The Future of Banking in the Metaverse

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From Nike’s acquisition of RTFKT to Meta Platform’s Chairman and CEO Mark Zuckerberg playing virtual pingpong, the metaverse has evolved from a buzzword into a way of doing business.

The metaverse could become a “river of entertainment in which the content and commerce flow freely,” according to Microsoft Corp. Chairman and Chief Executive Satya Nadella in “The Coming Battle Over Banking in the Metaverse.” Created by integrating virtual and augmented reality, artificial intelligence, cryptocurrency, and other technologies, the metaverse is a 3D virtual space with different worlds for its users to enhance their personal and professional experiences, from gaming and socializing to business and financial growth.

That means banking may ultimately come to play a significant role in the metaverse. Whether exchanging currencies between different worlds, converting virtual or real-world assets or creating compliant “meta-lending” options, financial institutions will have no shortage of new and traditional ways to expand their operations within this young virtual space. Companies like JPMorgan Chase & Co. and South Korea’s KB Kookmin Bank already have a foot in the metaverse. JPMorgan has the Onyx Lounge; Kookmin offers one-on-one consultations. However, banks will find they cannot operate in their traditional ways in this virtual space.

One aspect that might experience a drastic change is the branches themselves. The industry should expect an adjustment period to best facilitate the needs of their metaverse banking customers. These virtual bank branches will need to be flexible in accepting cryptocurrencies, non-fungible tokens, blockchains and alternative forms of virtual currency if they are to survive in the metaverse.

However, not everyone agrees that bank branches will be that relevant in the metaverse. The idea is that online banking already accomplishes the tasks that a branch located in the metaverse might fulfill. Another issue is that there is little current need for bank branches because the migration to the metaverse is nascent. Only time will tell how banking companies adapt to this new virtual world and the problems that come with it.

Early signs point to a combination of traditional and new banking styles. One of the first products from the metaverse is already shining a light on potential challenges: The purchase and sale of virtual space has significantly changed over the past year. In Ron Shevlin’s article, “JPMorgan Opens A Bank Branch In The Metaverse (But It’s Not What You Think It’s For),” he writes, “the average investment in land was about $5,300, but prices have grown considerably from an average of $100 per land in January to $15,000 in December of 2021, with rapid growth in the fourth quarter when the Sandbox Alpha was released.”

The increasing number of virtual real estate transactions also means the introduction of lending and other financial assistance options. This can already be seen with TerraZero Technologies providing what could be described as the first mortgage. This is just the beginning as we see opportunities for the development of banking services more clearly as the metaverse, its different worlds and its functions and services mature.

Even though the metaverse is still young and there are many challenges ahead, it is clear to see the potential it could have on not only banking, but the way we live as we know it.

Understanding the Cannabis Banking Opportunity

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The legal cannabis industry is growing exponentially each year, creating extraordinary opportunities for financial institutions to offer services to this largely underbanked, niche market.

Revenue from direct marijuana businesses alone is expected to exceed $48 billion by 2025, part of a larger $125 billion cannabis opportunity that includes hemp, CBD and other support businesses, according to information from Arcview and BDS Analytics.

In the last few years, the number of banks providing services to cannabis businesses has increased, along with an expansion of the products they are offering. Financial institutions are moving far beyond being “a place to park cash’ which defined the pioneer era of cannabis banking. Today, our bank clients are approaching the industry as a new market to deploy all of their existing products and services, including online cash management, ACH origination, wire transfers, lending, insurance, payments and wealth management. Additionally, a contingent of banks are trailblazing bespoke solutions.

For banks wanting to better understand what the current cannabis banking opportunity looks like, we recommend starting by:

Exploring the Entire Cannabis Ecosystem
A common pitfall for banks considering a cannabis line of business is failing to grasp the true market opportunity. It’s important that bankers explore the entire supply chain: growers, cultivators, manufacturers, distributors and delivery operations and public-facing retail and medical dispensaries that make up the direct cannabis ecosystem.

Beyond that, there is a supporting cast of businesses that service the industry: armored couriers, security firms, consultants, accountants, lighting companies, packaging companies, doctors who prescribe medical cannabis, and many more. These are not plant-touching businesses, but they require additional scrutiny and often struggle with non-cannabis-friendly institutions. All this is in addition to the significant hemp market, which represents an additional $40 billion opportunity by 2025.

