Banks Make Changes Following Wells Fargo Crisis

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incentive-12-16-16.pngIt seems almost everyone with a bank account knows the story: a relatively small group of people within a large organization committed fraud by opening unapproved customer accounts in order to earn performance bonuses under a production-based incentive plan. The scandal badly bruised the bank’s stellar reputation, forced the CEO to step down, and resulted in a significant loss of shareholder value, before the election turned the tide for many bank stocks.

It has also prompted a widespread industry examination of retail incentive practices. Whether it is through the OCC’s horizontal review of sales and marketing practices or board requests at smaller community banks, the industry is taking a look at both the cultural aspects of sales expectations and the design and controls of the programs themselves.

In November 2016, Pearl Meyer conducted a survey of actions banks are taking to address the potential issues uncovered by the scandal. This study included 57 respondents representing both small and large institutions across the country. The key outcomes indicate that four out of five banks have had an internal or external inquiry regarding their retail incentive plan practices. Most banks are unlikely to make significant changes to their retail incentive plan design and instead are focusing on communication and training as well as enhanced documentation, controls and monitoring.

The aftermath of the Wells Fargo scandal will be that banks are expected to examine their retail incentive programs and the controls supporting them. To that end, we believe there are five questions that banks should ask and answer with respect to their retail incentive programs.

What does our plan reward? About half of respondents to our bank survey indicated using volume metrics and cross-selling metrics (55 percent and 47 percent respectively), which have been criticized as a part of the scandal. However, few are planning to discontinue these metrics (6 percent to discontinue volume and 4 percent to discontinue cross-selling). Use of either metric may put additional pressure on banks to demonstrate how their controls and administrative procedures curtail fraud or misconduct.

Approximately 70 percent of respondents use growth metrics and 34 percent use profitability or revenue, which are much more difficult to manipulate. Nearly one-third have a discretionary component for branch or individual performance that can help reinforce positive behaviors and “right size” awards.

How is our plan monitored? Participants received inquiries from executive management (72 percent) and their boards (51 percent) who may be unfamiliar with the specific details of the retail incentive programs. Banks are addressing the additional oversight through increased monitoring and controls (46 percent) and greater reporting to senior management or the board (42 percent). Reporting elements need to remedy the fact that boards have a responsibility to ensure the bank’s incentive compensation arrangements do not encourage inappropriate risk. Directors often have no visibility into retail incentive plans, have no easy way to quickly understand the impact, do not know what their rights or authority are in understanding, determining, and remedying the risk, and have no plan for how to react. These issues need to be addressed to appropriately monitor the risk.

Are our expectations reasonable? The last element of reporting—how many employees are meeting performance goals—can identify unreasonable expectations or flag the need for better training or management. Collecting performance data over time to see trends in performance, expectations and payouts may also prove useful.

What are our customers experiencing? More than a quarter of respondents indicated that they will develop or enhance their customer complaint process. The process should not only handle specific complaints but also aggregate the complaint types to identify systematic breakdowns in the customer experience.

Are we staying true to our values? Critics have indicated that perhaps the largest failing at Wells Fargo was an environment where branch staff feared that nonperformance would result in job loss. Monitoring of employee satisfaction by business line and mechanisms to provide feedback without repercussions can help identify problems before they escalate.

Given the large-scale publicity of the Wells Fargo scandal, someone—customers, employees, regulators, or shareholders—will likely ask how your retail incentive program is different and what you have done to protect against fraud or misconduct. Accordingly, banks should conduct an assessment of retail incentive plan designs, risks and controls, as well as gain a better understanding of the branch sales culture and leadership.

New Incentive Compensation Rules Will Impact Banks and Their Boards

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incentive-compensation-6-27-16.pngRecently, four of six regulators issued an inter-agency proposal for new rules on incentive compensation under §956 of the Dodd-Frank Act. The new rules replace the joint rules proposed in 2011, which never went into effect. Banks boards must approve incentive compensation plans for senior executives and “risk takers” under the framework of the law.

Four Key Differences
While some of the re-proposal is the same, there are important differences between the new rules and the 2011 rules. Here we touch on four key differences, and one important similarity.

