Uninteded Consequences of Executive Change in Control Provisions

You're a top performer at your bank and an executive from a competing bank wants you on their team. You recently got a new boss, and it isn't gelling. So the offer is timely.

You check out the competing bank. Do your due diligence. You respect their executives. Their numbers look good. Heck, you've lost a few deals to them. This bank deserves serious consideration for a job switch.

Hold on! You check their proxy statement. The CEO is 67. And he/she has a 2.99x change in control (CIC) contract. Nope. You're out. This bank's gonna sell so the CEO can pull the golden parachute rip chord. Why would they walk away with a gold watch when they can get paid for three years while sipping boat drinks in the Bahamas?

This hypothetical situation is an unintended consequence of executive CIC payments. The incentive gap between selling the bank and retiring while remaining independent is perceived as too big. 

Reasons for CIC Arrangements

There are legitimate reasons for change in control contracts. Meridian Compensation Partners, in their 2017 Study of Executive Change in Control Arrangements list the following reasons:

• Keep the Executive Neutral to Job Loss. The primary purpose for CIC arrangements is to keep senior executives focused on pursuing all corporate transaction opportunities that are in the best interest of shareholders, regardless of whether those transactions may result in their own job loss.

• Retain Key Talent. Corporate transaction activity may create uncertainty for critical executive talent. This uncertainty may create significant retention risk for a company. An executive with sufficient severance protection may be less likely to leave voluntarily to seek other employment in the face of transaction-related uncertainty.

• Maintain Competitive CIC Benefits. A majority of large public U.S. companies provide their senior executive officers with some level of CIC protection. Thus, companies provide CIC protection to attract and retain the top talent, especially in industry sectors undergoing substantial change or consolidation. 

Unintended Consequences

Aside from making it more difficult to get top performers to come to your bank when the CEO nears retirement, there are other unintended consequences. Other executives that may be retired in place (RIP) may hang on a little too long waiting for a buyer to come knocking and trigger their CIC payments. They are less likely to be making difficult decisions that will cause disruption yet might move your bank forward and position the bank for long-term success during this waiting period. 

Middle managers and high potential employees can read proxy statements too. Imagine the regional branch manager that wants to propose a change in hiring practices and development plans to turn branches into high performing sales and advisory centers. It will be difficult, but it is what customers are demanding. Should we do it? Nah, CEO is about to pull the chord. Multiply that perception several times over, and you have a bank that is losing pace with the market, making a sale a fait accompli. 

Shareholders celebrate the CEO's birthday too. I invest in bank stocks and have looked at a CEOs age on more than one occasion as a decision-point. This could artificially increase the valuation, making a sale more likely because the bank would have to earn its way into an inflated valuation. And shareholders may have bought in with the anticipation of a sale.

Development plans that help your high potential employees follow an executive track are shelved because of budget pressures. I am generally a cynic but most CEOs I know act in the very best interest of their bank. But what if, in the back of their mind where we rarely visit, they know that if they keep deferring the long and purposeful journey of developing multiple homegrown executives capable of becoming the next CEO, the board will opt to sell because there are little to no succession options. Under Jack Welsh, GE always had two or three people ready to go. Big company, I realize, but something to think about.

What To Do

What should you do about it? I asked a couple of executive recruiters and they didn't help me out. So I came up with one on my own. Unique, yes. A little out there, yes. Consistent with building a long and enduring business model, I believe yes.

Offer a Retirement Stock Plan (RSP) to ALL employees. Before you stop reading, let me describe it and run the numbers. One reason that institutional shareholders complain about CIC arrangements is because they put money in an executives pocket at the expense of shareholders. When a bank sells, the buyer assesses its value, then subtracts deal expenses. And a big deal expense is executive contracts.

But what if there was an incentive to stay and build the bank for the long-term, and retire? And instead of it only being available to executives, make it available to all employees that have been with you a minimum amount of years and retires.

