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A tall order in FICC at Morgan Stanley

May 17, 2013 by William

Ambition should be applauded, but only so long as it stays on the right side of achievable.

James Gorman must be getting tired of being asked about his fixed income business. At this week’s shareholder meeting, the chairman and chief executive of Morgan Stanley was again being grilled over whether there is a profitable future for a mid-sized player in fixed income.

In particular, the question for Gorman and for Colm Kelleher, the fixed income veteran who runs the institutional securities division at Morgan Stanley, is how a bank without the scale of a JP Morgan or a Deutsche Bank (which generate two or three times the revenues as their smaller rival) can compete in fixed income without taking as radical approach to restructuring as, say, a UBS.

For the timebeing, Gorman is confident that there is a profitable future for the division, just so long as it can keep bringing down the risk-weighted assets in its fixed income business to levels that are no longer punitive in terms of capital. He said this week that he saw no reason for more job cuts, that the business was roughly the right size, and that its RWA diet was not only on track but ahead of target.

It has already reduced its RWAs by 35% from $390bn since it first announced its crash diet in the third quarter of 2011, and this year has cut them to $253bn , slightly deeper than scheduled. It plans to reduce them by another fifth to $200bn by 2016.

What does that mean in practice? On the back of some fairly simplistic assumptions, this translate into a reasonable target, but one which will require everything to come together and work smoothly in a manner that has not traditionally been associated with fixed income at Morgan Stanley.

Take the following assumptions:

  • In 2016, the fixed income division at Morgan Stanley will have $200bn of RWAs under Basel III.
  • Assume a 9% equity ratio (as Morgan Stanley does), and it will fund these RWAs with $18n of equity.
  • Assume that in order to be sustainably profitable, the division needs to generate a net return on equity of 12%, and it will have to generate net profits of just under $2.2bn.
  • Assume a tax rate of 30%, and it will have to generate pretax profits of $3.1bn.
  • Assume a pretax margin in the fixed income division of 40%, and you end up with a revenue target of just over $7.7bn in Morgan Stanley’s FICC division in 2016:

Screen shot 2013-05-17 at 11.50.35

This $7.7bn is only 37% ahead of the $5.6bn the FICC division made in 2012 and it has nearly four years to get there. That translates into a compound growth rate of just 8%, which suddenly makes the target look like child’s play.

But there is a but. Several of them in fact. The target of $7.7bn may be little more than a third above the divisional revenues from last year, but it is an altogether more challenging 70% higher than the bank’s FICC revenues over the past four quarters of $4.6bn (that annual growth rate has just gone up to 14%).

This is because in the first quarter of this year, Morgan Stanley’s FICC business posted an unpleasant surprise for the third time in the past four quarters, with revenues falling by 42%, compared with an industry average of 13%. A big reason for last year’s disappointing performance was the downgrade by Moody’s in the second quarter, and the bank has said that it does not see the $1.5bn it made in FICC in the first quarter as a ‘ceiling’ of any kind. But neither point changes that the target is tougher than it at first looked.

At the same time, Morgan Stanley will have to generate revenues not far short of its banner year in 2009 to hit the $7.7bn target, but with a lot less ‘stuff’ to play with and a lot fewer staff to play with it. It target of $200bn in RWAs is around one third less than the $310bn in RWAs off which it made $5.6bn last year, and around half what it used to deploy.

And, with little prospect of any growth in industry-wide revenues to give Morgan Stanley a leg up towards it targets, any growth will have to come by stealing market share off others. This means the bank will have to beat bigger players like JP Morgan, Goldman Sachs and Deutsche Bank in taking market share from other firms who are retrenching in fixed income.

Oh, and there will be no room for any mistakes or accidents over the next four years.

Of course, it’s not impossible. But it might be a lot harder in practice than it looks on paper.

 

 

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Putting the fun back into investment banking

May 13, 2013 by William

Something needs to happen to snap the industry out of its gradual circle of decline

‘Most of the time, I don’t have much fun. And the rest of the time, I don’t have any fun at all’. Woody Allen might just as well have been talking about investment banking, which, if truth be told, just isn’t very much fun any more.

Over the past few years, investment banks have been struggling to come to terms with their fall from grace. In the face of stuttering economic growth, increased regulation and their new found status as social and political outcasts, investment banks have found that the economics of their business don’t really add up anymore.

