In the post-crisis landscape, banks have a lot of eyeballs on them at all times. Investors have become increasingly influential, executive pay is drawing close scrutiny and banks' business decisions are open to the court of public opinion. Regulators further tightened the reins in October 2014. Federal Reserve Bank of New York president William Dudley told banks that they were being watched and reminded them that the Fed will not hesitate to dismantle an institution if its activities are deemed too risky for depositors.
Dudley's comments suggest it may be time for banks to make some changes to the way they do business. But bank board members can have a hard time identifying the right way to mitigate risk while maintaining business operations and retaining C-suite talent. The solution lies in modifying the behavior of a bank's chief executive. Whereas legislation does not drive behavioral change, compensation — and the form it takes — does.
Banks seeking to minimize risk factors and meet legislative demands should consider executive compensation through supplemental executive retirement plans, a non-qualified retirement or deferred compensation plan designed with C-suite executives in mind. Banks report these programs as deferred compensation in their FDIC call report, and they are known in the academic arena as "CEO insider debt."
A SERP is a promise to pay the executive a meaningful portion of his or her salary throughout retirement. It is designed to influence executives' long-term behavior. Since assets cannot be irrevocably set aside to make retirement payments in the future, the benefit is unsecured. Therefore the executive is motivated to make sure the bank stays in business for decades to come.
SERPs can create an environment for a risk-averse bank led by a cautious CEO with a long-range view of the business' trajectory. The CEO has a vested interest in the bank's health and is motivated to make more conservative decisions that lay the groundwork for a stronger institution — one that will be able to fulfill its promised payments.
As a result, SERPs create an environment where the CEO is more aligned with the bank's debt-holders and deposit insurer in the short-term rather focusing primarily on its shareholders. This leads to better decision-making and improves the quality of the bank's business assets in the long-term.
Managing Short- and Long-Term Risk
SERPs can also be used to address other risks that banks face, including their debt-to-equity ratios, compensation structures and executive succession planning. The proof is in the numbers.
In a review of industry data, our firm found that in the years during and following the recession (2007-2014), 43% of banks at one time or another reported a SERP liability. Of this group, more than 95% of banks offering SERPs remained intact. Of the banks that failed, 64% did not report a SERP liability.
Our analysis also suggests that banks with a SERP in place are more likely to have a favorable modified Texas capital ratio — a measurement considered to be a leading indicator of a bank's likelihood of failure. The MTCR measures a bank's "bad" assets against its tangible capital. Banks that report deferred compensation liabilities have better MTCRs than those that do not, according to our review of FDIC call report data. Our conclusions about the effects of this benefits package are supported by academic studies, including one from the FDIC.
SERPs appear to help address personnel risk too. Because the bank needs to succeed well into the CEO's retirement years, these packages ensure that the CEO will be interested in establishing a legacy with successor management that allows the benefit to be realized as the bank thrives.
The banking industry will continue to face the challenge of mitigating risk for the foreseeable future. SERPs can go a long way in helping keep risk low while supporting the bank's long-term success. It is clear the Federal Reserve and other regulatory authorities are watching the industry and will not hesitate to step in should the need arise — so make sure your bank is prepared.