Banking bonuses can't be left to market

Both Martin Wolf of the FT and the Economist have joined the chorus for containing bank bonuses in today's conditions. Wolf wants a 'windfall tax'. The Economist asks that a 'funding premium' be recovered from banks before bonsuses are calculated- this would compensate the tax payer for government support to banks.

I think the problem goes beyond the present crisis. We need to view executive pay in banks as a potential source of systemic risk. I cannot see the market responding suitably to this problem. We will soon require regulators to approve top management pay in banks. This is not as novel as it sounds- the RBI has been doing it for long. The challenge for regulators is to put in place norms for executive pay at banks and apply these to the entire sector. We need regulators in different countries to agree on this as otherwise we are bound to see 'regulatory arbitrage'.

More on this in my ET column, Reining in rogue bonuses

Corporate architecture

One of the things about post-reform India is that companies have spruced up their looks and environs. Go to the Bandra-Kurla complex in Mumbai and you get at least a faint whiff of Manhattan, with ICICI's headquarters standing out. Among campuses, Infosys must be one of the stars, each one meticulously designed and spectacularly well-maintained. But those who are more sensitive to architectural style than I am have a different view, and this is the subject of an Outlook feature, which is interesting read.

The main point is that many of our organisations seem to want grandeur in their buildings but are not very concerned about whether it is rooted in Indian sensibilities or the Indian environment. For instance, there is a readiness to go in for glass buildings regardless of whether these energy efficient or even aesthetically pleasing. ( In passing, Outlook must be among the very few in the media willing to take pot-shots at Infosys):

This September, two supposed marvels of institutional architecture were unveiled before the public. The first, in honour of the fast-approaching Commonwealth Games, was a Lutyens-style makeover—large white pillars and incongruous purple-black glass—for the Ajmeri Gate side of New Delhi railway station. The second was the spanking-new addition to the Infosys Mysore campus: the classical Greek architecture-inspired Global Education Centre-2 (GEC-2). Inaugurated by a radiant, admiring Sonia Gandhi who said she wouldn’t mind “bunking party politics” to study there, it was hyperbolically proclaimed by Infosys chief mentor Narayana Murthy to be “the largest monolith classical building of post-independent India”.

The GEC-2 might win the awe of its young executive trainees, and the New Delhi railway station the glancing attention (or dismay) of those hurrying through it, but these two buildings nevertheless throw up a few questions about the practice of institutional architecture in India. Is imitating the architecture of the past—including colonial styles intended to intimidate and subjugate us—really the way to engage a contemporary public? Why does institutional architecture in India invariably entail ransacking the past and reducing it to a bunch of carefully traced out columns and pediments? Is it possible to adapt historic references to modern uses in a responsible, low-impact manner?

Here is what one of the critics has to say about Infosys' latest wonder:

The GEC-2, to Burte, is a missed opportunity for Infosys to provide a counterpoint to the wasteful, power-guzzling, glass-faced cut-rate copies of Singaporean skyscrapers that have now become synonymous with IT sector buildings. “This overblown rhetoric is a letdown considering what we know to be Infosys’s progressive work culture, and their emphasis on a knowledge economy,” says Burte. “A low-impact, climate-sensitive, energy-efficient, sensible building; a vision of sustainable corporate living and working, would be commensurate with the image we have of them.”

Another critic concludes that our latest buildings are a comment on national character:

“Right now, we see ourselves as second-rate; our approach is just to play catch-up to other cultures—the Chinese, the Europeans, or Lutyens. It’s about time we followed our own instincts.”

Rating agencies and Indian debt

India has always received a raw deal from rating agencies. This carries a cost to the country. India's present sovereign rating of BBB implies that Indian companies will rate lower and hence pay highs spreads over the risk free rates. Taking into account outstanding ECBs and NRI deposits and assuming that they cost 2 percentage points more than they should, Jaimini Bhagwati estimates that the additional forex outflow to India on this account is $2 bn annually.

Of the rating of BBB for India, Bhagwati writes:

Is it really credible that as of November 2009, the Government of India (GoI) has a higher probability of defaulting, over a five-year horizon, on its external debt obligations as compared to Enron four days before it went bankrupt or Lehman in the second week of September 2008? Currently, the GoI’s BBB– rating is the same as that of Iceland and the UK is rated triple A while China is placed at A+. Are countries rated higher if they impose fewer controls on their capital accounts? Clearly, the answer is that CRAs do not have the answers. One way forward could be for India to push for discussions about perceived anomalies in sovereign ratings in FSB and BCBS forums. Since rating agencies serve a quasi-regulatory function, we could seek the setting up of a multilateral CRA.