Thinking Beyond Fees
Aside from low-cost deposits, many financial institutions initially entered this niche line of business for additional fee income. While the industry still provides strong fee opportunities, including account opening fees, monthly account fees per license, deposit fees and fees for services such as ACH and cash pickup, these can vary greatly from market to market and will decrease as more financial institutions build programs.

Instead of limiting their focus to fees and deposits, banks should understand the full breadth of the services and solutions they can offer these underserved businesses. Most services that a bank provides their average business customer can be offered to legal cannabis businesses — and there is a significant opportunity to create additional services. We believe there are products this industry needs that haven’t been created by banks yet.

Banks thinking about where to start and what products to add should consider common challenges that legal cannabis businesses face: electronic payment products, cash logistics, fair lending and the numerous difficulties around providing opportunities to new business owners and social equity entrepreneurs. Bankers should become familiar with the industry; find out what it’s most similar to — namely agriculture, food processing and manufacturing — as well as how it is unique. That’s where the real opportunity lies.

Building a Scalable Program
To safely service this industry and meet examiner expectations, banks need to demonstrate they understand the risks and institutional impact of banking cannabis and have the capabilities to accomplish the following, at a minimum:

  • Consistent, transparent and thorough monitoring of their cannabis business clients and their activity, to demonstrate that only state legal activity and the associated funds are entering the financial system.
  • Timely and thorough filing of currency transaction reports (CTRs) and suspicious activity reports (SARs).
  • Ability to gracefully exit the line of business, should the bank’s strategy or the industry’s legality change.
  • An understanding of the beneficial ownership structures, particularly when working with multi-state operators.

Performing these tasks manually is time consuming, prone to error and not suitable for scale. Technology allows banks to automate the most tedious and complicated aspects of cannabis banking compliance and effectively grow their programs. Look for technology that offers advanced due diligence during onboarding, detailed transaction monitoring, automated SAR/CTR reporting and account monitoring to ensure full transparency and portfolio management in your program.

Finding a Trusted Partner
When it comes to partners, banks must consider whether their partner can quickly adapt to changes in rules and regulations. Do their tools support visibility into transaction level sales data, peer comparisons and historical performance? Have they worked with your examiners? What do they offer to help banks service both direct and indirect businesses? Can they help their institutions offer new and innovative products to this line of business?

Banks weighing which partners they should take on this journey need to consider their viability for the long run.

Reconsidering Pay Strategy in the Wake of Inflation

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Say goodbye to the Goldilocks economy, where moderate growth and low inflation sustained us for years. Our global economy and social norms have careened from crisis to crisis over the last 24 months. The world has faced down a pandemic, unprecedented restriction of interpersonal interactions, and disruption of worldwide supply chains. And yet the world economy is booming.

Opinions vary about the reality, root cause, and associated solutions for inflation and low unemployment. But what’s critical is that the growing expectation of future inflation is a self-fulfilling prophecy, and that it stresses the systems for retaining and motivating employees.

Inflation simply is another type of disruption, albeit one that impacts companies and employees at nearly every level. Higher input costs lead to lower corporate margins. Higher costs of goods lead to lower individual savings rates (i.e., margins).

People costs are rising, too. Thinking about people cost as in investment allows strategic discussion about maximizing return. The good thing about people investments relative to say, commodity costs, is that cost levers are largely in corporate control and the tradeoffs can be managed. We view it as an imperative to consider changing pay strategy to reflect the reality of a world where the dollar does not go as far.

Companies and boards should think about how well pay strategy addresses four needs:

Need 1: Is our pay/reward strategy about more than dollars and cents?
Employees have far more choices for employment at this time and can command dollars from multiple places and roles. It is worthwhile to think hard about culture — what makes your culture unique, what people value in their roles, and what might be missing — and then build incentives and reward systems that support those activities in balance with financial performance.

Need 2: Does the pay strategy create the right balance of stability and risk?
Adapting pay programs to be more “risk-off” in the face of a highly uncertain external environment may be appropriate. Think about employees as managing to a “total risk” equation. When the expectation was that corporate growth was close to a given, then the risk meter could accommodate taking more risks to earn potentially more money.

Need 3: Are we making the best possible bets on our top talent?
Paradoxically, it might be a time to take more talent risk by digging deep to find your best people and providing them with differentiated rewards, visibility and responsibility. This is the heart of performance management, and it can always improve. The increased risk comes from investing more in fewer people. What if the assessment turns out to be incorrect or if someone leaves? Managing this risk versus avoiding it is the path to success.