This malaise was reflected in a strangely subdued set of first quarter results for investment banks:

Screen shot 2013-05-13 at 16.42.03

Overall revenues dropped by 7% compared with the first three months of 2011 (which was hardly a great vintage). The banks’ traditional engine room of fixed income misfired badly, and revenues from equities fell by a few percent. The only bright spot was investment banking (that is, new issues and advisory business) which increased from a low base last year. Despite the banks’ valiant efforts on costs, pretax profits slipped by 1%.

Whether this is part of a longer term decline or marks an industry pausing for breath depends on your timeframe. As I argued in a recent column in Financial News, one quarter in isolation doesn’t spell doom for the entire industry – but it is the fourth year in a row in which revenues have fallen compared with the previous year. As with the decline of the Roman Empire, it could years and you may not even notice that you’re doomed until it’s too late.

Step back and look at the numbers on a trailing 12 month basis (which gives you a moving average of four quarters), and the decline and fall seems a little little clearer:

Revs and profits

Since 2009, revenues from fixed income, equities and investment banking have fallen by more than a quarter, and pretax profits have slumped by 40%. Sure, things have improved from the lows seen in the middle of last year, but any recovery ran out of enthusiasm in the first quarter and flatlined instead.

It’s even less fun when you look at profitability, which has been crushed by lower levels of activity, stubborn costs, and an increase in regulation:

IB ROE Q113

Return on equity at big investment banks has basically halved since 2009 to just 12%, according to my analysis, which is roughly the same as the industry’s cost of equity. The big five US investment banks managed an ROE of 14%, compared with their European rivals on 10%. In 2006, average ROE was more than 26%.

Even these numbers probably flatter the industry, because many of the investment banks in the sample have carved out the crappier stuff from their business into a separate unit, which boosts their reported divisional numbers, but does nothing for shareholders. And most banks still have to cut back their risk-weighted assets or increase the equity in the business, or both.

Of course, it’s not all bad news. While the crisis may have skimmed some of the excess off the top of the market, the long term trends around savings, investing and capital-raising are all positive (otherwise we’re all doomed). But, as with forecasts of a return to 2% economic growth in the UK or European Union, any promised recovery in investment banking always seems to be six to 18 months away.

A recovery could come too late for some. Just to rub it in, The Economist ran an excellent report last week on the future of investment banks called Twilight of the Gods which concluded:

This is not to say that the industry’s revenues will not bounce back from their current low levels. There is bound to be some growth as the banks’ corporate clients regain their appetite for takeovers and start selling bonds and shares, and as rising equity markets lure investors back into trading more. Yet these revenues are unlikely to return to their recent peaks in the near future, and ROEs have almost no chance of getting back to their lavish pre-crisis levels of 25% or more. Indeed, even the banks’ more modest goal of returning 15-20% to shareholders seems elusive in view of the sea of new regulations.

If you’re after fun, it’s probably a good idea to look elsewhere, at least for the next few years.

 

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All change at the top: the great investment banking reshuffle (again)

April 26, 2013 by William

As Rich Ricci leaves Barclays to spend more time with his racehorses, investment banks are clearing out an entire stable of top management

RicciA year ago I wrote that there had rarely, if ever, been so many departures, at such a senior level, and at so many different firms at the same time. But since then, far from settling down, the great investment banking reshuffle has accelerated into a wholesale clear out.

The (perhaps inevitable) departure of Rich Ricci as head of the investment bank at Barclays means that 10 of the largest 14 investment banks have removed or changed their chief executive since the beginning of 2012.

This generational shift has the benefit of introducing new faces and perspectives to the very top of investment banks. But you cannot help but worry that the changing of the guard at so many banks at once – at a time when the industry is still struggling to define its business model, purpose and future – might just be storing up trouble.

It is worth noting that these 10 investment banks have combined annual revenues of around $150bn and a combined balance sheet of more than $7 trillion. That’s quite a juggernaut to hand over to inexperienced drivers.

To be fair, it’s not as if investment banks are parachuting in graduate trainees to run the business. At Barclays, Ricci will be replaced by Eric Bommensath, the head of markets, and Tom King, head of investment banking, both of whom are older than Ricci and are experienced executives.