This will put a premium on your talent management processes. Much like GE that shed 10% of its workforce each year using employee evaluations as the means to identify the 10%, a bank that implements an RSP must motivate high potential and otherwise good employees to stay, while having a process to improve or remove low performers so they don't hang on to get their RSP.

Math

It all comes down to a spreadsheet. Suppose Schmidlap National Bank, a $1.5 billion in asset bank, implements an RSP that pays 50% of a retiring employee's salary in Schmidlap stock if they retire after a certain age and have served between five and ten years at the bank. It would pay 100% of salary if they are there more than 10 years. Schmidlap can restrict the stock to protect against employees "retiring" and going to the competitor.

Here is what I think it would cost:

Many of the assumptions are aggressive, such as one executive retiring per year (at the average salary of all executives, including the CEO), and other employees retiring as a VP or AVP. If 5% of Schmidlap's 250 FTE employees retire annually, that's 13 per year at a $1.5 billion bank. That seems aggressive to me too. But I didn't want to undershoot the cost.

Based on my assumptions, this would cost Schmidlap $1.0 million per year and represent a 5% reduction in net income, and a 2.6% increase in operating expenses. I think banks can look hard within themselves to offset this cost with a mix of process improvements resulting in cost savings, and asset growth. My firm recently did a process review for a similar sized bank and made recommendations for $3 million in improvements, most of which were annual and recurring. We just taped a podcast with an emerging core processor that has 50% cost savings from your current core costs as a target. If half of the RSP was paid by growth, that would be $25 million in growth if it was added with a 2% incremental ROA.

I think the benefits would far exceed the costs. For one, it is a stock grant plan that adds to the bank's capital position to support growth. Second, it puts executives and employees on an even keel. It benefits both. Third, it reduces the incentive for the CEO and other executives to "pull the chord" and sell when they near retirement, which in turn helps the culture throughout the bank to manage it with an eye toward building a long-term future. It's a culture builder.

This doesn't mean the bank won't sell. If it hasn't earned its right to remain independent, that option remains on the table. And executives wouldn't be able to collect both a CIC and RSP at a sale event, in my opinion. Most states have laws that boards should consider all constituencies when making decisions: shareholders, customers, employees, and communities. An RSP would benefit all employees that gave a significant portion of their professional lives in service to the bank. 

What do you think? Any other ideas out there?

~ Jeff

Small Bank-Big Bank: Spending on People, Technology

I was recently slated to speak at an industry conference and I was diligently preparing when the organizer asked if I would be on a panel instead. Fine. But what about my diligent preparation?

I have a blog.

My remarks, should I have made them, were going to revolve around how much large banks spend on strategically significant resources compared to small banks. I took no bias into my search. I ran the data, and here are the results based on bank Call Report data.

The initial news was good. Smaller banks, either under $10 billion in total assets or the smaller group, under $1 billion, dedicate a greater proportion of their total operating expense to salary and benefits. The under $1 billion cohort spends nearly 9% more of their operating expense on employees. This would seem to be crucial, as I frequently hear bank strategy teams identify employees as a strategic advantage smaller banks have over larger ones.

Not so fast. I broke down salary and benefits per employee as well. And in that case, it appears as though the larger financial institutions pay more. The greater than $10 billion banks pay $103,235 per employee versus the under $1 billion banks at $76,411, a 26% difference. That explains why no hands went up at the Pacific Coast Banking School when the director asked how many students went to college to be community bankers.

To further the challenge for small financial institutions, the $1 billion to $10 billion cohort pays 12% more. So if the altruist wants to work for a community bank that is closer to its communities, they can make more with big brother. 

I understand that many, if not most under $1 billion banks are in rural areas, and therefore the salary and benefits disparity may be misleading. But we would be hard pressed to find a college senior that says they'll take a 26% pay haircut and work in Tombstone, Arizona. Although I'm sure there are exceptions.

I'm sure Tombstone is nice. I use as an example recognizable by all. Please refrain from angry comments and e-mails.

