Magazine article The Journal of Lending & Credit Risk Management

Compensation and Bank Culture

Magazine article The Journal of Lending & Credit Risk Management

Compensation and Bank Culture

Article excerpt

Integration of an effective, all-encompassing compensation system is key to the balance of a financial institution's sales imperative and asset quality. When all units focus on bank culture, as opposed to credit or sales culture, and a disciplined vision, the bank is positioned for success. Discussions on the construction of compensation plans can be found in previous articles by Larr appearing in the Journal in 1995.

From Bahnhof Strasse to Lombard Street, from Wall Street to Main Street, a surfeit of financial opportunity continues the escalating trend of the last 30 years in the markets. This surfeit is the root cause of episodic asset quality stress, which has appeared with nagging frequency in financial markets around the world. Few submarkets are insulated from asset quality stress and reciprocity of vulnerability appears to be intensifying.

This article focuses on the role of compensation within bank cultures and its relationship to bank asset quality. More specifically, the hypothesis and observations that follow are directed toward the wholesale side of a bank's credit risk exposures as opposed to retail, although, in some respects, the remarks also apply to retail. For the purposes of this article, the distinction between wholesale and retail is defined by whether the assumption of a particular risk exposure is individually underwritten without the use of scoring templates, models, or formulas.

Find the Connection, Assess Now

Every society - be it country, city, village, scout troop, sports team, or business enterprise - has an idiosyncratic culture. Each culture is complex, shaped by human nature, leadership, societal purpose, and the environment. Arguably, the most powerful influence in a bank is human nature (more specifically, self interest) in a context of compensation and its impact on asset quality.

A bank's revenue generation can harmonize with its imperative to maintain defined asset quality. Put another way, what some people call the "Odd Couple," that is, bank sales and asset quality, can be integrated. The issue is how compensation can be a catalyst for symbiosis rather than the root of dysfunction. Compensation and its subfacets can and should be integrated as a tool for bank management to unify, rather than disconnect, sales and asset quality.

Lest there be any doubt, let's remind ourselves about the damaging ramifications of asset quality problems by posing a few questions:

* Of the 10 largest American banks in 1980 how many are not around today, largely because of asset quality problems?

* Recently, a number of Japanese banks have failed - for what reason?

* Why were a number of well-known investment banks in the late '80s and early '90s rescued from severe difficulty by strong parent institutions?

* What caused the dramatic failure of Barings?

Cutting through all the ratios and financial detail, one finds quality banks are defined by rating agencies as those with stable growth earnings over time. Asset quality problems are an anathema to both stability and growth.

Recently, articles voicing concerns about asset quality erosion in America and globally have been appearing. For some months, the Federal Reserve's surveys have been echoing the same theme. Some might argue that, if the Paul Revere-like warnings of impending asset quality problems are correct, the die is cast. For an individual bank, such may not be so. Even if the industry "Delphi Oracles" are correct, it is never too late to avoid, minimize, or mitigate. Now is always a good time for a bank to reassess risk management policies, procedures, and practices, including those related to compensation.

In Culture, It's All for One

A word about credit culture. To be successful, a bank must be one culture, not a credit culture with a sales or other culture. When revenue generation is not integrated with risk management in the bank's culture, it is courting trouble. …

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