Six Questions for Peer Group Selection

July 18th, 2018

peer-group-7-18-18.pngMost banks use peer groups to evaluate their executive compensation programs. However, since every peer group process is unique, creating hard and fast rules is not usually the best approach to take. We pose six questions that may change the way you think about your compensation peer group.

1. Is asset size the best size indicator?
Organizational size is the most important predictor of executive compensation within banking. However, the relevant measures of firm size go beyond total assets. Our analysis shows that revenue and market capitalization equally correlate with CEO compensation.

For banks that have outsized non-balance sheet businesses, such as private banking, trust or mortgage, asset size only captures a portion of the overall size of the organization. If this describes your bank, consider using a broader measure such as revenue to better reflect the true size and complexity of your organization.

2. How should you think about location?
Location can be an important consideration in peer groups, but its best definition may be different than what you expect. In some cases, the characteristics of each bank’s specific market are more important than its actual geographic location.

For example, we conducted an analysis comparing CEO salaries at banks in the 50 largest metro areas to those at banks in smaller markets. We found that CEO compensation differs significantly based on market size, with asset-adjusted salaries in metro areas 10 percent higher on average than non-metro areas.

Not all banks choose to use location to define their peer group. If you do, consider thinking beyond what’s right next door.

3. Should you filter for business mix?
While it may seem counterintuitive, business mix actually does not have as much impact on executive pay as you might think. Whether looking at commercial versus consumer focus, banks versus thrifts or traditional banking versus specialty businesses, we don’t see significant differences in executive compensation, as long as the organization size is properly scoped.

However, business mix can have a great impact on performance. You may choose to consider business mix more carefully if you intend to use peer groups to formally measure performance.

4. What role do bank financials play?
It is important to understand the nuances of banking financials when reviewing performance against your peers. For example, what are the unique factors impacting the financials of your bank and its peers? Is your profitability best measured through return on assets, return on equity or return on tangible equity? How should we consider the impact of deferred tax asset write downs in 2017 or a peer reporting a 2 percent return on assets?

All in all, it’s critical to make sure that all parties involved understand how the story behind the numbers impacts peer group selection.

5. Should you review compensation as part of the peer selection process?
Potential peers sometimes have unique compensation situations that are not representative of typical market practice. While we do not recommend basing peer selection on compensation levels, there are a few outlier situations to look for. For example, does the company have significant management ownership? Executive compensation in these situations can be subject to different market forces than at most public banks and, as a result, may not be representative of typical practices.

Has the bank recently gone through a mutual-to-stock conversion? Newly-converted banks often make significant upfront equity grants to management followed by a period of infrequent grants. This unique equity pattern makes direct market comparisons more complicated.

Is the bank subject to a regulatory enforcement action? Severe regulatory enforcement actions can impact executive compensation levels. Know how to identify these banks, and consider whether they will be good comparators for your compensation plans.

6. Should your process be the same as that of ISS or Glass Lewis?
The proxy advisory firms ISS and Glass Lewis have their own peer group selection procedures based on their need to review thousands of public companies. For public banks, it is appropriate to identify your own set of relevant criteria rather than relying on the processes of shareholder advisors. However, it is still important to understand how they select peer groups, how it differs from your process and how this can lead to a different assessment of compensation and performance.

Peer groups may seem simple to construct, but without careful thought, peer group decision-making can result in groups that do not provide ideal comparisons.. Asking the right questions will help you craft more effective peer groups.

blemke

Bryan Lemke is a director in McLagan’s corporate and consumer banking consulting practice in the Minneapolis office. During his six years at McLagan, he has helped clients design compensation programs that are both value-enhancing for the organization and market-competitive for its employees.