The Return of Darwinian Banking


Listening to Ben Plotkin, EVP and vice chairman at the investment banking firm Stifel Nicolaus Weisel, as he provided a broad industry overview at our Bank Executive & Board Compensation event last week in Chicago, the image that came to mind was a heavy-weight boxer who has been staggered by repeated blows to the head but somehow is still standing.

Looking at the fundamentals, there’s no question that the U.S. banking industry has been bloodied by the worst economic downturn since the Great Depression of the 1930. According to Plotkin, the industry’s profitability plummeted from a high-water mark of $128.2 billion in 2006, to $97.6 billion in 2007 – to just $15.3 billion in 2008. Plotkin illustrated this on a bar chart, and that dramatic 2009 earnings decline resembled a Sears Tower elevator dropping from the top floor to darn near the basement.

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“Unreal” Earnings

Of course, we all know that industry’s record profitability from 2002 through 2006 was fueled by the bubble economy and a hyperactive mortgage market. Or as Plotkin put it, “A lot of people say those earnings weren’t real.” And indeed they weren’t considering how much of that money was given back in the form of loan and bond losses, but I think it’s also amazing that the banking industry didn’t sustain even more damage than it did.

The number of banks on the Federal Deposit Insurance Corp.’s troubled institution list rose to 829 in the second quarter of this year, but banks are dropping at a much lower rate than in the early 1990s, when the collapse of the commercial real estate market resulted in many more bank failures than we’re likely to see this time around.

Improving Trends

But there is light at the end of the tunnel for most banks, and it’s not necessarily a freight train hurtling towards them. Based on Plotkin’s numbers, it would seem that the industry’s asset quality problems have finally peaked. After rising sharply from 2006 through 2009, non-performing loans have finally leveled out and even declined slightly to about 3.2% in November. Healthy banks with strong balance sheets (including better than average asset quality) have also been able to raise capital from institutional investors.

The industry’s net interest margin (which is essentially the difference between the interest rate on a loan and all the costs associated with getting that loan) has also shown recent improvement. Through the first two quarters of 2010 the margin was approximately 3.85% — compared to 3.39% in 2006 and 3.35% in 2007, when the industry was (ironically enough) rolling in dough. Those numbers say two things to me.

One, loan pricing is gradually improving as bankers are able to charge higher rates on their loans. And two, the industry compensated for its cut-rate pricing in 2006-2007 with volume – which turned out to be a recipe for disaster.

Why would the big pension and mutual funds be willing to invest capital in a troubled industry? Perhaps because they anticipate a predatory environment in which the strong and the swift will devour the weak and the weary. “Many of the catalysts for renewal of the traditional M&A market are beginning to take shape,” Plotkin told the audience. Asset quality is slowly beginning to improve, signaling potential acquirers that the worst is over. Strong banks have access to capital, so they can afford to acquire. And banks with diminished earnings power and little or no access to institutional sources of capital may find that selling out to a more highly valued competitor is their only viable strategy to reward their long suffering owners.

It’s a Darwinian principal that has helped drive bank consolidation for the past 25 years, and no doubt for a few years more.

 

Say What on the CEO Pay Ratio?


The first day of our annual Bank Executive and Board Compensation event got off to a rousing start with two back-to-back sessions focused on how the regulations are effecting the compensation committee’s role. After the session, I had a chance to follow up with Mike Blanchard, partner at compensation advisory firm Blanchard Chase, for a quick video recap on his recommended approach for handling the controversial CEO pay ratio requirements.

Click play button to start the video:

As Mike points out in the video, the full effects of this new regulation are not yet known and will vary by company. However, the best way to deal with this piece of the regulation is to be prepared to tell your story on why you pay what you pay, talk through the process and feel good about your decisions. The last thing you don’t want is to find yourself contemplating something crazy like outsourcing your janitorial services just to help minimize the disparity in salaries.

