Committee to Review Governance in Banks in India (P.J. Nayak Committee)


Ajit Kumar AJIT KUMARWISDOM IAS, New Delhi.

The report of an RBI-appointed committee under the chairmanship of former Axis Bank head P.J. Nayak that reviewed issues of governance in banks was released on 12th May 2014 and made the following main recommendations.

- Given the lower productivity, steep erosion in asset quality and demonstrated uncompetitiveness of public sector banks over varying time periods (as evidenced by inferior financial parameters, accelerating stressed assets and declining market share), the recapitalisation of these banks will impose significant fiscal costs. If the governance of these banks continues as at present, this will impede fiscal consolidation, affect fiscal stability and eventually impinge on the Government's solvency. Consequently, the Government has two options: either to privatise these banks and allow their future solvency to be subject to market competition, including through mergers; or to design a radically new governance structure for these banks which would better ensure their ability to compete successfully, in order that repeated claims for capital support from the Government, unconnected with market returns, are avoided.

- There are several external constraints imposed upon public sector banks which are inapplicable to their private sector competitors. These constraints encompass dual regulation (by the Finance Ministry, and by the RBI, which goes substantially beyond the discharge of a principal shareholder function); the manner of appointment of directors to boards; the short average tenures of Chairmen and Executive Directors; compensation constraints; external vigilance enforcement; and applicability of the Right to Information Act. Each of these constraints disadvantages these banks in their ability to compete with their private sector competitors. The Government and RBI need to move to rapidly eliminate or significantly reduce these constraints, in the absence of which managements of public sector banks will continue to face an erosion of competitiveness. Further, it is only after these external constraints have been addressed would it be practicable for public sector banks to address a host of internal weaknesses which affect their competitiveness.

- There is a need to upgrade the quality of board deliberation in public sector banks to provide greater strategic focus. There are seven themes which appear critical to their medium-term strengths comprising Business Strategy, Financial Reports and their Integrity, Risk, Compliance, Customer Protection, Financial Inclusion and Human Resources. All other items for discussion should be brought to the Boards by exception and should typically be discussed in committees of boards. Among the seven themes identified for detailed board scrutiny, a predominant emphasis needs to be provided to Business Strategy and Risk.

- As the quality of board deliberation across firms is sensitive to the skills and independence of board members, it is imperative to upgrade these skills in boards of public sector banks by reconfiguring the entire appointments process for boards. Otherwise it is unlikely that these boards will be empowered and effective. Specific recommendations for this purpose are separately made in this report.

- The Calendar of Reviews needs either to be revoked, or else to be freshly designed so as to ensure that the time of the board is spent largely on the seven critical themes listed in Recommendation 3.1, with specific attention given to business strategy and risk management.

- The Government needs to move rapidly towards establishing fully empowered boards in public sector banks, solely entrusted with the governance and oversight of the management of the banks. The transition path for this is contained in separate Recommendations.

- The Government should set up a Bank Investment Company (BIC) to hold equity stakes in banks which are presently held by the Government. BIC should be incorporated under the Companies Act, necessitating the repeal of statutes under which these banks are constituted, and the transfer of powers from the Government to BIC through a suitable shareholder agreement and relevant memorandum and articles of association.

- While the Bank Investment Company (BIC) would be constituted as a core investment company under RBI registration and regulation, the character of its business would make it resemble a passive sovereign wealth fund for the Government's banks. The Government and BIC should sign a shareholder agreement which assures BIC of its autonomy and sets its objective in terms of financial returns from the banks it controls. It is also vital that the CEO of BIC is a professional banker or a private equity investment professional who has substantial experience of working in financial environments where investment return is the yardstick of performance, and who is appointed through a search process. While the non- executive Chairman and CEO of BIC would be nominated by the Government, it is highly desirable that all other directors be independent and bring in the requisite banking or investment skills.

- The CEO of the Bank Investment Company (BIC) would be tasked with putting together the BIC staff team. BIC employees would be incentivised based on the financial returns that the banks deliver. If such incentivisation requires the Government to hold less than 50 per cent of equity in BIC, the Government should consider doing so, as it will be the prime financial beneficiary of BIC's success.

- The Government should cease to issue any regulatory instructions applicable only to public sector banks, as dual regulation is discriminatory. RBI should be the sole regulator for banks, with regulations continuing to be uniformly applicable to all commercial banks.

- The Government should also cease to issue instructions to public sector banks in pursuit of development objectives. Any such instructions should, after consultation with RBI, be issued by that regulator and be applicable to all banks.