More flak for Goldman

Goldman Sachs is set to pay out record bonuses. Its employees should be thrilled and not thrilled. The latter because the bonus payment is likely to comes as a climac to a period that has turned out to be a PR disaster for the once-admired financial giant.

Goldman's soaring profits are today perceived as unfair- the result of implicit taxpayer guarantees and the demise of competitors such as Lehman and Bear Stearns. They are somehow not seen as legitimate reward for success. In the US, a rash of agitations has broken out against the firm. Goldman CEO, Lloyd Blankfein, did not help matters by claiming that he and his firm were doing 'God's work. This remark added various sections of the clergy to the firm's critics.

Blankfein said his remark was meant to be a joke. This points not just to a poor sense of humour but to poor judgement- the public is in no mood today to listen to jokes from Goldman top brass. Blankfein also apologised for the firm's role in the present crisis and the firm promised a commitment of $500 mn towards financing small businesses. But these moves have done little to assuage popular anger.

FT has an article that analyses the principal reasons for the firm's success for so many years now:

Goldman’s stellar performance has been built on two main strengths: a long-standing commitment to making money as a firm rather than a collection of individuals; and a daring boldness in trading and regulatory matters.

....The theory is simple: unlike other banks, where star traders routinely overrule lowly compliance officers, at Goldman the two roles have equal status. “The risk management side is just as powerful as the risk-taking side,” says a former executive. “If a trading desk makes $35m in a week, the attitude at other firms is to let these guys do whatever they want. At Goldman it is: ‘What am I missing?’ ”.

......By cultivating trading and advisory relationships with thousands of companies and investors, Goldman gains knowledge it uses to inform its own trading.

Banks are banned from “front-running” – using specific information provided by clients to trade on their own account before they act on behalf of customers. But they can, and do, use aggregate information, “market colour” gleaned from their interactions with investors, hedge funds and companies. By virtue of being the world’s largest and best-connected trader, Goldman has turned this into an art that has raised rivals’ eyebrows but not sparked regulators’ attention.

So, what does it add up to? Good people and risk management, of course, but also superior information and networking. In the present environment, add implicit government backing and weaker competition. The short point: profits at Goldmanare not driven exclusively by superior skills. Hence the widespread public hostility.

Goldman may look invincible for now. But a basic truth can't be wished away: business cannot succeed in the face of hostility. Just one false step somewhere and the regulators, politicians, media and the social sector will come down on Goldman like a ton of bricks. The biggest challenge for the firm is softening popular anger. It's doubtful that a deep-rooted culture can change sufficiently for the purpose.

HRD panel for PSBs

This is the best news PSBs have, perhaps, had in a long time. The government has constituted a panel headed by BoB ex-CMD A K Khandelwal to look into various HRD issues at PSBs. It is a timely move because PSB unions are planning a march to parliament next month and a strike in support of various demands, including strengthening PSBs.

Apart from a status report, the committee’s mandate include preparing an action plan on how to professionalise 27 public sector banks. Besides, the government wants to work out a system of succession plan at these banks, which often have to do without a chairman for months altogether.

In addition, the committee has been asked to recommend how the banks should go about preparing their recruitment plans and whether it was desirable to follow common hiring and HR practices across all these banks, accounting for nearly 75 per cent of the business carried out in India.

I am pleased because I have made the argument for constituting an HRD panel for PSBs more than once in my ET column and I have been shouting that HRD should be the no 1 priority for PSBs, not consolidation or overseas branches or getting into new areas such as insurance. My argument is simple: until you have strengthened HRD at PSBs, don't even think of other things. What has galvanised the government into action is the prospect of nearly three fourths of senior management at PSBs retiring by 2012. I only hope this is not a case of too little, too late.

I hope the committee doesn't get sidetracked into issues like performance-linked pay. I am extremely sceptical - as many academics are- about the merits of variable pay even in the private sector. In the public sector, it could be a disaster. Those at the helm need to realise one thing: you don't compete through imitation.

Fresh bout of disinvestment

Hopefully, we should soon see a fresh bout of disinvestment, with several unlisted PSUs being brought to the market. That's very good news. Not because it will help contain the fiscal deficit, as some commentators have rushed to point out. The fiscal impact of disinvestment tends to be exaggerated. Its real value lies in its potential to bring about greater commercial discipline through listing on the stock exchange.

