incentive structures for financial regulation

8/7/2019 Incentive Structures for Financial Regulation

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Lecture 2Poonam Mehra


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Overview

Financial markets involve allocation of resources

Financial institutions are intermediaries

Finance markets are unique

y Financial operations are complexy High Technological Innovation

y Three Premises: inter-temporal trade, risk andinformation

Pervasive Market Failure

Case for Intervention


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External Regulation

Financial Regulation could be external orinternal

Until recently, most of financial regulation wasexternally imposed

Monopoly of Regulators in decision making But with complexity in operation and speed of

innovation , external regulation finds it difficult tomaintain pace

Emphasis on internal controls Incentives??


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Issues in Incentive Design

Asymmetric Informationy Regulators and/or depositors do not have perfect

information about risk taking behavior of managers

y If regulators can observe the portfolio risks of a bank onlyimperfectly, is it possible to keep systemic risk low simplyby introducing regulation??

Problem aggravated due to technical progressy Complex derivative products

yTransfer of funds

Traditional accounting practices inadequate

Incentive Issues of Regulation design


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Principal-Agent problem

Principal: Owners of Capital, represented by Regulator

Agent: Financial Institutions

Example from the mutual fund Industry

Issues:

y

Management Capability of the institutions unknownto regulator: Adverse Selection

y Inability to monitor the Institutions: Moral Hazard

y Residual Risk


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Adverse Selection

Principal lacks information about the type of the agent

It refers to the case of hidden information

Example: Quality of risk management techniquesvaries across institutions

Should the same regulation apply to all?

Solution:

y Screening

y Signaling


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Screening

Uninformed party (regulator ) offers a contract

Tries to screen the different pieces ofinformation the

informed party (financial institutions) has

Menu of Contracts: Self-select Group

All choose the same: Bad may mimic the good

Carrot and Stick Approach

Problem: bad drives out the good


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Signaling

Signaling: contract offered by informed party, tries tosignal its abilities

y Adoption ofBest Practices

y Ongoing relationship: Reputation

y Contract with right incentives and credibility

y Delegation

Internal Audit

External Audit


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Moral Hazards

Moral Hazardarises when the principal cannotmonitor what the agent does

Moral Hazard gets reflected in the form of hiddenaction

There is no perfect solution to the problem

Solution to Moral Hazardy Use of Incentives : Pay Structure

y Regulation


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Pay Structures and Risk

Established controls may not induce favorable actionby agents

A

gents respond to pay off structure

Loss due to downward risk < potential upward gain

i.e. a convex pay structure induces agents to take morerisk

Typical pay structure induces differential response torisk and return


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Pay offstructure and Risk

Red: risk averseYellow: risk lover

Success of risky action

Reward to Agent

Minimum bonus outcome

BasicSalary

BonusCap


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Regulation

In bankingindustry, moral hazard could arise due toaction of

y managers

y

investors

Possible solution

y Official regulation

y Encouragement of Private sector lending

y Impose cost on those who commit mistakes


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Forbearance

Ex ante: high punishment and strongincentive required toensure good governance

Ex post: is it always sensible for regulators to stick to originalrules

May be not

Other factors affect decision of the regulator

y Political: an election year

y International reputation

y Other parties affected

A

ll this factors may lead to forbearance Forms of forbearance

y Delayed intervention and disclosure

y Financial aid


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Cost Benefit Analysis ofForbearance

Advantage Disadvantage

Systemic Consequence

Forced liquidity may notalways yield proper value

Going Concern Value

Bankruptcy entails highcost

If forbearance failsy Actual cost to public

increases

y Lock in effect

Reduces future Incentiveto follow regulation

A cost benefit analysis offorbearance is notpossible ex ante


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Size Matters

Forbearance applies more to large/ core sectors

BigFirms feel regulation is more for SmallerFirms

Large Firms are more diversified and more creditworthy

Too Big to Fail- doctrine

Medium Sized Firms may be induced to expand thebalance sheet

Large Firms may take excessive risk


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Example: Bail outto RBS

RBS bailout costliest worldwide

Government's total bailout of the bank equals 45.5billion pounds or about 74 billion dollars.

