Commercial Banking Incentive Trends 2012

Putting together incentive plans is an art, not a science. Unfortunately and fortunately, those plans are most effective in motivating our associates to do exactly what we ask. As hard as we try, we just can't exactly predict how they are going to get there. Consequently, these plans get tweaked every year, when we discover that employees found ways to get "in the money" that we never envisioned. A good example is 2011 plans that included meaningful dollars for asset quality improvement, based upon 2010 experience of the importance of working out troubled assets hard and diligently. In 2011, asset quality generally improved across the board, and associates enjoyed a windfall.

As we look forward to 2012, the year when loan growth means the most, what lessons can we learn about incentives for our commercial bankers? Below are some thoughts.

1. Determining the size of the incentive pool. One mistake we all try hard to avoid is overpaying. How do we avoid this going forward? One answer is to determine the pool of available funds by the value created through the sales activity, once it materializes: Economic Value Created (EVA), Return on Risk Based Capital (RAROC), Net Income After Charges (NIAC) etc. If we take a portion, say 20%, out of every dollar the shareholders make, and set it aside for incentives, we are virtually guaranteed that there will be a fair distribution of value created between the shareholders and the associated, which is what we're after. Calculating any of these returns isn't easy and is subject to much debate, but it does establish a direct line between the shareholders and the employees, which is what good incentives are based upon.
2. How frequently do you pay? If your goal is to use incentive dollars to motivate associates to change behaviors in a way that will create value for themselves as well as the shareholders, pay more frequently. The greater the frequency of payment, the greater the dependency of the associate on the incentive pay. It becomes a part of their regular earnings instead of an annual windfall. The closer the reward to the effort, the greater the motivation to do more and better.
3. How long should you defer part of the compensation? There are several benefits to deferral. First, the regulators expect it. Second, you'll only pay for value truly created if the deferral is long enough to allow the credit to season (all too often the lender collects the incentive and leaves the bank before the loan deteriorates). Third, you create golden handcuffs in time, as the pot of gold at the end of the rainbow grows quarter after quarter, year after year. At the same time, deferring too much or too far will demotivate your associates, since satisfaction is at its highest when the action and its reward are closely linked.

How much should you pay? The first question is, should you pay as a percent of salary or as a percent of value created? I'd highly recommend the latter if you can measure it with any level of accuracy. Then the question arises, how much is too much? I refer back to the first point: if you have a fair distribution between the shareholder and the associate, there shouldn't be a situation when paying the associate on value created is too much. One must be careful to exclude or cap products that will lead to aberrational behavior, such as loan growth beyond a certain point, or the sale of derivative products and other sophisticated instruments that might not be well suited to all customers. Overpaying for these products, even if they create meaningful value to shareholders, will lead to bad behavior.

How subjective should incentive criteria be? I strongly believe in highly quantitative incentive programs. Behavior changes most effectively when the associate knows with crystal clarity that if they achieve certain results, they will get paid a specific amount. Subjectivity deteriorates too often into popularity contests. At the same time, we all have those high performers who don't fit into the corporate culture and consequently earn big bucks but are a rock in everyone's shoe. That's where a small measure of subjectivity is helpful, but too much of it can be harmful.

How involved should the finance side be involved? Keep Finance informed frequently. Tell them how the team is doing and make sure accruals are taking place periodically, following the "no surprises" rule. Get their buy-in upfront to the incentive pool as well. They understand ROI and will generally support large incentives when the shareholders are assured far larger returns.

Clawbacks. Clawbacks and holdbacks are commonplace in the commercial banking business, particularly for asset quality and documentation. The problem is, there are too many items and the amount of the "ding" is often too small. Focus on the 3-4 most important indicators you'd like to improve (e.g. % of loans with critical exceptions, average portfolio grade vs. the company average) and make the financial impact of failure meaningful. Marginal dings speak volumes.

Create a downside, not only an upside. A good incentive plan is accompanied by a good and clear performance management plan. Work with your HR team to build one that facilitates and depersonalizes dismissals of non-performers such that even the most faint-hearted managers can't avoid facing non-performers, coaching them and, if necessary, terminating them.

To team or not to team? Team incentives are a double edged sword: they ensure that the portfolio manager and administrative assistant do their best to help your rain makers succeed. At the same time, they eliminate individual accountability. There are ways to strike a healthy balance between these two elements. But, when in doubt, reward individually. Like Liat says, this is why nobody likes group projects in high school. You were basically guaranteed that someone would slack off. It's human nature. And right she is!

Frequency of reporting. How often should you let your people know how they're doing relative to plan and incentives? The more frequent the information the better they will perform. Some banks have real-time reporting. That's the best. It fires up the competitive spirit and lifts the entire team. You know you've done well when your people check the scoreboard several times a day.

Incentive plans are the most effective tool management has to communicate to the team what is most important to the bank and its shareholders this year. It should also be used as a coaching guide to help associates improve performance so they can win, get paid, and feel rewarded for their efforts. Help them get "in the money" by frequent reporting and by using ratios such as

• Calls to proposals
• Proposals outstanding to approved
• Approved to funded

These and other simple metrics can lead every single team member to success, and the incentive plan provides the foundation for that communication and performance plan.