Disinvestment helps improve performance when combined with competition and better board room governance. Liberalisation has taken care of competition. More needs to be done on board-room governance in PSUs. Unlike in the private sector, there is scope for doing a great deal more, as I argue in my ET column, Disinvest for better governance.

Tackling asset bubbles

There is a sense that we have to do something about asset bubbles in order to prevent major financial disruption although it's not clear what is to be done and at what point. Frederic Mishkin, writing in the FT, draws a distinction between "credit bubbles", which are driven by excess bank lending, and "irrational exuberance", such as the boom in IT stocks in 2001. The former are a problem, he says, because they endanger banks. The latter are ok, some investors get burnt, that's all.

Right now, Mishkin argues, the US does not face a credit bubble although various asset prices may have shot up. Credit is, in fact, in short supply, so monetary tightening would be premature.

I am not entirely persuaded about this distinction. Take a stock market bubble. It could be driven, not by excess domestic credit growth, but by a surge in foreign inflows. Does this need to be tackled or not? A sudden withdrawal of foreign funds could cause the stock market to collapse and it may derail investment plans of companies to which banks are exposed. Domestic bank credit has not driven the stock bubble, yet banks could be imperilled.

Of course, the central danger to guard against is bank exposure to risk assets- real estate, stocks and commodities. But, it's not necessary that banks are at risk only from bubbles caused by excess credit. There could be an indirect impact on banks from the collapse of bubbles for which banks are not primarily responsible. Corporates' overseas borrowings, which find their way into the domestic market, for example.

Some bubbles may be more dangerous than others, as Mishkin points out, but all bubbles may need watching.

Rich pickings for independent directors

Naresh Chandra, former cabinet secretary, made a cool Rs 2 crore from his independent directorships last year, according to an ET story. This included Rs 75 lakh from Vedanta. Omkar Goswami, the economist, raked in Rs 1.3 crore. Deepak Satwalekar, formerly of the HDFC group, and Rama Bijapurkar, marketing consultant, are among the big earners.

Not to grudge anybody their earnings but has there been any attempt to evaluate board performance and contributions of board members? And what is an optimal level of payment for board members? When payments are too low, you can't get good people. Whey they are too high, you can't expect independence.

I don't have the answers. But I am surprised these questions aren't being pursued. I guess it suits all concerned not to be asking these questions.

Indian corporate sector's lip service toeducation

India's corporate sector bemoans the lack of investment in education and the resulting skill shortages. It talks of education a a great opportunity. Businessmen have been quick to latch on to money-making opportunities in professional courses- engineering, medicine, management. But their commitment to producing first-rate educational institutions has been zilch, as Devesh Kapur points out in TOI.

The commitment of Indian business to philanthropy in higher education was strong prior to independence and has dwindled ever since. Pre-independence, business interests not only made the transition from merchant charity to organised professional philanthropy, but did so in a significant way. They created some of India's most enduring trusts, foundations and public institutions, including the Aligarh Muslim University, Banaras Hindu University, Jamia Millia, Annamalai and Indian Institute of Science. Of the 16 largest "non-religious" trusts set up during this period, 14 were major patrons of higher education.

Today, the so-called not-for-profit educational institutions do not engage in philanthropy. Their income comes from fees rather than endowments and investments. Thus even while the number of "trusts" set up for philanthropy in higher education has been steadily rising, the total share of "endowments and other sources" in higher education funding has been consistently falling - from 17 per cent in 1950 to less than 2 per cent today. Some of this decline is to be expected, as the government has expanded its role in higher education, yet the extent is remarkable.

So, what is the implication for policy? If we accept that quality in education exists only in the non-profit model and Indian business is not interested in this model, how do we produce quality education? The answer, it would seem, is a combination of higher investment by government and foreign universities. I have my doubts about foreign universities coming in entirely on their own: their cost structure would make it difficult for them to provide mass education. Perhaps, central universities and the proposed national universities forging partnerships with foreign universities may be a solution.

Greater government investment would also require putting in place proper governance mechanisms. This does not mean leaving matters to academics or 'autonomy' as interpreted by some IIT and IIM faculty, which means boards run by professionals, with government keeping a distance. This hasn't worked and it won't work, as I have argued ad nauseam in my posts. The proposed collegium for IIMs and the pan-IIT council are the sort of mechanisms we need but much work needs to be done to make these effective.

