Among the myriad of requirements set out by the Dodd-Frank Wall Street Reform and Consumer Protection Act, being placed on community banks is now the responsibility of reassessing compensation packages offered to employees, including commercial lenders.
Section 956 of Dodd-Frank, which has been proposed for comment and applies to banks with assets of $1 billion or more, requires the direct examination of compensation practices by regulators of banks with over $50 billion in assets. For banks with assets between $1 billion and $50 billion, regulators are now directed to look at compensation practices as part of their examination procedures.
A Key Driver
Dodd-Frank is currently directing banks to restructure compensation packages in order to incentivize more responsible behavior by lenders and other employees. This is largely due to the fact that, during the recent financial crisis, incentive compensation plans provided financial incentives for lenders and other employees to take unsafe actions that benefitted themselves but exposed the bank and shareholders to high levels of risk.
Some banks are going so far as eliminating incentive compensation for lenders beyond what is available to all other bank employees. But this may be turning out to be a double-edged sword; Lenders, by nature, are salespeople— and the best way to boost sales (i.e., loans) is to boost the incentives for doing so. A well-structured compensation plan will reward lenders for doing the right thing, both for the bank and for the borrower. It should be implemented so that a portion of the return is based on the lender’s personal performance in the following seven areas:
• Business development
• Relationship management
• Bank profitability
• Lender portfolio profitability
• Lender portfolio asset quality
• Timely and accurate assignment of asset quality ratings (AQRs)
• Policy exceptions and variances that have not been approved
Most importantly, your plan should guard against “three-year wonders”; lenders who come in hungry for bonuses, aggressively grow their portfolio by making risky loans, collect their pay, and then disappear before the loans go bad in year three. The best way to defend against this is to make timely and accurate assignment of AQRs part of your lender comp plan. The responsibility for assigning, monitoring and changing AQRs should fall on the lenders, so it’s important to reward them for grading loans accurately.
For example, a lender could be tempted to understate the risk of a 5-rated loan by lowering the rating to a 3 in order to increase the chances of approval or a lower interest rate. After the loan is approved, the lender can downgrade the loan to a 5. On the other hand, a lender may overstate the risk of a 3-rated loan by increasing it to a 5 so as not to downgrade it later. Neither of the situations are acceptable, and the plan should be structured so that lenders are financially penalized for errors like this.
Incentive Plans for Underwriters
Incentive compensation plans aren’t just for lenders; they can be created for any bank employee whose job directly affects the bank’s financial performance — even underwriters. However, underwriters’ and lenders’ incentives are basically polar opposites: Whereas a lender’s default position is to say “yes” to loans, an underwriter’s is to say “no.”
These ‘built-in biases’ should be taken into consideration when structuring comp plans. Business development components should be weighted more heavily for lenders and the asset quality components more heavily weighted for underwriters.
Above all, your incentive compensation plan should reflect your bank’s overall goals, priorities and culture. It should also incent lenders, underwriters, and other employees to make decisions that are in the best interests of all stakeholders: your customers, the bank, and its shareholders.
Incentive Comp for Mortgage Originators
Title XIV of Dodd-Frank pointedly addresses incentive compensation for loan originators of consumer credit transactions secured by a dwelling. In particular, the Consumer Financial Protection Bureau (CFPB) has issued new rules implementing these requirements, as well as revising and clarifying existing regulations and commentary on mortgage originator compensation. The final rule revises Regulation Z 1026.26 et seq to implement amendments to the Truth in Lending Act (TILA).
It implements requirements and restrictions imposed by Dodd-Frank concerning loan originator compensation; revises or provides additional commentary on Regulation Z’s restrictions on loan originator compensation; and establishes tests for when loan originators can be compensated through certain profits-based compensation arrangements. Provisions of the rule that did not become effective last June became effective on January 1, 2014.
If you have any questions about incentive compensation plans or would like to discuss the options available to you, please feel free to contact our professionals at (417)881-0145 or visit us at www.whitlockco.com.