A CEO of a community bank recently asked us an important question: “why should I pay my lenders any incentive to do their jobs, they already make a good salary?” We hear this question often from different management teams. We believe that part of every lender’s compensation should be variable and that incentive pay should be based on strategic priorities for that specific bank. The sales compensation for a commercial lender should reflect the bank’s business objectives, the economics of the business, market segmentation, and product mix. Currently, in today’s market, there are five outcomes that banks should desire, and lenders that can better achieve those outcomes should be paid a higher bonus or commission.
First, some community banks believe that they operate in a startup model because their banks may be young or growing. However, lender compensation should be viewed through a different lens. Banking is a mature industry with little organic growth, and sales compensation strategies should be based on a mature industry framework. Compensation for sales efforts is substantially different for growing versus mature industries.
Second, there are many reasons why banks may want to start compensating commercial lenders based on performance, even if historically this was not done. Some of those reasons are as follows:
- The bank is not meeting its business objectives. This could be ROA, low loan volume, prepayment speeds or deposits.
- The product mix is undesirable. Bank management may want a particular category of loans or deposits.
- Go-to-market switch. The bank enters a new market or has a new product that is now emphasized.
- Change in business economics. For example, technology drives changes in costs, and therefore, the profitability of products change.
- Change in customer preferences. Currently, customers shop via the internet and are offered more choices for bank products. Banks need to respond to attract the right lenders who can also provide the right products through various delivery channels.
Third, in designing a commercial lending compensation plan, banks must consider the amount of influence the commercial loan officer has on clients’ decisions. There is no point in compensating employees if those employees cannot influence customer behavior. The table below shows characteristics that define sales influence.
The more control or influence the lender has over the sales process, the higher the incentive compensation should be as a percentage of total compensation. For example, a lender selling non-owner occupied commercial real estate (NOOCRE) loans without any cross-sell, at an established bank with high local awareness, has much less influence over the decision making process versus a lender selling a C&I loan, in a new territory, for the small, lesser-known bank, requiring several cross-sell products. The latter takes a higher quality relationship manager and one that likely needs greater compensation.
Current Important Incentive Variables
In the current banking market, we see five primary goals that banks can achieve by paying commercial lenders incentives to achieve these outcomes.
Fees. In a low-interest-rate environment and a flat yield curve, the ability for lenders to charge fees is a great benefit for banks. While the average commercial lender generates very little fee income for community banks, we see many examples where lenders create $100k to $1mm in annual fee income on relatively modest loan portfolios (under $100mm in portfolio assets). There are many products that allow lenders to generate fee income on commercial loans, deposits, and treasury management services. In today’s market, the most significant source of commercial non-interest income is hedge fees.
Develop relationships. We define a banking relationship on three variables – a) cross-sell and upsell, b) the percentage of wallet, and c) lifetime value of a relationship. For the average industry, upselling and cross-selling can increase revenue anywhere between 10% to 50% and add a few percentage points to ROE. In banking, those numbers are markedly different. The average community bank has thousands of customers, and the vast majority (close to 90%) have a zero or negative ROE. Cross-selling, an increasing percentage of wallet and increasing lifetime value can add 50% to 100% of revenue and can increase ROE by 10 to 20 percentage points.
Stable deposits. This is an important subset of relationship building. The ROE on DDA products can be 100%. Stable deposits are one important cross-sell product that is by far the largest value driver for community banks.
Credit quality – EVA. One of the most important measures of performance for credit-intensive products is Economic Value Added (EVA). EVA measures a company’s economic profit created that is in excess of shareholder’s required return. For example, assume that management wants a return on equity of 10% based on shareholder minimum return. There is no reason to motivate employees to generate loans that are objectively expected to earn less than 10% ROE – if shareholders cannot obtain their minimum return on investment, then they should sell the bank or lower their minimum return. However, size matters and the value of higher ROE on larger assets is more powerful than equal ROE on lower assets. EVA allows management to compare apples to apples. The EVA of the $1mm loan, with 14% ROE is $40k (14% ROE minus 10% cost of capital, times $1mm). To get the same EVA on a $500k loan would require an 18% ROE (a difficult outcome to achieve in an efficient market). Banks must motivate lenders to achieve higher EVA by using RAROC (Risk-Adjusted Return on Capital) modeling that takes into account overhead and origination costs, and expected loss based on the probability of default and loss-given-default.
The stickiness of relationship. This is one of the most overlooked but insidious phenomena in banking. Banks should favor profitable assets and deposits that stay with the institution for as long as possible. However, we sometimes see the exact opposite - for example, consider construction, property rehab, and NOOCRE short-term investment loans. Not only do these assets have short expected lives, but lenders that move from bank to bank have an easy time taking their customers with them to a new employer. Management should incent commercial lenders to create institutionalized relationships that stay beyond a change in the lender’s employment. This can be done with prepayment provisions, friction costs created by deeply embedded products or by introducing multiple sales touchpoints.
Every bank will develop a different strategy for incentive pay for commercial lenders. However, there are currently five significant outcomes that commercial lenders can affect. It is well worth for banks to pay incentives for commercial lenders to achieve these five specific outcomes.
Submitted by Chris Nichols on July 29, 2019