Compensation’s New Normal

Banks across the Southeast are struggling mightily with a recession and survival issues, but SCBT Financial Corp. has been doing quite well, thank you. A sharp young management team plotted a conservative path well before the financial crisis emerged, and then stuck to it. The result: While it has some asset-quality concerns-what bank doesn’t?-the Columbia-based parent of South Carolina Bank & Trust earned $13.6 million in 2009, and even managed to maintain a healthy dividend.

The relatively strong performance is good news, of course. But it also poses something of a dilemma for $2.7 billion SCBT’s board-and more specifically, its compensation committee-as members contemplate a fistful of new rules and guidance from Washington aimed at forcing banks to build stronger linkages between risk and incentive pay.

Directors reckon the biggest threat to SCBT’s future is that a rival might poach CEO Robert Hill Jr., or other key executives responsible for the good numbers. They find it more than a little ironic that the very rules meant to inspire a better handle on risk could, in fact, exacerbate it by limiting their ability to pay more than a less-disciplined competitor might offer those managers, while still holding true to their commitment to pay employees for performance

“We know [our executives] have been getting calls from other banks,” says Susie VanHuss, 70, SCBT’s compensation committee chairman and a six-year director. “We’re torn between competing interests. We don’t want our incentives to encourage inappropriate risks, but we also don’t want to lose members of this management team. … That’s our biggest concern, and we’re not sure the new rules take that into account.”

To strike the right balance, the board is going with a blend of old and new. Incentives are still important-no one is saying they aren’t-but the metrics have changed. Where once “soundness” was simply assumed, for instance, now such factors as credit quality, classified loan levels, and regulatory CAMELS ratings account directly for about half of executives’ cash and equity bonus plans. Traditional measures, including profitability and growth are important, too. “But it’s low,” VanHuss explains. “We don’t want people chasing bad loans to get growth.”

Base pay has been bumped for some executives to reward them for strong relative results at a time when directors don’t feel that absolute performance reflects the amount or quality of work involved. The company also is continuing a trend started several years back of putting more executive pay in restricted stock with a four-year vesting period, which encourages more long-term thinking. “We hope that will be enough to keep them and meet the requirements,” VanHuss explains.

Welcome to the new world of bank compensation-a place where up is down, confusion reigns, and tensions are rising. The details are still works in progress; the rules open to considerable interpretation. Because they’re so new, few directors feel comfortable talking for attribution about the government’s mandates, or how their institutions are addressing them. Even many regulators are confused. One source tells of a big law firm giving examiners crash courses on pay practices. “They haven’t had to deal with compensation plans before and don’t know what to look for,” she says.

Boiled down to its essence, the latest government crackdown has two core risk-oriented thrusts: to help ensure that employees aren’t encouraged by incentive plans to take “inappropriate” risks that could threaten the health of the institution, and to place more of employees’ bonus money at-risk for longer periods of time, which in theory should keep them from chasing short-term gains at the bank’s long-term expense.

Before all is said and done, the absolute numbers behind pay might not change all that much, compensation experts say. But the new regime will almost certainly lead to some stark changes in both the definition of good performance and how incentives are paid.

Indeed, experts say it’s not far-fetched to think that five years down the road, the idea of paying for mere earnings growth or production, combined with peer-group pay comparisons, will seem as quaint as a passbook savings account. “When we look back, we’ll wonder how in the world we ever could have just paid people for pure volume, without examining the longer-term consequences,” says Dan Borge, a director who specializes in enterprise risk management for LECG, an Emeryville, California-based consulting firm.

The new rules and guidance reflect a more-than-sneaking suspicion in Washington that the way bankers were paid was at least a contributing factor-and perhaps a major cause-behind the devastating financial crisis that sparked a crippling recession. Too many bankers were rewarded for chasing short-term returns, the thinking goes, without enough consideration given to the long-term risks. When things turned south, shareholders and, in some cases, the Federal Deposit Insurance Corp., were left to absorb the losses.

They’re also a reaction to public anger over big bonuses paid to executives of some Wall Street TARP recipients. New York State Comptroller Thomas DiNapoli reported that Wall Street bonuses jumped 17% last year, to more than $20 billion. According to an analysis of the top 38 financial services firms by the Wall Street Journal, banks paid their employees more in 2009 than any other year.

Such figures, coming amid a stinging national debate over the government bailout and double-digit unemployment rates, make the industry’s paymasters appear, at best, embarrassingly tone deaf and unable to manage their own compensation affairs.

