A performance-based compensation policy for employees is important for reforming the incentive structure of state-owned banks.
There is a saying that banking business is a risk business. More specifically, banks are not there to avoid risks; they are supposed to take risks to maximise profits for shareholders. In the process, the management of the banks, if they are successful, benefit from bigger pay rises and larger bonuses. So, the interests of bank managers and employees are nicely aligned with those of the institution and its shareholders, and there is a harmonious relationship of mutual benefit among them. With a suitable degree of competition among the banks, the free market promotes the efficient allocation of the community's savings deposited with the banks to people raising funds to finance their economic activities generally, including their businesses, consumption and investment.
In the classic case of banks owned by the state and run by civil servants, one notices some fundamental differences. Clearly, the description of banking business as a risk business is less applicable. To start with, there could be policy loans directed by the government at various levels. It is doubtful that such policy loans could ever be made on the basis of the credit-worthiness of the borrower and how meaningful it is, under the circumstances, to look at credit risks, not to mention pricing, monitoring and managing risks properly.
It is often difficult to see clearly precisely what constitutes the interests of the shareholders, the bank, its management and employees, and how those interests relate to each other. Even if such a bank is to be run as a truly commercial bank, motivated principally to maximise profit, the system, as we understand it, does not seem to provide the correct incentives for those managing the day-to-day business of the bank to take risks in pursuit of that profit objective. On the contrary, the system promotes risk avoidance by bank management and employees, simply because they do not derive tangible benefits from successful risk-taking but, disproportionately, get the blame for unsuccessful risk-taking. The interests of the shareholders and the interests of the bank management and employees are much less aligned, if at all. Consequently, the important function of financial intermediation is performed less efficiently than could be achieved. Those who should have credit get less than they need, or none at all, and those that should not get any get ample. And, of course, the asset quality of the banks is lower than would otherwise be the case.
It can be argued, of course, that everyone in a state-owned bank in a classic sense, from the board members, executive or non-executive, to the management and the employees, all have a responsibility to pursue and protect the interests of the shareholder, which is the State. This probably explains why there may be a need for multiple layers of staff in different departments, to monitor compliance with all the rules, and endless form-filling and reporting, which have the effect of lowering the productivity of bank staff and, of course, increasing the number of staff needed for running the bank.
This is what I envisage to be the sort of background (with a great deal of generalisation of course) against which the Mainland started banking reform in earnest a few years ago. At the heart of the issue is one word - incentives. While cleaning up non-performing loans and straightening out management practices, much has been done by the Mainland authorities to reform the incentive structure of the state-owned banks at the shareholder and top-management level, including turning the state-owned banks into shareholding companies, introducing foreign strategic shareholders, and offering the banks to the public through listing. These efforts are commendable and the results should be apparent as time goes on. Nevertheless, the importance of reforming the incentive structure at the working level - the people that actually take on risks for the bank on a daily basis - should not be overlooked. There is a need for a comprehensive review of human-resources policies including hiring and firing, and more importantly, introducing performance-based compensation. I would argue that, realistically, since the priority interest of the typical employee, for example the loan officer at a branch of the bank in a county or a province, is the monthly pay cheque that keeps his family going, the incentive system for inducing him to do a good job must take adequate care of this specific interest. The banks should really have their own employment system and remuneration policy and one can see the signs that reform in this respect has already started. I am very hopeful that an independent and flexible employment and remuneration policy that gives the right incentives for bank staff to do a good job would not necessarily increase staff costs and erode profits - there would be corresponding savings in staff numbers and, importantly, a sharp reduction in non-performing loans. It may also lower the hitherto unusually high incidence of malpractice, since personal financial interests are less likely to feature in the exercise of authority over how money is allocated.
Joseph Yam
16 March 2006
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