The past 12 years have seen our financial system and institutions take a beating. Starting with the global financial crisis of 2007-08 and through the (undivided) Andhra Pradesh microfinance crisis of 2010, the Infrastructure Leasing & Financial Services (IL&FS) case of 2018, the Punjab National Bank case (2018), the Yes Bank case of 2020 and other such cases, there are numerous examples of failures in corporate governance. As noted earlier, increasingly, a key priority for the Reserve Bank of India (RBI) over the years has been ensuring good governance and proper functioning of the board in banks and financial institutions (FIs). This becomes all the more important during the present coronavirus (COVID-19) crisis, when banks and FIs are likely to come under greater financial and institutional stress. In fact, now is the time that RBI must become even more vigilant and ensure that banks and FIs remain safe, especially from the perspective of financial stability.
Accordingly, this crucial issue of corporate governance of banks and FIs during and after COVID-19 is taken up in a series of articles, covering different facets of corporate governance with real-life examples and data.
The one folly that has often led to failures in corporate governance in banks and FIs is the fact that we (the regulator and supervisor included) take great comfort if the board comprises of the so-called eminent people. While that may prove to be true in many instances, all of the above are representative examples of how the so called five star boards failed in corporate governance in real time.
Often, people look at the high-profile membership of the board as a surrogate for good corporate governance. But, despite having the equivalent of five-star boards, many banks and FIs have come under attack for various weaknesses in corporate governance. Interestingly, much of this is said to have happened despite many of these financial institutions having what bystanders would often call a five-star board—that is, a board packed with well-known personalities. And this is where a common judgement made with regard to corporate governance has, often repeatedly, proved costly in the financial sector. This is quite apparent if you look at the investment due diligence, credit rating and evaluation reports.
These use the presence of a five-star board to claim that governance in these banks and FIs is very good. Yet, as past years have shown through the above-mentioned and other cases, there were several controversial governance-related issues in many such banks and FIs, as espoused by the following:
a. Inadequate checks and balances over executive decision-making and whimsical behaviour by the board and/or senior management of banks and FIs.
b. Insufficient transparency about ownership and control and related-party transactions in banks and FIs.
c. High stakes acquired by promoters’ friends, well-wishers and families in order to maintain control over the bank or FI.
d. Lack of truly independent and nominee directors, well-functioning and diligent board (nomination and other) subcommittees, conflicts of interest at board, senior management and operational levels, and other such aspects at banks and FIs.
e. Lack of transparent reporting to the outside world by banks and FIs.
f. Manipulation of processes regarding board functioning at banks and FIs.
g. Non-transparency in the process of allotment of shares/options at banks and FIs, and
h. Insufficient transparency about the (banks/FIs/groups) operational strategies and overall financial position.
Therefore, with the mere presence of a five-star board, it cannot be assumed that there is good corporate governance at the bank or FI. The regulatory and supervisory architecture must provide sufficient incentives for facilitating good corporate governance, while at the same time creating disincentives for bad governance. This point needs strong emphasis and this assumes greater importance during the present COVID-19 crisis—when banks and FIs are likely to be under greater financial and institutional stress and where a lot of the depositors' funds are at stake.
What is really interesting to note is that all of the corporate governance violations listed earlier have happened despite the concerned banks and FI boards having so-called strong independent directorial representation. Therefore, using board membership as a surrogate for good corporate governance is really fraught with danger and instead, RBI must devise appropriate incentive and disincentive mechanisms to ensure good corporate governance in real time.
Let us look at the IL&FS case in closer detail, as the IL&FS is a systemically important FIs, with huge concerns over financial stability. While other examples can be cited from the US subprime and India, the IL&FS case of 2018 is a rather well-known one and is used for illustrative purposes as it concerns a systemically important FI.
Forget the founders and senior management. What about the independent directors and/or nominee directors who remained mute spectators even as IL&FS accumulated over Rs1064 billion (see Table 1 below) in debt as on 31 March 2018—a significant proportion of which consisted of short term borrowings, which doubled from around Rs124 billion as on 31 March 2015 to about Rs248 billion as on 31 March 2018? In other words, short term funds comprised almost 24% of the total debt of Rs1064 billion as on 31 March 2018, which is rather high for an infrastructure finance company like IL&FS, where asset liability mismatches can be commonplace.
That said, who are we talking about here when I talk of a five-star board?
Let us start with the independent directors. First on the list of the illustrious group of independent directors is Sunil Behari Mathur who has served on the board of IL&FS since January 2005. He is a former chairman of LIC and also former administrator of the Specified Undertakings of the Unit Trust of India (SUUTI). Mr Mathur (as per the 2017-18 IL&FS annual report) was chairman of the all important nomination and remuneration committee and also a member of the crucial audit committee.
I wonder how Mr Mathur, as chairman of the nomination and remuneration committee, approved a payout of Rs204.55 million to Ravi Parthasarathy in 2017-18 (as per IL&FS annual report for year 2017-18, reproduced in tables 3 and 4 below), especially given that as per the consolidated financial statements, the IL&FS group had: a) posted losses of around Rs18.87 billion during 2017-18 (see table 2 above); and b) accumulated a burgeoning debt of around Rs1064 billion as on 31 March 2018 (see table 1 above). The same question can be raised for other key management personnel as well—be it Hari Sankaran (who had a payout of Rs77.60 million in 2017-18 as per IL&FS annual report for year 2017-18) or Arun K Saha (whose payout was over Rs69.99 million in 2017-18 as per IL&FS annual report for year 2017-18). Why was their remuneration so very high, especially when the IL&FS group itself had been burdened with burgeoning debt and dramatically increasing losses, as noted above?
