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NAYAK PANEL RECOMMENDATIONS

1.0 Introduction
The Committee to Review Governance of Boards of
Banks in Indiawas constituted by the RBI Governor on
20th January, 2014, under the chairmanship of former
Axis Bank Chairman P.J. Nayak. Following have been its
Terms of Reference.
1.1 Terms of Reference
1. review of the regulatory compliance requirement of
the boards of banks
2. the working of these boards
3. regulatory guidelines on bank
ownership/concentration and
4. an examination of board compensation guidelines
1.2 Background to the constitution of the committee
RBI sought a committee which could clinically dissect
the reasons behind inherent inefficiency of the
public sector banking industry that has lately been piling
up bad non-performing assets.
Incidentally, weeks after the Nayak committee was
constituted in January, RBI wrote a long letter to then
financial services secretary, on what ails the public sector
banks. Many of the issues that affect bank governance
ranging from tenure of the chairman to composition of
a bank board and government ownershipwere

highlighted in the RBI letter.


The financial services secretary then got back to RBI,
defending the governments stance on almost each and
every issue. He even took the blame for rising nonperforming assets of the public sector banks as the
government pushed these banks to give many project
loans in the wake of the North Atlantic financial crisis
in 2008-09.
The central bank has subsequently written back to his
successor, G.S. Sandhu, refusing to accept the
governments arguments and reiterating its stance on
governance and other critical issues.
The timing of the release of the report and the exchange
of letters between RBI and the government is interesting.
Clearly, the Indian central bank wants the new
government to appreciate the problems that have been
plaguing the sector and remedy them on a war footing
before public sector banks see more value erosion in the
market.
The industrys expectations from the new Central
government are very high. Which is why the banking
indices of both BSE and National Stock Exchange in the
past one month have risen the highest among all indices.
1.3 The changing market structure in Indian Banking
Given:
the lower productivity,
steep erosion in asset quality and
demonstrated non-competitiveness of public sector
banks over varying time periods (as evidenced

by inferior financial parameters, accelerating stressed


assets and declining market share),
The recapitalisation of these banks will imposes
significant fiscal costs. If the governance of these
banks continues as at present, this will impede fiscal
consolidation, affect fiscal stability and eventually
impinge on the Government's solvency.
Consequently, the Government has two options:
either to privatise these banks and allow their future
solvency to be subject to market competition,
including through mergers;
or to design a radically new governance structure for
these bankswhich would better ensure their ability
to compete successfully, in order that repeated
claims for capital support from the Government,
unconnected with market returns, are avoided.
1.4 External Constraints on Public Sector Banks
Part of the reason for the governance, difficulties which
public sector banks face arises from a number
of constraints they confront, many externally imposed
on them, others internal to their functioning.
The Government and RBI need to move to first remove
the external constraints imposed upon them, so that
these banks are not disadvantaged in relation to private
sector banks, which are uninhibited by them.
The external constraints include the following:
Dual regulation, by the Finance Ministry in
addition to RBI. The Finance Ministry's directives
could be both explicit (through the issue of

guidelines) and through undocumented suasion. For


instance, in the period October 2012 to January
2014 the Finance Ministry issued 82 circulars to
public sector banks. Private sector banks are free of
dual regulation.
Board constitution. All directors (other than
shareholder-elected ones) are appointed by
the Government. It is unclear how any of them can
then be deemed as independent, leading to
an egregious violation of SEBI's Listing Guidelines.
Unlike in private sector banks, the boards have
no governance role or control over bringing in
directors with special skills. Average tenures of
Chairmen and Executive Directors are short, all of
which lead to the weak empowerment of boards. The
contrast with the boards of private sector banks is
sharp.
Significant and widening compensation
differences between public sector and private sector
banks, leading over time to skill differences,
particularly for certain key and specialized positions.
External vigilance enforcement, through the CVC
and CBI, which could inhibit the desire to
take commercial risks otherwise deemed acceptable.
It also puts a premium on fidelity to process, and
slows decision-making. Private sector banks handle
vigilance solely through internal enforcement.
Applicability, although in a limited way, of the
Right to Information Act. Private sector banks are
free of this.

