It's been seven years since the banking industry nearly imploded in the financial crisis, and yet, according to a recent survey by BankDirector.com, most banks today haven't yet changed the fundamental way they incentivize their executive teams to prevent a repeat of the crisis.
At the core of the problem is a lack of skin in the game, and for bank investors, that's a big problem.
Management rewards should be in line with investor success, but they're not
One of the root causes of the financial crisis was that bank executives didn't have a personal stake in the institutions they were leading. According to the BankDirector.com 2015 Compensation Survey, they still don't.
Bank executives today are still resoundingly paid with short-term pay structures. Less than half of all respondents in the survey reported that their bank paid executives with equity annually. Only 31% offered restricted stock and 21% offered stock options.
The median bank CEO salary in 2014, on the other hand, was a healthy $382,205. The median pay for CEO's of banks with more than $2 billion in total assets was just north of $2.8 million. 70% of CEOs received a cash bonus in addition to that salary, sometimes worth millions by itself.
That's a lot of cash just for showing up at the office from Monday to Friday each week. What's even worse is that 25% of respondents reported that CEO compensation was not tied to any performance indicator at all.
That's right -- the CEO shows up, does literally anything at all, and still gets paid hundreds of thousands, if not millions, of dollars.
It's exactly this type of environment that allowed subprime mortgages to flourish. It facilitated massive leverage throughout the industry. For many executives, the game was to load up, get paid, and get out before the house of cards collapsed.
When the house of cards did collapse, as they always do, investors were left with pennies on the dollar, and the communities these banks were supposed to serve were left with underwater mortgages, bankruptcies, and an economy in ruin.
In the BankDirector.com survey, 72% of bank executives responded that in addition to a salary and a cash bonus, the most desired additional form of compensation is a retirement benefit.
In other words, when the executive retires, after collecting a very healthy salary and large cash bonuses for their term as a leader of the bank, the executive also expects to get a recurring retirement benefit, presumably untied to the performance, condition, or health of the bank they are leaving behind.
Investors have the power to change the status quo
For the bank executives themselves, it only makes sense that they'd pursue these payment structures. Running a bank, however large, is one of the most challenging jobs out there. The industry is fraught with risk, highly regulated, and yet essential to the healthy functioning of the U.S. economy.
It's only human nature that these individuals would attempt to negotiate for salaries and bonuses that will provide the most safety for themselves and their families. And in that regard, cash payment today is much safer than equity compensation that vests over five or 10 years. Cash is king, after all.
For bank investors though, these compensation structures are downright dangerous and misalign the motivations of management and ownership. That's why any bank stock investment decision should include a review of a the bank's executive compensation structure.
There will certainly be exceptions, but banks that structure executive compensation to shareholder performance will be more likely to follow prudent risk management practices, avoid dangerous businesses like subprime lending, and better serve the communities they depend on.
To make sure management is working for you and not themselves, find the banks that award management with restricted stock and stock options tied to long-term, performance-based objectives.