Consequently 84.4. percent of the stakes of the bankwere held by the government

Issues:

Series of bailout: example of lock in effect

Provide stability

Alternative was bankruptcy

Ex post: bank survived

Tax payers as stakeholders may gain in themedium and long term


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Individual vs. System

Erosion can be caused by

y Behavior ofinstitutions managers

y Adverse Market Movement

Manager should be blamed more for theirindividualfault, whether due to lack of effort, lack of skill,willingness to take excessive risk

Not punishing a managerin case of market movementmay encourage herdingbehavior

Extreme outcomes cannot be predicted


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Case Study: Satyam

Satyam Scam in the contemporary corporate

world:A Case Study in Indian Perspective

Founded in 1987 by B. Ramalinga Raju

Provides IT services

Listed in NYSE & Euronext

7th Jan, 2009 Raju confessed of manipulating accountsby $ 1.47 billion & resigned

In the study, we try to look at liability of:

y Promoter, Director

y Independent Directors

y Auditors


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Confessions ofMr. Raju

Inflated (non-existent) cash & bank balances of Rs.5040 crores on the balance sheet as of September 30,2008

Non-existent interest of Rs. 376 crores accrued

Understated liability of Rs. 1230 crores on account offunds

Overstated debtor position to the tune of Rs. 490crores

For 2nd quarter of 2008 alone, artificial cash and bankbalances were raised by Rs. 588 crores


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History of Ownership Pattern (%

ofEquity Holding)Date Promoter

s holding(%)

Mutual

Funds

(%) - Non-

Promoters

Banks,

FI's,

Insurance

Cos. (%) -Non-

Promoter

s

Foreign

Institutio

nal

Investors(%) - Non-

Promoter

s

Corporate

Bodies

(%) - Non-

Promoters

Individual

s (%) -

Non-

Promoters

Other

Non-

institutio

ns (%) -Non-

Promoter

s

Custodians

Totalequity

holding

(%)

Mar 2001 25.60 17.24 1.90 33.76 4.46 15.98 1.05 0.00 100.00

Mar 2002 22.26 12.11 2.33 37.67 4.08 10.94 10.60 0.00 100.00

Mar 2003 20.74 8.88 4.37 43.02 3.90 8.47 10.61 0.00 100.00

Mar 2004 17.35 7.39 4.33 51.27 2.95 6.06 10.65 0.00 100.00

Mar 2005 15.67 7.58 3.32 56.06 2.24 4.47 10.65 0.00 100.00

Mar 2006 14.02 5.70 1.74 52.48 2.06 4.06 19.94 0.00 100.00

Mar 2007 8.79 6.00 5.63 47.22 0.94 10.64 1.27 19.52 100.00

Mar 2008 8.74 4.88 8.13 48.22 0.59 8.75 1.24 19.46 100.00

Source: Study by Prof. Subrata Sarkar, IGIDR


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Liability as a Director, Promoter

Criminal Conspiracy

Cheating

Criminal breach of trust

Forgery

Falsification of records

Additional chargesy Breach of fiduciary duty

y Violation of companies Act

y Misrepresentation ofBS and P&L statementy Omission & falsification of company documents

y Serious Frauds Investigation Office

y US shareholders can file law suit

Arrested on these charges Non-bailable


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Liability ofIndependent Directors

Counterbalance weakness of management

Ensure legal and ethical behavior

Extend the reach of company

Clause 49 of listing Agreement

y At least 50% of the board should comprise of non-executive directors

y Independence of Judgment

y No material Relationship

y No Pecuniary Relationship

Under SEBI and Company Law, all directors cannot be heldresponsible as institutional and independent directors arenominated and nominated directors are not legally liable


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Liability ofPWC in Satyam Case

PWC was paid double the normal fees usually paid toauditors

Re-appointed seven times

Section 227, 233 require auditors to accurately, fairly and

diligently review and audit company account Failure results in a penalty upto Rs. 10,000

Section 62, 63 says any persons issuing false propsectus isliable to 2 years imprisonment and fine upto Rs. 50,000

ICAI can initiate disciplinary proceedings against an audit

firmy Leading to disqualification from eligibility to act as

statutory auditors

y Suspension/debarment


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Conclusion

Satyam: one of the very successful and sought aftercompanies can also go wrong

y Questions the belief large or successful institutionsshould be above regulation

Moral Hazard

y Monitoring difficult

y Independent directors need to be made liable

y Auditors: How reliable they are?

