Compensation and Credit Risk Management

By Larr, Peter | Journal of Commercial Lending, October 1995 | Go to article overview

Compensation and Credit Risk Management

Larr, Peter, Journal of Commercial Lending

The first part of this two-part article provides recommendations for senior managers on how to define behavior and compensation standards for credit risk professionals. The author describes the relationship between compensation and credit risk using a credit subculture pyramid and details the role of compensation in risk prevention, risk intervention, and risk correction activities. These risk management processes, which are common to all institutions, will only be successful if the pyramid levels beneath them provide a strong foundation for the bank's credit subculture. The second part of this article, to be published next month, presents a basic framework on which to base a compensation program.

In recent years, many bank managements have been ruminating about the value derived from compensation associated with credit risk management. As a banker in the fourth decade of his career, with both line and staff experience, and as an observer of the specialized field of compensation, I believe the commercial banking industry has a "Pogo problem." As the wise Bayou philosopher once observed, "We have met the enemy, and they are us."

The Pogo problem occurs when a bank does not have a clear vision of its business or the ability to tie compensation appropriately to the nature of its business. Too often, the result has been to reward behavior that is contrary to the bank's goals and objectives.

This article discusses compensation in the context of credit risk management rather than revenue generation.(1)

When compensation is structured with an excessive bias toward revenue--a not unusual situation--it often becomes a hindrance to the establishment of one culture in a bank. To be successful, a bank must have only a single culture, not a credit culture with a sales culture or other type of culture. Any bank with a sales subculture that is at odds with its credit subculture is courting trouble. Instead, an overriding bank culture must reconcile both revenue expectation and risk assumption.

Ineffective compensation usually falls short by not addressing the credit subculture and, more practically, credit risk management concerns. The emphasis of Part 1 of this article is the context into which compensation, as it relates to credit risk management, should be placed. It also includes how to define the activities and behavior on which to base compensation.

Part 2 discusses a generic framework for designing a compensation plan. The macro elements of compensation (as opposed to program details and specific plan construction) are emphasized because compensation plan and administration difficulties are more often caused by a disconnection from a bank's values and goals than from a deficient understanding of the necessary components in the design and administration of a compensation program. (Of course, sometimes both shortcomings are involved.)

While the principles espoused apply to wholesale and retail credit risk management, the focus is on wholesale. Wholesale risk management is where many in the industry are experiencing the greater difficulty integrating compensation policy into overall business management. Wholesale banking is defined as those risk assumptions that are individually underwritten as opposed to decisions made using templates, models, or other types of formulas. Typical wholesale exposures include working capital loans, acquisition financing, letters of credit, and derivatives. Examples of retail exposures are credit cards, home mortgages, and, in some banks, small business loans.

This article particularly applies to traditionally organized banks in which sales staff (that is, relationship managers) and risk controllers (credit officers) share the maintenance of the desired risk profile of the bank, albeit in differing degrees and manners. However, a small number of banks are organizing their wholesale business in ways that depart significantly from the traditional method. …

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