“There’s a lot of frustration and populist anger bubbling up,” explains Brian Gardner, a Washington analyst for investment bank Keefe, Bruyette & Woods. “People are resentful about these big paydays at a time when the country is in such economic trouble. … The politicians don’t want a replay of what’s occurred over the past three years.”

The new regulations are, in many ways, an extension of the requirements that were part of the Troubled Asset Relief Program. Here’s a recap of what’s on tap at present:

Boards of publicly traded banks are now required by the Securities and Exchange Commission to conduct thorough reviews of incentive programs for “material adverse risk” that mimic, in some ways, last spring’s “stress tests” of large-bank TARP recipients.

The reviews are expected to address incentive practices for all employees, not just the top brass, as in the past. If those offerings are found lacking, boards are expected to adjust performance metrics, payout timelines, and other components of the packages to dull down the potential risks they might present to the institution.

Boards are expected to disclose any negative findings in a new, separate narrative about those incentive practices. Proxy statements must also disclose the fair value of stock and option awards when they are awarded, as opposed to merely reporting the accounting charge, and the fees paid to consultants and their affiliates, in an attempt to reveal potential conflicts of interest.

New Federal Reserve guidance, meanwhile, prods all banks to weigh the “full range” of risks associated with specific jobs, including the potential for damaged reputations, regulatory clashes, and the “cost and amount of capital needed to support those risks.” It emphasizes longer-term performance measures and holding periods for incentive payouts, as well as communicating a “systematic” risk approach to all employees.

Under the guidance, pay packages at the 28 largest banks in the country will be subject to a “horizontal review,” stacking their practices against those of other large companies. Those that look to be outliers on the risk front would get closer scrutiny from the Fed. For smaller banks, the Fed has recommended tighter reviews of compensation practices as part of the regular examination processes.

More is likely on the way. In January, the FDIC’s board voted three-to-two in favor of a preliminary proposal that would inflict higher deposit-insurance fees on banks with compensation practices that, in the eyes of examiners, don’t “align employees’ interests with those of the firm’s stakeholders, including the FDIC”-a direct shot across the bow on safety and soundness.

The proposal, which was in a comment period when this story went to press, would push institutions to incorporate deferred stock awards and clawbacks into bonus payment schemes. Those that don’t add such provisions could get slapped with higher deposit insurance premiums.

Other agencies, too, might weigh in with their own initiatives. Meanwhile, directors are keeping a wary eye on Congress and the Obama administration, both of which are targeting compensation reform as a key part of their financial overhaul strategies. Final legislation could still be a ways off, because any compensation-related law changes will be tied to the broader reform effort, including such meaty issues as too-big-to-fail and consumer protection.

The good news, according to KBW’s Gardner: “What eventually comes out of Congress won’t be a game-changer. It will reinforce what the regulators already are working on. There’s a lot of rhetoric, but there’s not a big appetite for bonus taxes or explicit dollar restrictions.”

Forcing boards and managements to better link compensation with risk and strategy will subtly alter the industry’s definition of success, proponents say, and for the better. The rules will promote greater board awareness of, and involvement in, how people throughout the organization are paid. The scrutiny could make compensation a more effective tool for driving strategy and profits. And since the results of risk reviews are published in the proxy statement, it could provide another way for good banks to stand out from the crowd.

“This is all really putting down into the rules what bank boards should have been thinking about all along,” says Eleanor Bloxham, CEO of The Value Alliance, a Columbus, Ohio-based board evaluation and advisory firm. “For a well-run institution, this is like getting free [public relations]. You’ll be able to demonstrate that your bank doesn’t have the same levels of risk and complexity as some of these larger institutions, and that the risks you do have are well-controlled.”

Broad mandates from on high are necessary to accomplish the task, they add, because no single bank board will voluntarily adopt pay practices that might put their institution at a competitive disadvantage to peers.

All that might be true, but the rules also have sparked an avalanche of competitive, philosophical, and logistical complaints across the industry. The outcry is loudest from community bankers who say they never had pay policies that posed threats to their institutions’ safety and soundness. Why should the board of a small agriculture lender in Nebraska be forced to perform compensation gymnastics for the sins of Citigroup?

Lawmakers and regulators “are trying to fix a global problem by focusing on the practices of a few bad apples,” says Claibourne Smith, 71, chairman of the board of trustees at Delaware State University and head of the compensation committee for $3.6 billion WSFS Financial Corp. in Wilmington, Delaware. “They’re using a sledgehammer to correct a problem that requires a scalpel.”