Need 4: How are we sure performance in the face of a more volatile outside world is being rewarded?
This is the most “structural” of the needs. Elements to consider would include:

  • Higher merit budgets
  • More modest annual incentive upside and downside
  • Incorporation of relative measurement into incentive programs
  • Rationalization of equity participation and limitations to a smaller group as needed
  • Designation of equity awards based on overall dilution or shares awarded versus dollar amounts

Each of these needs has material tactical considerations that require much discussion about implementing, communicating and managing change. But unlike other major costs, rising people costs present an investment opportunity for increased returns rather than just a hit to the bottom line.

Does Your Bank Have a Dream Team?

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succession-10-24-17.pngMany bank boards of directors and CEOs are proud of their bank’s executive team. And rightly so! Yet frequently those feelings of pride dissolve into uncertainty when the bank is faced with the decision to promote a banker into a top executive position or even the CEO role.

How does this happen? Why do well laid out succession plans sometimes evaporate in the face of reality when the time to elevate someone finally arrives? One reason, based on our experience working with hundreds of community bank boards and executive teams, is that directors are often missing context when faced with a promotion decision. The lack of relative perspective on comparative candidates for similar roles may at times impede the comfort level necessary for a board to validate a major promotion decision.

Succession plans are frequently aspirational in nature for community banks: long on good intentions towards the executive and bank, yet short on taking advantage of the time available to fully develop and groom worthy successors for key roles. In order for a bank board to feel comfortable supporting a CEO’s recommendation for a C-Level executive promotion, or for the board to align around a promotional decision into the CEO role, a robust assessment, development and monitoring program needs to have taken place along the way.

True clarity around the bank’s strategic plan and growth objectives is also critical. Alignment among the key decision makers—usually the board of directors or trustees, along with the CEO—provides a consistent viewpoint on what the bank needs in its next leader. Strategy informs profile on many levels, including both tangible skills and leadership competencies, and collectively these must also mesh with the company and boardroom culture to enable a successful leadership transition.

Once a bank’s strategic direction is updated and affirmed, an appropriate next step is often to conduct a management assessment of the existing leadership team. At a minimum, this exercise should provide a developmental action plan to help elevate performance of the senior team—even when that performance is already solid.

Evaluating the leadership team provides multiple benefits, including:

  • An objective evaluation of the strengths, scalability, areas of development and desire for more responsibility—particularly when conducted by an independent party.
  • Creation of a “road map of development,” which can be taken to boost executive performance and enhance succession viability.
  • Increased likelihood of retention of high potential bankers due to the feeling of being “valued” and “invested-in” by the organization.
  • Higher morale, as employees see the investment in future leaders as a sign of a commitment to growth and continued independence.
  • A lower risk of a sale or merger driven by a talent deficit, as good succession planning enhances the continuity of leadership and strategy.

A robust management assessment program should have several critical components:

  • Input from the CEO and board that aligns strategy and the desired/needed profiles of future leaders for key roles. These profiles are often different than an incumbent’s profile.
  • Extensive in-person interview time with a qualified industry talent expert. This should involve both behavioral and chronological interviewing techniques.
  • Use of a third-party assessment tool to help understand an executive’s full range of behaviors and leadership attributes, and the ability to benchmark against desired profiles.
  • A peer evaluation survey to garner candid input from close colleagues. Such a 360° process can provide valuable insights to help guide developments plans.

There is no more important responsibility of an incumbent CEO and community bank board than to develop the strongest possible leadership team and potential CEO successors. An informed board with a strong range of perspectives on the bank’s executive talent is best positioned to make promotional decisions on future bank leaders and the next CEO. A robust management assessment program provides the right foundation for good governance and successful succession planning.

Five Common Sense Board Oversight Techniques

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oversight-4-3-17.pngIt seems that all of the banking industry is abuzz about the prospects of potential legislative changes and financial regulatory reform. It is anticipated that Representative Jeb Hensarling will propose Financial Choice Act 2.0, bringing broad and sweeping changes to banking laws and a great number of regulatory changes. While most of the industry supports these changes, it is unclear if any of them will ultimately become law. With uncertainty about whether change in regulatory oversight will be made, we suggest that banks take a look at the functioning of their constant regulator: the board.

Most bank board members would recoil at the notion that they are regulators. They correctly view their role as enhancing shareholder value, which includes setting the strategy for the bank. In some cases, it is a dynamic strategy. However, the oversight function of the board requires that board members serve as the bank’s primary line of regulatory oversight. The board needs to ensure that the bank not only has reasonable programs in place designed to promote compliance with laws and regulations, but also that the bank is appropriately implementing the strategic plan adopted by the board. With that in mind, we believe bank boards can improve their oversight function by adopting some of the key proposals under discussion for regulatory reform.