Happy Employees = Happy Communities


This past week, Bank Director and The NASDAQ OMX Group hosted our sixth annual Bank Executive & Board Compensation Event in an unseasonably warm Chicago. After an early registration and light breakfast, over 270 bankers and advisors from across the country gathered in the large ornate grand ballroom of the Intercontinental Hotel to kick off our two-day event with an opening session on the Future of Performance Compensation Plans.

Moderated by Todd Leone of Amalfi Consulting, a panel consisting of a compensation committee chair, senior human resources executive and a board chairman shared their insights on how to design compensation programs that deliver a competitive edge, while still rewarding the CEO and balancing the needs of the company and shareholders.

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To jump start the session, Todd presented the attendees with an overview on the four regulatory factors that have changed the responsibilities of compensation committees, and therefore making their position the most challenging of the board. These regulations consistencies include:

  • Compensation committees are now being held accountable for performance-driven compensation plans across the entire organization, including the lowest paid employees.
  • Clawbacks are predicated upon reinstatement of earnings, and performance bonuses will need to be re-paid if a loan goes bad.
  • Committee members will be instrumental in reviewing the risk of compensation plans and should have an audit process in place.
  • Members will need to look beyond the fiscal year to ensure that the team is focused on long-term goals as well as short-term ones.

Many observations and recommendations were presented by the three panel members but the following topics were considered the highlights of the discussion.

Managing Regulations & Risk Review

  • Greg Ostergren, the compensation committee chairmen for Guaranty Federal Bancshares, a $732-million institution out of Missouri, described the effectiveness of hiring a chief risk officer to help manage regulations, review compensation plans and to help the bank stay ahead of curve.
  • For smaller community banks where resources may be limited, panelists recommended that the compensation committee take on the duties of risk oversight. In some cases, the human resources or internal auditing team can take on this role of giving a more objective viewpoint.
  • While TARP banks are ahead of the curve with regard to risk review, panelists were in agreement that non-TARP banks should follow suit just to be prepared for the regulators.

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Incentive Based Pay Structures

  • When it comes to executive compensation plans, one approach is to develop a mixed ratio plan that accounts for performance metrics, company culture, and business development. Paul Barber, SVP & HR manager for Graystone Tower Bank, a $1.6 Billion non-TARP bank, shared that 50% of their executives’ incentive compensation is based on credit quality.
  • A panel member also suggested that 30-35% of the Relationship Manager’s reviews be based on a clean portfolio.
  • Bonus incentives for the commercial lenders can be changed from cash to stock options, so that employees are compensated on the performance of the bank over long periods of time rather than the ability for someone to make a quick buck.

Recruiting & Retention Challenges

  • With all the regulations coming down the pike, attracting top talent to a troubled bank can be a challenge. One creative solution is to bring new recruits on as consultants before submitting them to the FDIC for approval as management.
  • Sam Borek, chairman and acting CEO of OptimumBank in Florida, reminded the group that while the FDIC doesn’t approve of signing bonuses, it does approve of staying bonuses which can aid in the recruiting of top management talent.
  • In terms of future compensation planning, clawbacks can actually work as a retention tool by requiring that the executive team receives a bonus after meeting their three-year goals during their employment term.

While several points were discussed among the panel, the overall recommendation was to consider what works best for your bank based on your region, business goals and staff needs. And as Sam Borek so thoughtful shared, his company’s number one stakeholder group is the employees, as happy employees create happy customers who make for happy shareholders who ultimately make for happy communities. Everything else falls in line behind that key mission.

Navigating the Sea of Financial Reform


navigate.jpgRecently, Bank Director and the American Banker presented the 2nd annual America’s Bank Board Symposium tailored to provide bank boards with the knowledge to develop, implement, and monitor strategies for their institutions. Several key industry speakers joined CEOs, board members and experienced financial leaders in Dallas to help navigate the sea of challenges facing bank directors today.

