The compensation of senior management must be worked out by an independent remuneration committee constituted of knowledgeable members, and this process must be seen to be transparent and fair

As I wrote in the article on the Moneylife website yesterday, the regulation of compensation at microfinance institutions (MFIs) needs to be improved. In this report, I have outlined four strategies that the stakeholders in the Indian microfinance industry (regulators, bankers, investors, credit raters and others, like the associations of MFIs) should seek to achieve in our own little ways. These are practical things to try and implement on the ground, to ensure that processes in the governance of compensation at MFIs become transparent and are indeed perceived to be fair. (Read, "Regulating the compensation awarded to bosses of MFIs".)

Strategy #1: Boards must play a proactive role in the governance of compensation at MFIs and the compensation system must not be in the grip of the CEO/senior management
First, the 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 (CEO, CFO, etc).

In fact, this has been a major problem with some MFIs in India. In cases where the compensation system has tended to be firmly in the grip of the CEO and/or senior management team, it seems prone to non-transparent actions, related party transactions and whimsical payouts to CEO/senior management, without sufficient rationale or justification. In fact, I see this as a major cause for the current microfinance crisis in Andhra Pradesh and the country, as at these MFIs, many of the (compensation) decisions were laden with significant conflict of interest and are questionable from a legal as well as ethical standpoint.

Therefore, it is in the interest of industry stakeholders to ask relevant questions as part of the day-to-day work and some of these questions are listed here.

•   Is the board of directors effectively taking overall responsibility for the MFI compensation system, including participating directly in the design and operation of this system?
•   Has the board ensured that the CEO and/or senior management team at the MFI are not controlling the compensation system?
•   Is the compensation policy aligned with the risk management framework of the MFI?
•   Has the board of directors at the MFI approved and periodically reviewed the compensation policy?
•   Has the board ensured that the compensation policy at the MFI does not provide incentives for excessive risk-taking?

Strategy #2: The boards of MFIs must have members with requisite compensation experience and real independence, so that they can effectively participate in the regulation of compensation
It is, therefore, 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) of the compensation system.

In a way, this is the fulcrum of a fair compensation system and the board members not only need to have the requisite experience, but they must also be able to use it in an independent and objective manner. This, in turn, implies that the boards of MFIs should not be filled with friends, relatives and yes-men, like M Damodaran, the former SEBI chairman, has argued.

Again, in the present crisis, in a few cases, nominee directors and other independent directors seem to have been silenced and their independence appears to have been compromised (on several occasions) with regard to matters of compensation and remuneration. This again, has left a very poor impression of the microfinance industry in India in the minds of the general public.

Here are some key questions in this regard.

•   Is the board composed of independent, non-executive members, without any conflict of interest?
•   Does the board have sufficient expertise (in terms of members) to assess risk management issues related to compensation?
•   Does the board have (members with) the skill and experience to reach an independent judgment on the compensation policy?
•   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?
•   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 on the board primarily because of their (personal) relationship with the CEO/senior management?

Strategy #3: An independent board remuneration committee must be established at each MFI to oversee design and operate the compensation system
While the previous two sections defined the role and responsibility of the board of directors, the key question that arises is how best the boards of MFIs can 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 discharge of the above roles and responsibilities by the MFI board, that is, the establishment of an appropriate independent remuneration committeeⁱ  and defining its mandate. It is through such a committee that the board of directors can design, monitor and reviewⁱⁱ  the compensation system to ensure that it operates as intended. Therefore, 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.{break}
Here are some important aspects.

•   The remuneration committee should be constituted in a way that enables it to exercise competent and independent judgementⁱⁱⁱ  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 microfinance 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.
•   To this end, the remuneration committee must work closely with the MFI's risk committee in the evaluation of the incentives created by the compensation system.
•   It should also ensure that the MFI's compensation policy is in compliance with global good practices and standards as well as the respective rules of national regulatory authorities.

Here are some more relevant questions.

•   Are there controls in place to regularly oversee the compliance of the compensation system? What are these and how sufficient are these controls? Is the independent board remuneration committee one of the key controls?
•   In order that the MFI board remuneration committee is able to operate independent of the senior executives, is it composed (at a minimum) of a majority of independent, non-executive (board) members without any conflict of interest^iv ?
•   Does the MFI board remuneration committee have (members with) the skill and experience to reach an independent judgement on the compensation policy?
•   Do the terms of reference/charter of the board remuneration committee suggest that it has sufficient powers (mandate) to perform its functions independently?
•   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 risk and risk management?
•   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?
•   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?  
•   Does the board remuneration committee at the MFI have unfettered access to information and analysis from risk and control function personnel (for example, risk management, finance, compliance, internal audit and human resources)?
•   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?

Strategy #4: MFI board remuneration committees must ensure an annual external compensation review
Last but not the least, the remuneration committee should facilitate an annual compensation review at the MFI and get it done externally. 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. 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.

Some relevant questions in this regard are given here.

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

Without question, irrational and adhoc compensation practices (at some MFIs) have been a major factor that has contributed (in some measure) to the microfinance crisis. Therefore, it is imperative that the Reserve Bank of India (RBI), the Union Ministry of Finance (MoF), and the microfinance industry undertake immediate and suitable action to address the issue of (such) unsound compensation systems prevalent at many MFIs. The action must be speedy, determined, cohesive and transparent, to help the microfinance industry in the country to regain its credibility and glory. I also hope that the RBI and the MoF focus on this, as part of their on-going exercise to develop a detailed regulatory framework for microfinance in India.

  ⁱSometimes 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.
  ⁱⁱTwo issues are relevant here. One is 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 on intentions.
  ⁱⁱⁱFrom BIS paper on Compensation and Corporate Governance, 2010.
  ^ivBIS paper on Compensation and Corporate Governance, 2010.

(The writer has over two decades of grassroots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural/urban development and urban poverty alleviation/governance. He has worked extensively in Asia, Africa, North America and Europe with a wide range of stakeholders, from the private sector and academia to governments.)