We have blogged about how low-interest rates, COVID-19 credit strain, and tough competition for quality commercial loans create a challenging environment for community banks. One way that community banks are responding to deterioration in net interest margin (NIM) is by embracing commercial loan hedging programs. These hedging programs can appeal to borrowers in today’s interest rate environment because borrowers are fearful that interest rates are more likely to rise in the future from such low levels and are motivated to lock their financing costs today. Most importantly, commercial loan hedging programs are one of the easiest ways for banks to generate non-interest income. This hedge fee income can equal one to two percent of the loan amount and can be recognized immediately without the borrower paying ANY fee upfront out-of-pocket. However, many banks have been asking us how to compensate their commercial lenders (if at all) for generating such fee income. In this article, we will address this question, provide ways to compensate for fee income, plus offer sample marketing materials.
Commercial Lenders’ Compensation
We believe that incentive compensation in the form of variable dollar payment to employees directly tied to the amount of the product they sell is one of the most motivating ways to achieve a bank’s sales goals. We also believe that banks should generate some hedge fee income on every commercial loan that they hedge.
Most banks already have lender incentive plans that account for revenue generated, and many banks pay lenders based on loan fees generated. Hedge fee income should not be overlooked as an incentive tool and to align goals. Hedge fee income is easily measured and can be a substantially greater source of fee income than loan origination fees, which are resisted by borrowers because they are a direct out-of-pocket cost (in contrast to hedge fee income).
It makes sense that banks that want to generate hedge fee income should align lender behavior that best benefits the bank. There are several ways that banks can create incentive plans for commercial lenders based on hedge fees generated. The four most common commercial lender incentive plans in the industry for hedge fee generation are as follows:
Set Dollar: Many banks pay commercial lenders a set dollar amount per million in loans booked through a hedge. We have seen this number in the range of $500 to $1,000. For example, on a $1mm, 25 due 15 loan, where the bank generates 20bps in hedge fee income or $18k in fees, the lender would earn $1k of that (assuming the lender compensation is $1k per million). Therefore, the bank is sharing approximately 5.4% of fee income with the commercial lender. The advantage of this structure is that it is simple to calculate. The disadvantage is that the bank needs to ensure that some minimum amount of hedge fee income must be recognized because, under this structure, the lender is motivated to use a hedge but not to maximize fee income for the bank.
Percentage: Some banks pay commercial lenders a percentage of the fee income. In the example above, the bank could set the lender’s incentive compensation to 5% of the fee income generated, and the lender would then receive about $1k compensation for that same loan and hedge fee. The advantage of this structure is that the bank’s and lender’s interests are more evenly aligned. However, lenders may be incented to maximize fee income and minimize the bank’s credit spread to maximize their fee payout. Therefore, banks must maintain more control over the fee/NIM balance or cap the maximum hedge fee income to create the desired behavior.
Hybrid: Another plan that we have seen used effectively is a hybrid of the above. Here management insists on a minimum hedge fee for all deals and pays the lender a standard incentive. In our example above, management sets a minimum of 10bps spread for all hedges and shares $1k per million with the lender. Management then allows lenders to include additional fee income and pay extra on any hedge fee above the minimum (for instance, it could be 10% of fee income generated above the first 10bps of hedge spread).
Basis Points: Lastly, some banks pay a set number of basis points of the hedge spread. The bank could pay the lender a 1bps hedge spread in the example above, which would equal about $925 for the $1mm loan. This method considers the profitability of the loan structure but creates some additional complexity for lenders to understand how loan structures relate to fee income.
How To Get More Value From Us
We favor simplicity in incentive pay, but every bank is different. A bank’s strategy should be framed in concert with the hedge program used, the ability of lenders to drive value and sophistication of the market. We have created generic hedge promotional material for commercial lenders that we can share with interested bankers (HERE), and we are willing to work with your bank to create marketing material specific to your needs (without charge). Shoot us an email and we will follow up about augmenting your marketing department for free while helping you generate potent load growth.
Submitted by Chris Nichols on November 30, 2020