  1. Adopt a limited number of key principles: A board’s primary guidance to management—the strategic plan—should set forth high level requirements for the direction of the bank. Developing a detailed operational plan at the board level, or attempting to co-manage the bank along with officers, is frequently counterproductive and causes management to spend too much of its time complying with the board’s requirements rather than building value in the business.
  2. Tailor oversight to the size and complexity of the institution: It is critical that the board’s oversight function evolve as the business model and the growth of the bank does. While we sometimes see boards impose requirements on management that are overly complex and burdensome, it is more common that boards fail to evolve their oversight as the bank grows and becomes more complex. This issue is particularly prevalent among fast-growing, acquisitive banks. Boards sometimes take the same approach to compliance and regulatory oversight as they did when the bank operated in a single community with a small number of conventional products.
  3. Eliminate concentrations of power: Just as many bankers find the unchecked power and single director structure of the Consumer Financial Protection Bureau objectionable, concentrating too much power in one or two directors can also be destructive for a bank. Among the bank failures we saw, a disproportionate number relied on the oversight and guidance of a single dominant director. A properly functioning board should foster discussion and debate among directors with diverse business backgrounds, risk tolerances, and points of view. Moreover, directors should feel accountable to each other and to shareholders.
  4. Eliminate useless reporting: Just as bankers seek to streamline regulatory reporting, board reports should be streamlined as well. When was the last time your board had a discussion about the usefulness of the various reports received at each board meeting? There is a terrible opportunity cost to having some of the best minds in the bank prepare reports that do not provide actionable information or, even worse, are ignored by board members. Boards should periodically discuss which reports are no longer helpful, and also, which types of additional reports might be beneficial as the business model of the bank evolves.
  5. Provide timely feedback: One of the less publicized provisions of the Financial Choice Act is a requirement for timely delivery of regulatory exams. Boards should adopt this policy as well with regard to key board actions and feedback to senior management. A concern raised in a board or committee meeting without timely resolution by the board can leave management in limbo, afraid to make any decision that might ultimately be deemed by the board to be a bad one. If the board’s oversight function raises a concern, boards should work to resolve the concern and take any necessary action as quickly as possible in order to allow management to move forward.

In a deregulatory environment, it may seem strange that attorneys would suggest that boards likewise streamline their oversight function. However, it is our belief that reducing regulation is not nearly as important as improving the effectiveness and efficiency of regulation. By focusing the board’s oversight function on monitoring the key risks of the bank in an efficient manner, board members will create more time to focus on developing effective strategy, and for their management teams to focus on building value for the bank. Thoughtful board oversight is as important as regulatory relief for the industry, if not more so.

Four Tips for Choosing a Bank Partner

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partnership.png

In January, I shared four tips for banks to consider when considering whether to enter into a new fintech partnership. How about the other half of that relationship? If you work for a fintech company, let me give you my perspective as a banker who has worked with many of them.

Cultural Alignment: This is probably one of the most important considerations for both parties. If you’re in the early stages of growth, you’re probably used to making decisions quickly, collaboratively and doing it without much red tape. For that reason, you probably consider most bankers to be seem slow-moving by comparison. First, I’d say that understanding the regulatory environment in which banks operate may alleviate some frustration. (There are often good reasons for banks to operate with caution. See tip number four, compliance buy-in, from my January article.) However, that doesn’t mean you should settle for a partner that doesn’t understand your culture—or worse yet, has established one that is at odds with yours. Look for a bank that’s responsive, allows you access to key decision makers, is open-minded to your ideas and commits itself to finding ways to make things work.

Strategic Fit:If you’re able to “check the box” on cultural alignment, you’ll want to consider strategic plans. Make sure you understand a few critical issues: How does this relationship fit into your strategic plan? Do you understand how the bank sees your service or technology fitting into its strategic goals? Exploring these questions helps lay the foundation for a mutually beneficial partnership. If you’re setting out to create a specific product or service, go past the initial implementation phase and consider sharing roadmaps with your potential bank partner. Just as it is important for us to understand where you’re looking to take your company over the next six to 24 months, it is important for you to know where the bank is headed and understand our approach to executing projects—both with the partnership and with other key initiatives.

