The debate over pay and bonuses at investment banks generates far more heat than light. To help cut through the confusion, here are 10 things we know or don’t know about what’s going on. My latest column for Financial News:
You should never confuse the size of your pay cheque with the size of your talent, said Marlon Brando. But a lot of people who work at investment banks will be doing little else over the next few months as the clock ticks down to bonus time.
Confusion is the operative word when it comes to pay and bonuses. The annual season of bonus-baiting is known as much for obfuscation and misinformation as for the anger generated by the huge rewards on offer. To help cut through the confusion, here is a 10-point guide to what we do and don’t know about pay at investment banks.
1) We know nothing
One of the few things we know for sure about pay and bonuses in investment banking is that we know very little about the actual numbers. The numbers that the banks publish on “pay” – or what they euphemistically call “compensation” – bear almost no resemblance to what they actually “pay” their staff in any given year. In fact, the numbers around compensation are so misleading as to be virtually meaningless.
This is because the numbers are a vague amalgam of salaries and benefits, deferred bonuses awarded in previous years but amortised over the length of the deferral period, and the cash element of bonuses awarded that year. But they exclude deferred bonuses, an increasingly large part of overall pay. This is one of the unintended consequences of the well-intended pressure from regulators for banks to defer a higher proportion of bonuses for a longer period.
So when you read that the “average pay at Goldman Sachs (or any other bank ) in 2013 was X”, the only thing you know about that number is that it is 100% wrong.
2) Except that we know pay is falling…
That said, it’s clear that pay is coming down (at least for most people in the industry – for a small group of people at the top it’s still going up). Total disclosed compensation at a sample of six investment banks that provide broadly comparable data has fallen by 6% so far this year compared with 2012, according to my analysis, but it has dropped by a quarter since its peak in 2007.
This number may be flattered by an increase in the amount of bonuses that have to be deferred, and even though it is not the same as what most of us would call “pay” it looks like “compensation” is heading in the right direction.
3) … and it’s falling faster than you might think
In fact, it might be heading to its lowest level in relative terms for as long as anyone has been angry enough about pay at investment banks to care. When you look at compensation as a proportion of revenue – known as the “compensation ratio” or “comp ratio” – in the first nine months of this year it was 39%.
This is the lowest “comp ratio” over the nine-month period in more than a decade, according to my numbers. And given that banks tend to slash pay in the final few months of the year in order to hit profit targets, the industry could be heading for a record low comp ratio of less than the 37% recorded in 2009. That’s in the realms of the real world: the comp ratio at the New York Times Company last year was a notch higher, at 38%.
It may still be too high – and the problem may be that revenues are too high as well – but overall the downward trend is clear. The comp ratio is below 50% at every big bank this year, with several below 40%. Not so long ago, the average was closer to 50%, with laggards like Credit Suisse and UBS often reporting comp ratios of more than 60% or even 70%.
4) Individuals feeling the pain
The fall in compensation in absolute and relative terms has translated into a significant fall in “compensation cost per employee”, which is a pretty good directional proxy for “pay per employee”. The average comp cost per employee this year is set to fall to around $278,000 (or about seven times the average wage in the UK), according to my analysis. That’s 6% down on last year but nearly 20% down from 2009 and 30% down from its peak in 2007.
In real terms, if you adjust the numbers for assumed annual inflation of 2.5%, then the average compensation cost per employee across the industry has fallen by 39%. Not many people can cope with a pay packet that can shrink so quickly.
Of course, an arithmetic mean of tens of thousands of staff in an industry where the rewards are increasingly skewed towards a small number of top performers is fairly useless as guide to typical “pay”. But it provides a good relative and directional indicator.
For example, the average comp cost per employee at Goldman Sachs will be something like $385,000 this year, the highest in the industry and more than double the $150,000 or so in the markets division at RBS. But before you start feeling sorry for the staff at RBS, note that the average has plunged by more than 40% at Goldman Sachs since 2007.
5) Real transfer of reward
The changes in pay mark a very significant shift in the balance of rewards between staff and shareholders. For example, in the five years before the financial crisis, the average comp ratio at investment banks was 47%. This year, it is likely to be closer to 37%.
Those 10 percentage points translate into roughly $20 billion of costs this year at the top 10 investment banks that is not being paid out to staff and is, instead, going back to shareholders in the form of profits. That $20 billion is roughly one third of those banks’ pre-tax profits. In other words, investment banks are 50% more profitable than they otherwise would have been if compensation had not fallen sharply.