1. The regulators have been “getting smart” on incentive compensation. While the 2011 rules seemed to have been proposed in a vacuum, the regulators have indicated that the new rules are based on their collective supervisory experiences gained over the last several years. The new rules incorporate practices that institutions and foreign regulators have adopted to address compensation practices that may have contributed to the financial crisis.

2. The new rules try to lessen the burden on smaller institutions by further dividing banks into categories based on assets and by scaling the requirements. The new rules recognize three categories each of which will be subject to varying levels of oversight:

  • Level 1 (greater than or equal to $250 billion);
  • Level 2 (greater than or equal to $50 billion and less than $250 billion); and
  • Level 3 (greater than or equal to $1 billion and less than $50 billion).

Institutions with average total consolidated assets of less than $1 billion will be subject only to the “safety and soundness” aspects described below. In most cases, the new rules apply the most stringent aspects only to Levels 1 and 2, while Level 3 just has primarily governance and recordkeeping obligations. However, regulators do have the discretion to subject Level 3 institutions to the rules applicable to Level 1 and 2 institutions.

3. The new rules get more specific about troublesome compensation designs. An incentive compensation arrangement will not be considered to appropriately balance risk and reward unless it:

  • Includes financial and non-financial measures of performance;
  • Is designed to allow non-financial measures of performance to override financial measures of performance, when appropriate; and
  • Is subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance.

4. The new rules extend mandatory deferral and clawback periods for Level 1 and 2 institutions. At their most restrictive, the new rules will require deferral for at least four years of at least 60 percent of senior executive officers’ incentive compensation and at least 50 percent of significant risk-takers’ incentive compensation. In addition, the new rules will require clawback provisions that, at a minimum, allow the institution to recover incentive compensation from the same individuals for seven years following the date on which the compensation vests, if the institution determines that the individual engaged in misconduct, fraud or intentional misrepresentation of information.

One Similarity
In addition to the foregoing key differences from the 2011 proposal, one important aspect remains the same. Similar to the 2011 rules, the new rules will prohibit all institutions from establishing or maintaining incentive compensation plans that encourage inappropriate risk by providing excessive compensation, fees, or benefits or that could lead to material financial loss to the covered institution. In this regard, the new rules continue to rely on the bank regulators’ “safety and soundness” guidelines respecting all compensation arrangements. In particular, in assessing the balance of risk and reward with respect to any compensation arrangement, institutions should consider all relevant factors including:

  • The combined value of all compensation, fees, or benefits provided to a covered person;
  • The compensation history of the covered person and other individuals with comparable expertise at the covered institution;
  • The financial condition of the covered institution;
  • Compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the covered institution’s operations and assets;
  • For post-employment benefits, the projected total cost and benefit to the covered institution; and
  • Any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution.

Effective Date and Transition
It is expected that the last two regulators will publish their version of the new rules in the coming weeks. Variation between versions is not expected. A comment period will follow publication by each of the regulators. The new rules will become effective approximately 18 months after being published in final form. The new rules will not apply to any incentive compensation plan with a performance period that begins before the final rules are effective.

Do You Have the Right Incentive Goals?

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The first quarter of every fiscal year finds compensation committees and management teams wrestling with setting performance goals for the coming year’s incentive arrangements. What does that process look like for your institution?  If your company hasn’t conducted a ground-up assessment of the goal setting process in recent years, consider taking a fresh look at your approach this year.

How does your institution select the performance measures?
In Pearl Meyer’s recent survey, Looking Ahead to Executive Pay Practices in 2016 – Banking Edition, respondents indicated the following three factors as having the greatest influence on performance measure selection:

We would argue that the “long-range or strategic plan” should carry substantially more influence in the selection of performance measures than the other two factors–doing so also takes substantially more effort and intentionality. In contrast to plucking some high profile measures from the approved budget, copying what peers are doing, or appeasing institutional investors or their advisors, selecting measures that effectively support the long-range or strategic plan requires a multi-step line of thinking that starts with the end goal in mind (long-term growth in enterprise value) and drills down to very specific actions that need to occur now in order to achieve the end goal.

Some practical steps in the process include the following:

  • Outline the company’s business objectives and strategy and the drivers of long-term value creation. Then select short- and long-term incentive performance measures that directly tie to the achievement of milestones toward these goals.
  • Identify and focus on the centerpiece financial metrics that will signal success within your company, your industry and the global economic environment.
  • Incorporate both “lag” metrics (that reward achievement) and “lead” metrics (that spur desired new actions and behaviors).

