ESG: Walk Before You Run

Covid-19 and last year’s protests over racial injustice added to the mounting pressure corporations face to make progress on environmental, social and governance (ESG) issues — but banks may be further ahead than they believe.

“ESG took on a life of its own in 2020,” says Gayle Appelbaum, a partner at the consulting firm McLagan. Institutional investors have slowly turned up the heat on corporate America, along with community groups, proxy firms and ratings agencies, and regulators such as the Securities and Exchange Commission, which now mandates a human capital management disclosure in annual reports. Customers want to know where companies stand. Prospective employees want to know if a company shares their values. And President Joe Biden’s administration promises to focus more on social and environmental issues.

Big banks like Bank of America Corp. and JPMorgan Chase & Co. have been responding to these pressures, but now ESG is trending down through the industry. With the right approach, banks may find that these practices actually improve their operations. However, smaller community and regional banks can’t — and probably shouldn’t — merely copy the ESG practices of their larger brethren. “People have to think about what’s appropriate for their bank, given [its] size and location,” says Appelbaum. “What are they already doing that they could expand and beef up?”

That means banks shouldn’t feel pressured to go big or go home when it comes to ESG. Begin with the basics: Has your bank reduced waste by encouraging paperless statements? How many hours do employees spend volunteering in the community? “When you sit down and talk to bankers about this, it’s interesting to see [their] eyes open,” says Brandon Koeser, senior manager and financial services senior analyst at the consulting firm RSM. The pandemic shed light on how banks support their employees and communities. “The reality is, so much of what they’re doing is part of ESG.”

Robin Ferracone, CEO of the consultancy Farient Advisors, tells companies to think of ESG as a journey, one that keeps strategy at its core. “You need to walk before you run. If you try to bite [it] all off at once, you can get overwhelmed,” she says. Organizations should prioritize what’s important to their strategy and stakeholders. ESG objectives should be monitored, revisited and adjusted along the way.

Stakeholders are watching. Glacier Bancorp CEO Randall Chesler was surprised to learn just how closely in a conversation with one of the bank’s large investors two years ago.

“One of our investors asked us, ‘Have you looked at this? We see your score isn’t very good; are you aware of that? What are you going to do about it?’ And that was the first time that we started to dig into it and realized that we were being scored by ISS,” says Chesler. (Institutional Shareholder Services provides an ESG rating on companies, countries and bonds to inform investors.)

It turned out that $18.5 billion Glacier was doing a lot, particularly around the social and governance aspects of ESG. The Kalispell, Montana-based bank just wasn’t telling its story. This is a common ESG gap for community and regional banks.

Glacier worked with consultants to develop a program and put together a community and social responsibility report, which is available in the investor relations section of its website, along with other governance documents such as its code of ethics. This provided the right level of information to lift Glacier’s score. “Our benchmark was, we want to be at our peer-level scoring on ESG,” says Chesler. “[We] ended up actually better. And we continue to watch our scores.”

“Community banks have the social and governance aspects covered better than many industries because [banks are] heavily regulated,” says Joe Scott, a managing director at Kroll Bond Rating Agency. Where they likely lag, he says, is around the environment; most are just beginning to assess these risks to their business. And it’s important that banks get this right as stakeholders increasingly focus on ESG. “We’re hearing that, beyond equity and debt investors, larger depositors — particularly corporate depositors, institutional depositors, state treasurers’ officers [and] others like that — are incorporating ESG into their considerations on who they place large deposits with. That could be a theme over time— other kinds of stakeholders factoring in ESG more and more.”

Key Compensation Issues in a Turbulent Market

As compensation committee chair, Susan knew 2020 was going to be an important year for the bank.

The compensation and governance committee had taken on the topic of environmental, social and governance (ESG) for the coming year. They had conducted an audit and knew where their gaps were; Susan knew it was going take time to address all the shortfalls. Fortunately, the bank was performing well, the stock was moving in the right direction and they had just approved the 2020 incentive plans. All in all, she was looking forward to the year as she put her finished notes on the February committee meeting.

Two months later, Susan had longed for the “good old days” of February. With the speed and forcefulness that Covid-19 impacted the country, states and areas the bank served, February seemed like a lifetime ago. The bank had implemented the credit loss standard at the end of March — due to the impact of the unemployment assumptions, the CECL provision effectively wiped out the 2020 profitability. This was on top of the non-branch employees working from home, and the bank doing whatever it could to serve its customers through the Paycheck Protection Program.

Does this sound familiar to your bank? The whirlwind of 2020 has brought a focus on a number of issues, not the least of which is executive compensation. Specifically, how are your bank’s plans fairing in light of such monumental volatility? We will briefly review annual and long-term performance plans as well as a construct for how to evaluate these programs.

The degree to which a bank’s annual and long-term incentive (LTI) plans have been impacted by Covid-19 hinge primarily on two factors. First, how much are the plans based upon GAAP bottom-line profitability? Second, and primarily for LTI plans, how much are the performance-based goals based upon absolute versus relative performance?

In reviewing annual incentive plans, approximately 90% of banks use bottom-line earnings in their annual scorecards. For approximately 50% of firms, the bottom-line metrics represent a majority of their goals for their annual incentive plans. These banks’ 2020 scorecards are at risk; they are evaluating how to address their annual plan for 2020. Do they change their goals? Do they utilize a discretionary overlay? And what are the disclosure implications if they are public?

There is a similar story playing out for long-term incentive plans — with a twist. The question for LTI plans is how much are performance-based goals based upon absolute versus peer relative profitability metrics? Two banks can have the same size with the same performance, and one bank’s LTI plan can be fine and the other may have three years of LTI grants at risk of not vesting, due to their performance goals all being based on an absolute basis. In the banking industry, slightly more than 60% of firms use absolute goals in their LTI plans and therefore have a very real issue on their hands, given the overall impact of Covid-19.

Firms that are impacted by absolute goals for their LTI plans have to navigate a myriad level of accounting and SEC disclosure issues. At the same time, they have to address disclosure to ensure that institutional investors both understand and hopefully support any contemplated changes. Everyone needs to be “eyes wide open” with respect to any potential changes being contemplated.

As firms evaluate any potential changes to their executive performance plans, they need to focus on principles, process and patience. How do any potential changes reconcile to changes for the entire staff on compensation? How are the executives setting the tone with their compensation changes that will be disclosed, at least for public companies? How are they utilizing a “two touch” process with the compensation committee to ensure time for proper review and discourse? Are there any ESG concerns or implications, given its growing importance?

Firms will need patience to see the “big picture” with respect to any changes that are done for 2020 and what that may mean for 2021 compensation.