the MFIs in India – here, the compensation system, which was firmly in the grip of the CEO and/or senior management team, witnessed non-transparent actions, related party transactions and whimsical payouts to CEO/Senior Management, without sufficient rationale or justification. In fact, I see these happenings as a major catalyst for the present micro-finance crisis in Andhra Pradesh and India as, at the concerned MFIs, many of the (compensation) decisions were laden with significant conflict of interest…and they are really questionable from a legal as well ethical standpoint…

Key Questions (Not exhaustive) For Various Stakeholders: Therefore, it is in our interest, as an industry stakeholder to ask relevant questions as part of our day-to-day work in the micro-finance industry and some of the key questions are given below:

  1. Are the board of directors effectively taking overall responsibility for the MFI compensation system, including by participating directly in the design and operation of this system?
  2. Has the board ensured that the CEO and/or senior management team at the MFI are NOT in control of the compensation system?
  3. Is the compensation policy aligned with the risk management framework of the MFI?
  4. Have the board of directors at the MFI approved and periodically reviewed the compensation policy?
  5. Has the board ensured that the compensation policy at the MFI does NOT provide incentives for excessive risk-taking?

2.   MFIs Boards Must Have Members with Requisite Compensation Experience and Real Independence So That They Can Effectively Participate in Governance of Compensation: This takes us to second aspect – i.e., therefore, it becomes crucial for the MFI to have board members with relevant expertise in compensation and perhaps risk management. More importantly, these members must have complete independence in dealing with the (design and operation) MFI’s compensation system. In a way, this is the fulcrum of having a fair compensation system at the MFI and the board members not only need to have the requisite experience but also must be able to use it in an independent and objective manner. This in turn implies that the boards of the MFIs should not be filled with friends, relatives and nodders as Mr Damodaran, the former SEBI chairman has argued. Again, in the present crisis, in few cases, nominee directors and other independent directors seem to have been silenced and their independence appear to have been compromised (on several occasions) with regard to matters of compensation and remuneration. This again, has left a very bad taste with the general public about the micro-finance industry in India.

Key Questions (Not exhaustive) For Various Stakeholders: The relevant key questions are given below:

  1. Is the board composed of independent, non-executive members, without any conflict of interest?
  2. Does the board have sufficient expertise (in terms of members) to assess risk management issues related to compensation?
  3. Does the board have (members with) the skills and experience to reach an independent judgment on the compensation policy?
  4. Are the relatives of the CEO and/or senior management on the board of the MFI? Are there close former associates and/or friends of the CEO/Senior Management, who are on the board of the MFI?
  5. Can the appointment of the above members to the board of the MFI be justified in terms of their professional expertise? Or are these relatives/former associates/friends there on the board primarily because of their (personal) relationship to the CEO/senior management?

3.   Independent Board Remuneration Committee Must Be Established At MFIs to Oversee Design and Operation of Compensation System: While the above two points define the role and responsibility of the board of directors, a key question that arises here is how can the MFI board best accomplish this? Neither can all members of the board spend their entire time on this nor can individual members of the board work on this in an adhoc manner.

In other words, there is a critical “how to” with regard to the discharging of the above roles and responsibilities by the MFI board – i.e., the establishment of an appropriate independent remuneration committee[i] and the defining of its mandate to function. And it is through this committee, that the MFI’s board of directors, can design, monitor and review[ii] the compensation system to ensure the system operates as intended.

Therefore, as noted above, it is critical that MFIs have a board remuneration committee as an integral part of their governance structure and organisation to oversee the compensation system’s design and operation on behalf of the board of directors. The following are important issues here:

·    The remuneration committee should be constituted in a way that enables it to exercise competent and independent judgment[iii] on compensation policies/practices and the incentives created (at the MFI) for managing risk, capital, liquidity and customer satisfaction.
·    In addition, the committee should carefully evaluate practices by which compensation is paid for potential future revenues whose timing and likelihood remain uncertain. This is a very critical lesson from the recent global financial crisis as also the current micro-finance crisis in Andhra Pradesh.
·    And while doing so, the committee should demonstrate that its decisions are consistent with an assessment of the MFI’s true financial condition and future prospects.
·    Further, to that end, the remuneration committee must work closely with the MFI’s risk committee in the evaluation of the incentives created by the compensation system, and 
·    It should also ensure that the MFI’s compensation policy is in compliance with Global Good Practices and Standards as well as respective rules of the national regulatory authorities