Many of those who have become head of an investment bank in the past year are lifers at their banks, such as James Forese, who stepped up to run the institutional client division at Citi in January, or Colm Kelleher, who this year took over as sole head of the institutional securities division at Morgan Stanley after the departure of former co-head Paul Taubman.

As with Bommensath and King at Barclays, many investment banks have opted for a co-head structure to ease the burden for relatively inexperienced executives of running an increasingly complex business.

Deutsche Bank appointed Colin Fan and Rob Rankin as co-heads of its corporate banking and securities division last May, and JP Morgan appointed Daniel Pinto and Mike Cavanagh to run its newly-restructured corporate and investment bank in the summer (and former head Jes Staley left his role as chairman this year). Both Credit Suisse (Eric Varvel and Gael de Boissard) and RBS (Suneel Kamlani and Peter Nielsen) both have adopted a new co-head structure for their investment bank.

To round things off, Didier Valet replaced Michel Péretié as head of Societe Generale’s corporate and investment bank at the beginning of last year, and last summer UBS investment bank replaced Carsten Kengeter with Andrea Orcel as chief executive of its investment bank, while Nomura promoted Atsushi Yoshikawa to run its wholesale business.

This leaves just Bank of America Merrill Lynch (where the banking and markets business is overseen by Tom Montag), BNP Paribas (where Alain Papiasse runs corporate and investment banking), HSBC (Samir Assaf) and Goldman Sachs (Lloyd Blankfein) as the only investment banks that are run by the same people as they were at the beginning of last year.

In many ways, this overhaul is welcome. The transformation in the industry over the past five years requires a different way of leading and managing an investment bank. The previous generation of chief executives had been programmed to deliver growth and scale, while the industry today perhaps demands a more nuanced and sophisticated approach.

But the changes are not without significant risks. First, however talented the new chief executives may be, it is a huge step up for them and a big change for the business. Second, however welcome the departure of their predecessors, investment banks can ill-afford to lose the sort of experience and institutional memory that they have built up over the years – particularly at such a challenging time and when senior client-facing bankers and top traders are also streaming out the door.

Third, any change – particularly change at the top – creates uncertainty. As new chief executives rethink their approach and look to stamp their mark on the business, they can trigger cascading departures of senior executives, interrupt momentum, and create strategic uncertainty.

Investment banks need to change. But staff, clients, shareholders and regulators could be forgiven for not wanting too much change at too many banks at once.

This article first appeared in Financial News on 18th April

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JP Morgan lives down to low expectations

April 12, 2013 by William

The big beast of Wall St did not have quite as happy a start to the year as it first looks.

JP Morgan has made a habit over the past few years of setting a high bar for its rivals each time it kicks off the banks’ earnings season.

And, with its main Wall St rivals set to report next week, it looked like it had done it again with a solid if not stunning performance in the first quarter. Its corporate and investment banking division seemed to have shrugged off concerns over a structural squeeze on the industry (expressed most bluntly by one of its own analysts when he said this week that big investment banks were almost ‘uninvestable’).

Overall revenues in the division increased by 9% compared with the same quarter last year, costs were slightly down, and pretax profits jumped 28%. Return on equity of 19% was the sort of profitability that most of the bank’s rivals can only dream of. Cue lots of talk of JP Morgan’s strong start to the year.

On closer inspection (as the following chart shows) the top line wasn’t exactly inspiring – particularly not for the bank which is top in almost every business line except equities. Investment banking revenues increased by just 4% on last year, equities was down by 6% and the bank’s giant fixed income business dropped by 5% compared with last year:

Screen shot 2013-04-12 at 13.29.18

The problem with this superficially solid performance is that it flatters to deceive. The underlying operational performance of the business is distorted by the accounting treatment of the bank’s own debt, known as ‘own credit’ or DVA.

This added $126m to the division’s numbers in the first quarter – not a huge amount on stated revenues of $10.1bn – but it artificially reduced the numbers in the first quarter of last year by $907m (or nearly 10% of divisional revenues).

If you strip out DVA form the stated results – and we know that we should because Jamie Dimon has repeatedly said that it has no relevance to the underlying performance of the business – a very different picture emerges, as shown by the following chart:

Screen shot 2013-04-12 at 13.29.59

Instead of increasing by 7%, revenues in the markets and investor services part of the investment bank actually dropped by 7% compared with the first quarter. Total revenues for the division fell by 2% instead of increasing by 10%.

