Incentive Alignment - How to Structure and What to Avoid

April 3, 2015 | Charles Bowen

Question

How can banks and loan officers be incentivized to encourage economic growth responsibly?

Answer

Incentives must encourage lenders to properly weigh risk and make decisions with a long term perspective in which they are exposed to both the upside and downside of authorized loans.


Wall Street IncentivesHumans are driven by a variety of motivations; in the workplace, these often come in the form of incentives tied to compensation. The theory is straightforward: if you reward desired behavior, it will lead to greater performance and the achievement of goals. Unfortunately, if incentive structures are not properly designed and managed, they may inadvertently encourage undesirable behavior which can lead to negative outcomes. In the late 2000s, systematic failures in the real estate market and the aggressive selling of mortgage-backed securities and derivative products by financial institutions contributed to a massive global economic recession. In addition to a lack of regulation, the "heads, I win; tails, you lose" compensation structure of lending exposed banks to excessive risk while loan officers raked in exorbitant bonuses. In the wake of this financial crisis in which many banks collapsed and others were bailed out with taxpayer dollars, regulation such as the Dodd-Frank Wall Street Reform and Consumer Protection Act have forced banks to reexamine not only their lending practices but also they way in which they incentivize their loan officers.


Skin in the game

As Mark Hochstein, Editor-in-Chief of American Banker, recently wrote about in his article Discussion: Should Loan Officers Have More Skin in the Game?”, some banks (such as San Francisco, CA-based First Republic) are utilizing clawback policies to encourage responsible lending and work out problems with loans when they arise. The policy ensures decisionmakers share not only the upside of a well-performing loan but also at least some of the downside if it goes afoul. First Republic CEO James Herbert explains “if a loan goes bad in first three or four years, you take the first hit, [...] and if you made X on that loan, we will claw back between four and six times that."

Incentives - carrots and sticksClawback policies are one tactic being used in an attempt to improve the risk culture in the financial services industry. About 20% of banks in the U.S. currently enforce some form of extended recovery periods to recoup incentives earned due to improper lending practices. Another 10% surveyed by the Chase Comp Group of Atlanta, GA last year “planned to implement such policies in the near future.” Surely not every loan will work out, but overly risky decisions or those “based on fraudulent activity, material misstatements, or inaccurate performance calculations” should be actively disincentivized.

In the residential mortgage industry, the OCC, The Board of the Federal Reserve, FDIC, SEC, FHFA, and HUD finalized a rule last year requiring a portion of the credit risk from loans be retained for extended periods by lenders. This ruling puts more liquidity pressure on lenders, provides more transparency to investors and will hopefully reduce the issuance of overly risky loans by mandating skin in the game policies.  


Incentive Alignment Theory

Even with the best intentions and highest moral standards, true incentive alignment which rewards only behaviors that positively affect all stakeholders can be very difficult to achieve. In his famed scholarly article “On the Folly of Rewarding A While Hoping for B” published in 1975, Steven Kerr of Ohio State University delved into the topic and provided several examples of misaligned incentives:

  • Orphanages - with budgets and staff sizes often tied directly to the number of orphans being cared for, facilities are incentivized to keep children in the orphanage rather than achieve their primary goal of placing them in good homes.

  • University Professors - in order to achieve a tenured position, many universities require professors to research and publish a great deal of work leaving them little, if any, time to focus on teaching students.

  • Physicians - there is much more downside to labeling a sick person well (embarrassment, threat of lawsuits) than there is a well person sick (continue potentially unnecessary and revenue-generating treatments).

  • Professional Athletics - coaches and players routinely discuss putting the team first and how it’s all about “the W,” yet their contracts often include large incentives for individual performance. If a MLB power-hitter earns bonuses for home run and RBI totals, how likely are they to jump at the chance to hit to right field or bunt in order to advance a runner?

Other examples can be seen in our everyday lives:

  • Budgets - if you don’t spend the entire allowance of a given budget, future allocations are likely to be slashed.

  • Quotas - if you achieve a sales goal during any period of time, chances are that goal will be increased for the next period.

  • When the neighbor’s dog is allowed to do his business in your yard every morning and you ask your kids to clean it up, what incentive does the guy (who hasn’t returned the socket set he borrowed from you eight months ago) have to change his behavior?


Legal Considerations

Not only can incentive structures be difficult to design and align with corporate objectives, they can create additional work for supervising managers and accounting departments. Proper documentation and taxation are critical to ensuring all employment and reporting laws are adhered to.

Documentation

With the passing of the Sarbanes-Oxley Act (SOX) in 2002, after major corporate and accounting scandals such as Enron and Worldcom, public companies are now held to an enhanced set of standards with the goal of protecting investors by “improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.” Privately-held companies are also held to many of the provisions in SOX which mandate more detailed reporting and transparency in their incentive programs.

In order to be both effective and legal, incentive plans must contain predefined and measurable performance metrics. These metrics must be able to be tracked with detail and time fences built around performance periods as well as recognition and recovery periods in the case of clawbacks. In a world with ever-increasing change, the calculation of incentives can become increasingly difficult as clients, employees, portfolios and business relationships shift. Extra care in the lending industry should be paid to high risk, IBG YBG (I’ll be gone, you’ll be gone) attitudes of loan officers who are primarily motivated by short-term commissions.


Tax Considerations

Financial incentives

Just like any other financial compensation such as hourly or salaried wages, incentives such as bonuses are subject to federal and state payroll tax withholding. Because incentives or bonuses are considered supplemental income by the IRS, they are held to a higher withholding rate. Depending on whether bonuses are paid separately or as part of regular paychecks, taxes will be calculated using either the percentage or aggregate methods. Consult your accounting department or auditor to ensure tax calculations are compliant with state and federal regulations.


Bottom Line

When incentives are properly aligned, employees perform better, companies and lenders make better decisions, and economic growth is responsibly encouraged. While this win, win, win scenario is possible, there are several pitfalls which must be avoided. Unless loan officers are motivated to take a long term investor’s approach either by incentives or repercussions, the draw of short-term gains via risky lending practices will continue to plague the industry and negatively impact the economy. It is strongly advised to seek counsel and follow best practices when designing incentive programs and routinely audit them in order to understand what behaviors they are truly encouraging.

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Topics: Georgia Banking Law