Bolstering Risk Management Through Pay Governance

Written by

Risk management has been top-of-mind for bank leaders over the past year. Even before the bank failures in March, there was increased concern among bank leaders around several areas of risk. According to Bank Director’s 2023 Risk Survey, which was released in March but conducted in January 2023, respondents’ concerns about interest rate, credit and liquidity risks all increased markedly in 2023. Bank executives and directors also identified cybersecurity and compliance as areas where their concerns have increased.

Following recent bank failures and the subsequent increased scrutiny by regulators, risk management has become the top priority of the board. As such, compensation committees are fine-tuning how their incentive plan designs and governance processes consider risk management.

Six Ways to Bolster Risk Management Through Executive Pay Governance
Boards can deploy the following safeguards to mitigate risk in their banks’ executive pay programs and signal to external stakeholders that managing risk is a priority. In addition to being effective, each practice is reasonably straightforward to implement.

1. Risk scorecard review by the compensation committee. Absent formal risk-based metrics or a discretionary incentive plan, there are limited mechanisms for the compensation committee to account for risk management performance in a typical annual incentive plan. Presumably, the risk or audit committees review key risk metrics continually. In advance of reviewing the end-of-year financial performance under the incentive plan, the compensation committee reviews the same risk metrics as a first step, either independently or jointly with the risk committee. Based on that review, they can exercise discretion to reduce the payout under the financial results if sufficient rationale exists, such as liquidity concerns or capital deficiencies, among other items.

2. Risk adjustments at the individual level. The committee can adjust earned incentives for senior executives and other key positions, like head of mortgage lending, chief credit officer or chief technology officer, based on performance against risk management priorities within their scope of influence. If a risk management rating or evaluation is part of their individual performance rating or scorecard, they can use it to influence the individual performance factor or individual performance component in the scorecard. If there is no mechanism built into the plan for individual performance, the committee can apply a last-step risk evaluation to inform any negative discretion they may apply.

3. Building more informed discretion into the incentive plan. Though proxy advisors recommend a strict formula, the absence of some discretion in an incentive plan for banks could be rife with unintended consequences. Building in a discretionary adjustment factor with predefined categories for consideration and a specific range for adjustments, such as plus or minus 15%, can align pay decisions with business and risk factors that may not be represented in preset incentive scorecard goals. This provides a mechanism for the committee to consider headwinds, tailwinds and risk behaviors when interpreting results.

4. Risk event triggers in the clawback policy. Restatement triggers will be mandatory for public companies’ clawback policy by Dec. 1. In addition to restatement, misconduct triggers are also common across the industry, while clawbacks triggered by risk events are generally only prevalent among large financial institutions. Adding a risk-event trigger for gross negligence contributing to insolvency can provide a consequential penalty for failing to prevent the worst outcomes for banks of all sizes.

5. Deferred cash. Providing a deferred cash vehicle can align executive interests with creditors and depositors and appropriately balance the shareholder alignment already provided through equity compensation. The value of deferred cash can be indexed to changes in the bank’s book value or an appropriate interest rate to preserve value against inflation; dividends can also be credited during the vesting period, just like a stock unit. The executive becomes an unsecured creditor of the bank with additional incentives to use sound judgment while driving shareholder value.

6. Audit committee confirms the pay and performance of the top audit executive. Many of the charters for the audit committees at large financial institutions task the committee with conducting the annual performance review and approving compensation for the chief audit officer. Midsize and smaller banks could add a level of transparency in their processes and reinforce the independence of the audit function by doing the same.

Managing financial risk is at the core of the industry’s value proposition. In support of this, it is essential that the board oversees programs and processes that reinforce this priority. Employing best practices in a bank’s executive pay program and governance processes can reinforce sound risk management for years to come.

A Framework for Incentive Plan Adjustments

Written by

Over the last few years, compensation committees have used their discretion more readily to approve adjustments that impact incentive award payouts. These adjustments were a practical matter during the pandemic and a more recently, to address the rapidly changing interest rate environment. Compensation committees made decisions to achieve appropriate outcomes, given external forces, while holding management accountable for results.

While compensation committees often spend time determining whether adjustments lead to a balanced outcome, they often pay less attention proactively thinking through the process which could be used for future decision making. The following principles create a framework that operationalizes the use of adjustments to metrics from year to year.

Principle 1: Accountability
Compensation committees should determine whether a potential adjustment was due to material external changes or factors that could have been avoided through better decision making. For example, accounting and tax law changes are regularly excluded for the year in which they are enacted and after the goals have been set. Conversely, taking a certain accounting or tax position that ends up being faulty is unlikely to be excluded from actual results, since it was a management decision.

Principle 2: Impact
Any modifications should include documentation from management regarding the impact of the adjustment on the payout and a year-over-year history of adjustments. The document should walk the compensation committee through the issue, the rationale for the adjustment and the financial impact. Assessing the effect to ongoing operations is an important aspect, since adjustments may be made due to a mid-year decision but then incorporated into the banks budgeting process on a go-forward basis.

