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.

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