Far from slashing its cost income ratio from 67% last year to 60% in the first quarter of this year as reported, the ratio flatlined at 61%. Most importantly, pretax profits didn’t jump by nearly a third, they actually slipped by 4%. And that stellar return on equity? While it is a lot higher than JP Morgan’s rivals it is a lot lower than the first quarter last year, not higher.

To be clear, there is nothing dodgy going on here: JP Morgan discloses DVA as it is required to do (and thankfully, given its distorting effect, those reporting requirements could soon be changing). But, it sends a confusing message.

The underlying result sends a more chilling message to Wall St: if the top bank in the industry had a flat start to the year with profits slipping backwards, the outlook for its rivals is even gloomier than we thought.

 

 

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An apology over the proposed bonus cap

March 27, 2013 by William

The proposed extension of the cap on bonuses to asset managers has exposed the true colours of MEPs in attacking bonuses: they just don’t like rich people. My latest column for Financial News

The Brussels Bonus Snatcher: Sven Giegold MEP

The Brussels Bonus Snatcher: Sven Giegold MEP

I feel that an apology is in order. Over the past few weeks, I may have inadvertently given the impression that the cap on bankers’ bonuses – which was confirmed by the European Parliament last week – might have been part of a thoughtful and rational set of reforms by European policymakers to reduce systemic risk.

On occasion, through a form of confirmation bias that I am sure will not be unfamiliar to many readers, I may have glossed over some of the more glaring inconsistencies in the arguments for such a cap, and in doing so have overlooked something that has been hiding in plain sight all along, but which has only become clear to me in the past week.

In short, I had failed to notice that the proposed cap on bonuses has very little to do with reducing systemic risk at banks which have (to differing degrees) enjoyed explicit and implicit government subsidies over the past five years. Instead, this measure, it is now clear to me, has everything to do with a populist and intense dislike of wealthy bankers being paid big bonuses (note that for the purposes of this debate the word “banker” means anyone who works anywhere in the financial services industry).

I would therefore like to take this opportunity to apologise to everyone concerned and, in the interests of transparency, to explain how I came to make such a serious mistake.

Mea culpa

First, and most importantly, I apologise most sincerely to politicians and policymakers in Brussels (or were they in Strasbourg last week?) for having misrepresented their views. In a number of conversations with some of the Members of the European Parliament behind the proposal, I allowed myself to become convinced that their motivation was economically rational and that they may have been driven by a higher purpose than mere populist “soak the rich” policies.

For example, while proponents of the bonus cap provided no evidence whatsoever of any causal relationship between large bonuses and banks getting into trouble, I acquiesced in their not unreasonable view that a cap on bonuses at one or two times salary was a sensible way of reducing the incentives for traders and senior executives of big banks to take unhealthy risks.

I found myself agreeing with the view that it was structurally unhealthy and immoral for banks to continue to award such high bonuses relative to fixed pay while they enjoyed a taxpayer subsidy to their funding and continued to pose huge risks to the rest of the European economy. And I was assured that this move had nothing to do with envy at the actual amount of money these people were getting paid when I was told by one MEP that he did not care how much people in hedge funds or private equity are paid “because they do not pose a systemic risk to the rest of us”.

It did not occur to me during these conversations that policymakers should attach any importance to the fact that the ratio of bonuses to fixed pay was already coming down (according to my own research it has fallen from more than 5:1 in 2010 to little more than 2.5:1 last year). I also wrongly assumed – because the issue was obviously not the absolute value of bonuses – that it did not matter that bonuses were falling of their own accord much more quickly than policymakers might have thought (they are down by more than a third since 2010).

Throughout this process, I missed some of the warning signs that should have alerted me. For example, when Philippe Lamberts, the Belgian Green Party MEP who was one of the main advocates of the bonus cap, said that he “absolutely agreed” that “these people get paid too much money” it did not occur to me that his underlying aim might be to reduce what they get paid. I also misread the European Green Party’s manifesto pledge for the European elections in 2009, which talked of putting financial markets “on a leash” and said: “Astronomical financial sector salaries and bonuses that reward risk and recklessness must be capped.”

