I remember a story I heard in my childhood. it goes like this. A cafe patron is furious that the quality of the coffee served is poor and demands to see the owner. He is told that this will be possible only when the owner returns from the neighboring cafe where he is drinking coffee. Then, almost a decade ago, the media highlighted the launch of a new model by a leading automobile company in Mumbai. Its senior manager was present at the launch in a five star hotel, but no one was using his company car. While the first story may have been apocryphal, the second actually happened. Now the Securities and Exchange Board of India (SEBI) clearly feels that when fund managers are dealing with public money, they should have a ‘skin in the game’.
From October 1, a new rule requires that all key designated employees of mutual funds (MFs) be paid a part of their salaries as investments in schemes managed by them. In this way, there will be a convergence of interests of mutual fund 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 recall that the Reserve Bank of India has mandated that the remuneration of private sector bankers in certain operations 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. Actually, the idea of stock options was based on this principle. Stocks were initially meant for senior management, but over time it moved downwards to allow more employees to join. The idea was to create an incentive for a company’s chief executive officer (CEO) to ensure that it performs well, which would be reflected in its share price by paying the top manager partly in stock. A higher share price with a fixed time frame for such stock allocation and vesting will serve as a reward.
Did the idea work? It did, in the beginning. But the 2008 Lehman crisis exposed the flaws of the concept. The CEO took unbridled exposure, which bodes well for the company’s growth as earnings and profits increased during his tenure. The stock market cried “hooray” as stock prices climbed. This was the era of great moderation, when Wall Street could never do anything wrong. When businesses and markets crashed, it was realized that CEOs made their money by selling their shares over time. Crisis come with a lag, and stock options work well in bullish times. After the accident, while the state was concerned over the revived institutions, the chiefs of the latter lived in luxury. This was when the concept of a claw came back; It was felt that top job contracts should include an enabling clause for the same. This is understandable, as episodes of rapid growth in the financial sector—retail lending, securitization, non-banking financial company (NBFC) boom, infrastructure lending—mostly ended 5-7 of this boom in one big bust. It was years later, when many CEOs left.
The skin-in-the-game concept, based on a book by Nassim Nicholas Taleb, addresses the issue of perverse incentives to expand an enterprise by taking unusual risks. We need to control this, and the best way is to get employees to do with their money what they do with other people’s money. This leads to some logical expansion.
Should bankers also be partly paid through deposits in their banks? Today, banks are paying very low deposit rates, as savers lament. So, why shouldn’t bankers, too, essentially channel their salaries into these low-yielding avenues? After all, if a fund manager should invest in the schemes of the same asset management company, so should the bankers. Similarly, should employees of insurance companies be forced to invest money in their insurance products even if they achieve less-optimal returns? Also, when banks and NBFCs issue loans, should their employees (or those at their investment desks) be forced to invest a part of their salary in those bonds?
Needle will 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 to all regions. However, manufacturing does not have such regulatory oversight. Also, the producers do not take money from the public. It is usually in the financial sector that these entanglements arise, as any kind of arbitrage would mean moving money from one source to another. The cost of arbitration is compensation for the risks partly handled. But poor decisions affect the returns of eventual savers, which SEBI wants to protect. Since the system cannot penalize those who make bad decisions, the solution is to make them part of the reward system so that their own earnings are also affected by their decisions.
This rule may make MF jobs less attractive. Think Equity Fund Manager Earnings ₹2 crores. If 20% of this must be invested every year in equity schemes that it manages, it means a forced investment. ₹40 lakhs. Considering that the individual has no choice like provident fund deduction, and our national savings rate is around 20%, this ratio is quite stringent.
It will be interesting to see how SEBI’s idea will work from the response of the affected employees to the final performance of these schemes. Funds tend to flow towards more dynamic people. However, what happens to fund managers who handle schemes that have very low traction?
Madan Sabnavis is Chief Economist, CARE Ratings and author of ‘Hits and Mrs: The Indian Banking Story’. These are the personal views of the author.
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