Putting it all together: risk-based incentive compensation in regional banks: a seven-part series explores risk management at regional banks to help senior managers make better decisions about methodologies and processes

RMA Journal, The, Sept, 2003 by John Kapitan

Think of risk management, and the images that come to mind are likely to be technical: theories, methodologies, systems, policies, and procedures. But this belies the overarching importance of organizational culture in setting and executing the risk management agenda.

Organizational culture is what makes tire employees of a firm pull together rather than in innumerable different directions. If risk is to be managed coherently, it is vital that the firm's culture supports it. There are two ways to achieve this.

The first is for the firm's senior management to make it clear in meetings and presentations that the risk management program and risk-adjusted performance are of primary importance. Employees should always be asking: Is the bank adequately compensated for the risk it is taking?

The second is to make risk part of the bottom line for employees, just as it's part of the bottom line for the bank. And that means adjusting compensation. Compensation is, in fact, probably the single biggest lever that executives can pull to influence organizational behavior.

A well-designed compensation plan, incorporating an appropriate element of performance pay, encourages the bank's staff to look for ways to manage risk at a grassroots level. This results in a distributed, firm-wide effort that benefits shareholders, who value risk-adjusted (not absolute) earnings.

A bad plan, on the other hand, is likely to give employees the wrong incentives: taking huge risks to boost returns, say, or looking for volume rather than profitability. At worst, it may drive them to activities that erode the value or even the stability of the firm.

Introducing Risk-Adjusted Pay

Unfortunately, while performance-based pay may be widespread at regional banks, the use of risk-adjusted performance measures isn't. Most performance is measured using GAAP profitability numbers, which don't adjust for risk or do so with very "coarse" return-based measures--such as return on assets or return on equity--using regulatory or judgmental capital factors.

GAAP profitability numbers, ROA, and ROE do not connect business results to shareholder value creation. They also don't provide proper incentives to mitigate risk, which usually results in the bank paying for volume, not value. The lack of a clear framework for risk/return trade-offs often leads to a culture that tends toward one of two extremes--cavalier or cautions.

The cavalier culture is driven by sales and volume; the main job of underwriters and credit officers is to restrain the business line from booking poor-quality credits. The cautious culture, by contrast, is so risk averse that lots of good business is left on the table to ensure very low losses and few nonperforming assets.

Neither culture optimizes risk-adjusted return--and both can be corrected by introducing appropriate measures of risk-adjusted performance that are then linked to compensation. This poses some unique challenges for regional banks.

Relationship value recognition. One key issue is that much of a regional bank's competitive advantage arises from its strong customer relationships. So business managers are unlikely to be pleased by a plan that fails to adequately recognize relationship value--and neither will customers react well to an abrupt change in their apparent value to the bank.

That means risk-adjusted measurement has to be introduced into pay gradually; and customer satisfaction needs to be recognized and rewarded--whether explicitly or through a discretionary component of compensation. One way to go about this is to convert an existing budget into its risk-adjusted equivalent and use that for the first year of the new plan. Another is to start out by giving the risk-adjusted measure a small weight in the compensation scorecard. That weight can be supplemented by giving the individual business unit's performance a small weight compared with firm-wide performance. Increasing the weights over time helps smooth the transition to risk-adjusted business unit performance.

Point system to avoid confusion. Regional banks also are more likely to have recently made other changes to their profitability model: cost allocation, funds transfer pricing, and so on. Adding another new component to the mix may confuse matters, especially for retail sales and relationship managers. It often helps to simplify the profitability model by using a "points" system that can be easily understood by frontline staff.

Getting It Right

One of the most difficult pay design issues is the compensation of business originators, particularly in lending. Sometimes, it makes sense to split the evaluation and payment plans for origination and portfolio functions. This is usually true when risks can be evaluated easily and transactions are transfer-priced. Retail credit products, including residential mortgages and credit cards, fall into this category.

At other times, however, only the originator has a really good feel for the risks involved and the potential changes to the risk profile over time. That implies the performance of origination and portfolio functions should not be split and originators' performance should be evaluated on performance over the life of the loan. Middle-market C&I or CRE lending often falls into this category.