- The transfer of the Government holding in banks to the Bank Investment Company (BIC), and the transitioning of powers to bank boards with the intent of fully empowering them, needs to be implemented in phases. The following three-phase transition is recommended:

Phase 1: (a) Legislative amendments enacted to repeal the Acts through which public sector banks have been constituted as statutory bodies, the incorporation of these banks under the Companies Act, and the transfer of their ownership to BIC, with Government initially holding the entire equity in BIC.
(b) A professional board constituted for BIC.
(c) All existing ownership functions in relation to banks transferred from the Government to BIC.
(d) All non-ownership functions, whether of a regulatory or development nature, transferred from the Government to RBI.
(e) BIC commences the process of professionalising and empowering bank boards.
(f) Ownership functions taken over by BIC from the Government.

Phase 2: (g) The reconstitution of bank boards coordinated by BIC.
(h) Bank ownership functions continued to be executed by BIC.
Phase 3: (i) All ownership functions transferred by BIC to the bank boards. The appointments of independent bank directors and whole-time directors (including the CEO) become the responsibility of bank boards.
(j) BIC ensures that each bank splits the position of the bank's Chairman into a non-executive Chairman (nominated by BIC) and a CEO (nominated by the board).
(k) Strict compliance ensured with Clause 49 of SEBI's Listing Guidelines, which stipulates a minimum number of independent directors. The Chairman, CEO, other wholetime directors and BIC's nominee directors, would constitute the 'inside directors', those connected to the bank's principal shareholder (viz. the Government). All other board members would be 'outside directors', and therefore be characterised as independent.
(l) A lead independent director would be nominated for each bank board by the set of independent directors. BIC would define the role of such directors.
(m) BIC ceases to exercise ownership functions, and morphs instead into exercising investor functions.
(n) Consequently, BIC is tasked with the responsibility of protecting the Government's financial investment in the banks, by raising the financial returns to the Government.

- It would be desirable for the bank licensing regime to move to a uniform license across all broad-based banks, irrespective of ownership, subject to inter-jurisdictional reciprocity considerations in respect of foreign banks, and niche licenses for banks with more narrowly defined businesses.

- Other than the Government's own stake, which would be unconstrained, all other investment limits recommended in Chapter 6 for different categories of investors in private sector banks should also be applicable to investors in public sector banks.

- It is desirable for the Government to level the playing field for public sector banks in relation to their private sector competitors. Reducing the proposed Bank Investment Company's investment in a bank to less than 50 per cent will free the bank from external vigilance emanating from the Central Vigilance Commission, from the Right to Information Act, and from Government constraints on employee compensation.
The Government should consider reducing its holding in banks to less than 50 per cent, in order that there is a restoration of a level playing field for public sector banks in matters of vigilance enforcement, employee compensation and the applicability of the right to information. Vigilance enforcement and compensation policy will thereafter be the responsibility of bank boards.

- In the context of the three-phase process earlier proposed, it would be desirable to entrust the selection of the top management of public sector banks during Phase 1 to a newly constituted Bank Boards Bureau (BBB). It is recommended that BBB be set up by an executive order of the Government and comprise three senior bankers chosen from among those who are either serving or retired Chairmen of banks, one of whom will be the Chairman of BBB. They would be bankers of high standing and the Government should select them in consultation with RBI. Where selections to top bank managements are proposed by BBB but not accepted by the Government, BBB will make a public disclosure.

-: The Chairman and each member of BBB should be given a maximum tenure of three years. During this period the transfer of powers to the Bank Investment Company (BIC) is envisaged and upon transfer to the BIC, tenure would cease. There will be no renewal of their contract thereby ensuring that BBB's autonomy and independence is not compromised. Their remuneration would be at least that of existing public sector bank Chairmen.

-: It is desirable to ensure a minimum five-year tenure for bank Chairmen and a minimum three year tenure for Executive Directors. Given the very large retirements in senior management positions expected in the next three years, well-designed personnel policies to identify talented people who have demonstrated success would enable them to be groomed for senior management. This could alter the demographic profile of top management with beneficial consequences. With younger people of talent and successful track record in top management, the minimum tenures would get automatically ensured.

- Cases of vigilance enforcement against wholetime directors and other bank employees for decisions taken by them must be based on evidence that the director or employee personally made a wrongful gain. For levelling criminal charges, fraud must manifest itself through evidence of self-benefit. In loan and expenditure cases, deviations from procedure must not constitute the sole basis for initiating criminal action.

- It is feasible and vital that in Phases 1-3 the selection process is initiated in good time to complete the appointments approval before the expiry of tenures of the incumbents. Delays presently occur because of vigilance clearance. It is recommended that this clearance be conducted only at the stage when candidates are short-listed, and not resumed after the Selection Committee recommends the candidate for appointment.

- The selection of non-official directors should be entrusted to the Bank Boards Bureau.

- It is proposed that, from the second phase, the maximum term for any director other than whole-time directors be restricted to seven years. Further, after any tenure on a bank board, there would be a cooling-off period of five years, for the director to return to the same bank board, and a two-year cooling-off period for the director to be appointed on the board of any other bank.