Once the measures are selected, how does your institution set performance expectations?
Respondents to our survey identified the following five factors as having the greatest influence on their performance goal setting process:

For performance measures that can tie directly back to the annual budget, the budget is a very common way to establish “target” performance expectations. This can be effective and appropriate, so long as there is high confidence among the board and management team that the annual budget represents the proper amount of rigor deserving of target incentive payouts. But the budget is not terribly helpful at setting performance expectations appropriate for “threshold” or “stretch/maximum” payouts. This is where observations regarding historical performance, both for your institution and your peers, can be extremely helpful.

Evaluating actual performance against the selected measures over the last several years (preferably five or more) can provide excellent information about the likelihood of achieving specific performance outcomes and can help you to be confident that the appropriate rigor is represented at all payout opportunity levels (i.e., threshold, target and maximum). A rule of thumb for the rigor of performance expectations is as follows:

  • Threshold performance/payout should be achievable about 80 percent of the time
  • Target achievable 50 percent to 60 percent of the time
  • Stretch/Maximum achievable only 10 percent to 20 percent of the time

Observing historical performance is an excellent way to calibrate the performance expectations with the respective payout opportunities and to understand directional trending on specific measures.

Most of the attention and speculation by investor groups surrounds the potential for insufficient rigor in the performance expectations, relative to the payout opportunities. This is a valid concern. It’s also a valid concern when performance expectations are unreasonably high, relative to payout opportunities, because that could discourage employees or potentially encourage them to expose the bank to excessive risks in pursuit of otherwise unattainable levels of performance. A little effort and historical data can go a long way toward addressing both concerns.

Selecting incentive performance measures and establishing the performance expectations are not routine, one-meeting-per-year exercises. If conducted in a thoughtful, intentional manner, your incentive plan design in the first quarter of 2016 can truly support your business strategy and drive behaviors that lead to growth in the value of your company. Make 2016 the year that you challenge—and improve—your incentive goal-setting process.

Incentive Plans: Who Makes the Cut?

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incentive-pay-1-11-16.pngBanks frequently ask the question: Who should be included in their various performance-based incentive plans? Of course the answer to this question isn’t clear cut. This article attempts to put some clarity—and statistics—behind this decision for both cash-based and equity-based incentive plans.

Cash-Based Incentive Plans
The eligibility for performance-based annual cash incentive plans ranges from zero employees to all employees. Yes, some banks still use a completely discretionary cash incentive or bonus program. The discretionary approach is not best practice, but is still prevalent. Today’s employees want to know what they need to do in order to receive a bonus, and companies are better served by giving these employees some clarity.

Budgeting for performance-based cash incentives can be relatively easy. Start by determining how much you are willing to share and what you can afford to share. It is recommended that you establish a minimum profit amount, or income trigger, that must be achieved before any cash incentive is paid. This gives you some cushion and protects your company and shareholders from paying bonuses it can’t afford. Once you have built in the cushion, run some cost estimates based on your eligible employees and their potential incentive awards.

The truly difficult part for performance-based cash incentive plans is the goal setting. Identifying overall company goals should not be complicated (lean on your strategic plan), but the individual and department goals may be challenging. It’s easiest to establish goals and track performance for production-focused positions. However, for operations-focused positions, companies sometimes decide to either base these positions’ annual incentive solely on corporate goals or “throw their hands up” and move to discretionary goals. It’s not easy, but banks should work to establish objective goals. You may not get it perfect the first time, but keep working on it. Goal setting is a process that you get better at over time.

So who should participate? Our Blanchard Consulting Group 2015 Bank Compensation Survey (which included 124 public and private banks and 140 positions) gathered data on bonus payments, incentive award opportunity levels, and the prevalence of performance-based incentive plans. The survey showed that the use of performance-based incentive plans increases with the size of the organization (from 41 percent prevalence in banks below $500 million in assets to 72 percent prevalence in banks above $1 billion in assets). The target award opportunity levels generally ranged from approximately 30 percent of salary for executives down to 2 percent of salary for entry level positions. One interesting finding from the survey was that every position had cash bonus/incentive amounts being paid. This doesn’t mean every bank paid bonuses to everyone, or that they were all based on performance, but it does mean there were at least a number of banks that paid bonuses all the way throughout the organization. Ultimately, the decision is up to each bank, but it is recommended that all full-time positions be eligible to participate in the cash incentive plan.

