Between March 10 and May 1, three regional U.S. banks failed. How were these bank failures similar, or different, than the bank failures of the Great Recession? We already know that there will be more regulatory pressure on banks, but what lessons can these failures teach directors about compensation? First, it is important to compare the Great Recession to the 2023 banking crisis.
Credit Versus Liquidity
The Great Recession was defined by a general deterioration in loan credit quality, incentive compensation that overly focused on loan production and a lack of a risk review process that incorporated the role incentives and compensation governance played.
Contrast that to 2023: Banks have upgraded credit processes and their risk review processes to evaluate the role of incentive compensation under the 2010 regulatory guidance of sound incentive compensation policies. Unfortunately, the banks that failed did not have enough liquidity to cover depositors who desired to move their money.
General Versus Unique
The three failed banks had unique patterns that responded dramatically to the increase in interest rates by the Federal Reserve and complicated each firm’s ability to fulfill depositor withdrawals. Silicon Valley Bank’s bond portfolio was long duration, and First Republic had a material portion of its portfolio tied to long-term residential mortgages. In contrast to the Great Recession, this banking crisis has more to do with business model and treasury management than actions of mortgage or commercial lenders.
Poor Risk Review
This is one area of commonality between the Great Recession and 2023. The Federal Reserve’s postmortem report on Silicon Valley Bank noted that the institution’s risk review processes were lacking. Specifically, the bank’s incentive plans lacked risk measures, and their incentive compensation risk review process was below expectations of a $200 billion bank.
“The incentive compensation arrangements and practices at [Silicon Valley Bank] encouraged excessive risk taking to maximize short-term financial metrics,” wrote the Fed in its postmortem report. This is a responsibility of the board of directors: Examiners review the board’s incentive risk review process as a part of their effectiveness evaluation, as well as a foundational principle of sound incentive compensation policies.
Lessons for the compensation committee must include considerations for what should be in place now versus what committees should be thinking about going forward. The compensation committee should have a robust process in place that examines all incentive compensation programs of the bank in accordance with regulatory guidance.
This process should evaluate each incentive compensation plan according to risk and reward, and monitor how each plan is balanced through risk mitigating measures. In addition, the incentive review process should be governed by a sound overall incentive compensation governance structure.
This structure is anchored by the compensation committee and works with a management incentive compensation oversight committee. It should dictate how plans are approved, how exceptions to plans are made and when the compensation committee is brought in for review and approval. As an example, if a major change is made to a commercial lender incentive compensation plan midyear, what is the process to review and ultimately approve the midyear change? Regulators expect those processes to exist today.
But all crises present new learnings to apply to the future. While there are a number of lessons related to a bank’s business model and treasury management, there are also takeaways for the compensation committee.
Going forward, banks need to move their mindset from credit risk mitigators to overall risk mitigators in incentive compensation. Credit risk metrics are often found within executive incentive plans as a result of the Great Recession. Banks should think how they can incorporate overall risk mitigators, beyond credit risk, and how those mitigators could affect executive incentive plans.
A risk modifier could cover risk issues such as credit, legal, capital, operational, reputational and liquidity risk factors. If all these risks rated “green,” the risk modifier would be at 100%; however, if credit or liquidity turned “yellow” or “red,” this modifier could apply a decrement to the annual incentive plan payout. In this way, a compensation committee can review all pertinent risks going forward and help ensure incentive compensation balances risk and reward.