Cash transfer versus NREGS

NREGS, the national employment scheme, drew a lot of flak when it was first introduced. It has since received some grudging credit and its critics have at least recognised the value of the fiscal stimulus it has provided.

The standard argument against NREGS, which is also the argument against subsidies, is that it is better to make transfers to a carefully targeted segment, namely, the BPL category. If you spend Rs 100 on the NREGS, Rs 20 will be siphoned off, Rs 30 will be spent on administration, Rs 20 on materials, which will be wasted because of poor quality of works, and only Rs 30 will reach the poor as wages. Far better to transfer Rs 30 to designated accounts.

Tushaar Shah addresses this argument in an article in TOI.

The NREGS launch in 2006 had created a widespread impression in many parts of rural India that it would eventually end up as a cash transfer programme. Many people believed the job card-holder household would be entitled to an annual cash transfer of Rs 10,000. This is why numerous well-off households and local bigwigs, including village sarpanchs, acquired them.

NREGS design - guaranteeing 100 days' unskilled manual work toany household, rich or poor, willing to do such work - minimises type II error. Even if the rich acquire job cards, they can benefit from NREGS only if they are ready to do unskilled manual work, which they are generally not. NREGS self-targets the needy. The BPL card, ration card and NREGS job card under cash-transfer denote entitlement, not what their holders do. That NREGS reduces type II error is evident in the fact the number of households registering for work that is much smaller than that of job card-holders. Again many NREGS projects remain unfinished and funds are returned because those who registered for work do not show up. This would hardly be the case if all job card-holders were automatically entitled to Rs 10,000 deposited in their accounts.

There you have it: cash transfers would amount to looting by the powerful in the countryside. Those who advocate it have no clue as to how things work in the countryside. Shah concedes that poor quality of works is an issue. But this needs to be addressed through better governance. Indeed, that is an argument I would make for NREGS, that by mobilising NGOs and other agents at the grassroots level, it becomes a powerful tool for improving governance.

One aspect of NREGS is that the access to information on the scheme is superior to what would be provided under the RTI Act. To make NREGS-based works worthwhile, we have to bring about greater accountability at the grassroots. It is a challenge, of course, but the effort is worth it, quite apart from the purchasing power it confers on the poor.

Novel suggestion on bank bonuses

Even that paragon of the free market, the Economist, has joined the chorus against bank bonuses. I suppose you could call that progress in thinking after the sub-prime crisis.

Banks argue that they have repaid government capital, they need to retail talent, that management pay is for shareholders to approve and that the government, the media and the public should stay out of it.

The Economist makes the point that the top ten investment banks at the start of 2008 made an average return on equity of just 8% between 1999 and 2008. Four made cumulative losses. Staff got four times as much as shareholders did in profits. So, bonuses are at the expense of shareholders.

Moreover, banks are handing out large bonuses to employees while arguing that higher capital requirements would be too onerous for them! In a free market, you could still argue that these are matters between management and shareholders and that the government and the public should stay out of it. But this is not a free market situation: the banks have been bailed out by tax payers and- more, importantly- still enjoy subsidies:

It is not just that they were saved from destruction. They got public capital (much of it now repaid), short-selling bans on their shares and rescues of counterparties, such as American International Group, which the public otherwise had no interest in saving. Today they enjoy laxer accounting, loose collateral rules at central banks, explicit debt guarantees and asset-purchasing schemes. And, critically, they can borrow cheaply because they are deemed too big to fail. All of them—from comparatively healthy Goldman to the nationalised weaklings—are being subsidised by the rest of us. As a way to keep cash flowing to the wider economy and help banks rebuild their capital, this subsidy made sense; nobody intended it to go to employees.

<>If we accept that outsized bonuses, courtesy of public subsidies, are just not on, how do we deal with them? The popular solution is to rein in bonuses. The Economist thinks this won't work and it will lead to micro-management by government. It proposes an alternative:

Assume that America’s top five investment banks would pay two percentage points more on unsecured borrowings without an implicit guarantee. On that basis the subsidy is $36 billion a year (compared with pay this year of perhaps $120 billion). Providing banks have built up adequate capital, they could face a funding “premium” in much the same way that they already pay premiums for deposit insurance......The premium would last at least until the state guarantees are withdrawn. The longer-term debate may yet move from wishy-washy living wills to breaking up banks (as the governor of the Bank of England suggested on October 20th—see article).