Some worry that stiff pay rules will leave banks at a recruiting disadvantage relative to other businesses and widen the disparities between the industry’s haves and have-nots. Already, some struggling banks have lost key managers, because regulators have limited what a poor-performing bank can pay.

Others argue too much government kibitzing already is neutering boards’ ability to use compensation as a tool for promoting shareholder interests. William Lansing, 64, retired CEO of Menasha Forest Products in North Bend, Oregon, and a director at Umpqua Holdings Corp. in nearby Portland, notes that many banks with capital from the Troubled Asset Relief Program have responded to bonus caps by simply boosting base pay-a move that’s antithetical to the pay-for-performance credo.

“We’ve worked very hard on our committee to design packages that are precisely what these government rules have taken away from us, because of this concern about risk,” says Lansing, who was chairman of the compensation committee until last year. “Now they’re saying, ‘Best practices are too risky’ … It’s stupid. If people are angry about bonuses, wait until they see this year’s proxy statements. A lot of [executives] are going to be getting 50% increases in their salaries to keep pace with nonbank companies.”

Even corporate governance wonks-the type you’d expect might applaud efforts to force directors to put their noses more to the grindstone-have philosophical gripes about what they see as a dangerous government intrusion into affairs that should be the province of boards.

“It’s highly problematic,” says Charles Elson, director of the University of Delaware’s corporate governance center. While he agrees with some of the core concepts behind the rules, such as putting bonus money at-risk over longer periods, having the government mandate it “is a long-term threat to free markets, and ultimately, corporate success.”

For most directors, the issues are more basic: Time and frayed nerves. There’s plenty of operational work for boards to be spending their time on in this environment. Now, committee members everywhere are talking more frequently with their audit committee brethren, consultants, and internal risk officers to identify and rectify possible compensation flashpoints. They’re also reading a lot more, trying to keep up with the evolution of the pay environment. VanHuss estimates she’s putting in more than 20 hours a week on SCBT’s compensation planning.

Despite those efforts, some say the whole exercise borders on futility. Incorporating risk measures into pay formulas won’t automatically keep an institution from running into trouble. Countrywide Financial Corp. incorporated risk measures into its compensation plans, but the big mortgage lender collapsed anyway, because those metrics weren’t reflected in the broader strategic thinking.

Todd Leone, president of Amalfi Consulting, a Bloomington, Minnesota-based firm that specializes in bank compensation practices, tells of one bank that has had credit-quality measures in its pay plans for years, but is now on the ropes. “A big part of it comes down to culture,” he says. “If you’re a commercial bank with 99% of its loans in C&I or commercial real estate, that’s what you do. Changing a metric in a performance plan isn’t going to sprinkle some kind of magic dust over the entire organization.”

Adds David Gordon, a principal in the Los Angeles office of compensation consultant Frederic W. Cook & Co.: “It’s healthy to go through the plans that motivate the people who expose the enterprise to the most risk. But most boards understand that there’s a phony precision to the metrics; that we’re trying to measure something that can’t really be quantified. … All you can really say is that certain provisions are directional.”

That has contributed to some tense moments in board meetings. Even stronger bank boards have found themselves at loggerheads with management, mostly over paying people for hard work or relatively good performance at a time when shareholders are suffering. “There has been some conflict between boards and managements in establishing new goals or metrics, as some board members are hesitant to move away from historical goals or measures that may not be reasonable in these times,” says Michael Blanchard, one of the two partners of Blanchard Chase, a compensation consulting firm based in Atlanta. “Another area where we’ve seen lively discussion is management’s concerns over retention when the market rebounds,” he adds.

At $9.4 billion Umpqua, the pay restrictions that came with its TARP capital have led to contentious exchanges between board members and CEO Ray Davis. TARP rules ban recipients from paying more than one-third of base salary in bonus and require them to address executive incentive plans that encourage “excessive” risk-taking.

When Davis argued that his executives needed a hike in base pay to compensate for the limits on bonus payments, directors blanched, worried that once the toothpaste of higher salaries was squeezed out, it would be difficult to get back into the tube. “If you give a guy with a $400,000-a-year (in salary) lifestyle a $600,000-a-year lifestyle, and then suddenly say you want to make some of that money at-risk again, that’s just not going to fly very well from a human-nature standpoint,” Lansing says.

The board split the difference. Davis hasn’t had a raise since 2007, but two of his top executives received modest bumps-one of 9%; the other 15%-in 2009. (Umpqua raised $215 million of capital in February and bought its way out of TARP.)

More than 600 banks still have TARP capital, which also comes with a statutory requirement to conduct risk reviews. Like Umpqua, they’ll find TARP-like pay rules waiting when they exit the program.

