Aligning Executive Pay with Risk Management in Banking

Posted by Paul McConnell on November 01, 2009  /   Posted in Compensation Committees

Originally published in Bank Director magazine.

Recent board director surveys indicate bank directors find current legislative and regulatory actions unwarranted, and that existing bank executive compensation plans do not encourage imprudent behavior or excessive risk. These opinions are diametrically opposed to global public perceptions that a serious problem exists with bank pay practices, and that substantial regulation is required. With governments racing to shape policy around public perceptions, bank directors will soon be left scrambling to retain talent if they do not use this current turmoil as an opportunity for proactive re-evaluation of the entire bank executive pay process.

Let us start by clarifying: executive pay practices did not cause the current crisis. In fact, our research indicates business unit incentives (e.g., trading, mortgage origination) were far more influential in the crisis than executive pay. Regardless, public perception is the board’s reality and, upon closer review, there are some changes that could be made to bank executive compensation programs that would better align pay with sound risk management.

As we have been reminded, banks have an exceptional obligation to operate for the long-term benefit of all stakeholders, not just maximizing shareholder return. Capital safety is the cornerstone of bank performance and the bank’s executive officers are uniquely positioned to manage the balance between risk and reward. These are the individuals (e.g., the CEO, CFO & Chief Risk/Credit Officer, etc.) that develop strategies and monitor risks, and are who the Board counts on to “see around the corner” in balancing current initiatives with long-term financial security.

To reassure the bank’s various stakeholders, executive pay should be revisited starting with a blank sheet of paper. For most of line management, use of salary, bonus and stock pay arrangements are likely still appropriate. But for the limited group of senior executive officers described above, who are directly responsible for managing to the long-term interests of investors and the public, we believe there is a very simple and powerful approach to employment, compensation and incentives that will provide a stronger incentive to deliver results for all stakeholders.

Remove key executive officers from the annual bonus plan, adjusting salaries to provide competitive total cash compensation. Free executives to more objectively set tough but prudent goals for the operating officers that appropriately balance risk and eliminate any perceived moral hazard associated with executives developing their own performance hurdles.

Establish an immediate, one-time equity stake for key executive officers upon accepting their role. Award this one-time grant in an amount comparable to the present value of awards an executive might receive for the role for remainder of their careers (e.g., for a CEO, perhaps 1% of the company in full-value shares), with vesting over the remainder of their careers based on time and relative company performance.

This one-time grant would provide an immediate, substantial financial incentive to operate for the long-term benefit of stakeholders. This approach reflects the investor-perspective, consistent with the practices of many private equity and venture capital investors. By establishing an ownership interest rather than an annual “pay” opportunity, banks can also eliminate the need for supplemental retirement, severance, life insurance and related income protection schemes. Critical to this approach, even vested portions of the award would remain non-transferable until a year or two after the executive’s employment ends, eliminating any opportunity to benefit from market timing or short-term appreciation in company equity.

By eliminating annual bonuses and annual incremental equity awards, and instead offering the executive officer fixed cash salary and an immediate investment stake, boards will recognize the unique role bank CEOs and other key executive officers play in managing toward the long-term health of the organization. Boards will also eliminate a number of performance and ethical obstacles created by existing arrangements. Executives would no longer “earn” their equity based upon annual assessments of short-term performance, the bias in goal-setting and selection of performance measures will be minimized, and the CEO would now evaluate risks and rewards in light of long-term value creation–without the added bias of personal short-term performance payoffs.

Properly communicated, this pay approach–simple, transparent and aligned with investors and public interest–will take an important step in changing the negative public perception of executive pay in financial institutions and signal that the CEO and the leadership team are committed to managing risk and reward for long-term value. While this may not be the perfect solution for any one bank, it provides directional guidance in responding to the justifiable public concerns and investor sentiments regarding managing bank risk.

Download this article in the PDF format.

Will Executive Incentives Keep the “Bailout” from Working?

Posted by Paul McConnell on January 28, 2009  /   Posted in Compensation Committees

The infusion of hundreds of billions of dollars of taxpayer funds into the domestic financial system has created a fundamental change in the ownership structure of most banks.  By establishing the U.S. government as the largest single shareholder in many of the TARP-participating banks, there is a divergence in shareholder objectives.   The government as an investor has provided cheap, patient capital in the form of preferred stock that only requires a 5% annual dividend and no price appreciation.  The Government has invested in these banks with the intention that these investments would stabilize the financial industry and get credit flowing again to the broader economy.  It wants financial recovery, job creation and economic growth.  However, historic financial industry practices and the incentive compensation arrangements offered to executives at these institutions may be working directly against the government’s public objectives.

The traditional investor objectives of maximizing economic value through growth in earnings and increased rate of return on capital employed, and the incentives that reward these results, are the heart of the conflict.  When faced with difficult economic times such as we are currently seeing, the natural reaction (as motivated by these incentive plans) is to avoid the loss of capital, cut off lenders that don’t meet high credit standards and generally batten down the hatches.  It is no surprise that bankers are acting consistent with their objectives and their financial interests.

Alternative Approach

If the “bailout” is to succeed, we need to find some way to reconcile these divergent interests.  It wouldn’t make sense to change the incentives for the bank as a whole; The Government’s investment is big, but it is only 10-20% of the total equity in these banks.  The other shareholder’s interests must be respected as well.  But to clarify objectives and maintain accountability for results within the institutions, one possibility is to build a new organization within the banks that is focused on the needs of this new, unique shareholder.  This “Rescue Bank” can be a separate legal corporation or an autonomous division, but it needs special staffing, leadership, and incentives that are attuned to the unique goals of its shareholder.  It is likely that the strongest economic impact will come from the small to medium sized businesses that have historically been the engine of job creation.  A large number of these are suffering from overextension, a shortage of capital and customers that cannot buy their products due to lack of financing.  These accounts could be transferred to the Rescue Bank, along with appropriate loss reserves that will create a level playing field.  Then the Rescue Bank could help these companies by utilizing flexible credit standards, refinancing, pools of investment capital and inexpensive financing facilities for their customers.

The Rescue Bank would need to be staffed by seasoned commercial bankers that have been through economic downturns and who are experienced in lending to troubled companies and by investment bankers that can help restructure balance sheets and provide creative secured lending.  The management group would comprise leaders that see beyond the bank’s balance sheet to its obligation of providing access to capital and general financial liquidity to the public.

Aligned Incentives: Executive & Employee Pay Plans

We know from experience that employee and management incentives do motivate the behavior that is asked for.  But if executive and employee pay plans are built around net income and financial returns, we will not get the kind of actions that this situation or this shareholder requires.  Instead, a very significant portion of the employees’ annual compensation should be tied to such metrics as: client revenue growth; job creation or saves; GDP growth within the market area; business startups; and public approval.

We don’t want these bankers to totally ignore the concept of profits, after all the Government money does need to be repaid.  Long-term incentives could be designed to balance the annual goals by investing a slice of the parent’s capital along with the government’s money (e.g., $1 for every $5 of TARP dollars).  This “common stock” would be credited with any Recovery Bank financial returns in excess of the 5% required on the preferred stock.  Grants of book value phantom shares (with conversion rights to the parent common stock) that vest when the TARP money is repaid would provide a powerful leverage to get this troubled economy up and running again.  If the Rescue Bank’s annual return on total equity only reaches 7%, these awards would grow by 17% that year – plus any kick from the recovery the parent’s stock price.

Incentives do work.  If we create the right ones for this situation, we as a country can more quickly work our way out of this difficult financial situation.

– Paul McConnell

Download this article in the PDF format.
© 2009 Board Advisory.
^ Back to Top