Key Questions (Not exhaustive) For Various Stakeholders: The relevant key questions are given below:

a.   Are there controls in place to regularly oversee the compliance of the compensation system? What are these and how sufficient are these controls? Is one of key controls, the independent board remuneration committee?
b.   In order that the MFI board remuneration committee is able to operate independently from the senior executives, is it composed, at a minimum, of a majority of independent, non-executive (board) members, without any conflict of interest[iv]?
c.   Does the MFI’s board remuneration committee have (members with) the skills and experience to reach an independent judgment on the compensation policy?
d.   Do the charter/ terms of reference of the board remuneration committee suggest that it has sufficient powers (mandate) to perform its functions independently?
e.   Is the board remuneration committee at the MFI responsible for the preparation of recommendations to the board regarding compensation, including those which have implications for the risk and risk management?
f.    Has the board remuneration committee at the MFI made recommendations to the board on the compensation to be paid to the highest paid employees, based on a pre-determined materiality threshold?
g.   Does the board remuneration committee at the MFI have access to advice, either internal or external, that is independent of advice provided to senior management? What has been the process used for commissioning external advisers to advise the board on compensation policy? Do these advisers report directly to the board remuneration committee? 
h.   Does the board remuneration committee at the MFI have unfettered access to information and analyses from risk and control function personnel (e.g., risk management, finance, compliance, internal audit and human resources etc)?
i.    Does the board remuneration committee at the MFI engage appropriate control function personnel in its deliberations on compensation policy? Do control functions at the MFI have input in the structure and determination of compensation?

4.   MFI Board Remuneration Committees Must Ensure An Annual External Compensation Review: Last but not least, the remuneration committee should facilitate an annual compensation review at the MFI and get it externally done. This review should be independent of any CEO/senior management interference and it should be submitted to the remuneration committee, board of directors and regulator. It should also be disclosed publicly. And it goes without saying that such a review should, among other things, assess (legal) compliances with the applicable rules and standards promulgated by the relevant regulatory authority.

Key Questions (Not exhaustive) For Various Stakeholders: The relevant key questions are given below:

  1. Is there an external annual compensation review at the MFI?
  2. What is the process developed for conducting the annual compensation review? Is it an objective and fair process without conflicts of interest?
  3. Does the annual compensation review assess the compensation policy’s compliance with the global principles/standards in the micro-finance industry, as well as standards (if any) promulgated by national supervisors?
  4. Does this include ensuring that all material compensation plans/programs (including those for executives and employees whose actions have a material impact on the risk exposure of the MFI) are covered?
  5. Does this include assessing the appropriateness of the plans/programs relative to organisational goals, objectives and risk profile of the MFI?

Without question, irrational and adhoc compensation practices (at some MFIs) appear to be a major factor that seem to have contributed (in some measure) to the present micro-finance crisis in Andhra Pradesh and India. Therefore, it is imperative that the micro-finance industry undertakes immediate and suitable action to address (such) unsound compensation systems, prevalent at many MFIs. And this action …must be speedy, determined, coherent and transparent… for the micro-finance industry in India to gain back its credibility and past glory. I also hope that the RBI sub-committee focuses on this aspect as part of its Micro-finance regulatory exercise…

[i] Some times the board may have people with requisite skills and experience and also independence. They however need to be appointed to the MFI compensation committee and there are cases, where this has not happened as the CEO/senior management have desired otherwise.
[ii] Two issues are relevant here and one is the fact that the compensation system will need to have controls to ensure compliance and in some ways, the committee itself is the main control available. Thus, the committee will have to also review the practical operation of the compensation system regularly for compliance with design policies and procedures. Compensation outcomes, risk measurements, and risk outcomes should also be regularly reviewed for consistency with intentions. That is very critical
[iii] Same as i above
[iv] Same as i above

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