Has anyone ever wondered why scandals keep emerging in the Indian banking sector with sickening regularity? This happens not only in the loosely regulated cooperative banks, but in high-profile private sector banks too. The latest one is the 'accounting irregularities' in one of the large private sector banks which was forced to go for a forensic audit by the banking regulator when the news of a major currency hedging loss surfaced a few months ago. The reasons are not hard to find—plain and simple accounting legerdemain! Apparently, the potential losses from currency hedging were not accounted for correctly.
As if this weren't enough, its board was forced to admit that another few hundred crores of interest income were ‘recorded incorrectly’ which led to a significant reduction in the bank’s earnings this financial year.
What takes the cake is that, shortly before the balloon went up, the chief executive officer (CEO) and chief financial officer (CFO) of this bank cashed out their share options, worth around a few hundred crore rupees. It is reasonable to assume that the executives sensed that the cat would be out of the bag soon and the stock would crash. They made their moolah, and shareholders were left holding the baby. There cannot be a starker example of insider trading.
One should watch this space to see if the regulators insist on a clawback, since according to newspaper reports, during the next couple of trading days following the discovery of accounting irregularity, shareholders of this bank lost around Rs20,000 crore as the stock crashed! The latest news is that the Securities and Exchange Board of India (SEBI) has launched an insider trading investigation in the bank. As ordinary mortals, we don’t know why it took the regulator such a long time to start an investigation.
What gets lost in the recriminations surrounding any such scandal is the ordinary shareholder’s plight. The depositors are often protected, one way or another, but the unwary retail shareholders lose their hard-earned money that is invested in the stock. One case in point is Yes Bank, which was eventually rescued by the regulators, but the retail shareholders’ investment became virtually worthless. Well, the bank has been rescued and is apparently climbing out of the hole, but it will be a long wait for the legacy shareholders to see their shares regain their value.
This takes us to the root cause—the value and valuation of stock options. Some may wonder: Why digress into this seemingly innocuous issue, but the fact remains that the compulsion to show spectacular growth and rising profits also comes from the stock options granted to the senior management. Whereas stock options are a legitimate tool to incentivise the people who make the business work, in our context, this often leads to disproportionate rewards to a chosen few, totally out of sync with the real value of the business. This is not confined to the banking sector alone, it extends to another important part of the financial services industry—the insurance sector. Some of the unlisted companies grant stocks at face value and then buy them back at highly inflated prices. One wonders who determines or validates the valuation and do they really know their apples from their oranges. As the heady growth of the insurance sector is now becoming vestigial, this makes the valuation very subjective.
Two arguments are advanced in favour of stock grants to the senior leadership of a business. The first is ‘attracting and retaining the best talent’. The second and parallel argument is that this is a worldwide practice. When you examine these arguments a bit closely, their hollowness becomes evident. All compensation policies are products of the overall economic, societal and cultural context. In our country, legions of highly talented and committed people work for public sector businesses without any stock options and most of these businesses are doing perfectly well. Secondly, the grant of stock options is often misused as a tool to bully the employees into not questioning the sharp practices of their business leaders.
This is very likely to have happened in Yes Bank’s case where none of the senior executives dared to question the shenanigans of the then-top leadership. Another invidious aspect is that this creates a huge imbalance between the compensation of a handful of top executives and the rest of the employee pool, whose overall contribution to the business is equally, if not more, important.
It is common knowledge that the package of an Indian private sector chief executive officer (CEO) can be hundreds of times that of the ordinary worker in the company. Any business leader will affirm the fact that the survival and success of a business depends on a number of external factors, such as its place in the overall economy, governmental and regulatory policies, competitive dynamics and in our own unique context, the ability to find a way to manage and manipulate the rule-based order!
Now, stock options do work well where a fledgling or start-up business wants to attract talent, because the survival and growth is at stake and the leadership team is putting their career and financial wellbeing at risk. However, this rationale is inapplicable to established businesses who have a stable state operation.
This is a good place to also examine yet another justification, that the market determines the value of the stock, at least for listed companies. Anybody with a rudimentary knowledge of the stock market knows how fickle the market price of a stock is. Anyone who has witnessed the gyrations in the Indian stock market over the past few years can readily understand this point.
The intrinsic value of a business doesn’t change overnight unless there is an adverse policy change, or a major irregularity surfaces as was the case with the bank mentioned earlier. The market value of stock options acts as the primary incentive for insider trading by the management. It is, therefore, a common practice in more mature stock markets that publicly-traded companies disclose information about stock sale and purchase by their key executives and board members, including the cashing out of the options.
Stock options are one of the drivers for accounting skulduggery and unethical or illegal business practices. Showing growth and profit at any cost becomes the mantra for the top management and not necessarily for the benefit of the common, retail shareholder.
It is relevant to draw a distinction between options and grants. Options are granted at a prevailing market price of a listed companies shares and the recipient has the option to take these up then or later if the price goes up meaningfully. A stock grant is pure and simple deferred payment, encashable after a certain years of employment. This is a strong retention tool but is far more susceptible to abuse than an options award.
One of the reasons for the culprits getting away is the lack of shareholder activism. If an incident similar to the one quoted earlier had taken place in any other regulatory environment, the business mentioned above would have faced a number of civil and criminal suits against its directors and officers. One doesn’t remember any such action having been brought against the officials of any business in our country.
Readers may remember the case of another large, storied bank–too big to fail– whose CEO was forced to resign and the bank had filed a case for recovery of stock grant proceeds, no doubt under pressure from the regulator. One doesn’t know the outcome so far. And, of course, no shareholder action or suit was brought against the directors and officers of the bank by any stakeholder whatsoever!
Our institutional investors do not seem to play an active role in monitoring the role of the board or the management style of the companies where they invest and most of the companies have ‘captive’ boards in any case!
It is time that the stock option practices are governed by a regulatory framework, at least for the financial sector businesses. This is so because the accounting practices in the financial sector, especially banks and insurance, are dependent on a number of assumptions and are not objectively verifiable. The least that can be done is to have a mandatory provision that the stock grants can be clawed back after a regulatory audit in case of a retiring or exiting employee. Ultimately, alert and active shareholder activism will act as a far more effective deterrent than merely the possibility of regulatory action.
(Shrirang V Samant has worked in senior leadership roles in the general insurance industry, both in public and private sectors, in India and abroad. He has been privy to the transition of this industry from public to private sector in the country and was the founding CEO of a multinational insurance joint venture- JV in India.)
Secondly, internationally there is a comprehensive IFRS Accounting Standard viz IFRS 2 Share-based Payments. In India, Banks & Insurance Entities are yet to implement IFRS Standards equivalent Standards called Indian Accounting Standards (Ind ASs)