Relook at Regulation


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History of Board of DirectorsClassificationMarch 2008 March 2007 March 2006 March 2005 March 2004

B Ramalinga Raju Promoter ExecutiveDirector

Promoter ExecutiveDirector




B Rama Raju Promoter ExecutiveDirector,

Promoter ExecutiveDirector,




Ram Mynampati Directorin wholetime employment

Directorin wholetime employment

MangalamSrinivasan (Dr.)

(Mrs.)

IndependentDirector

IndependentDirector

IndependentDirector

IndependentDirector

IndependentDirector

Krishna G Palepu Non-executive,Gray Director

Non-executive,Gray Director

Non-executive,Gray Director

IndependentDirector

IndependentDirector

Vinod Dham IndependentDirector

IndependentDirector

IndependentDirector

IndependentDirector

IndependentDirector

M Rammohan Rao(Prof.)

IndependentDirector

IndependentDirector

IndependentDirector

T R Prasad IndependentDirector

IndependentDirector

V (Prof.) IndependentDirector

IndependentDirector

V P Rama Rao(Retd.) (I.A.S.)

IndependentDirector

IndependentDirector

IndependentDirector

IndependentDirector

C Satyanarayana(Retd.) (I.A.S.)

IndependentDirector

Board Size

9 10 7 6 7% of IndependentDirectors

55.56 60.00 57.14 66.67 71.43



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Board of Directors: Financial Year 2008

Directors Name Director

Designation

Director

Classification

Board MeetingsAttended

Total Number of

Directorships

Total Number of

CommitteeMemberships

B Ramalinga Raju Ch Promoter ExecutiveDirector

4 3 0

B Rama Raju MD Promoter ExecutiveDirector

3 4 1

Ram Mynampati Exec. Director &President

Directorin wholetime employment

4 4 0

MangalamSrinivasan (Dr.)(Mrs.)

Director IndependentDirector

3 2 0

G Palepu Director Non-executive,Gray Director

4 3 0

Vinod Dham Director IndependentDirector

1 9 0

M Rammohan Rao(Prof.)Director

IndependentDirector4 6 4

T R Prasad Director IndependentDirector

4 9 4

V. S. Raju (Prof.) Director IndependentDirector

4 4 2



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Directors Remuneration: Financial Year

2008

DirectorsName

Designation Salary Sitting Fees Bonus/Commission

Otherpayments

TotalRemuneration

B RamalingaRaju

Ch 18,00,000 18,00,000 24,43,355 60,43,355

B Rama Raju Md 16,80,000 16,80,000 10,47,725 44,07,725

Ram Mynampati Exec. Director &President

3,52,28,512 3,52,28,512

MangalamSrinivasan (Dr.)(Mrs.)

Director 80,000 12,00,000 12,80,000

Krishna GPalepu

Director 40,000 12,00,000 79,51,000* 91,91,000

Vinod Dham Director 10,000 12,00,000 12,10,000

M RammohanRao (Prof.)

Director 1,20,000 12,00,000 13,20,000

T R Prasad Director 1,20,000 11,33,333 12,53,333

V. S. Raju(Prof.)

IDirector 1,30,000 11,33,333 12,63,333



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Auditor Details for Satyam

TotalAuditFees ( in lakhs)

Out of PocketExpenses*

Non-AuditFees*

TotalPayments

to Auditors*

Non-Audit Fee%

Mar 2001 PriceWaterhouse &Co.

21.00 0.00 21.00 42.00

50.00Mar 2002 Price

Waterhouse &Co.

21.00 3.03 23.22 47.25

49.14Mar 2003 Price

Waterhouse &Co.

55.00 1.83 9.00 65.83

13.67Mar 2004 Price

Waterhouse &Co.

55.00 1.28 9.00 65.28

13.79Mar 2005 Price

Waterhouse &Co.

55.00 1.37 9.00 65.37

13.77Mar 2006 Price

Waterhouse &Co.

100.00 1.00 14.00 115.00

12.17

Mar 2007 PriceWaterhouse &Co.

248.00 1.00 118.00 367.00

32.15Mar 2008 Price

Waterhouse &Co.

362.00 5.00 6.00 373.00

1.61


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