For good measure, when you look at compensation relative to profits, it has fallen to less than double net earnings across the big investment banks, according to my analysis. That may not sound great, but it is a big shift from a historical average of more than three times profits.
6) More flexible than it looks
One of the most common criticisms of pay at investment banks is that, like petrol prices or energy bills, it often goes up but rarely seems to come down. That’s a little unfair. The increase in deferrals demanded by regulators increases the fixed element of pay and reduces the banks’ flexibility accordingly (because a bonus deferred into next year has to be paid regardless of next year’s performance).
Look more closely, and you can see that the part of the pay that banks can control is more variable than you might think. Assume that in any given year, half of an investment bank’s compensation bill is in the form of salaries, with the rest divided equally between deferred bonuses from previous years and cash bonuses awarded for the current year. If total compensation has fallen by 6% this year – and salaries and previously awarded bonuses are broadly fixed – then bonuses awarded for this year have fallen by somewhere closer to 30%.
This helps explain why investment banks are frantically trying to get rid of staff: reducing bonuses in any given year will only have a marginal impact on that year’s costs, and will take years to work through to the bottom line, whereas removing entire salaries is far quicker.
It also helps undermine the common criticism that the proposed bonus cap in Europe will reduce the flexibility that banks need to manage their compensation bill. Truth is their compensation costs are already highly inflexible because of deferred bonuses, so the cap will make only a marginal difference.
7) And the winner is…
For plenty of staff at investment banks the picture is far from gloomy. Averages can hide a multitude of sins, one of which is that banks are applying much more differentiation between staff when it comes to bonuses. Good performers – people who make more money for the bank than you might expect for someone sitting in their place – will get proportionately more. Mediocre performers and middle-level staff, who are useful for heavy lifting but are eminently replaceable, will get proportionately less. Juniors or bad performers will get nothing.
Most recently, the European Banking Authority has disclosed that more 2,700 staff at banks in the UK earned more than a million euros last year – an increase on 2011 – and that their average pay increased by nearly one third.
With equities and parts of investment banking up by more than one fifth this year, it’s going to be a good bonus season for some. If you work in fixed income, which is down 15% across the industry this year, not so much.
8) Keep on falling
However fast pay may be falling across the industry, it still has scope to fall further. The head of one investment bank told me recently that he thought pay had come down to about as low as it could reasonably go, which was odd given that his investment bank struggles to make a net return on its equity and pay is its single biggest cost. Relative to what they make in revenues and profits, the staff still get paid too much (or there are too many of them).
So far this year, investment banks have managed to make a return on equity that covers their cost of equity – but only just. Shareholders have been putting up with this mediocre performance in exchange for first-class pay for years, and it is hard to imagine them doing so forever.
It is equally hard to imagine that in three or five years, as tougher regulations kick in, and more of the business is automated and outsourced, that pay at investment banks will be anything like what it is today for all but the very best performers.
9) Pay isn’t the problem
Whisper it quietly, but pay isn’t the biggest problem for investment banks. As the numbers in this article demonstrate, pay is coming down – and faster than you might think. The problem is that other costs are going up.
For example, since 2009, compensation at investment banks has fallen by 16%, according to my numbers. However, over the same period, overall costs have only dropped by 2%. This is because “non-compensation costs” – all the boring stuff like premises, IT, travel and expenses – have shot up by 14% and are stubbornly refusing to come down.
Pay is falling at such a rate that it will soon drop below half of the banks’ total costs. The real challenge for investment banks is to bring down their non-compensation costs with the same vigour with which they have attacked their comp costs.
10) Cutting through the confusion
Of course, it would be relatively easy to cut through the confusion about what is happening with pay at investment banks. Instead of creating ever more layers of complexity, regulators could require banks to publish awarded compensation (what most people would call “pay”) each year alongside the “accounted compensation” that they currently disclose. This would include salaries, benefits and bonuses awarded for the period in hand, and would give a far clearer understanding of a complex issue that could help defuse the anger and misinformation that characterise the debate over pay and bonuses.
There is nothing stopping the banks from doing this today, but perhaps they prefer to hide behind the confusion.
-This article first appeared in the print edition of Financial News dated November 18, 2013