In concluding my apology, I should thank Sven Giegold, the German Green Party MEP, for bringing my numerous errors to my attention…

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Stephen Hester: the banker who works (almost) for free

March 8, 2013 by William

If you think the chief executive of RBS gets paid too much, think again. He gets paid nothing like as much as the outraged headlines suggests…

Hester1It is difficult to think of a better way of reigniting the moral outrage at fat cat bankers than for the chairman of a lender that is majority-owned by UK taxpayers to say that the bank’s chief executive is “modestly” paid.

So when Sir Philip Hampton, chairman of the Royal Bank of Scotland, said as much at a recent parliamentary hearing, another round of “Hesteria” ensued as people lined up to make angry comparisons between Stephen Hester’s “modest” pay and that of nurses, teachers and social workers.

But amid all the righteous indignation, something was missing. More or less everyone seemed to agree that Hester is paid way too much; but no one appeared entirely clear about the actual amount. Scratch beneath the (often misleading) headlines and several things become clear.

First, Hester has been paid a fraction of the money that most people seem to think he’s got. And, as Hampton said, while Hester is not struggling to pay the gas bill, the RBS chief executive is taking home far less than what his peers receive (for, arguably, a much tougher job).

Second, my analysis shows Hester’s pay has been so modest that he actually lost almost as much money by giving up his previous job as he has made in his four years as chief executive of RBS, meaning that he has been working for (almost) free.

And third, the chasm between what he actually gets paid and what most people think he gets paid highlights that pay structures and their disclosure are an awful lot more complicated than they should be.

Headline numbers

It plainly looks absurd to say that Hester is “modestly” paid when you look at the headline numbers. His package, which hasn’t changed over the past four years, quickly adds up to the sort of Bond-villain-type numbers that have settled into the public consciousness: a salary of £1.2m, a pension contribution of £420,000, a potential bonus of up to £2.4m, as well as a long-term incentive scheme with a headline value of between £3m and £4m. In theory, this adds up to almost £8m a year.

Last year, at the peak of the annual pay “Hesteria”, one newspaper breathlessly reported that the RBS boss had been paid more than £35m since taking over as chief executive of RBS. Sadly for Hester, that’s not quite true.

If you add up the headline value of what Hester could have been paid in salary, pension, benefits, bonus, LTIPs and options over the past four years (assuming that he hit every target and that every scheme paid out in full and immediately), then you get to something like £32m.

But Hester has actually been paid “only” £7.6m since November 2008. On top of this, he has been awarded something like £4.9m in deferred pay in the form of share bonuses and longer-term incentive schemes that will vest over the next few years and which, depending on performance hurdles and the RBS share price, could yet turn out to be worth a lot less.

To put £7.6m in perspective (and I freely admit this is only one of many potential viewpoints), it’s about one fifth of the $60m or so that Lloyd Blankfein has been paid as chief executive of Goldman Sachs and one sixth of what Jamie Dimon at JP Morgan Chase has been paid over the same period.

Opportunity cost

To add insult to injury, Hester has been paid a lot less than what he would probably have earned had he politely rejected Alistair Darling’s kind offer to become chief executive of RBS in 2008 and, instead, stayed put as chief executive of British Land. In fact, he might be more than £7m out of pocket…

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Bankers’ bonuses: for a few dollars more…

March 5, 2013 by William

The EU proposal to cap bankers’ bonuses may well be barking mad – but its critics have hugely overstated its likely impact.

Boris Johnson thinks it is moronic. Lots of lawyers think it might be illegal. The head of the banks’ main lobby group thinks it will undermine European competitiveness. And one government minister has warned that it might threaten hundreds of thousands of jobs in banking in the UK (no, really).

So it seems funny that for big banks like HSBC and Deutsche Bank, the European Union’s proposed cap on bankers’ bonuses is little more than a rounding error. In fact – as is often the case – the actual financial impact of the proposal seems inversely proportionate to the amount of heat and noise it has generated.

HSBC this week disclosed what it paid its most senior staff in its annual report for 2012. Its 314 so-called ‘code staff’ (senior management and employees taking material risks) shared $529m in pay between them last year, an average of $1.68m. This was divided into $144.7m in fixed pay, and $384.3m in variable pay, which translates into a variable / fixed ratio of 2.66 times.

