4 min read.Updated: 05 Oct 2021, 01:54 AM ISTMadan Sabnavis
The logic of aligning the interests of fund managers and investors could apply to other sectors too
One recollects a story heard in childhood. It goes like this. A café patron is infuriated that the quality of coffee served is poor and demands to see the owner. He is told that this would be only be possible once the owner returns from a neighbouring café where he is having his coffee. Then, a decade or so ago, the media highlighted the introduction of a new model by a leading automobile company in Mumbai. Its senior managers were present at the launch, held at a five-star hotel, but none was using a car of their company. While the first story may be apocryphal, the other actually happened. Now the Securities and Exchange Board of India (Sebi) evidently feels that when fund managers are dealing with public money, they must have ‘skin in the game’.
From 1 October, a new rule requires that all key designated employees of mutual funds (MFs) be paid a part of their salary as investments in the schemes they manage. This way, there will be congruence in the interests of MF investors and investment managers. What is good for investors is good for fund managers. One can argue whether the regulator should insist on such rules, but that is a different issue. One may recollect that the Reserve Bank of India has mandated that remuneration of private-sector bankers in certain functions follow a different set of rules, which includes a ‘claw back’ clause.
The concept of ‘skin in the game’ is not new to the corporate world. Indeed, the idea of stock options was based on this principle. Stocks were meant for senior management to begin with, but percolated down the line over time so that more employees got covered. The idea was to create an incentive for a company’s chief executive officer (CEO) to ensure that it did well, which would reflect in its share price, by paying the top manager partly in stock. A higher share price would serve as a reward, with fixed timelines for such stock allocations and vesting.
Did the idea work? It did, initially. But the Lehman crisis of 2008 exposed the concept’s flaws. CEOs had taken unbridled risks, which worked well for company growth as income and profits swelled during their tenures. Stock markets cried “hurray" as share prices climbed. This was the era of the Great Moderation, when Wall Street could never do anything wrong. When businesses and markets crashed, it was realized that CEOs had made their buck by selling their shares over time. Crises tend to come with a lag, and stock options worked well in boom times. After the crash, while the state fretted over reviving institutions, the latter’s chiefs lived in luxury. This was when the concept of a claw back came in; it was felt that top job contracts should include an enabling clause for it. This makes sense, as fast-growth episodes in the financial sector—retail lending, securitization, the non-banking financial company (NBFC) boom, infrastructure lending—have mostly ended in a major bust. This was 5-7 years after the boom, by when many CEOs had left.
The skin-in-the-game concept, on which Nassim Nicholas Taleb has written a book, addresses the issue of perverse incentives to expand an enterprise by taking abnormal risks. We need to control it, and the best way out is by getting employees to do with their money what they do with other people’s money. This leads to certain logical extensions.
Should bankers also be paid partly through deposits in their banks? Today, banks are paying very low deposit rates, as savers lament. So, why should bankers also not be made to put their salaries mandatorily in these low-yielding avenues? After all, if a fund manager must perforce invest in schemes of the same asset management company, this should also hold for bankers. Similarly, should employees in insurance companies be forced to put money in their insurance products even if they fetch sub-optimal returns? Further, when banks and NBFCs issue debt, should their employees (or those on their investing desks) be forced to invest a part of their salary in those bonds?
The needle will also turn to officially registered investment advisors as well as mutual fund distributors who provide such services. Should they also be asked to invest in such financial products? Ideally, this rule should apply across sectors. Manufacturing, however, does not have such regulatory oversight. Moreover, manufacturers do not take money from the public. It is usually in the financial sphere that these conundrums arise, as any kind of intermediation would mean money taken from one source being channelled to another. The cost of intermediation is partly compensation for risks handled. But inferior decisions affect the final saver’s returns, which is what Sebi wants to cushion. Since the system cannot punish those who take poor decisions, the solution is to make them part of the reward arrangement so that their own earnings are also affected by their decisions.
With this rule, MF jobs may become less attractive. Think of an equity fund manager earning ₹2 crore. If 20% of it must be invested every year in the equity schemes she manages, it would mean a forced investment of ₹40 lakh. Given that the individual has no choice, like with provident-fund deductions, and our national savings rate is about 20%, that proportion is quite stiff.
It would be interesting to see how Sebi’s idea will work, starting from the response of affected employees to the final performance of these schemes. Funds tend to flow to the more dynamic ones. What happens, though, to fund managers handling schemes which have little traction?
Madan Sabnavis is chief economist, Care Ratings and author of ‘Hits & Misses: The Indian Banking Story’. These are the author’s personal views.
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