Friday, September 3, 2010

Capping executives’ compensation in Nepal

My latest piece is about the issue of capping executive pay and compensation in Nepal. The central bank and Ministry of Finance are arguing for a cap on executive’s pay. The executives vehemently oppose it. Who is right? Well, I think the answer differs depending on if we look this issue from strictly business or societal perspectives. The issues I raise here is that it is not the central bank’s principle mandates to cap executive’s pay. It should rather try to fulfill its unfulfilled mandates.

Salary Ceiling

Is it NRB’s job to cap pay of executives?

The Nepal Rastra Bank (NRB) has locked horns with the financial sector over the recent capping of executives’ pay. The central bank wants to curb executives pay, but the executives vehemently oppose that notion. All over the world, the fat paycheck of executives have been the subject of controversy for quite some time now. It gained steam following the EU and the US governments’ decision to cap executives’ compensation of institutions bailed out by taxpayers during the global financial crisis. This monetary interventionist fad was picked up by the developing countries as well. Hence, we are witnessing the same happening in Nepal.

Amidst all the populist rant, it should be realized that NRB is stepping on a turf where it traditionally has not. This job is also not within its principle mandate, i.e. to maintain “price stability, and external and financial sector stability to facilitate high and sustainable economic growth”. High pay of executives has nothing to do with both these variables. In terms of incentives to drive a particular institution’s interests in a healthy competitive environment, the paycheck fetched by executives seems justified. On the other hand, from societal perspective and widening wage inequality, it is not morally okay. On this issue, the central bank has a very limited mandate and role to play.

Mind you, I am not defending extremely high compensation. I am just wondering why the NRB is engrossed in something it is not explicitly mandated and wasting time and resources when it has slacked on its explicit mandate. An appropriate body to look into this matter could be the Ministry of Finance (MoF).

Inflation has been double-digit since 2008. People are reeling under rapidly changing prices of daily consumable goods and services. Its policies to promote sustainable long-term growth are not working. It failed to check real estate bubble, which is scooping up most of the loans from the banking sector. This sector’s contribution to GDP has been very minimal. Lately, the NRB rolled out policies to restrict loans to the real estate sector. Though a right move, it might be a little too late. The damage is already done. It is now trying to mitigate the pain. Meanwhile, it has failed in monitoring and managing remittances inflows. The result has been devastating: Bubble in real estate and construction sectors, widening balance of trade deficit, and balance of payments deficit.

That said, in the present context, let’s be clear that the central bank can do very little in bringing down inflation rate as it is not a demand-driven rise in prices in the first place. A greater weight on the rise in price level has to do with cost push factors and supply side constraints such as supply chain disruptions, low production and cartels deliberately fixing prices at the product market. The MoF and the Ministry of Commerce and Supplies should play an active role in addressing these constraints. This has nothing to do with executives’ compensation. The same goes with the NRB’s effort to attain long-term sustainable economic growth.

Back to the row over executive pay. Executives are paid based on the pay scale sanctioned by an institution’s directors. If shareholders are dissatisfied with performance of an institution and its executives, then they can vote for changes based on the number of shares they own. They are the ones who should be running the show, not the central bank, whose intervention might affect incentives to perform to the fullest by executives. It is strictly a business dimension to the pay debate.

The issue of capping executives’ compensation emerged after the global financial crisis beginning mid-2008. Even after being bailed out by taxpayers, executives in big financial institutions in the US and the EU fetched huge amounts of bonuses and salary. Public anger fueled when they knew that the institutions rescued by the federal government were offering huge compensation to executives that had failed to deliver amidst rising foreclosures and layoffs. To quell public dissent, a “compensation czar” was appointed to monitor and recommend compensation of executives working in the institutions rescued by the US government. This constraint was lifted when institutions paid off the loan to the government. The EU is also restricting compensation of executives on a similar basis.

This incident is copied in Nepal, though wrongly. None of the banks or financial institutions (BFIs) has been rescued by the government by injecting taxpayers’ money. The only place where taxpayers’ money is being used is in the loss making public enterprises. The government must cap salary and bonuses in debt-ridden, loss-making public enterprises before it clamps down on the private sector, where it has not put in a dime for rescue efforts.

However, if the activities of BFIs pose systemic risk to the entire economy, then the central bank and MoF have to intervene to minimize damage, not through capping pay of executives but through tighter supervision and regulation. For instance, if the BFIs engage in excessive lending to a handful of sectors even after knowing that the risks might be pretty high, thus putting depositor’s money and the whole economy at risk, the central bank has to step in and curb such lending practices. This is what happened recently in the real estate and construction sectors. It does not mean that the central bank has to go after the income fetched by executives.

That being said, I am not sanctioning the notion that executives should fetch hefty salary and bonuses that are not justified by any means. No doubt, salary of executives is pretty high. Unaudited financial reports of 26 commercial banks show that salary and perks increased by 23 percent and bonus by 7 percent this fiscal year. Average monthly salary of a CEO is estimated to be above US$8,000. Lower rank employees barely earn US$150 per month. Roughly, the lowest to highest wage ratio is 1:40, which is extremely high in Nepali context. In fact, it is morally not right in a country where annual per capita GDP is below US$450. This a moral dimension to the pay debate. This also should not be ignored.

When job market is stagnating, macroeconomic situation deteriorating, inflation staying at a very high level, and opportunities squeezing, it obviously fuels anger when people read about executives fetching monthly salaries that an average citizen cannot even earn in his lifetime. This is something BFIs and executives should ponder upon because it independently fuels anger in the society they themselves are a part of. The government and central bank could give into public pressure any time.

There could be a middle path to business and moral dimensions to the executive pay debate. For instance, a “fair” way could be that executives’ paycheck may be a function of a basket of indicators: Long-term growth prospects, overall debt, non-performing loans, rate of return from unproductive sectors (which should have minimal weight as the returns appear to be cyclical in nature), long-term rate of return from productive sectors, and diversification of investment and loan portfolios, among others. If there are strict, transparent and easily comprehensible criteria, then there would not be much controversy over this issue, which has been wrongly taken up by the central bank while failing to fulfill its explicit mandate.

[Published in Republica, September 1, 2010, pp.6]