In order to bring this ratio down to 2:1 to comply with the bonus cap, HSBC could (in theory) reduce the bonuses it paid to senior staff by around $30m. Or, it could increase fixed pay to bring it up half the level of variable pay.

Assuming it were to choose the latter (and I think that’s a fairly safe assumption), then it would have to raise fixed pay by $31.6m for its most senior staff to ensure that that it complies with the bonus cap but they don’t lose out.

This may sound a lot and any increase in fixed costs is undesirable but let’s put it in perspective. That increase of $32m is less than 0.2% of the bank’s total wage bill around the world last year. And it is little more than 5% of the $571m that HSBC paid last year to the UK government through the bank levy (although I have not heard the UK government warning that its own bank levy will threaten the competitive position of the City of London and/or put hundreds of thousands of jobs at risk).

Of course, at HSBC there may be a few hundred more staff around the world whose bonuses might break the proposed cap (and who might need a top up in their salary as a result). But it is hard to think that the total ‘cost’ to HSBC of addressing the bonus cap would be higher than $40m to $50m. And of course, this is not an additional cash cost – it is merely transferring a variable cost (that had become increasingly fixed anyway) into a fixed cost.

A better guide might be Deutsche Bank, which provides a unique level of disclosure over what it pay its senior staff and what it pays staff in the rest of the bank. In 2011, Deutsche Bank paid its top 1,363 staff worldwide a total of €1.94bn. This was made up €437m in fixed pay and €1.504bn in variable pay. That’s a ratio of 3.44 times. Here’s the relevant part of its remuneration report last year:

DB CIB

Again, let’s assume that all of these staff are covered by the proposed cap and that the bank raises salaries (rather than cuts bonuses) to comply . This would add €210m to fixed pay across the group (and reduce variable pay by  the same amount).

That’s an annoying increase in fixed costs but its hardly going to break the bank. Deutsche Bank also (uniquely) discloses what it awarded in compensation for all of its staff last year:

DB group

From this, we can see that fixed pay was €5.9bn across the group while variable pay was €3.5bn. That means 63% of Deutsche Bank’s pay across the group was fixed last year, and just 37% was variable.

Adding another €210m to the fixed bucket is annoying, but it only increases fixed pay by 4% and the overall proportion of pay that is fixed increases to 65% (from 63%).

The problem with this is more than an issue of posturing and negotiation. One of the MEPs who has helped drive the bonus cap said that one reason for the move (apart from a strongly held sense of social justice in the European Parliament) is that he and other MEPs  had got tired of being lectured by the banks about the potential impact of every minute detail of every proposed reform since the financial crisis and warned of the terrible consequences that would follow.

As they failed to materialise, the patience of MEPs snapped. By treating every issue like General Custer’s last stand, the banks had talked themselves into a cul-de-sac. And it looks like they might just be doing the same again.

 

 

 

 

 

 

 

 

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Bonuses: in the line of fire again

February 19, 2013 by William

The proposed cap by the European Parliament on bankers’ bonuses will have wide-ranging and unintended consequences

A year ago, a proposal by the European Parliament to cap bankers’ bonuses at no more than one times fixed salary seemed like little more than angry chatter in the corridors of power in Brussels. Now it is about to become law.

This begs the question of whether it would be a “defeat for common sense” (as it has been described by the FT), whether Europe is “butting in on our bonuses” (in the words of Mayor of London Boris Johnson), or whether the cap is an annoying but manageable inconvenience for banks.

Of course, this politically-motivated proposal will do little to reduce overall pay in the industry, because salaries will rise to offset any potential loss of income. And it will increase fixed costs at banks when banks need all the flexibility they can get, potentially increasing risk in the system.

A good place to start is with the numbers. You get a clue as to where MEPs might be coming from when you look at what banks pay their staff today (or at least in 2011, the latest year for which comparable data is available).

This chart shows the average pay for the most senior staff at banks in Europe in 2011 as per the banks’ disclosures with the Financial Services Authority or local regulators (you might assume that these numbers will be down by around 10% to 15% for 2012):

Screen shot 2013-02-19 at 10.50.31

On average senior bankers in this sample of more than 3,500 staff were paid just under $2m each in 2011, ranging from an average of $3.6m per employee for the 119 most senior staff at JP Morgan in London, to an average of $1.3m for the 386 most senior staff at taxpayer-owned RBS. (To put this in perspective, the official salary of an MEP is €95,484, although the expenses are quite generous).