My second data search revolved around IT expenditures using the same asset size cohorts. Actually, the Call Report category is Data Processing expense. Although I've been poked for using this 70's-80's phraseology. You know who you are!

A note on the data. It does not include personnel.

The news looks good for smaller banks, spending a relatively larger proportion of their operating expenses on IT. But the larger banks are gaining ground, growing this line item at a compound annual growth rate of 10% over the past 10 years. The banks in the middle cohort spend relatively the least on IT.

What was alarming was how little this expense represented of total operating expenses. Reading industry literature one would think IT would dominate the expense ledger. Not so. 

But it will. 

Were there any surprises in the above tables?

~ Jeff

Cultural Conversation in Banking

Are your incentives consistent with your strategy and culture?

I was recently interviewed by the Financial Managers Society on this topic, and as a lead-up to my presentation on the subject at the upcoming FMS Forum in Las Vegas in June.

Here are excerpts from the discussion.

FMS: Why is measuring account openings such a misguided endeavor?

JM: If a bank measures product profitability, costs follow activity. Those that don't measure product profitability intuitively tend to believe that the number of accounts drives the work more than balances, even though balances, for the most part, drive revenue in banking.

So if customer A comes in with $10,000, an accounts-driven institution would try to split up that $10,000 between two or three accounts so they can hit their targets. The profit-focused bank, on the other hand, would do what the customer originally intended, and open up that checking account knowing full well that they would get similar or equal spread on the $10,000 in the single checking account, but have less back-office expenses to absorb than if they opened three accounts.

FMS: Which numbers should matter in the quest for better profitability - and why?

JM: Co-terminous spread and direct pre-tax profit - and the trends for both - would create an environment to drive profitability rather than activity. Bankers typically hold lenders accountable for the size of their portfolio and their production. What if they were instead held accountable for the spread (after provision), both in dollar aggregate and the ratio, and the trend for each?

So if Lender A had a $50 million portfolio at a 1.25% co-terminous spread, or $625,000, would that be better than the lender with a $35 million portfolio, with a 2% co-terminous spread? The math says no. But who reaps more reward in today's environment?

FMS: Bigger picture, how can the right incentives lead to a better culture?

JM: We look for the path of least resistance in terms of meeting goals and incentives - it's human nature. If I'm a branch manager whose incentive kicks in if I grow branch deposits by 10%, then I'm looking to do that with the least resistance. So I might call my regional manager daily for CD rate exceptions to get that $200,000 CD, even though with the rate exception, that CD might have a five-basis-point spread.

On the other hand, if I was held accountable for growing my branch's co-terminous deposit spread, would I still chase the CD customer? Or would I maybe seek the operating account at the tire and battery shop down the street, even though that might bring 25% of that CD balance to my branch? Multiply that logic to every profit center within the bank. Now you have a culture!

Are You a Bank With Benefits?

The American Bankers Association (ABA) recently announced a new benefit to assist its employees with repaying student debt. Beginning next month, ABA will provide each eligible employee up to $1,200 per year toward the payment of student debt, in addition to their current compensation. According to the Society for Human Resource Management, only four percent of employers nationwide offer this benefit. 

Is this an altruistic statement regarding the $1.4 trillion of student debt in America, or a prudent employee benefit targeting recent college graduates that each average $30,000 in student debt?

I recently proposed this topic for my firm's podcast, This Month In Banking, which is released on the last Wednesday of every month. Shot down. Too boring. But hey, I have a blog too! And I think it is an extremely important topic in talent acquisition and retention.

According to the Bureau of Labor Statistics June 2016 report, salaries, commissions and bonus accounted for 68.6% of total compensation, and benefits accounted for the remaining 31.4%. This is an increase from 29.9% in 2013. So benefits is a large, and increasing proportion of total compensation.

What makes the ABA announcement interesting is: 1) it is a benefit specific for those that carry student debt, meaning mostly millennials, and 2) that they felt they should announce it.