Interestingly, the above parallels the US subprime crisis. Both before and after going public, investment banks typically paid out half their revenues in compensation. Firms also paid out huge compensation even when they made losses. For example, Merrill Lynch paid out 141% in 2007—a year it suffered dramatic losses
. This is what happened in the US subprime and it looks like we have not learned anything from this crisis that shook the world.
Back to the independent directors of IL&FS, let us move on to RC Bhargava, who I have met once—I travelled with him on a flight from Delhi to Hyderabad, several years ago. My brief discussions on the flight with him impressed me but I am shocked that he was part of a board that allowed such irrational compensation to key management personnel (read Ravi Parthasarathy, Hari Sankaran and Arun K Saha) and also let them run IL&FS in the (irresponsible) manner they did.
RC Bhargava is a stalwart by any standards and I cannot fathom why he allowed what happened at IL&FS to happen. Mr Bhargava, who is the chairman of Maruti Suzuki India Ltd, was also a topper in his 1956 batch of Indian Administrative Services (IAS)—he has been an independent director of IL&FS since August 1990. And what needs emphasis here is that he was a member of the all important risk management committee (RMC) of IL&FS and also chair of the audit committee. His credentials notwithstanding, the fact of the matter is that he could not persuade the RMC to meet even once, subsequent to its meeting of 22 July 2015. The fact is that the RMC met just once in four years—the only meeting of the RMC was held on 22 July 2015 during the period from 1 April 2014 to 31 July 2018. In other words, Mr Bhargava could not convince the RMC to meet for as long as three whole years since 22 July 2015—this is worrisome.
Furthermore, that he was part of a board that allowed key management personnel to reward themselves with huge packages in 2017-18, even as the group incurred huge losses of Rs18.87 billion during the same year, is just unacceptable.
A third high-profile independent director is Michael Pinto, who has had a distinguished career in the IAS. He has served as an independent director at IL&FS since July 2004 and the fact that he did nothing to stop the mess at IL&FS says it all. He was part of three important committees—the audit committee, the risk management committee, and the nomination and remuneration committee—yet neither could he stop Ravi Parthasarathy and other senior management personnel from running IL&FS as their personal fiefdoms, nor could he prevent payout of irrational compensation to these key management personnel (i.e., Ravi Parthasarathy, Hari Sankaran and Arun K Saha) by IL&FS, despite its huge debt burden of about Rs1064 billion and dramatic losses of around Rs18.87 billion in 2017-18.
The above apply equally to other independent directors as well as nominee directors from institutions like Life Insurance Corporation of India (LIC), ORIX Corporation (Japan), Abu Dhabi Investment Authority (ADIA), Central Bank of India, State Bank of India (SBI) and others. If the this is what a five-star board can deliver, I would rather not have one even under normal circumstances, let alone the present COVID-19 situation, which calls for greater accountability of banks and FIs and their boards.
The very premise of good corporate governance hinges on the ability of independent and nominee directors to act impartially, objectively and with prudence, keeping in mind the overall vision of the bank/FI and its duty to all of its shareholders including customers. Sadly, this did not happen, as independent directors in many of the institutions lacked accountability and true independence in their functioning. Some of them were even compensated for by way of stock options and the like—instruments that compromised their independent functioning. Further, as many of them owed their appointments to the promoters, chief executive officers (CEOs) and senior management, this perhaps seriously limited their ability to function independently.
Strangely, even directors nominated by institutional investors remained quiet, and sometimes they did not even write a dissent note when the board norms and procedures were seriously violated. As an aside, it must be noted that the current procedures adopted by institutional investors to ensure the accountability (and effective functioning) of their nominee directors also appear rather weak. I will not go into the specifics, but there are numerous examples of situations at banks and FIs that could have been salvaged, had the independent (and nominee) directors acted independently and truly in the interest of the (minority) shareholders.
And going forward especially during the COVID-19 crisis and thereafter, the RBI would do well to ensure that there are clear regulatory (and supervisory) standards with regard to appointment, roles, compensation and evaluation of independent directors and that these are followed in implementation, so that corporate governance in banks and FIs does not exist merely on paper. This is one place where urgent regulatory reform for ushering in responsible finance, having accountable banks and financial institutions and a stable financial sector— during the COVID-19 era and thereafter—could begin in right earnest. What the RBI exactly needs to do to ensure this during and after the COVID-19 crisis are aspects that will be discussed in a series of forthcoming articles.
(Ramesh S Arunachalam is author of 12 critically acclaimed books. His latest release in January 2020 is titled, “Powering India to Double Digit Growth: Five Key Steps To A Robust Economy”. Apart from being an author, Ramesh provides strategic advice on a wide variety of financial sector/economic development issues. He has worked on over 311 assignments with multi-laterals, governments, private sector, banks, NBFCs, regulators, supervisors, MFIs and other stakeholders in 31 countries globally in five continents and 640 districts of India during the last 31 years.