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Monday, 21 April 2014

Share the relative wealth

Wall Street, City pay still must fall by a third

James Gorman is right that investment banking is overstaffed and overpaid, as he told the Financial Times last week. But neither the Morgan Stanley boss nor his global peers have proven adept at taking action. Last year, total wages at securities firms that are members of the New York Stock Exchange and the average pay per employee in New York increased even as industry profit fell, according to a report this week from the state’s comptroller.

In third-quarter earnings reports that begin with JPMorgan’s on Friday, U.S. banks have an opportunity to set aside less for pay. Across seven top Wall Street and European banks the bill for traders, advisers and money managers needs to drop by a third or more from the current total approaching $100 billion just to give shareholders an unexciting return on equity of around 10 percent, according to a new interactive Breakingviews calculator.

Compensation has declined since the financial crisis. Most investment banking units now set aside between 40 percent and 45 percent of their trading, advisory, asset management and securities services revenue to cover salaries, bonuses and benefits - down by up to five percentage points on pre-recession numbers. JPMorgan’s bill is the lowest at around 35 percent.

But shareholders are still suffering. Of the leading firms, only JPMorgan and Barclays are on track to post a return on equity within range of 10 percent or more this year, according to Thomson Reuters data. That’s a level widely seen to just about cover the cost of capital for bulge bracket securities houses. Goldman Sachs is the best of the rest, with 8.5 percent. The others, Bank of America, Morgan Stanley, Citigroup and Deutsche Bank, are return-on-equity dwarves. Someone invested equally in all seven banks is likely to reap an average ROE of only about 7 percent this year.

Most financial giants, in other words, need to worry less about their employees’ paychecks and more about their shareholders. The old argument that reducing pay would leave firms exposed to mass defections has lost some force. As Gorman made clear, there are already too many bankers chasing too few fees. And hedge funds and boutique advisory firms have already lured away many of the brains they want.

Taking the seven banks collectively, to reach a 10 percent ROE would require slicing more than $30 billion, or about a third, out of their pay allocations, the Breakingviews calculator shows. That gives an idea how far the industry still has to go. But it’s simplistic - targeting the same ROE for all the banks and achieving it solely by cutting investment banking pay creates some oddities, like a 90 percent cut in BofA’s compensation pool.

Alternatively, suppose all the banks including Barclays just reset the ratio of investment bank and asset management compensation to revenue to the same, lower level. Targeting an average 10 percent ROE for the seven banks overall requires this pool of compensation to fall to only slightly above 25 percent of revenue. Apply that rate to all the banks, and their returns this year would range from BofA at about 6 percent to Goldman at more than 13 percent.

That is an extreme scenario for pay. But for at least some banks, it would provide shareholders with returns much closer to what they are hoping for. Of course, despite market conditions, a big risk would be that top bankers leave en masse. But with per-head pay overall still close to $200,000, investment banking would hardly be a hardship posting. A bit of warning, for instance in the coming earnings reports, would give employees time to adjust their expectations. And if some were to quit, that would at least prune the industry’s overgrown ranks.

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Run the numbers: How much does bank pay still need to fall? Target an average 2012 return on equity for seven global banks, and see what that means for average compensation - and their individual ROEs if they cut pay accordingly.

The third-quarter earnings season for U.S. banks kicks off on Oct. 12. JPMorgan and Wells Fargo are set to report results then. Citigroup follows on Oct. 15, Goldman Sachs on Oct. 16, Bank of America on Oct. 17 and Morgan Stanley on Oct. 18.

Thomas DiNapoli, the New York State comptroller, on Oct. 9 released an analysis of securities industry profit, jobs and pay.


This view has been updated to reflect refined inputs to the Breakingviews calculator.

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