On the heels this event, I had the chance to catch up with one of the presenters, Susan O’Donnell, Managing Director with Pearl Meyer & Partners, an independent compensation consulting firm, to further explore her insights on what she believes are the top three issues concerning directors. Below is what she shared with me via email:

1. Responding to a Rapidly Changing Regulatory Environment
New regulations and requirements are coming at bank directors at an unprecedented pace, particularly in the last decade. Whether Sarbanes Oxley, recent banking regulatory agency guidance on risk assessment of incentive compensation practices, or new proxy disclosure requirements under the Dodd-Frank Act – there is a much greater need for board members to keep up with the rapid and constantly changing regulatory environment. This is particularly true of public banks that now have to meet even more disclosure requirements.

2. Understanding Changing Executive Compensation Trends, Including the Role of Risk Management
Keeping informed of the emerging best practices has also become a major challenge, as boards today must ensure their executive compensation practices reflect sound risk management, pay-for-performance alignment and align with shareholder interests. Board members (particularly compensation committee members) need to adapt their institution’s compensation practices, where appropriate, to reflect the new regulations and emerging best practices, while continuing to support their unique compensation philosophy.

What was ‘acceptable’ practice several years ago might be considered inappropriate today. For example, incentive compensation programs that place significant (or sole) focus on profits and top line growth may be perceived as potentially diverting banks’ focus on safety and soundness. Regulators are reviewing incentive plans with a new “set of glasses” and board must also review their executive compensation programs through these new lenses.

Severance/change in control benefits are also changing in response to increased scrutiny and transparency. Provisions such as the gross-up payments to cover the taxes to the executive under certain situations used to be common several years ago, but are no longer considered appropriate. And companies that continue to put such provisions in place with new contracts will come under increased pressure from shareholders and shareholder advisory groups, potentially impacting future Say on Pay votes. Boards need to be aware of these changing perspectives and the potential reaction from regulators and shareholders.

As executive compensation is under increased pressure, boards need to be ready to respond to the new level of scrutiny. More importantly, they will need to articulate their own compensation philosophy and develop programs that address their own unique needs, rather than chase historical market practice, which in many cases is no longer applicable or appropriate.

3. Responding to Increased Transparency, Disclosure and Shareholder Influence
The new disclosure requirements, starting in 2006 and culminating with many new requirements enacted through the Dodd-Frank Act, are placing a greater spotlight on executive compensation (and governance) practices. With a brighter light comes increased scrutiny.

With Say on Pay, shareholders will have an opportunity to vote their approval (or disapproval) of bank compensation programs. While non-binding, the votes will be public information, subject to media scrutiny. As such, boards will need to listen and be prepared to adapt or change in response to the feedback they receive.  It is critical that boards today focus on ensuring their proxy disclosure effectively communicates their compensation philosophy, programs, decisions, rationale for decisions and pay –performance alignment.

Boards will also need to know and understand their shareholders better. Say on Pay, Proxy Access and the loss of the Broker vote will increase shareholders’ influence on compensation programs and banks should be prepared for this new level of transparency and disclosure.

The Characteristics of Success

With all the new regulations and increased scrutiny within the financial industry, I was curious to know what characteristics would separate the winning banks from the losing ones over the next five years. O’Donnell highlighted these top three traits that she recommends bankers will need to make it through this period of reform:

1. Adaptability: Bank boards will need to be responsive to all the changes going on in the industry, including the new economic, business and regulatory requirements.

2. Leadership: Boards that exercise strong leadership as they navigate the bank through challenging times will more than likely come out on the winning side.

3. Focused: Boards must have clearly defined goals and strategies, knowing what needs to be done to execute them effectively.

One thing I’ve learned very quickly since joining Bank Director is that these are without a doubt some of the most challenging times the U.S. banking industry has experienced in quite some time. But with knowledge, flexibility and effective execution, I am confident that smart bankers will continue to excel at growing their financial institutions.