Chief Risk Officers usually grow into their positions via Credit, Finance, Audit, Compliance, and similar disciplines. Few, if any have substantial background in Human Resources and compensation systems.
But an understanding of compensation issues in a banking organization, especially as expressed in the incentive compensation system, is an important element in the CRO’s job requirements.
While this is emphatically the case in larger banking organizations, all banks are required to pay attention to how incentive compensation systems may affect the bank’s safety and soundness.
When stakeholder interests split
In my previous blog—"Defense! Three lines of defense!"—I introduced the idea of the principal-agent problem, which we all live with in corporate life. Simply stated: What’s good for the agent or employee may not be in the best interests of the bank not its shareholders.
Regulators have gone so far as to posit a divergence of interests between the agents and employees; the bank’s stockholders; and safety and soundness issues.
They have a point, at least with respect to publicly held banking organizations with enough public float to allow for an active trading market. In these organizations, the interests of stockholders may be short-run profit and stock price improvement. If that happens, these short- term stockholders sell and reap their reward; the subsequent results are no longer their concern.
This may not be the case for many community banks, but it is worth bearing in mind.
What is the case for all banks is that incentive compensation systems have many benefits, but they also have the potential to amplify the principal-agent problem and potentially undermine the safety of the bank.
Two Cs: compensation and culture
Incentive compensation systems are intended to induce behavior aimed at defined outcomes, but they are also an important element in creating the bank’s culture.
This latter aspect I view as more important than the former. A bank’s overall compensation system, including its incentive compensation structure, is an important determinant in the kind of people it attracts as employees. It is therefore a self-sustaining significant input into the culture of the bank.
A CRO should be part of the process of structuring and monitoring incentive compensation systems throughout the bank. As mandated by federal regulators, the bank needs to conduct a review of its incentive compensation systems that apply to any employees who, individually or as a group, have the potential to expose the bank to material risk. A CRO should include in this analysis executive, non-executive, front-line, and back-office employees.
If there is the potential to expose the bank to material risk, then balance in the incentive compensation arrangements is key. Part of a CRO’s role is to work with Human Resources, senior management, and the board’s Compensation and Risk Committees to offer a view of the various incentive compensation programs offered in the bank.
Especially in the case of executive compensation plans, this is often done by outside consultants. The CRO needs to be part of that process. In this way the bank has input from the officer who is charged directly with executing the ERM program.
The hallmarks of unbalanced incentive compensation arrangements are 1. significant amounts, 2. paid in cash, 3. based on volumes or transactions, and 4. promptly after the events measured.
Very few, if any, incentive compensation arrangements have all these characteristics, but the extent to which each element is present in the arrangement will determine whether it is sensible for the bank to sustain it.
Some may believe that a program can be made acceptable, or even highly desirable. Their method: Highly controlling authority to originate transactions for those who are paid under an incentive program
That’s appealing. But I find that human ingenuity is more potent than some may think. When enough is at stake, controls are weakened, formally or informally, and in the long run the bank suffers.
Incentive pay: a risk right in front of you
Bringing balance to incentive compensation arrangements is necessary. Risk-adjusting all transactions or activities is essential. In doing so, the CRO should weigh in on the full range of risks to which the bank is subject, including for example, operational, legal, and reputational.
Even if transactions and other activities are thoughtfully adjusted for risk, deferral of some or all of the incentive award payments should be part of the incentive program.
How is this justified? It’s simple.
The future is uncertain, no risk adjusting system is perfect, and negative outcomes take time to appear. An employee who has earned a reward should be subject to ongoing risk of loss if transactions prove harmful.
Another mechanism to consider is to pay awards in company stock or related instruments, rather than cash. In that way if the bank absorbs negative outcomes the value of the awards diminishes or may even disappear. This is likely to be more effective at the executive level, where the influence is more closely related to stock performance, than at the more general line or sales levels.
Striving for balance is the CRO’s goal, working in tandem with management, human resources, and other compensation experts. The board of directors ultimately oversees the incentive compensation systems in the bank. In doing so it may heavily rely on an independent Compensation Committee. The CRO, directly with the Compensation Committee or in coordination with the Risk Committee, should be sure to be part of that process.