This is the third and final blog in our series on Incentive Compensation Management: An Integral Part of Your Enterprise Performance Management Process. We also invite you to read Part 1, The Good, The Bad, and the Ugly, and Part 2, Escape from Alcatraz.
Like many community banks in small towns and cities, STAR Financial Bank has roots as a family-owned small business that has grown to 40 branches in Central and Northeast Indiana, and $1.9 billion in assets for the STAR Financial Group. With growth have come ongoing challenges, such as scaling performance across multiple locations, thriving in an increasingly competitive and regulatory environment , and keeping up with technology and banking best practices.
We adopted an automated platform for profitability reporting in early 2013 to establish better consistency and consensus around our reporting, and gain a deeper understanding of our most profitable customers, products, officers, and locations. Once this platform was established, we were ready to determine how to use the information we could now access to make STAR more profitable.
As these discussions were taking place, there were growing internal concerns about our longstanding third-party commercial banker incentive model. All officers were allocated an equal percentage for risk and servicing, but management felt that certain officer payouts were excessive. And while officers received a 15-page personalized monthly reporting package, there was a surprising lack of transparency. In addition, we had to maintain a separate Access database to feed the third-party incentive model, and an administrative assistant devoted a quarter of her time to maintaining the model.
Creating a Better Approach to ICM
Our Finance Department proposed that we leverage our new profitability reporting information to replace STAR’s third-party commercial incentive model. We held seven internal meetings over three months to iron out the details for a quadrant model that would incent risk-adjusted profitability and loan growth. Specifically (as seen below), one axis of the quadrant shows an officer’s “S&B Coverage Ratio” which is their risk-adjusted portfolio profitability divided by their salary and benefits expense. The other axis of the quadrant is the officer’s “Loan Growth” for the year. This is expressed as a percentage growth of their YTD average loan outstanding balance over their individual baseline balance.
Incentive Compensation Quadrant Model
Source: STAR Financial Bank
While the new model was flexible enough to incent either deposit growth or a combined growth of loans and deposits, we opted to initially incent only loan growth in hopes of reversing a few years of flat growth in our commercial loan portfolio.
Under our new program, bank officers are no longer able to sit idly on their portfolios and collect lucrative payouts without any loan growth. To be eligible for an annual incentive payout, officers must grow their average outstandings. Behavior soon changed, as our loan portfolio demonstrated. In 2011-2013, STAR flat-lined in its commercial loan outstandings. Following the implementation of the new incentive model in 2014, STAR grew its average commercial loan outstandings by 9.8 percent in 2014, 8.0 percent in 2015, and 7.7 percent in 2016.
Commercial Loan Growth with New ICM Model
Source: STAR Financial Bank
While we can’t attribute all of our commercial loan growth to the new incentive model, we believe it clearly has a driving and motivating influence on our commercial line of business. In addition to portfolio growth, our new incentive compensation model generates three key outcomes: better alignment with desired outcomes, improved transparency, and increased efficiency.
Better Alignment with Desired Outcomes
We now have a more forward-looking approach to credit risk that aligns behavior with desired outcomes. Officers with riskier portfolios have greater risk of loss allocations, which in turn negatively impacts their risk-adjusted profitability. Portfolio mix is now considered when allocating fixed and variable costs. There are no payouts to officers with unsatisfactory profitability or no net growth. As we’ve managed individual payouts, this model has generated far less controversy than in the past.
To achieve greater transparency, officers receive a personalized 13-month profitability report of their portfolio, including month-to-date and year-to-date (YTD) data on customers sorted by profitability, upcoming 12-month contractual loan and deposit cash flows, and YTD originations. There also are clear lines distinguishing the next levels for payouts on the quadrant model.
Our new incentive compensation model has also improved efficiency. The length of our monthly officer report reduced from 15 pages to eight. Monthly officer reports are pushed out to individual SharePoint® folders, and the reports are available in one week compared to up to six weeks using the previous model.
The transition activities required to leverage profitability reporting with a home-grown incentive model weren’t completed without some pains. We underestimated how much time it would take to agree internally when replacing our third-party model with a newly developed system. Stakeholders, such as Finance, Commercial Lending, and Human Resources, had their own priorities. We also discovered “dirty” data, especially with FTP rates for certain loan categories having unique amortization structures, which created a new project for us to tackle rather quickly. We also spent additional time debating cost methodologies. Despite a rocky first year, we are pleased with the efficacy of the new model.
Profitability reporting is meaningless unless it’s used for decision making and/or incentive purposes. For STAR, an improved incentive compensation system has produced desired behaviors that align to corporate goals and strategies. No model will be perfect, but there are smart people in every organization who can develop new ideas.
We’ve also realized how powerful it is to have all source data in the same place. Integration of profitability reporting, FTP results, spread analysis, and incentive compensation is now more transparent and interactive at STAR. Concerns about data consistency, accuracy, and accessibility have been eliminated. Buy-in of the results throughout our organization has affirmed that the time and resources we devoted to our profitability and ICM reporting systems have provided tremendous returns.