During the credit boom, senior executives at the world’s largest investment banks often argued that businesses had improved in two significant ways, writes Peter Thal Larsen, the FT’s banking editor, in the On Monday column. First, they had become better at managing trading risk. Second, their pay structures were more flexible, allowing them to cut costs rapidly in a downturn.
The subprime meltdown, which has so far been responsible for almost $40bn of losses at Citigroup, Merrill Lynch, Morgan Stanley and UBS, has put paid to the first claim.
The second also looks unlikely to survive the current bonus round, in Thal Larsen’s view. And this should have far-reaching consequences for how investment banks are valued in future.
Ever since they abandoned the partnership structure, investment banks have struggled with how to pay employees. During the boom of the late 1990s they used long-term guaranteed contracts to lure and retain top bankers. But when business dried up, the bonuses still had to be paid.
In recent years, a different approach has become the norm on Wall Street and in the City of London. Banks structured bonuses to include a greater proportion of restricted stock, which is released over several years. And they set explicit targets for compensation costs as a proportion of revenues, typically around 50 per cent.
The pitch to investors was simple: we may give our staff half of everything they bring in, but this will rise and fall in line with the state of the business.
This formula worked well in boom years, but is beginning to creak. Of the Wall Street banks that have released fourth-quarter earnings so far, the two most affected by the subprime meltdown reported sharp increases in their compensation ratios. In 2007, Morgan Stanley’s wage and bonuses bill rose 18 per cent, to $16.6bn.
This in a year when the bank’s revenues fell 6 per cent, it wrote off $9.4bn in subprime losses, and was forced to raise $5bn from China Investment Corporation. At Bear Stearns, the bonus pot shrank by a fifth, but revenues fell more than a third.
Morgan Stanley’s John Mack and Jimmy Cayne of Bear Stearns may have done the decent thing by skipping their bonuses this year, but they clearly did not ask the same of their employees. Do not be surprised to see Citigroup and Merrill Lynch follow suit.
There is a certain logic to this largesse. The subprime losses are generally the work of a small number of people working in the fixed income division. Meanwhile, other parts of the business have enjoyed record years. It may be in the bank’s interests to pay to keep its best people, even if there’s not much left for shareholders.
This argument fails to acknowledge the fact that all employees benefited when the fixed income operations were raking in the profits during the credit boom, and should probably share in the losses. It also highlights a fundamental flaw in the bonus culture: that costs and benefits associated with risk-taking are not equally shared.