I don't think it is a mystery that bank employees seem to be getting older. And that succession planning in our industry is an issue. Since the financial crisis our industry's brand as a go-to employer has been hurt. And hurt badly. 

How do we attract quality, younger people and then retain them to be the future leaders of our industry? 

What employees value is in the eye of the beholder. Younger workers, for example, value cash on the barrel-head. Less important would be insurance (health or life), and retirement benefits. Not that it is unimportant. According to the Willis Towers Watson Global Benefit Attitudes Survey (What a mouthful! Some marketing person should revisit that title.), only 42% of US respondents said they would opt for more pay/bonus as opposed to other benefits if they had the choice (see chart). So other employees have different priorities.

For younger employees, there are some startups that focus on benefits important to them, such as Gradifi, that focuses on student loan paydown. Imagine the recruitment and retention with this benefit!

But as this benefit becomes less important to employees, perhaps a migration to something more meaningful, such as a greater 401k match, a more robust health plan, or life insurance benefits. Is it practical to earmark certain benefits dollars per full-time employee, and let them select, in menu fashion, what is important to them? For example, the recent college graduate may opt for a student loan paydown benefit, and take a high-deductible HSA health insurance option, rather than the traditional plan.

I think what is clear is that benefits that are important to your employees differ over different times in their life cycle.

Can bankers devise a cost-effective benefits program that recognizes this, would help them attract the best talent, and keep them?

~ Jeff

Say on Pay for Financial Institutions

Researchers at Rice University performed a study on CEO compensation, including bank CEOs, relative to average employee compensation. The study was in reaction to the media's often cited pay disparity between the CEO's of the largest institutions and their rank and file employees.

As for banks, the Dodd-Frank Act mandates that all corporations administer a non-binding shareholder vote on the compensation of its executives. For publicly traded banking institutions, the study found the mean pay ratio was 16.6x, well within the 25x bounds identified by Peter Drucker in 1977.  

Not leaving well-enough alone, I did some digging into the matter on my own, knowing that when you move up the banking food chain (i.e. asset size), the disparity, or ratio, will get larger. But most community financial institutions don't live in that world, or so I thought. 

So I searched for publicly traded financial institutions with total assets between $1 billion and $3 billion that reported their CEO's total compensation (i.e. was not "NA"). The search yielded 148 financial institutions. I then took their annualized salary and benefits expense for their last reporting period and divided by their full-time equivalent employees ("FTEs") to come up with average salary and benefits per employee, and compared to the CEO's total compensation. 

The results are in the following table:

Although not the exact methodology of the Rice study, the table indicates that publicly traded community bank CEOs are not excessively compensated.

Since I went that far, I decided to see if there was a correlation between the CEO compensation multiple and financial performance, such as Return on Average Assets (ROAA). 

I took my search of $1 billion - $3 billion financial institutions and narrowed it down to $1 billion to $1.2 billion to keep a tight range, yet yield a decent sized sample. I eliminated companies with multiple bank subsidiaries, because the granular salary plus benefits and FTE data is typically at the bank-level. Plus I had to look and calculate manually. The search resulted in 36 financial institutions. 

I separated them into quartiles based on ROAA. The results are in the below table.

Each quartile had nine financial institutions. Interestingly, the bottom quartile performer had the greatest CEO to average employee pay disparity, the highest CEO total compensation, and the highest average employee salary. But I'm not certain the message here is to not pay employees well. Perhaps the bottom performers have too many employees AND pay them well, lacking the expense discipline to elevate financial performance.

The middle quartiles are similar in total CEO compensation and average employee compensation. In fact, the top through the third quartile are intuitive in their financial performance versus compensation versus the pay multiplier. 

In my experience, there are some financial institutions that pay executives well regardless of their relative financial performance. This was the main logic behind Dodd-Frank's Say on Pay.

The answer may not be in reducing executive compensation, although some Boards should consider it based on the facts. The answer, in my opinion, is to find ways to increase the compensation of rank and file employees. If we were socialists, we would mandate it and everyone would gravitate towards the lowest common denominator in employee productivity and financial performance would plummet.

