BREAKINGVIEWS-Investment banks' next challenge: cutting salaries

Tue Nov 6, 2012 4:15pm IST

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(The authors are Reuters Breakingviews columnists. The opinions expressed are their own)

By Peter Thal Larsen and George Hay

HONG KONG/LONDON, Nov 6 (Reuters Breakingviews) - Investment banks are facing a new conundrum: how to cut their employees’ salaries. The industry made a collective blunder when it responded to the crisis by upping basic pay, particularly for senior bankers. That has made it harder for banks to cut costs as revenue withers. Reversing the hike won’t be easy, especially as regulations remain uncertain. But if the alternative is to chop a greater number of jobs, employees may reluctantly agree.

There’s no question that investment banks regret their decision to hike salaries in 2009. At the time, it seemed a smart way to carry on stuffing cash in bankers’ pockets, while complying with new rules requiring bonuses to be largely paid in shares that cannot be cashed in for several years. As soon as some banks took the lead, the rest of the industry felt compelled to follow or risk losing staff. Some senior bankers saw their basic pay double almost overnight.

If investment banks were still as busy as they were before the crisis, they could have coped. But as revenue shrinks and new regulations bite, banks are under intense pressure to cut costs. Slashing bonuses alone won’t do the trick: fixed pay at investment banks rose by 37 percent between 2007 and 2011, according to a study by McLagan published by the Association for Financial Markets in Europe. It now accounts for 55 percent of banks’ total compensation costs, compared with 30 percent before the crisis.

Higher salaries also weaken one of investment banks’ key management tools - the concept of paying for performance. When salaries were a smaller proportion of total compensation, bankers could be expected to work hard to justify their bonus. But collecting a large monthly paycheck dulls that incentive. In the past, the dreaded “donut” - a zero bonus - was a clear signal to start looking for work elsewhere. Today, bankers may decide it’s worth sticking around just for the salary.

Yet reversing pay hikes is easier said than done. To begin with, any investment bank that takes the lead in cutting salaries risks losing its best staff to rivals: the industry’s collective interest will be overwhelmed by the competition for talent.

As banks like UBS (UBSN.VX) embark on another round of culls, that risk may be smaller than before. Even then, however, paying a lower salary for the same job probably breaches employment law in many countries. Aggrieved bankers could respond by tying up their employers in messy and expensive lawsuits. Goldman Sachs (GS.N) got around the problem by inserting a clause into the contracts of London-based bankers that gave it the right to reverse salary hikes. Rivals were less farsighted.

Regulation is another reason to pause. The European Union is considering a proposal that would prevent banks from paying bonuses worth more than 100 percent of salary. As long as such schemes are still being discussed, banks will be reluctant to take drastic action on salaries for fear of getting boxed in on what they can pay in total.

That leaves two options: a gradual approach, and arm-twisting. So far, the former is the most popular: as staff leave, they are being replaced with employees on lower pay. Privately, executives admit that bankers of the same rank in the same department already receive different salaries. Inflation also helps: by keeping base salaries flat, their nominal value is gradually eroded.

But this strategy is unlikely to deliver the quick results demanded by shareholders who want banks to cut costs and deliver a higher return on equity. That’s where arm-twisting comes in. At the top level, banks can shame their employees into accepting lower salaries, or refuse to award future bonuses unless they accept a change to employment contracts.

Lower down the organisation, banks may have to appeal to their employees’ sense of collective self interest: either they all accept a pay cut, or the bank will be forced to cut costs by axing a larger number of jobs. This kind of bargaining is commonplace in the manufacturing industry: during the crisis, steel and car workers accepted reductions in pay as an alternative to factory closures and widespread redundancies. Bankers may think themselves a long way away from the shop floor, but it is in their interest to apply the same logic. Hands up who’s volunteering to be the union representative?

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CONTEXT NEWS

- Performance and remuneration in investment banking: Findings of an industry study by McLagan, May 2012: www.afme.eu/WorkArea//DownloadAsset.aspx?id=5983 - For previous columns by the authors, Reuters customers can click on [LARSEN/] and [HAY/]

(editing by Chris Hughes and David Evans)

((peter.thal.larsen@thomsonreuters.com))

((Reuters messaging: peter.thal.larsen.thomsonreuters.com@reuters.net)) Keywords: BREAKINGVIEWS BANKS/PAY

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