The high numbers make bankers an easy target but MEPs seem more upset by the ratio of bonuses to fixed salaries for these senior staff – that apparently encourages them to take huge risks – as shown in this chart:

Screen shot 2013-02-19 at 10.50.47

On average, variable pay for senior bankers was three times the level of fixed pay in 2011, ranging from around five times for the most senior staff at JP Morgan, Barclays and Bank of America Merrill Lynch, to less than two times for their counterparts at RBS and Citi. It is worth noting that this ratio has fallen sharply from 2010, when it stood at around seven times, and I reckon that in 2012 it will have fallen even further, to perhaps 2.5 times.

But take another look at the right hand side of the chart, which shows the ratio of variable to fixed pay for all staff in 2011 in the investment banking division at Barclays (where bonuses represented 66% of salaries) and Deutsche Bank (82%).

Of course, banks are not going to slash overall levels of pay simply because the European Parliament waves a wand that limits the ratio of bonuses to fixed pay. Instead they will just increase fixed pay accordingly or find other ways round the problem, by increasing pensions contributions or other payouts.

This next chart shows the increase in fixed pay that would be required to make up the difference if banks had to impose a one-to-one ratio tomorrow. On average, banks would have to double the fixed pay of their most senior staff but at some banks it would have to triple.

(In theory banks could slash bonuses by an average of two thirds to bring them into line with a one-to-one ratio with salaries but somehow I think this is less likely).

Screen shot 2013-02-19 at 11.30.23

The combination of these charts shows that when it comes to senior staff any cap on bonuses would be hugely disruptive. Banks would argue that these staff are the most important to the banks’ shareholders, the most internationally mobile and the most attractive to other sectors such as hedge funds or private equity. In other words, they are the most likely to migrate to countries and sectors with less regulation.

That said, it is clear than once you get below the top few hundred staff in most banks, the ratio of bonuses to fixed pay drops rapidly. Most staff at investment banks can only dream of one day earning a bonus that is larger than their salary. As such, the proposed cap on bonuses would have an impact on only the top few percent of staff at investment banks. The impact would be particularly light if the final ratio imposed on bonuses is two-to-one relative to salaries instead of one-to-one.

This may be the most important few percent of staff for any bank, but these changes are unlikely to have the cataclysmic effect on banks that many of them might have you believe.

 

 

 

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Proprietary trading is dead. Long live proprietary trading?

January 29, 2013 by William

Whatever else you might say about investment banks, please don’t mention the “p” word. Not “p” for pay, but “p” for proprietary trading. My latest column for Financial News.

As the debate over the future of the “p” word rumbles on, you might have thought that the new, low-fat, slimline Wall Street had already moved on. Investment banks have been falling over themselves over the past few years to explain that they don’t do the “p” word any more. But if that’s true, why do they still get so worked up about it?

The proposed ban on the “p” word is otherwise known as the Volcker Rule, named after former Federal Reserve chairman Paul Volcker, for whom the banks no doubt reserve another “p” word altogether.

It was originally introduced as part of the Dodd-Frank smorgasbord of financial reform and was supposed to have been implemented last year, but has since morphed into a nearly 300-page rule that has been delayed until mid-2014 in the face of fierce lobbying and obfuscation.

The reason why investment banks are still so jittery about the “p” word is that they do an awful lot of stuff that looks remarkably “p”-like and for which neither they nor US regulators have yet to come up with a clear and simple definition.

The banks call this stuff market-making, client facilitation, customer accommodation, or principal transactions. Sometimes they call it “enlightened positioning”, but only really as a private joke.

Coming up with a clear and workable definition of when a bank is using its capital on behalf of a client and when it is using its capital to engage in the “p” word is why the Volcker rule is stuck in discussions between US regulators.

Banks are afraid that some of this stuff can look like the “p” word even when it isn’t. If the “p” word is defined too broadly it will undermine legitimate market-making and massively reduce liquidity to the detriment of everyone.

Funnily enough, any changes would be particularly detrimental to the banks themselves. Of course none of them engages in the “p” word any more, but, gosh, they are facilitating an awful lot of client accommodation.