Equity-Based Incentive Plans
The days of having stock-option plans that include all employees in the bank are long gone. Equity-based plans are far more prevalent in the executive and officer group than other employees. However, some banks are still using equity at lower levels in the organization. The Blanchard Consulting Group 2015 Bank Compensation Survey gathered data on equity plan prevalence, employee eligibility in banks with a plan, and grant prevalence over a multi-year period, from 2012 to 2015.

The findings showed that much like cash incentive plans, the prevalence of equity-based plans increases with the size of the organization: 26 percent of banks below $500 million in assets have equity-based plans and 55 percent of banks above $1 billion in assets have them. The most interesting findings from our equity review surrounded the eligibility data. Not surprisingly, 70 percent of executive level positions had equity plans. These numbers dropped to below 10 percent for some entry level positions, but surprisingly, the mid-level positions showed eligibility in the 20 percent to 40 percent range. The actual grant prevalence data over a multi-year period was generally above 75 percent for executives and stayed above 40 percent for many mid-level positions. This shows that banks with an equity plan are using it well below the executive level.

In summary, it seems clear that banks are leaning towards including more of their employee base in their cash and equity-based incentive plans when they have these programs. This requires extra work in administration and communication, but hopefully is creating an engaged staff that is driving towards the success of the bank in a unified way.

How to Set Performance Metrics that Drive Success

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incentive-pay-10-12-15.pngGenerally bank incentive programs reward team members for the achievement of bank-wide financial results. However, important goals which actually build value, such as customer retention, operational improvements and talent management, are often overlooked. Strategy-based compensation marries a bank’s compensation programs with its business strategy, rewarding team players for performance which results in the achievement of strategic objectives. A helpful tool in designing a program that works is a strategic road map, which clearly identifies activities and players needed to achieve results and create value for your organization.

Creating Your Strategic Road Map
The foundation of strategy-based compensation is an understanding at all levels of the organization as to which activities are required to achieve the stated objectives. A road map to execution will identify the focal points—financial/capital requirements, customer consideration, technology needs and the alignment of talent—as well as the value drivers to push success. Laying out your strategy demonstrates team placement and individual responsibilities within the broad scheme. The illustration below is a hypothetical strategic map for a community bank. Efforts in talent management, operation process, and customer satisfaction ultimately drive the desired financial outcome: growth in income and shareholder value.

Incentive Design Considerations
Among banks, executive incentive plans typically measure bank-wide performance across three buckets:

  • Balance sheet goals (e.g. growth in loans and deposits);
  • Earnings (e.g. return on assets and/or equity); and
  • Portfolio quality (e.g. regulatory ratings, non-performing assets, and/or net charge-offs).

As demonstrated in the strategic map above, these financial metrics are outcome-based and generally reflect the results of efforts. Limiting the overall focus of incentive plans to financial objectives potentially limits the program’s ability to reward and motivate the actions required to realize the success of the business strategy. Forward-looking organizations support differentiating their incentive programs beyond the typical financial focus.

From an executive perspective, incentive plans can incorporate value-driving performance metrics such as:

  • Growth in deposits from new accounts;
  • Expansion of lending activities specifically tied to new markets;
  • Identification of acquisitions;
  • Increases in operating efficiencies, new technology platforms;
  • Demonstration of robust succession planning efforts beyond; and
  • Customer satisfaction and usage.

Below the executive level, team members should be rewarded for areas within the strategic map that they can directly impact. For example, branch managers or operation officers are instrumental in increasing efficiencies and improving customer experiences. However, these individuals have limited line of sight and impact on loan growth or capital requirements. Linkage of incentives to particular elements of the strategy map drives towards the stated strategic outcome.

Goal Setting
Equally as important in the incentive design process is setting performance goals. Designing an incentive plan to drive performance beyond the day-to-day requires setting goals with sufficient stretch to push superior market performance. Testing where your target performance goals sit relative to your bank’s and your peers’ past performance, as well as market expectations, demonstrates the rigor of your goals. For example, from a financial perspective, is the achievement of your loan growth target a walk in the park or a more difficult and dramatic home run?

