Monday, June 01, 2015

Bank Board Compensation: An Amateur's View

Lately I have been asked to opine on bank Board compensation. Although not a compensation expert by any means, I suspect I am being asked for an outside-the-box opinion. This reminds me of one of my colleagues favorite quotes; "those that live outside the box have never been in it." But with most areas that are outside of my technical expertise but within my industry expertise, I tend to revert to common sense.

What are we trying to accomplish with Board compensation?

The FDIC Pocket Guide for Directors identifies the Board's responsibilities as:

- Select and retain competent management.

- Establish, with management, the institution's long and short-term business objectives in a legal and sound manner.

- Monitor operations to ensure that they are controlled adequately and are in compliance with law and policies.

- Oversee the institution's business performance.

- Ensure the institution helps to meet its community's credit needs.

How do we establish a compensation plan that is consistent with the above?

I have opined in the past that financial institutions' fixed to variable expense equation tilts too much towards fixed. So why exasperate the situation by creating more fixed expense with Board compensation? 

But there are certain moral hazards to incentive compensation at the Board level. Basing it on short term financial performance encourages greater risk taking. And the Board is responsible for the safety and soundness of the institution. To overcome this moral hazard, I suggest two things: 1) make the incentive compensation based on three-year average performance, and 2) include safety and soundness metrics to the equation.

This is similar to an unnamed bank that was suggested to me by an industry compensation consultant. I looked it up in their proxy, and their plan, which was for both executive management and the Board, looked similar to the below table.

The unnamed bank did not name the performance metrics, calling them "Category 1", "Category 2", etc. because the actual metrics need not be disclosed. Shareholders that deem themselves compensation experts are a dime a dozen so why give them ammunition! 

So I decided to insert what I thought would be performance metrics consistent with Board responsibilities. 

The metrics are relative to a pre-selected peer group, which is very common in executive compensation. But rather than limiting performance metrics to short-term, the unnamed bank used three-year averages. Meaning that there would be no payout for the first three years. All calculations thereafter would be based on three-year averages.

This did two things: 1) encouraged longer-term thinking so strategic investments can be made so long as it improved longer term performance, and 2) discouraged short-term risk taking that might result in future losses. It is not perfect, but what plan is?

The above table goes beyond the traditional performance metrics, and includes risk ratios such as leverage ratio growth, non-performing assets to total assets, net charge-offs to loans, and the one-year repricing GAP to assets. These are all risk metrics. But they should also be consistent with the Bank's strategic plan. If the plan calls for better than market growth, perhaps the leverage ratio will decline in relation to peers, etc. In such a case, perhaps exceeding long-term projected leverage ratios would be the metric.

The final addition, which was not in the unnamed bank's comp plan, was achievement of strategic objectives. I have expressed my concern over banks short-term, budget-centric focus on business results that discourage long-term strategic thinking that builds sustainable institutions. Why would I encourage it in a Director Comp Plan? 

So achieving strategic objectives is a litmus test to making the incentive comp available for payment. Note that not all strategic objectives need to be achieved because incenting for 100% success encourages sand-bagging, which is another industry obstacle to long-term excellence.

If adopted, Director's that received $30,000 in annual compensation could be eligible for incentives that increase total compensation by one third. Not an immaterial sum. Such comp could be paid in cash or stock, and expensed as incurred.

I recently mentioned to an industry colleague and bank Board member that you don't want to create unfunded liabilities for Board compensation that will ultimately get deducted from a buyer's offer to your shareholders, should one come your way. The savvy shareholders will catch on, and could make your life a little uncomfortable. 

What are your thoughts on incentive comp for Board members?

~ Jeff

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