Compliance Expertise: Look for a partner that not only has deep knowledge of the regulatory field, but is willing to work with you to navigate it. Having the compliance talk early on allows you to test if the bank is one that can help you avoid potential compliance headaches down the line, is willing to help develop alternatives where appropriate, and is genuinely invested in the success of the partnership.

Business Terms: If you have found a bank partner that is both culturally and strategically aligned with your company and has the right mindset when it comes to risk management, the discussions around business terms—while critically important—should fall into place rather easily. Beware of a contentious, back-and-forth negotiation; at this point both organizations should be in agreement around what success looks like. While it is important for you to establish an agreement that allows you to achieve your goals, remember that is exactly what your bank partner is looking for as well. Having a “we’re in this together” mentality also helps. You have a great idea to bring to market and an innovative team to make it happen. Your bank partner provides industry experience, a charter, access to a balance sheet and FDIC coverage—all of which will be valuable (and depending on your business plan, potentially necessary) contributions that will prove to be even more important down the road.

Keeping a few of these concepts in mind as you approach your next business development meeting with a potential bank partner will increase the likelihood that you will have a successful experience.

M&A Alert for Banks: Preparing to Be a Buyer

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strategy-1-27-17.pngBefore a board and management of a bank pursue an acquisition, they should realistically assess their bank, the characteristics of the board and the shareholders, and the alternatives available.

The board and senior management should develop a strategic plan for the bank. The Federal Deposit Insurance Corporation has cited an increasing number of banks for lack of strategic planning in matters requiring board attention. The Office of the Comptroller of the Currency also has focused on strategic planning in the last few years. 

All board members must share a commitment to the strategic plan. Divisiveness in the boardroom often jeopardizes a bank’s ability to achieve its objectives.

The board has a fiduciary duty to make fully informed business decisions as to what is in the best interests of the hypothetical shareholder who is not seeking current liquidity. Management must assume the responsibility of educating the board (or bringing in consultants to do so) regarding the bank’s strengths and weaknesses, its inherent value, and the market(s) for targets. The board and senior management should meet regularly to discuss the bank’s strategic direction.

Debate in the planning process is healthy, but once the board agrees on a course of action, the board and management should speak with a united voice.

The board and management should communicate the bank’s strategic direction to shareholders. If key shareholders disagree with the direction, the board and management should arrange for such shareholders to be bought out or be comfortable that the bank need not do so. It is difficult to achieve strategic objectives if the board and key shareholders are working at cross purposes.

Evaluate Alternatives
The prospective buyer has a number of alternatives for enhancing shareholder value or multiple paths to be pursued at the same time. The board should evaluate such alternatives to identify the most attractive transaction.

Evaluate Your Prospects for Success
In embarking on bank M&A in the current environment, sellers will demand assurances that buyers can close. Here are some of the factors purchasers should consider:

  • Community Reinvestment Act and compliance ratings: Purchasers need to understand the “hot button” issues driving regulatory reviews and stay up to date. Yesterday’s focus on asset quality, anti-money laundering and Bank Secrecy Act compliance and third-party relationships have been joined by redlining, incentive compensation, concentration risk and cybersecurity, among others.
  • Capital levels: Determine whether the bank’s capital is sufficient to support an acquisition. If not, where will your bank obtain the needed funding?
  • Management: Does the purchasing bank have sufficient senior management capacity to staff the acquired bank or will target management be needed to implement the acquisition?
  • Systems and facilities: The purchasing bank’s board should evaluate whether the bank has compliance management systems and an enterprise risk management program that can scale for the acquisition.

Coming up with a good strategic plan while considering the bank’s alternatives is important for the board to discuss before embarking on an acquisition.

Negotiating the Transaction
There still may be a problem: What if there are very few targets that the bank has identified as “fits,” and none of them are in the market to sell?

Increasingly would-be buyers are willing to consider offering stock as part or all of the merger consideration. There are several drivers of this newfound willingness. First, buyers must meet increasingly challenging capital requirements. The exchange ratio in the merger may offer more attractive pricing to the buyer than issuing common equity to the market. Second, sellers have become more willing to accept private or illiquid stock as merger consideration. This may be a function of sellers’ understanding that economies of scale offer potential for greater returns on investment while enabling sellers to refrain from taking their “chips off the table” as would be the case in a cash sale. The recent run up in the stock market indexes has not yet translated into a general increase in M&A pricing. Third, a transaction that provides for a significant stock component allows for more one-on-one negotiations. Lastly, a strategic combination allows for mutuality of negotiation.