How is a smart comp committee to proceed? For most, the process is centered on a solid risk-review analysis. Both the SEC and the Fed demand it, and while the wording is slightly different, the gist is the same: identify and fix incentive plans that might, inadvertently or not, be sending the wrong message to employees about what the organization values and how much risk-taking is considered acceptable.

A good place to start is by taking an inventory of all incentive plans. Many directors have been surprised by what they’ve found, since it’s long been an accepted practice for boards to hammer out the details of top executives’ compensation and then leave it to management to set everyone else’s incentives.

In today’s environment, Blanchard Chase Partner Diana Chase says taking a compensation plan inventory is a necessary component of the risk assessment process. She advises that this is also an area where senior management and/or human resources can and should provide assistance. “One approach,” she offers, “is to have management prepare a ‘compensation resource book’ that contains a summary of all incentive plans utilized by the bank. This document is then reviewed by the bank’s risk officer, or team, with areas of risk presented to and discussed with both management and the board.”

The typical mid-sized bank has dozens of different programs-covering everything from trading, brokerage, or trust operations to bonuses paid to tellers for referring customers to personal bankers. Large banks could have hundreds. Don’t let that stop you. One key objective of the rules is to match incentive payouts with the risk incurred by the bank for the activities that generate those payouts.

As with any other board matter, it’s important to ask a lot of questions and document directors’ diligence. “You want to go through the process-look through the plans, get outsider opinions-and keep good minutes,” says Michael Melbinger, chairman of the executive compensation and employee benefits practice at Winston & Strawn, a Chicago law firm.

“If there’s a blow-up in the future, you want to be able to prove that you studied it” to avoid liability, Melbinger adds. “The law will say, ‘Did you go through a process to arrive at some reasonable judgments?’ If you have, the [pay formulas] can still be wrong without creating liability.”

The questions should cover the gamut: “Is the mix of pay too short-term oriented? Is there too much cash and not enough stock? Are the performance measurement periods reflecting the periods where there is risk from the performance?” asks George Paulin, Frederic W. Cook’s CEO. “And what are the risk mitigators? Are you requiring that shares be held or that you have clawback provisions?”

The review might show that the teller’s referral incentives don’t involve any risk to the institution but that the package for a lending officer whose bonus is tied to origination volume, without also accounting in some way for loan performance, might.

Think hard about worst-case scenarios. A key issue behind the industry’s recent problems was that no one-not even the biggest, savviest players-seemed to consider that real estate prices could drop precipitously, or that certain parts of the credit market could freeze. At WSFS, directors have asked staff “to generate scenarios where employees could make decisions that fall outside of the policies and guidelines we have in place,” Smith explains.

Look also for red flags in plan design, such as pay mixes that are heavily weighted toward short-term incentives or pay more cash than equity, or bonus plans that offer big payouts for homeruns: they could tempt managers to turn up the dial on risk to achieve the numbers. “You don’t want to offer high incentive payments for once-in-a-blue-moon events,” Gordon says.

For CEOs, that could mean eliminating something as simple as paying four times base salary for quadrupling net income and setting more-reasonable targets with slightly lower payouts. “If you say, ‘We’re not going to pay any bonuses unless we get an 8% return on equity next year,’ is that realistic?” Leone asks. Employees will work to attain the goals that are set, “and you don’t want them pursuing things that aren’t in the best long-term interests of the organization.”

For frontline employees, dig deeply and probe to make sure you understand the nuances and how various plans fit together-and fit with the broader strategy. Create a list to work from: plans that don’t aggravate risk at all, those that present some modest risk to the company, and ones that might pose a problem. Some banks, for instance, pay bonuses to underwriters based on credit quality, which could balance out the risk presented by the loan officer’s production incentives.

One good way to mitigate risk is to make the bonus smaller relative to the base, Leone explains. “If I’m making $100 a year, and the most I can make in bonus is $15, I won’t kill myself-or put the institution at a higher risk-to achieve it.”

Make sure the timing matches up. No one wants a mortgage originator to walk out the door with a big cash bonus, only to see his book of loans blow up on the bank two years later. Instead, compensation consultants say, performance metrics should emphasize long-term profitability over short-term production, while incentives payments should be weighted toward equity, with vesting or holding periods of at least three to five years-long enough for those loans to show if they have any warts.

It’s important to note that the new rules aren’t about eliminating risk, or even minimizing it, but rather about boosting board understanding and oversight of incentive compensation plans within their organizations. A “high-risk” incentive plan might be good for the organization as long as it doesn’t put the company in harm’s way.

