The law of small(er) numbers

“NAUGHTY or nice” is not a discussion investment bankers have with Santa before Christmas but one they have with their bosses early in the new year. The haggling usually opens with the boss saying what a tough year it has been and the bankers, often experienced traders and dealmakers, talking about how valuable they are. This year’s negotiations will be unusually tense. At stake will not simply be pay, an issue complicated by the introduction on January 1st of a bonus cap in Europe, but also jobs.

After peaking at the end of 2010, employment in the investment-banking industry has been declining steadily. Deutsche Bank reckons that the number of bankers employed by the ten largest firms will fall by about 3,000 in 2014, leaving the total 20% below its peak. Add in job losses at smaller firms and declines in support staff, and total worldwide employment in the industry may fall by 20,000 this year.

Pay is dropping too. At Goldman Sachs and JPMorgan Chase average pay slipped by about 5% in the first nine months of last year, a figure that is probably representative of the wider industry. Over the longer run, average pay at the world’s biggest investment banks has barely changed (see chart), which means it has fallen slightly after inflation. The pace of pay cuts is likely to accelerate, senior bankers say.

The biggest reason for the cutbacks is that after decades of growth in revenues (punctuated by brief declines), the investment-banking industry is facing a structural downturn. Regulators in America have banned banks from trading securities for their own profit. Higher capital standards everywhere are forcing investment banks to shrink their balance-sheets and regulations are making banks move much of their derivatives trading from opaque and profitable “over-the-counter” transactions onto exchanges and into central clearing-houses, where fees are likely to fall.

Although final figures are not available, the investment-banking revenues of the industry’s biggest firms probably fell by about 5% in 2013, according to Coalition, a data-provider. That leaves them about a quarter lower than their peak in 2009.

In fact, the industry’s revenues and profitability have fallen far more sharply than pay and employment. McKinsey, a consultant, reckons that for the 13 biggest investment banks revenues have fallen by 10% a year since 2009, while costs have dropped by just 1% a year. The main reason for this mismatch is the relentless optimism of those who work in the industry. Most big banks hired energetically after the financial crisis, hoping to gain a greater share of the market as rivals cut back.

Another reason is the difficulty in making incremental cuts at investment banks without shutting down whole departments. Trading businesses often have large fixed costs such as computer systems and compliance departments that are difficult to shrink. Simply thinning the numbers of traders and bankers often results in revenues falling faster than costs.

A failure to cut costs fast enough means that the industry’s profitability has been ruined. Average returns on equity for the biggest investment banks slumped to about 8% last year, according to McKinsey. Without deep cost cuts it reckons this figure will fall to 4% by 2019. That sobering prospect is now prompting deeper cutbacks, particularly at European banks such as UBS, Credit Suisse and Royal Bank of Scotland which are getting out of whole lines of business. UBS, for instance, has decided to get out of most debt trading and is trimming about 10,000 jobs.

Against this backdrop there is one part of bankers’ pay that is likely to rise. New rules that came into force at the start of the year in Europe will prevent banks from paying thousands of key employees bonuses that are bigger than their annual salaries. The result will not be the cut in total pay that European lawmakers expected. Instead banks have already figured out wheezes to work around the rules.

The first is to bump up basic salaries while reducing the portion of pay allocated to a bonus. This cuts against much of the work done by regulators to tie bankers’ pay to performance and to defer large chunks of it so it can be withdrawn if the bank subsequently does badly. In Britain, for instance, the country’s highest-paid bankers received bonuses in 2012 that were 3.8 times their salaries.

Across the industry most big banks have signed up to international principles under which 60% of bankers’ total pay should be deferred (and thus not part of basic pay), according to Oliver Wyman, another consulting firm. That trend is likely to reverse in Europe, bankers say. “The more I pay in fixed, the less I have to claw back,” complains the boss of the European arm of a large international bank. “This doesn’t do what the legislation wanted it to do.”

A second wheeze being tried by international banks is to exploit a loophole that allows them to pay bonuses that are twice as large as normally allowed if shareholders approve this in a vote. Since many are structured as subsidiaries whose only shareholder is their parent bank, getting shareholder consent is a doddle.

Other ploys include paying monthly cash “allowances” or granting forgivable loans that only have to be repaid if the banker leaves within a certain period of time. The impact of these ruses will, however, be limited, mainly because of relentless pressure on banks to cut pay to improve returns for shareholders. After years of watching their employees naughtily pocket large cheques while passing losses on to shareholders and taxpayers, the owners of banks are in no mood to be nice.