But we're capitalists. And the way to increase real compensation is to improve productivity. That means instead of needing ten people in a department with average wages, we do it with seven people and pay above average wages. 

Time and again my firm reviews departmental processes that are outdated and unnecessary, technologies that are underutilized, and managers that protect "the way we've always done it".  If executives don't assume a leadership position in removing inefficiencies and elevating real wages while improving financial performance, perhaps their compensation should be evaluated.

As technology changes, it is difficult to keep up with process change. But the cost of doing business should decline as industries and the technologies that support them become more mature. When I performed my research, even though the asset size of the financial institutions was tight, the amount of FTEs per institution varied widely. One had 130 FTEs, another had 521. And average salary plus benefits varied, with the top payer averaging $135k, and the bottom payer averaging $45k. 

The top payer, by the way, was in the bottom quartile financial performer, and the lowest payer was the last bank in the second quartile. Somewhere in between lies the answer for your financial institution.

Any thoughts on pay philosophy?

~ Jeff

Note: The below SNL Financial article by Kiah Lau Haslett alerted me to the Rice study. It may require a subscription to view:

https://www.snl.com/InteractiveX/article.aspx?ID=30979109&KPLT=4

Compensation Conundrum: Do banks pay CEOs too much?

Banking has taken a beating in the media and court of public opinion in the past two years. Some of it has been unfair, particularly with how banks were associated with subprime mortgages (very few were originated by banks) and how community banks were lumped in with the practices of very large financial institutions (FIs). But if we are to be honest with ourselves, some of it is deserved and we should take positive steps to repair our image, better serve our customers, and lead us into the future.

I would like to look at three issues regarding our profession, and focus on Executive Compensation in this post:

1. Executive Compensation;

2. Fees; and

3. Product Pushing

Executive Compensation

My commentary may be the equivalent of digesting castor oil for some readers and it may not earn me fans in the executive suites of the very large FIs. But I do not think the value some executives deliver is commensurate with their compensation.

An egregious example is Charles Prince, former CEO of Citigroup. He took control of the behemoth bank when the stock traded in the $50’s, left amid huge losses in subprime mortgages when the stock price fell into the $30’s, and it is now trading at around $4. He didn’t receive severance, but he somehow received compensation and benefits of around $29 million at departure (see link). Was he worth it? I think I could have delivered that performance for much less.

In an era where community banks differentiate themselves on service and relationships, it is mysterious why we pay executives so much more than those responsible for delivering the service and building the relationships. I understand in a community bank environment executives serve this function also, but community FIs should examine their compensation strategies and the makeup of their employee base to determine if both are consistent with executing a relationship driven strategy. Paying the senior executive several multiples more than those that determine the success or failure of your strategy may not be a very good practice. See table below.

The CEO compensation in the table is highly skewed towards smaller banks, as my experience has been that they typically make more. However, I don’t want to suggest that CEO’s or other executives make less. On the contrary, I am suggesting that those most responsible for executing on your strategy are compensated more.

I understand the most extreme examples reside in mega-banks, but the video below represents how our entire industry may be viewed.

 

How can a community FI achieve a state where successful customer relationship staff are compensated more? The FI should look within itself. What percent of staff are dedicated to serving existing customers and winning new ones versus staff that is behind the scenes? In my experience, community FIs over-invest in outdated processes that should have long ago been replaced with technology. Having less support personnel frees up greater resources to elevate the quality of relationship management staff, improve retention of such employees, and differentiate you from the mega-bank.

What are your thoughts on your FIs compensation strategy?

I will discuss Fees and Product Pushing in future posts.

~ Jeff

Link to Charles Prince story

http://www.marketwatch.com/story/former-citigroup-ceo-prince-to-get-295-million-plus-bonus

Link to BLS stats
http://www.bls.gov/oes/current/naics2_52.htm