“Simply minimizing risk could be a trap. Banks make money by taking risks. You could erode profitability to the point where you lose the franchise at the end,” Borge says. “But you want to make better risk-return decisions and ensure you’re not inadvertently encouraging people to take the wrong kinds of risk.”

Experts say smart compensation committees are nurturing stronger information-sharing relationships with managements, who might otherwise be reluctant to cede their authority on pay matters. They’re also communicating overviews of the review process, along with the reasons behind it, to employees to create organizational buy-in.

“The most difficult part is the resistance of humans,” says Bloxham, who helped introduce one of the industry’s first risk-based compensation systems at the old BankOne Corp. in the 1990s. “People have trouble getting their sea legs when you introduce something new. But once people begin to understand what an economic return or risk number represents, they’ll get comfortable with it.”

If it doesn’t have them already, the board should open its own line of communication with the bank’s primary regulator to stay “in the loop” on what management is being told. Directors “need to know what’s an acceptable rate of progress and what are acceptable things to do,” Borge says. “You don’t want to get halfway into the process and find that you’re doing things they don’t want you to do.”

The review could prove to be the easy part. Many bank boards report that they’re finding none of those “inappropriate” risks on their books, validating their traditional approaches. (A banking company with no risks, isn’t required to disclose anything, but might want to anyway, for the PR benefit.)

Some, such as SCBT, have begun incorporating credit-quality and regulatory ratings into their incentive formulas. They’re also getting more refined in benchmarking practices, not simply looking at the pay levels of peers, but also the performance of those peers.

Many have begun by reaching for the low-hanging fruit. Clawbacks have already become much more common, though they are used more to safeguard against fraud than pure performance. Many banks have begun employing holding periods that pay out parts of the bonus several years down the road. “If you have a strong year, instead of paying out a 200% bonus, you pay out 150%, and hold the other 50% for three years to make sure the performance holds.”

The move away from option grants continues to pick up steam, consultants say, with banks opting instead for performance or restricted shares, which are seen as better linking pay to longer-term performance. It’s a better motivator for managers to actually have something in pocket to lose, the theory goes, than merely a lost opportunity to buy something cheap. And many of those grants now have longer vesting periods, or stipulations that the stock be held for a certain period of time-say, five years or so-to allow employees to feel the long-term effects of their decisions.

None of this is easy-especially in the present operating environment. It’s virtually impossible for a board or management team to predict what the economy might look like even six months down the road, let alone three or five years from now. “With the economic conditions, there’s no way for us to set any sort of realistic long-term goals,” SCBT’s VanHuss explains.

With time, Borge says boards will need to get even more sophisticated in how they measure risks, employing enterprise risk management systems and capital costs into the equation. “Rather than saying the CEO’s comp will be based on achieving 5% growth in reported earnings, it will be more about how much earnings growth was created in excess of the capital charges that were needed to generate those earnings,” he says.

Similar measurement, aided by internal enterprise risk management systems, will be needed at lower levels in the organization. For a commercial lender, for instance, a good plan might eventually examine the life cycle of the business. “At each point, you’d say, ‘We’ve created interest rate risk, credit risk, maybe some liquidity risk, and perhaps even some reputational risk if we’re involved in shady lending practices,’” Borge says.

Differentiating between various types of operational risk will become more important. Borge offers the example of two business unit heads, each of which earned $25 million in a year. “They earned the same amount, but one used $20 million of risk capital and the other used $40 million,” he explains.

Assuming capital costs of 15%, a charge of $3 million would be taken from the first employee’s initial earnings, while $6 million would be subtracted from the latter’s. “The employee who took more risk would have lower risk-adjusted earnings, and should get paid less,” Borge says.

On the board itself, Melbinger anticipates a greater emphasis on finding compensation or risk expertise as the gravity of the rules settles in. “As with audit committees, you’ll want to be able to say, ‘We brought Mr. X onto the board in part because of his extensive experience with compensation or risk-related matters,’” he says.

There’s more than a little irony to all this hubbub. For years, many of the biggest compensation-related concerns have centered on whether incentives have any effect in motivating employee behavior. “Now, everyone is worried that incentives might be motivating people too much,” Leone says.

Ultimately, boards that pursue a dual track-seeking out reasonable profitability combined with reasonable risk-based incentives-are the ones that will thrive in the new environment. “In the end, all you want is to encourage employees to be concerned about the long-term financial success of the enterprise,” Gordon says.

It’s a goal that shouldn’t be that difficult to achieve for a board that’s willing to take on the challenge.

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