A great deal of ink has been spilled of late on the topic of executive compensation. Assessments of officer pay range from "obscene" to "more than merited."

Little attention has been focused on another group that has responsibilities similar to senior management's for guiding the fortunes of a banking organization: the outside members of the board of directors.

Bank holding companies generally are failing to exploit the advantages associated with incentive-based compensation for directors. This could place banks at a competitive disadvantage relative to other types of financial service firms, at a time when banking companies are attempting to compete directly with them.

Not surprisingly, data from Standard & Poor's show that larger bank holding companies pay higher annual retainers to their directors than smaller ones do. In our study, we looked at compensation at six money- centers, 22 major regionals, and 41 regionals.

The retainers paid to directors of money-center organizations were, on average, almost three times as large as those paid at regional banks.

The organization paying the largest retainer among money-centers was First Chicago NBC Corp.; among major regionals, highest retainers were paid by SunTrust Banks Inc. and Wachovia Corp.; and among regionals, Union Planters Corp. Of this group, only SunTrust paid meeting fees in addition to the retainer.

State Street was the only major regional not to pay a retainer in 1996, and four regionals paid no retainer. Pay per meeting is more similar across the three categories, with the major regionals posting the highest average of $1,300. The boards of money-center organizations tend to meet more frequently, however, than at major regionals or regionals.

Assuming they attended all meetings, directors at major regionals would be paid about $10,500, money-center directors about $10,000, and regional directors some $7,300 in meeting fees.

Almost all the regionals also paid fees for committee meetings, but only two-thirds of the money-centers did so. And though most of the major regionals provide a pension plan for directors, only 15% of the regionals and none of the money-centers offered pension-related benefits to directors.

Stock grants are more prevalent at larger organizations. However, only about one in three of these holding companies awarded equity as a component of director compensation. When stock was granted, the amounts tended to be similar across categories, and fairly small.

Money-centers awarded an average of 465 shares, major regionals averaged 456 shares, and regionals, 328 shares.

These same bank holding companies were even less likely to grant options to directors. Only about one in four, on average, included options in the director compensation portfolio, and none of the money-centers did so.

When options were awarded, the volume tended to be larger, on average, than share grants, and averaged 1,900 for the major regionals and 1,960 for the regionals. One regional, Union Planters, awarded each director 50,000 options in 1996, far surpassing the second-largest grant of 6,000 by Star Banc Corp. The value of these options is highly dependent on certain contract characteristics, such as the exercise price and the maturity.

The key benefit of using options as a component of the compensation package is that contracts can be structured to provide strong incentives to the holders of the option to increase the value of the underlying asset: the holding company's equity.

The incentive value of stock and option grants is certainly recognized in the compensation of the senior management of these same bank holding companies. In 1996, the average incentive component of the total pay package for the five highest-paid bank holding company executives was 48% at money-centers, 54% at major regionals, and 47% at regionals.

About half the pay of senior executives is incentive-related. There is no logical reason why outside directors, who are responsible for selecting and overseeing the same management, should not be compensated the same way.

In venture capital-financed firms, practically all of the directors' compensation is incentive-based. Shareholder suits against directors of these firms rarely occur, as the owners recognize that the directors' interests are thoroughly aligned with their own.

For nonbank financial service companies, the annual director retainers tend to be larger than the overall averages for bank holding companies, ranging from about $27,000 at consumer finance companies to $17,800 at savings and loan associations and at property and casualty insurance companies.

Most of the average retainers are lower than those at money-center and major regional bank holding companies, however. The highest individual retainers were paid by American Express ($64,000, diversified group) and Providian ($54,000 consumer finance group). Neither of these companies paid meeting fees in 1996.

Pay per meeting at non-bank companies, except at S&Ls, tends to be higher than for bank holding companies, but the number of meetings per year for the nonbank firms is substantially less. A smaller percentage of these firms relative to bank holding companies pays additional fees for committee meetings, and about one in four offers pension plans to directors, except for life insurance companies and S&Ls, where retirement packages are offered by most firms.

Perhaps the key differences in director compensation relate to incentive compensation. All of these nonbank categories reveal relatively high percentages of grants of either stock or options (and in some cases both) relative to bank holding companies. Eight of every 10 consumer finance companies grant options to directors, and three of every four life insurance companies do the same.

Most S&Ls include options in their director compensation packages. The smallest percentage of nonbank firms granting options (diversified financial firms at 37%) is larger than the highest category at bank holding companies. The size of these grants often are sizable, averaging more than 11,000 options per director at finance companies and more than 4,000 at diversified finance companies.

The largest grantors of options were Cash America (20,000), MBNA (nearly 17,000), Countrywide Credit (roughly 15,000), and Green Tree Financial (12,000). Freddie Mac granted 9,600 options to directors, and Torchmark (life insurance), 6,000. The average number of options granted by S&Ls was 2,225.

Nonbank firms were less likely to grant stock than options, although more than four of every 10 did so in the life insurance and diversified categories. The average number of shares paid to directors by the grantor nonbanks was 669, and the largest such grants were by Freemont General (property/casualty, 2,600 shares) and Sovereign Bancorp (S&L, 2,400).

The data suggest that nonbank financial firms have been more aggressive than bank holding companies in using incentive-driven compensation for directors. Skewing the pay package toward a longer-term perspective and offering some upside potential makes excellent economic and financial sense, because it better aligns the welfare interests of the directors with those of the shareholders they represent.

Using more incentive-driven compensation also should increase the supply of highly qualified candidates for bank directorships. Financially savvy individuals recognize that a bank directorship offers a relatively limited upside and an unlimited downside in the form of potential lawsuits from shareholders and regulators.

By offering equity and/or options as a part of the compensation package, the returns on a directorship become more in line with the performance of the company. The argument holds for banks of all sizes.

Because community banks often pay neither retainers nor committee fees, the upside to a community bank directorship is especially limited. The use of incentive-driven compensation makes even more sense for community banks and bank holding companies. The lack of a liquid market in some community bank stocks can be addressed through the use of "phantom stock" or "stock appreciation rights."

The use of incentive-based compensation for directors is trending upward in the economy at large. From 1992 to 1995, the percentage of firms in the S&P 500, Midcap, and Smallcap indexes with incentive pay for directors increased to 68%, from 50%. Firms that use the strategy paid approximately 30% of director compensation, on average, in this form.

Academic research confirms that increased equity ownership by outside directors is positively related to firm value, to the board's efficacy at monitoring the chief executive officer, and to the likelihood that poorly performing CEOs will be dismissed. It is true that many directors of large bank holding companies are well-paid executives of other firms, but constraining the pay of directors on income and wealth distribution grounds makes little economic sense.

Though restricting director pay to cash compensation might produce a minuscule shift in the distribution of wealth, it harms millions of shareholders who forgo the gains associated with better-aligned incentives. Incentive-based pay for directors is on the rise in the banking industry, but a fairly large proportion of bank holding companies still rely exclusively on cash compensation.

To become more effective competitors in the dynamic financial services sector and to improve prospects for generating still higher returns for equity owners, bank holding companies should get on board the incentive- based director compensation train as promptly as possible.

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