Magazine article The RMA Journal

Loan Officer Compensation and Bank Performance: Investing Wisely in Loan Officer Compensation Can Pay Dividends for Community Banks

Magazine article The RMA Journal

Loan Officer Compensation and Bank Performance: Investing Wisely in Loan Officer Compensation Can Pay Dividends for Community Banks

Article excerpt

For community banks, the human capital of loan officers and their credit judgment are a major source of value creation. Loan officers lending to small and medium-size businesses should identify and fund positive net-present-value projects--and reject the others. In doing so, loan officers create revenue for the bank and the business, minimize loan losses, and generate economic growth in the local area.

Given their skill requirements, compensating and retaining qualified lenders is a constant challenge for community banks. In November 2012, the Wall Street Journal reported on a survey showing that the average compensation package for commercial loan officers was up 17% in 2012 to $101,376, a result of the critical shortage of people with the required expertise. (1)

But banks must control costs. Consider the situation of senior managers at a community bank reviewing a salary survey for business loan officers. Should they offer salaries at the higher end of the range to attract the very best prospects and take other steps to retain highly competent personnel? The results of one study suggest an affirmative answer to this question. (2)

This article first considers how financial theorists view a bank's monitoring process and the role loan officers play in it. It then discusses what the empirical models say about the relationship between loan officer compensation and a bank's financial performance.

Bank Monitoring in the Theory of Finance

As defined by researchers, monitoring is the act of obtaining private information about the borrowing firm through its multiple interactions with the bank.

Indeed, it is through the bank-borrower relationship that banks obtain information about a business borrower's creditworthiness. One source of information is the borrowing firm's checking account at the lending bank. Monitoring this account should provide an early warning about a firm experiencing a sudden and sharp decline in sales, unexpectedly high expenses, or other financial problems.

A broad definition of monitoring also includes the initial screening effort. Clearly, this is where most undesirable business loans should be identified. The project to be funded should be a positive net-present-value project--that is, the present value of the expected cash flows from the project must exceed the cost--or the firm will have difficulty repaying.

Theoretical studies have suggested additional reasons why banks that invest more resources in monitoring should have better financial performance.

Information is costly to obtain, but it is often reusable, so it can be employed to monitor other borrowers.

Moreover, a bank has overlapping generations of loan officers. Since every local market is different, it is important for the more senior officers to pass their specialized knowledge of the local economy and business community on to others. Specialized knowledge by sector is also valuable, and banks focusing on certain types of businesses have an information advantage when lending to them. For both reasons, there should be a strong incentive to invest in loan officers who have superior information-production and information-processing skills.

Ideally, the result will be a bank with a strong credit culture based on monitoring and bank-borrower relationships. Loan officers and senior management should understand that lenders perform a better service for the bank when they reject a bad loan than when they recommend a marginal one. Loan officers compensated even in part on volume do not have an incentive to do this.

Desiqn and Results of the Study

As discussed, monitoring is beneficial, but it is also costly. Do the benefits outweigh the costs?

Consider the Reports of Condition and Income (call reports) for all banks following the commercial lending business model as defined by the FDIC. (3) These banks have 25% or more of their total assets in commercial and industrial loans, real estate construction and development loans, and loans secured by commercial real estate properties. …

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