In looking at the current year-end process, we see a variety of factors depressing pay: a stagnant economy, political pressure / the need to deliver greater shareholder returns, the European debt crisis, the elimination of prop trading, and deleveraging due to increased capital requirements. All of these factors will lead to decreased pay levels for banking and capital markets employees; however, the question of whether we are experiencing a down cycle versus a reset remains.
The first three factors mentioned above are ones that will likely work their way through the system over time, and then recede. The economy will inevitably bounce back and the various other pressures and crises will resolve themselves without creating a fundamentally different revenue (and thus compensation) opportunity for most banks. However, the last two factors, the elimination of prop trading and the deleveraging of firms, are likely to have lasting effects on both business structure and pay for certain groups of employees.
As firms are compelled to use capital more sparingly, they will also strengthen links between pay rates, capital usage and the risk profile of businesses. For businesses like asset management or wealth management, the impact will be limited – these businesses do not commit significant capital, and will not experience a reset in pay levels as the result of deleveraging or loss of trading profits. Interestingly, corporate banking, which is highly focused on lending firms’ capital, will likely not have a reset either, as cost of funds, loan loss provisions and other metrics that acknowledge the use and inherent risk of committing capital have always been integral to the pay equation. In this regard, the lending businesses have already come of age in setting compensation levels based on capital usage.
In somewhat stark contrast is the banking and capital markets business. While firms were realizing enormous profits from mark-to-market snapshot views of transactions, compensation was linked primarily to revenue with limited focus on metrics like return on risk-weighted assets (RORWA), which is now a fundamental metric for measuring performance. Because of the shift away from pure revenue metrics for determining performance, there will be some degree of reset for pay levels in this area. If firms are committing significantly less capital, generating less profit, and forging a stronger link between pay and RORWA, pay will simply come down. The questions are less about whether there will be a reset, but rather, how big, how broad, and what will be the consequences of the coming action?
Will this affect all roles in banking / capital markets?
Further review of the profitability and RORWA within lines of business will not only drive the reset of pay levels for employees in sales and trading; it will also drive firms’ long-term business strategies. And in this brave new world of RORWA, it will be even more critical to benchmark these metrics so that firms can better understand what it really means for a business to perform well.
So, what does this mean for pay rates in sales and trading? Again, the sensitivity will be linked to the capital committed. Employees trading on behalf of clients and not taking long positions may see payouts equal to those of the past. Employees engaged in complex derivative transactions that tie-up large swaths of capital with uncertain valuation and long settlement horizons will inevitably see a decrease in pay as these businesses are rationalized and leverage is cut. Headcount reductions in these areas may offset the lower risk-adjusted profits to allow per capita pay to rebound eventually, but pay rates for large teams within firms maintaining scale are unlikely to bounce back any time soon.
Employees engaged in equity and debt capital markets may see some downward pressure on pay, but not a long-term significant downward reset – the money committed by firms in these transactions is limited, and the downside risks are easy to quantify and understand.
If banking / capital markets revenue shrinks how material is this?
Will this change the banking / capital markets competitive landscape?
What are some strategies for firms to help cope with the new environment?
What is the likely outcome of all of this?
Firm-wide compensation spend and the focus on sharing rates between employees and shareholders will temper pay even as firms focus on bottom up performance and reward at the product and division level. Over time, firms will adjust their business models and smaller teams in capital intensive businesses may reach pay levels well above this year. Likewise, favorable market environments in flow businesses may result in years of higher pay for key performers in these products. However, the per capita pay opportunity in aggregate and over time will be far below the high water mark of 2005-2007.
This broad pay reset will require organizations to focus more than ever before on aligning performance and reward, determining the ‘right’ performance metrics, and identifying how they differ by business area. The greater alignment of performance and reward will by nature create greater pay differentiation across firms and within a firm (across products and individuals).
This reset does not necessarily translate into reduced pay levels for all individuals, but does mean lower pay for the average performer. Greater differentiation by business based on risk-adjusted returns and significant divergence in pay between the highest performers and average performers will be required to attract and retain key staff while balancing pay with shareholder returns.
ABOUT THE AUTHORS
Warren Rosenstein is a Principal at McLagan. Mr. Rosenstein has authored numerous articles and whitepapers, most recently in the Conference Board Review and The Secured Lender. He can be reached at (203) 602-1205 or firstname.lastname@example.org.
Blake Kerrick is the Head of Banking and Capital Markets at McLagan. In this role, Mr. Kerrick provides performance and reward consulting services to the leading global banks and securities firms, regional banks and broker-dealers, and commodity trading firms. He can be reached at (203) 602-1239 or email@example.com.
Doris Van Beck is the Chief Operating Officer at McLagan. Ms. Van Beck focuses on global compensation surveys, market practice studies and incentive plan design for leading banks and securities firms. She can be reached at (203) 602-1208 or firstname.lastname@example.org.