The three-year average total shareholder return of the KBW Regional Banking Index was greater than 13 percent as of June 30, 2013. Banking stocks are recovering, creating renewed interest in programs that reward executives appropriately for continued growth in share price and dividend yield.
Options provide the most direct reward for creating shareholder value. If the stock price goes up, executives and shareholders alike share in the upside. The counter argument is that options are far too subject to market whims and since an executive receives more “return” with options as the stock price increases, this could motivate the very behaviors that started the financial crisis.
Restricted stock may seem like a safer alternative, but without some type of performance element, the awards may just serve as an incentive for executives to stay put, at least until their awards vest.
In this environment, how do directors design equity awards that will provide a meaningful link back to shareholder value?
There are five questions that directors can ask to gain clarity and create an effective equity grant strategy:
1. Who should receive an award?
There is often a consensus that senior management should receive equity as a normal part of the pay program. The subject of debate is typically who should receive awards below that level. Competitive practice, dilution and financial impact all play a role in determining how deep equity awards are granted within a bank. In our experience, the answer truly depends on the culture of the organization and what messages the bank wants to send regarding the behaviors that are most valued. If individual performance is important, defining and rewarding a pool of top performers can be highly effective. If revenue production is king, granting equity to top producers in areas such as commercial lending may aid in the retention of key rainmakers.
2. Is the goal of granting equity awards to reward performance or to retain executive talent?
In a recent survey conducted by Pearl Meyer & Partners, reward and retention tied at 89 percent as the top long-term incentive objectives for banks. Such multiple strategic objectives may call for granting both time- and performance-based awards. For example, a bank may decide to grant part of the award in time-vested restricted stock that is subject to holding requirements and provide the remainder as performance-based restricted stock.
3. Should performance-based awards strictly reward total shareholder return or operational performance that may result in a higher stock price?
In the same survey, nearly 70 percent of banks said they evaluate their long-term incentive programs on the basis of positive operational performance, versus 42.7 percent who focus on gains in total shareholder return. Members of management who believe that vagaries in the stock market are not under their control generally would prefer measures that correlate to increased shareholder value such as earnings per share, tangible book value, return on assets and return on equity as the key metrics for granting stock or vesting stock.
4. Once an award is exercised or vested, what is the executive’s obligation?
One of the primary reasons for granting equity awards is to promote executive stock ownership, since tying a significant portion of an executive’s wealth to share price puts that executive on the same side as shareholders. The counterargument, however, is that long-term incentives are just that—incentives—and if performance is achieved, the executive should be able to reap the reward. Defining retention requirements and/or ownership requirements upfront can address these issues by establishing reasonable expectations around the executive’s obligation and what may be received as a reward.
5. How do we handle competing goals in our equity grant strategy?
Often, bank boards and management teams want to achieve multiple goals in their equity strategy. Being deliberate in the mix of equity types, the selection of eligible employees and the achievable retention/ownership guidelines will provide a balanced approach.