- Any director on the board of a public sector bank will be eligible to be a director on the boards of at most six other listed companies.

- A partner or employee of a firm auditing a bank would be conflicted in becoming a director in another bank, in view of the client information which auditors have access to. Likewise, for such partner or employee to be a director in the same bank being audited would violate auditor independence. Therefore, no such partner or employee should be a director on the board of any bank.

- RBI directors should step down from bank boards during Phase 3 of the transition process, unless a bank is troubled or raises special concerns.

- The positions of bank Chairman and CEO should be separated during Phase 3 of the transition process.

-: RBI should designate a specific category of investors in banks as Authorised Bank Investors (ABIs), defined to include all funds with diversified investors which are discretionally managed by fund managers and are deemed to be fit and proper. ABIs would therefore include pension funds, provident funds, long-only mutual funds, long-short hedge funds, exchange-traded funds and private equity funds (including sovereign wealth funds) provided they are diversified, discretionally managed and found to be 'fit and proper'. ABIs would exclude all proprietary funds (including those which are hedge funds or set up by corporates), non-banking finance companies and insurance companies.

- A single ABI should be permitted a maximum 20 per cent investment stake in a bank without regulatory approval provided it possesses no right to appoint a board director. An ABI which is given board representation, and thereby exercises a measure of influence, should be permitted a lower 15 per cent maximum investment limit without regulatory approval. Every other investor should be permitted no more than 10 per cent without regulatory approval.

- It would be impractical for either RBI or a bank to conduct a prior scrutiny on whether an investor is 'fit and proper' before an investment occurs. If, however, at any stage and based on information laid before it, RBI concludes that an investor in a bank is not fit and proper, RBI would be entitled to freeze the investor's voting rights in the bank and to seek its disinvestment within a specified time period. As the initial onus of belief in being fit and proper therefore falls on the investor, RBI should also consider offering an informal guidance service on whether past regulatory or other action against an investor would disqualify categorisation as fit and proper.

- For promoter investors other than ABIs it is proposed that the continual stake ceiling be raised to 25 per cent.

- It would be inappropriate for regulation to stipulate a period within which banks should be listed, particularly from a governance perspective, as premature listing could be injurious to minority shareholder interests. It would therefore be desirable to modify the 2013 guidelines for new private sector banks accordingly.

- For banks identified by RBI as distressed, it is proposed that private equity funds, including sovereign wealth funds, be permitted to take a controlling stake of upto 40 per cent.

- The principle of proportionate voting rights should constitute part of the regulatory bedrock which fosters good bank governance, as it aligns investors' powers in shareholder meetings with the size of their shareholding. It is therefore desirable for RBI to raise the limit for voting rights to 26 per cent, in accordance with legislative changes recently enacted. It is also desirable to further amend legislation to remove all constraints on voting rights in order to align it with company law.

-: Where the principal shareholder in an entrepreneur-led bank is also the bank's CEO, RBI should satisfy itself that the board is adequately diversified and independent, with professionals of high standing. Where RBI lacks confidence of such independence, the controlling shareholder should be asked to step down as CEO.

- Wherever significant evergreening in a bank is detected by RBI, it is recommended that RBI imposes penalties wherein:

1. Unvested stock options granted to officers who have indulged in the practice, and to all whole-time directors, be cancelled in part or in full.
2. Monetary bonuses paid to such officers and to all whole-time directors, be clawed back by the bank, in part or in full.
3. The Chairman of the audit committee be asked to step down from the board.

- As the stance of RBI supervision has now moved from detailed to risk-based supervision, it is desirable for supervisors to conduct random detailed checks on the reported quality of banks' asset portfolio, particularly in those banks where compensation through stock options is liberally provided.

-: Boards of all banks, and particularly of the new private sector banks because of their dominant market share, need to provide oversight on customer protection in the distribution of third-party products, including matching the positioning of these products with customer demographics, customer income and wealth, and customer risk-appetite; and ensuring that product features are clearly explained to the customer.

- Profit-based commissions for non-executive directors should be permitted .

- The minimum and maximum age prescribed by the Companies Act at the time of appointment should be applicable to all directors of private sector banks. For whole-time directors, the maximum age should be 65.

- For old private sector banks where RBI has doubts about whether boards are adequately independent of the controlling shareholders of the banks, RBI should mandate that all director appointments be made with the prior approval of RBI. It should be RBI's endeavour to ensure adequate director independence in the board.

- In old private sector banks where RBI has doubts about whether the CEO has full control over the executive management of the bank, it should examine the precise areas of intervention by directors in bank committees and outside of it, and mandate a separation between board oversight and executive autonomy.

Monday, 11th Apr 2016, 09:06:53 AM

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