Compensation committees should discuss potential adjustments at the time business decisions are made, so that it builds in adequate time to review requests. Last-minute requests for adjustments put the compensation committee in the difficult position of understanding incentive outcomes and the rationale for adjustments at a time when agendas are jammed-packed with year-end decisions. The committee’s inclination may be to simply acquiesce and move the meeting along, leaving directors afterwards feeling strong-armed into a point of view.

Principle 3: Bank and Market Practices.
The compensation committee should develop a guideline document that identifies the categories of adjustments it may or may not exclude. For example, events outside of management’s control that could have a material impact to the business, such as tax and regulatory changes and natural disasters, are common adjustments. Certain non-recurring expenses due to mergers and share buybacks may also be excluded in the year in which a business decision is made but was not part of the annual budget. For these events, compensation committees should ascertain whether management’s decisions provided a positive impact to shareholders and the adjustment eliminated a potential disincentive to act in shareholder’s best interests.

There should be documentation summarizing current and historical adjustments the compensation committee could use as a reference to ensure consistency year-over-year. Often adjustment decisions are discussed in executive session, leaving little documentation around the rationale; and the actions become buried in multiple meeting minutes throughout the years. Listing the categories of potential adjustments and the history of past actions will help clarify which adjustments are acceptable while allowing flexibility for unique circumstances.

Principle 4: Timeframe of Adjustment
Compensation committees should assess whether the reason for adjusting is a short- or long-term issue. For example, a one-time management decision that would likely result in better performance over the long-term may reduce an annual incentive payment in the current year, but increase the value of future award payouts, in both the annual and long-term incentive programs.

Developing a framework that evaluates adjustments along with a process for deliberation is likely to result in more confidence in the outcomes, greater consistency in practice and a more efficient process for management and the compensation committee.

How Fintechs Are Impacting Conventional Pay Practices

Written by

Traditional banks are facing unprecedented talent market pressures to retain key people, while also needing to attract talent from the financial technology industry to execute their own business transformations at an accelerating rate.

As the pressure on traditional banks increases, the question of “how much?” is no longer the only relevant question to be answered. Equally important is understanding how compensation opportunities should be structured and potentially delivered to ensure offers remain competitive.

PitchBook, a Morningstar company, has tracked over 820 companies in their fintech industry database as of October 2021. A third of these companies are less than five years old and well-funded by venture capital investors looking to capitalize on the industry’s explosive growth. Growth requires highly skilled, experienced talent to drive it. The fintech revolution has many traditional banks evolving their business models to remain relevant in this highly competitive market.

Seven Notable Pay Practice Trends from the Fintech Industry
The following seven pay practice trends are common across the fintech industry and essential for banks to understand. Financial institutions are likely to encounter several of these practices when competing for talent, and should consider which may work well within their programs to bolster competitiveness.

  1. Highly Competitive Salaries. Many fintech companies were established in high-cost cities, and the pay levels established in Silicon Valley often ripple through their national pay structures. Market-leading base salaries establish a firm offer upfront for prospective candidates.
  2. More Equity Compensation. High company valuations support granting equity more broadly in the organization; candidates coming from that environment will expect an equity grant.
  3. Equity Grants at Hire. It is common in high-tech markets to make an upfront equity grant at the time of hire between two and four times annual target levels to establish a foundational level of ownership.
  4. Shorter Equity Vesting Periods. The age-old belief that longer vesting periods promotes retention is being challenged by some high-profile tech firms. These companies are opting for monthly vesting over a multi-year time frame. Some even opt for full vesting within a year.
  5. Specialized Incentive Plans. The bank’s “corporate plan” may not fit the needs of a developing Banking-as-a-Service venture or fintech business unit. As such, a customized incentive geared towards growth or achieving strategic objectives may better support these businesses in the critical early stages.
  6. Retention Awards for In-Demand, Specialized Skills. Candidates with anti-money laundering, cryptocurrency and treasury function experience are highly sought after by firms and are experiencing large jumps in pay when they change employers. “Lock-in” retention equity awards are one way that companies are attempting to retain their employees.
  7. Flexible Work Arrangements. All industries are encountering this, but this is old hat for fintech companies that have historically emphasized this style work. Flexible work arrangements have become an expectation for most employees with in-demand skills.

For traditional banks, the realities of the broader competitive labor market are further complicated by the increased talent crunch in the fintech industry. Amid these unprecedented labor market pressures, traditional banks would do well to ensure relevant stakeholders are well informed about the realities of the broader competitive labor market and the need for a nimble talent strategy. Understanding both the “how” and “how much” of pay will prepare organizations to respond proactively to these market realities and provide an advantage when competing in the marketplace for talent.