Incentive Compensation Management: The Good, The Bad, and the Ugly

Part 1: The Good, the Bad and the Ugly

Incentive compensation management (ICM) programs are one of the most critical factors in determining the success of financial institutions. After all, a financial institution is, at its roots, a sales and services organization. Ensuring that your customer-facing associates are incented to support both the institution’s goals and clients’ goals not only aligns their behaviors with successful outcomes, but also provides them with a reward system that contributes to a high level of career satisfaction. Richard Branson famously stated: “Clients do not come first. Employees come first. If you take care of your employees, they will take care of your clients.”

While I fully agree with Mr. Branson’s sentiments, it also is key to consider whether the employee behavior you are incenting supports the strategic goals of your institution. Achieving this alignment is one of several benefits of a unified approach between ICM and enterprise performance management (EPM) processes.

In this initial blog, I will discuss the reasons why ICM programs are so important, especially in today’s challenging banking environment. In my next blog, I will explore the benefits of a unified approach between ICM and EPM processes. We will then hear from a bank practitioner about the value realized by using a unified approach at his institution. 

The Good, the Bad, and the Ugly

An effective ICM program aligns individual behaviors with your organization’s goals, and helps ensure that leadership can attract and retain the people needed to execute upon those goals. It also safeguards the institution by ensuring compliance with regulatory requirements related to incentive compensation. Incentive plans that are too narrowly focused, or ill-designed, can have the opposite effect. Let’s explore the good, the bad, and the ugly of incentive compensation management programs within the banking industry.

The Good

Good ICM programs improve performance, add value to the organization, increase customer satisfaction, and help attract and retain the best employees. In the 2016 Financial Institutions Compensation and Benefits Survey^[1] conducted by Crowe Horwath LLP, 378 bank executives identified the following as their top three areas of concern:

1. Motivating employees for better performance (82.9 percent concerned; 4.5 of 5 importance rating)
2. Retaining and motivating the right people (89 percent concerned; 4.5 of 5 importance rating)
3. Finding and hiring the right people (81.6 percent concerned; 4.5 of 5 importance rating)

Clearly the ability to find, retain, and motivate customer-facing employees is top-of-mind for financial industry leaders. One of the best ways to accomplish these goals is to provide incentive-based rewards. In the same survey, respondents indicated that cash-based incentive programs as a percentage of base pay have nearly doubled since 2011 (13.7 percent compared to 7.6 percent).

And finally, good incentive management programs can help reduce risk and support regulatory alignment for the organization. The Federal Financial Institutions Examination Council (FFIEC) has provided guidance^[2] to banks and credit unions encouraging them to structure plans for employees, both executives and otherwise, based on how their actions have the potential to “pose a threat to the organization’s safety and soundness.” This could affect, for example, senior executives who are responsible for all activities institution-wide, loan officers who originate loans, or any employee who has the potential to “expose the organization to material amounts of risk.” Regulatory guidance goes even further, stating that incentives should “be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.”

The Bad

One of the most important lessons learned from the 2008 financial crisis is that not all growth is good growth for financial institutions. The focus on growth regardless of its strategic fit or profitability, and a lack of understanding regarding the inherent credit risks posed by such growth, led to significant difficulties across the entire industry. At that time, most banks and credit unions were paying incentives based on growth and production. For example, many institutions compensated loan officers based on loan portfolio growth. While this increased compensation for many loan officers, it frequently did not support common organizational goals for profitable growth, and therefore often was detrimental to the overall health of institutions.

While the 2008 recession was not caused solely by misaligned incentive compensation programs, loan growth that only considered volume—with minimal consideration for credit risk, profitability, or strategic-fit factors—significantly contributed to the negative aftermath experienced by the financial industry and U.S. consumers. There is nothing wrong with paying incentives for loan growth, but paying incentives based on the quality of the loans should be at least as important to the institution. What happens if the growth was achieved at the expense of credit quality? Or if the loan officers under-priced the loans, waived fees, or paid higher rates on deposits for these customers in order to obtain the loans? Without proper measurement and incentive plans in place, the impact of these decisions may not be felt for many months, or potentially years to come.

The Ugly

The 2016 Wells Fargo Bank^[3],[4] scandal provides another cautionary tale around misaligned incentives. This example illustrates an even more direct correlation between poorly planned ICM programs and their negative consequences.

Recall that Wells Fargo sales employees were found to have opened millions of fraudulent accounts without customers’ authorization. The employees did this to meet sales quotas and earn incentives as part of the company’s longtime sales policies, which rewarded employees for selling multiple financial products to the same customer.

The impact to the bank?

• Fines: Wells Fargo was fined $185M, a direct financial cost to the company and its shareholders
• Additional financial impacts: Industry experts have estimated the scandal could cost an estimated $1.7B in litigation costs and even more in reputation damages
• Job losses: 5,300 Wells Fargo employees were fired due to their alleged involvement
• Turnover in leadership: Former Wells Fargo CEO, John Stumpf, resigned in October 2016, soon after news of the scandal broke
• New incentive programs: In January, the bank implemented new incentive programs that are not sales/production based

The Wells Fargo scandal provides a clear example of how incentive programs that are too narrowly focused can inadvertently encourage ugly behaviors.

Incentive compensation management continues to be a hot topic in the financial industry given recent events, coupled with the significant impact that ICM can have on an institution’s ability to meet and exceed its quantitative and qualitative goals. To positively impact performance, ICM programs must be transparent and well designed.

In my next blog, I will focus on the value of a unified approach between your institution’s ICM and EPM processes, and how it can help with achieving the goals of an effective incentive compensation management program.

^[1] Crowe Horwath LLP: “Employee incentive plans leave room for improvement.” Banking Exchange, Feb. 27, 2017.
^[2] Long, T.W.: “Interagency guidance on sound incentive compensation policies.” OCC Bulletin, June 21, 2010; OCC: “Guidance on sound incentive compensation policies.” Federal Register (Vol. 75, No. 122), June 25, 2010.
^[3] McCoy, K.: “Wells Fargo revamps pay plan after fake-accounts scandal.” USA Today, Jan. 11, 2017.
^[4] Zoltners, A.A., et. al.: “Wells Fargo and the slippery slope of sales incentives.” Harvard Business Review, Sept. 20, 2016.