Just offering the selling shareholders stock may not be enough to convince a reluctant seller to consider a transaction. Would-be community bank buyers must recognize that there are social issues in any transaction (even when the merger consideration is cash). Accordingly, the buyer must evaluate in advance the roles of senior management of the seller, retention arrangements to proffer, severance to provide as well as bigger picture social issues such as board representation, combined institution name and headquarters.

A focus on the social issues and a willingness to put stock on the table may allow community bank buyers to continue to compete for acquisitions despite the rebounding stock market. Other competitors may be able to offer nominally more attractive pricing, but such an offer may not have better intrinsic value.

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.

Heightened Standards for Directors: What You Need to Know

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directors-10-15-15.pngOn September 2, 2014, the OCC issued guidelines establishing heightened standards for certain institutions with $50 billion in total assets and for “highly complex” institutions, noting that it does not intend to apply the guidelines to community banks. However, the guidelines distill the OCC’s characterization of directors’ responsibilities that apply regardless of asset size. In this regard, the guidelines should be required reading for directors of every bank.

With regard to the role of directors, the OCC did not adopt a higher standard of director liability than the law generally provides (depending upon state of incorporation or chartering). This approach is very different from that espoused by the Federal Reserve Board’s Governor Tarullo in his controversial speech last year. Governor Daniel Tarullo exhorted legislatures to change the standards governing director conduct to impose a duty to meet regulatory and supervisory objectives (not just a duty to their institution and shareholders). The OCC notably bypassed the opportunity to try to extend director obligations beyond statute. Thus, the guidelines need to be read in conjunction with the existing legal framework.

The OCC reformulated what are in many cases age-old principles of director conduct. The guidelines are beneficial to directors in a variety of ways. Notably, the OCC sought to reclarify the divide between director and managerial responsibilities. To understand the significance of such line drawing, directors need to be aware of the regulatory approach to conflating the roles of directors and management since the downturn. Specifically, administrative actions, matters requiring attention and supervisory correspondence, have discussed the directors’ obligations to become further involved in their institutions’ activities in a quasi-managerial tone.

The OCC’s guidelines, however, note that they do not impose managerial responsibilities on boards or suggest the boards must guarantee any particular result. Instead, the OCC notes that the board’s duty is the traditional one of strategy and oversight.

However, there are increasing expectations for directors, particularly in terms of oversight of risk management. First, the OCC expects institutions to establish strategic plans that set forth a risk appetite. The board then must hold management accountable for adhering to the framework established. The guidelines clarify that the board provides active oversight by relying on risk assessments prepared by the departments of risk management and internal audit. Thus, although the board’s active oversight is in reliance on risk assessments, the board still must evaluate whether the risk appetite is being exceeded.

This expectation for oversight of risk tolerance have been seeping down the landscape and has become common practice for banking organizations of over $1 billion. I have seen institutions of $600 million and $700 million in total assets adding chief risk officers and risk committees. Risk assessments have proliferated like kudzu. Whether the guidelines are only expectations generally for the systemic important financial institutions (SIFIs) or not, these principles are becoming mainstream ideas for community banks as well. For SIFIs, the scope and pervasiveness of the risk management and mitigation framework are yet to be fleshed out.

The OCC expects boards to provide a credible challenge to management. Specifically, boards, in reliance on information from independent risk management and internal audit, should question, challenge and, when necessary, oppose decisions to expand the bank’s risk profile beyond its risk appetite.

The guidelines note that boards are not prohibited from engaging third-party experts to assist them. Thus, the OCC keeps open the well-worn ability of directors to rely on others for guidance (although the fiduciary decision-making remains exclusively the province of the board).

Otherwise, the OCC trots out existing basic minimum standards for corporate governance. Specifically, the guidelines provide that boards should conduct annual self-assessments. The guidelines also note that the OCC will review director training to see if it touches on all appropriate areas. Moreover, the guidelines note that directors must dedicate time and energy to reviewing and understanding the key issues affecting their bank. Those expectations are hardly new.

In short, the guidelines represent a mixed bag for bank directors. The OCC’s adherence to the separation between board and managerial responsibilities and directors’ ability to rely on third-party experts is reassuring. The OCC’s discussion of risk management and engaged directors challenging managerial direction are not threatening in themselves. Director concerns lie in the notion that examiners will expect an increasingly elaborate edifice of risk tolerance and assessment. For community banks, the question is how much of this edifice will they need. Thus, it is not the principles that are controversial, but the way in which such principles will be measured that causes concern for director liability.