Last year Goldman Sachs made $10.8bn from market-making and a further $5.9bn from other “principal transactions” (which is not the same as the “p” word because the holding period is longer). All in, that’s just over $17bn in revenues out of a total of $34.2bn. So trading in one form or another accounts for half of Goldman Sachs’ revenues – up from just over one third the year before.

Nearly 40% of the revenues in the investment bank at JP Morgan came from principal transactions last year, up from 30% the year before. In the market division at Bank of America Merrill Lynch, the figure is closer to 60%, up from about 45% the year before. The institutional securities business at Morgan Stanley makes more than 70% of its revenues from “principal transactions”.

It may not be a surprise that big Wall Street investment banks make a half to two-thirds of their money from marketmaking or principal transactions in some form or another. But it is a useful reminder to everyone else what is at stake and why they still get upset at every mention of the “p” word so long after they supposedly banished it from their vocabularies.

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Making sense of investment banks in 2013

January 14, 2013 by William

Could 2013 be the year when UBS is broken up, Morgan Stanley sells out, BNP Paribas and SocGen get back together, and Bob Diamond stages his comeback? My latest column for Financial News.

The plot thickens…

In terms of scandal at investment banks, 2012 is likely to prove little more than an amuse-bouche. On top of a drip-feed of settlements for money-laundering, tax evasion, and the mis-selling of derivatives, the Libor scandal is set to dominate the first half of the year.

With more than a dozen banks still under investigation, a series of ever more damning regulatory judgements might make traders and executives at Barclays look like choirboys on a school outing.

The wholesale abuse across the industry of Libor could attract the attention of an ambitious politically-motivated regulator – perhaps Benjamin Lawsky, head of the New York State Department of Financial Services – and lead to a multi-billion dollar Spitzer-style industry settlement.

Regulators may turn to more draconian sanctions this year, and 2013 may see a criminal prosecution of a bank or an extended (or even permanent) ban from a particular market, if only to encourager les autres.

One danger for banks is that regulators’ antennae will be more finely tuned to conflicts this year. If the market in new debt issuance collapses under its own weight this year – and many bankers think it has long since entered bubble territory – what price an investigation into whether banks were shorting the debt of issuers they were bringing to market? Or whether they were saying one thing about the securities in public and another thing in private?

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Calling it a day

No-one likes to admit defeat but 2013 could be the year when several investment banks finally decide to throw in the towel – or are forced to do so.

If the rump investment banking business at UBS doesn’t start performing quickly, shareholders and Swiss regulators may lose patience and engineer the sale of what would be an attractive asset. After all, “Warburg” has a nice ring to it.

The public uproar that might meet any eventual Libor settlement at RBS could trip the UK government into fully-nationalising the bank, which would probably lead to the closure of what is left of its markets business (and maybe renaming the rest of the bank as National Westminster).

Many banks are on the regulatory equivalent of “final warning”, and it is not difficult to imagine what shareholders and regulators would do to the investment banking divisions of banks like Citi, Credit Suisse, Nomura, Societe Generale or UBS if a fresh scandal – say another multi-billion dollar rogue trader – were to hit them in 2013.

Gimme shelter

The relentless pressure on capital and margins could force several investment banks to seek shelter in the arms of a bigger and more stable parent. Morgan Stanley has fought hard to retain its independence but if it can’t hit a return on equity of 10% this year maybe it would be time to reconsider. Perhaps a big solid US bank like Wells Fargo could provide a suitably capitalised and comfortable home?

Alternatively, why not go with giant Japanese bank Mitsubishi UFJ, which owns more than 20% of Morgan Stanley after it rescued the bank during the financial crisis and with which it has a thriving joint venture business in Japan. Such a deal may or may not involve some form of tie-up with Nomura, whose future as a standalone securities firm is, at the very least, up for discussion.

Other banks might look to set aside old rivalries and, with the blessing of domestic regulators, tie the knot, although it is unclear what you would call the result of a merger between Credit Suisse and UBS, or between BNP Paribas and SocGen.

Other investment banks could seek shelter in the less sexy but more stable areas of the industry such as securities services and transaction banking. What price someone like Goldman Sachs continuing its diversification away from trading with an acquisition of, say, Northern Trust, or State Street? Or HSBC buying Bank of New York Mellon? One problem is that these firms have an annoying habit of trading above book value, making them prohibitively expensive for most banks with a big investment bank attached.

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