The Government and RBI need to move to rapidly


eliminate or significantly reduce these constraints, in
the absence of which managements of public sector
banks will continue to face an erosion of
competitiveness.
Further, it is only after these external constraints have
been addressed would it be practicable for public
sector banks to address a host of internal weaknesses
which affect their competitiveness. The high leverage
that banks operate under makes banking a riskier
commercial activity than most non-financial businesses.
Unless banks are extremely well run and with a strong
focus on financial returns, they tend to falter.
The Central Government is a good example of a bank
shareholder which has suffered deeply negative
returns over decades.
It is therefore in the Government's own interest to
provide clarity in the objectives set for bank boards, and
to thereby improve governance and management.
1.4 The Pace of Reforms as suggested
The onus of remedying this situation through radical
reformlies primarily with the Central Government. In
the absence of such reform, or if reform is piecemeal and
non-substantive, it is unlikely that there will be
material improvement in the governance of these banks.
This could impede the Government's objective of
fiscal consolidation. The fiscal cost of inadequate
reformwill therefore be steep.

1.5 Reforms for Public Sector Banks as suggested bythe


Nayak panel
If the Government stake in the public-sector banks were
to reduce to less than 50 per cent, together with
certain other executive measures taken, all the previously
mentioned external constraints would disappear. This
would be a beneficial trade-off for the Government because
it would continue to be the dominant shareholder
and, without its control in banks diminishing, it would create
the conditions for its banks to compete more
successfully. It is a fundamental irony that presently the
Government disadvantages the very banks it has
invested in.
1.5.1 New Governance structure for Banks
The Report proposes that the Government distances itself
from several bank governance functions which it
presently discharges. For this purpose it recommends that:
the Bank Nationalisation Acts of 1970 and 1980, together
with the SBI Act and the SBI (Subsidiary Banks)

Act, be repealed, all banks be incorporated under the


Companies Act, and
a Bank Investment Company (BIC) incorporated under
Companies Act, be constituted to which the
Government transfers its holdingsin banks. The
Government's powers in relation to the governance of
banksshould also be transferred to BIC.
The details: While the Bank Investment Company (BIC)
would be constituted as a core investment company
under RBI registration and regulation, the character of its
business would make it resemble a passive sovereign
wealth fundfor the Government's banks.
The Government and BIC should sign a shareholder
agreement which assures BIC of its autonomy and sets its
objective in terms of financial returns from the banks it
controls.
It is also vital that the CEO of BIC is a professional banker or
a private equity investment professional who has
substantial experience of working in financial environments
where investment return is the yardstick of

performance, and who is appointed through a search process.


While the non- executive Chairman and CEO of
BIC would be nominated by the Government, it is highly
desirable that all other directors be independent and
bring in the requisite banking or investment skills.
The transition to BIC:
(Through this information, please understand the tone of
transformation, learning the details per se is not
necessary!)
The transfer of the Government holding in banks to the
Bank Investment Company (BIC), and the transitioning of
powers to bank boards with the intent of fully empowering
them, needs to be implemented in phases. The
duration of this transition is expected to be between two and
three years.
The following three-phase transition is recommended:
Phase 1:
a) Legislative amendments enacted to repeal the Acts

through which public sector banks have been


constituted as statutory bodies, the incorporation of these
banks under the Companies Act, and the
transfer of their ownership to BIC, with Governmentinitially
holding the entire equity in BIC.
b) A professional board constituted for BIC.
c) All existing ownership functions in relation to banks
transferred from the Government to BIC.
d) All non-ownership functions, whether of a regulatory or
development nature, transferred from the
Government to RBI.
e) BIC commences the process of professionalizing and
empowering bank boards.
f) Ownership functions taken over by BIC from the
Government.
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Phase 2:

g) The reconstitution of bank boards coordinated by BIC.


h) Bank ownership functions continued to be executed by
BIC.
Phase 3:
i) All ownership functions transferred by BIC to the bank
boards. The appointments of independent bank
directors and whole-time directors (including the CEO)
become the responsibility of bank boards.
j) BIC ensures that each bank splits the position of the bank's
Chairman into a non-executive Chairman
(nominated by BIC) and a CEO (nominated by the board).
k) Strict compliance ensured with Clause 49 of SEBI's Listing
Guidelines, which stipulates a minimum
number of independent directors. The Chairman, CEO, other
whole-time directors and BIC's nominee
directors, would constitute the 'inside directors', those
connected to the bank's principal shareholder
(viz. the Government). All other board members would be
'outside directors', and therefore be

characterized as independent.
l) A lead independent director would be nominated for each
bank board by the set of independent
directors. BIC would define the role of such directors.
m) BIC ceases to exercise ownership functions, and morphs
instead into exercising investor functions.
n) Consequently, BIC is tasked with the responsibilityof
protecting the Government's financial investment
in the banks, by raising the financial returns to the
Government.
The CEO of the Bank Investment Company (BIC) would be
tasked with putting together the BIC staff team. BIC
employees would be incentivized based on the financial
returns that the banks deliver.If such incentivization
requires the Government to hold less than 50 per cent of
equity in BIC, the Government should considerdoing so,
as it will be the prime financial beneficiary of BIC's success.
1.5.2 The end of dual regulation:

The Government should cease to issue any


regulatoryinstructions applicable only to public sector banks,
as dual
regulation is discriminatory. RBI should be the sole regulator
for banks, with regulations continuing to be
uniformly applicable to all commercial banks.
The Government should also cease to issue instructions to
public sector banks in pursuit of development
objectives. Any such instructions should, after consultation
with RBI, be issued by that regulator and be
applicable to all banks.
1.5.3 Bank Boards Empowerment and Related
Appointments:
The Government needs to move rapidly towards establishing
fully empowered boards in public sector banks,
solely entrusted with the governance and oversight of the
management of the banks.
Empowering Bank Boards:
There is a need to upgrade the quality of board deliberation
in public sector banks to provide greaterstrategic

focus. There are seven themes which appear critical to their


medium-term strengths comprising Business
Strategy, Financial Reports and their Integrity, Risk,
Compliance, Customer Protection, Financial Inclusion and
Human Resources. All other items for discussion should be
brought to the Boards by exception and should
typically be discussed in committees of boards. Among the
seven themes identified for detailed board scrutiny, a
predominant emphasis needs to be provided to Business
Strategy and Risk.
Board Constitution:
As the quality of board deliberation across firms is sensitive
to the skills and independence of boardmembers, it
is imperative to upgrade these skills in boards of public sector
banks by reconfiguring the entire appointments
process for boards. Otherwise it is unlikely that these boards
will be empowered and effective.
The process of board appointments, including appointments
of whole-time directors, needs to be

professionalized and a three-phase process (as described


above) is envisaged. In the first phase, until BIC
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Lal(neeleshlal007@gmail.com)
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becomes operational, a Bank Boards Bureau (BBB)comprising
former senior bankers should advise on all board
appointments, including those of Chairman and Executive
Directors. In the second phase this function would be
undertaken by BIC, which would also actively striveto
professionalize bank boards. In the third phaseBIC would
move several of its powers to the bank boards.
In the first phase in BBB, the chairman and each member of
the bureau should be given tenures of up tothree
years. From the second phase, the longest term for any
director other than whole-time directors in banks would
be restricted to seven years. The panel also proposed a
cooling-off period of five years for a director to return to
a bank board, and a two-year cooling-off period fora director
to be appointed on the board of a different bank.

Also, a director on a PSB board could be a directorof only six


other listed companies.
Recommending splitting the post of chairman and managing
directors, the report sought a term of at leastfive
years for bank chairman and at leastthree years for executive
directors.
The report also suggests that the Board of Directors are
positions that need to be offered to those who have
atleast 10-15 years actual banking or experience/knowledge
of financial institutions (not as a restingplace for a
"cushy" job for retiring government officials, politicians and
their friends and relatives).
1.5.4 Freedom from external vigilance control and RTI
It is desirable for the Government to level the playing field
for public sector banks in relation to their private
sector competitors. Reducing the proposed Bank Investment
Company's investment in a bank to less than 50 per
cent will free the bank from:
external vigilance emanating from the Central Vigilance

Commission,
from the Right to Information Act, and
From Government constraints on employee
compensation.
Vigilance enforcement and compensation policy will
thereafter be the responsibility of bank boards.
1.6 Ownership Issues and Boards of Private Sector Banks
Problems and Recommendations
1.6.1Governance issues in private sector banks originate from
an altogether different set of concerns. There are
issues which arise from ownership constraints stipulated by
RBI, which could misalign the interests of
shareholders with those of the management. In several other
jurisdictions, these constraints are less rigid.
Rigidity keeps out certain kinds of investors and thereby
reduces the pool of capital that banks couldotherwise
attract. When individual shareholdings are small, investors
also tend to be more disengaged.
Allowing larger block shareholders generally enhances
governance. In order to permit certain kinds of

investors to take larger stakes, it is proposed that a category


ofAuthorised Bank Investors (ABIs) be
created, comprising all diversified funds which
arediscretionally managed by fund managers and which
are deemed fit and proper.
Composition: ABIs would therefore include pension funds,
provident funds, long-only mutual funds,
long-short hedge funds, exchange-traded funds and private
equity funds (including sovereign wealth
funds) provided they are diversified, discretionally managed
and found to be 'fit and proper'. ABIs would
exclude all proprietary funds (including those which are
hedge funds or set up by corporates), nonbanking finance
companies and insurance companies.
It is proposed that an ABI be permitted a 20 per cent
equity stake without regulatory approval, or 15 per
cent if it also has a seat on the bank board. All other financial
investors should be permitted upto 10 per
cent.