In addition, setting performance goals requires an understanding of the timelines for execution. The strategic map should illustrate the milestones required to execute your objectives and your short- and long-term incentive programs should align accordingly. For example, entry into a new market may require the identification of a branch to acquire or new construction, as well as staffing. The time frame required to complete these activities and their successful deployment is likely to vary and may not be easily compartmentalized in a typical incentive plan performance period of one or three years. The most successful incentive program designs will demonstrate a level of flexibility.

Driving Performance Beyond the Day-to-Day
Incentive programs are powerful tools when designed properly. The program’s design should dovetail with your business objectives, timeframes, and lines of sight among participants. Further, these programs should be frequently monitored, reviewed, and revised as appropriate to ensure they support your bank’s evolving strategic objectives, thereby driving performance beyond the day-to-day.

Designing Annual Incentives to Improve Pay for Performance

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10-2-13-Pearl-Meyer.jpgAnnual incentive programs are one of a bank’s most important tools for executing a meaningful pay-for-performance philosophy. The degree to which they drive strategic priorities and shareholder value depends on three important design dimensions:

  • The selection of performance measures
  • The degree of difficulty built into performance goals
  • How payout levels are calibrated with different levels of performance

The Banking Edition of Pearl Meyer & Partners’ On Point Survey: Annual Incentive Plans for Top Corporate Officers provides insight to the most common practices as reported by 31 banking institutions (representing 22% of the total survey group), the majority of which are publicly-traded. Among the findings:

Banks typically build their annual incentive around three to five key financial measures. The most common performance measure, used by 58 percent of bank survey participants, is net income (including earnings per share or EPS). Operating income is the second most common measure, used by 46 percent of respondents, and top line revenue or sales is used by 31 percent. In addition to financial measures, most banks use individual performance to either modify the calculated bonus amount (45 percent) or independently generate a portion of the annual incentive amount (23 percent).

Performance goal-setting is arguably the most difficult and also one of the compensation committee’s most important responsibilities. Fifty-five percent of banking participants base annual performance goals on the board-approved budget. Among those banks that do not reference the budget, 26 percent reported using long-term internal standards (e.g., 1 percent return on assets, or 10 percent earnings growth) and 10 percent each used either long-term strategic plan objectives or other forecasts.

In addition to a target goal, 71 percent of respondents establish a threshold/minimum goal and a superior/maximum goal as a consistent percentage (e.g., 80 percent and 120 percent) of the target performance goal each year. While defining a consistent range around target is a reasonable approach, institutions should take care to evaluate the degree of difficulty of goals each year—120 percent of budget may be a reasonable goal in one year, but extremely aggressive in another year. Also, 120 percent of budget will be a more or less aggressive level of performance depending on which financial measure is used.

Only 7 percent of banking participants consider other factors in setting goals, such as degree of difficulty relative to peers/industry expectations and/or the level of performance expected by shareholders. In addition to evaluating approved goals externally relative to peers and industry performance, as well as shareholder expectations, every compensation committee should also understand the difficulty of achieving goals relative to the bank’s internal historical performance and planned investments and expenditures during the year.

Almost all annual incentive plans are designed to pay out 100 percent of the target award opportunity for achievement of the target performance goal. However, survey respondents reported much more variety in maximum payouts for achievement of superior goals—ranging from 19 percent of respondents with a maximum payout of 100 percent of target (i.e., no upside leverage above target performance), to another 19 percent of respondents with a maximum of 150 percent or 200 percent of target. Payout levels for threshold and superior performance should be adjusted to appropriately reflect the degree of difficulty for achieving each goal. For example, a plan design in which threshold performance to achieve any award at all is 90 percent of target goal should have a higher payout (perhaps 60 percent of target) than if the minimum threshold to achieve any award is 70 percent of the target goal. (In this case, perhaps a 20 percent payout would be appropriate.)

Conclusion

An effective annual incentive plan links and appropriately calibrates performance goals and payout opportunities, taking into account the degree of difficulty involved in meeting goals. Moreover, as part of good plan design, compensation committees should understand how the goals relate internally to the bank’s historical performance results and anticipated future investments, and externally relative to peer performance and shareholder expectations. By taking such steps, companies can improve the strength of their performance-pay relationships.