1.6.2The shareholding permitted to promoters of banks is


also tightly structured at present. Under the 2013 RBI
guidelines, while such investors could begin with large stakes
in banks, after some years they would need to
reduce their stake and eventually can own no more than 15
per cent.
The Report proposes increasing the continual stake ceiling
to 25 per cent.
It also proposes that for distressed banks, privateequity
funds - including sovereign wealth funds - be
permitted to take a controlling stake of upto 40 per cent.
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Lal(neeleshlal007@gmail.com)
7 www.visionias.in Vision IAS
1.6.3The Report also proposes that the principle of
proportionate voting rights should constitute part of the
regulatory bedrock that fosters good governance.
Please note that Other than the Government's own stake,
which would be unconstrained, all other investment

limits as recommended above for different categories of


investors in private sector banks should also be
applicable to investors in public sector banks, as suggested by
the Nayak Panel.
1.6.4 It is also necessary for boards to be vigilant about the
quality of the loan asset portfolios as these
sensitively affect the integrity of financial reporting. In
private sector banks senior management is incentivised
on the basis of bank profitability, and the compensation paid
out - through stock options - is in substantial
measure contingent on the stock price of the bank. There is
a potential incentive to evergreen assets in order
that provisions do not make a dent in profitability.
Wherever significant evergreening in a bank is detected by
RBI, it is recommended that penalties be
levied through cancellations of unvested stock options and
claw-back of monetary bonuses on officers
concerned and on all whole-time directors, and thatthe
Chairman of the audit committee be asked to
step down from the board.

With RBI also having moved away from detailed to riskbased supervision, the annual financial
inspections investigate the asset quality reportingaccuracy of
banks less rigorously. It appears desirable
therefore that RBI conducts random and detailed checks on
asset quality in these banks.
1.6.5Boards should also define for third-party productswhat
constitutes proper selling practices. Products need to be
matched with customer demographics, customer income
and wealth, and customer risk-appetite.
1.6.6 The minimum and maximum age prescribed by the
Companies Act at the time of appointment should
be applicable to all directors of private sector banks. For
whole-time directors, the maximum age should be 65.
1.6.7 Profit-based commissions for non-executive directors
should be permitted in, but not before, Phase 3 of the
transition process as described above.
1.6.8 Old private sector banks typically began as community
banks, although some have attempted to outgrow their
historical origins and imitate the new private sector banks,
bringing in diversified boards and broad basing senior
management. However, many other banks have
management styles where the community hold
remains intact, either tacit or explicit. The designation of a
'promoter director' then develops, who controls
shareholder voting, the board and the employees. The CEO
thereby becomes disempowered.

RBI should attempt to diversify boards in banks where


independence is not visible, by mandating prior RBI approval
for directors in such banks. RBI should also mandate a
separation between board oversight and executive
autonomy.
1.7 View-points and analysis wrt the recommendations:
In some sense the recently released report of the Reserve
Bank of Indias (RBI) Committee to review
governance of boards of banks in India, chaired by P J
Nayak, completes the third arm of the triangle of the
new policy framework of the RBI under Governor
Raghuram Rajan, the other two being the Urjit Patel
Committee report which advocated inflation targeting
and that of the Nachiket Mor Committee which
addressed financial inclusion. These three reports
together constitute the broad contours of a grand new
monetary-bankingfinancial inclusion policy
configuration of the RBI.
The committee which had one representative from a PSB
(a retired official) and one from the Securities
and Exchange Board of India was dominated by financial
market participants and specialists. It is, therefore,
no wonder that its report oozes with the sentiment of
financial market fundamentalism. Surprisingly, there was
no representative from the Ministry of Finance, banking
trade unions and investor groups.
With respect to the fit and proper criteria to enable
ABIs to become shareholders, there has been proposed

an indirect road to privatisation which will expose Indian


banking to the global forces of banking a move that
can be questioned in the aftermath of the global
financial crisis.
However, there is no denying that one of the basic
problems with our PSBs is undue influence of
the government. The example of a leading PSB being
arm-twisted to lend to a near-bankrupt airline company
is fresh in our memory. Many of the recommendations
do not require legislation and hence have a much
higher likelihood of implementation, which will help
strengthen corporate governance standard, particularly
at the state-owned banks.
The need of the hour, then, is to professionalize banking
management that is also socially responsible, and to
not necessarily allow the well-known predatory agents of
capitalism like hedge funds to own our banks.

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