With year's end fast approaching, bankers are thinking bonuses. Or this year, how those payouts may shrink given downbeat results for much of Wall Street.
But the real group singing the holiday blues should be shareholders. Even as overall compensation costs are tending to decline, the share of the profit pie that goes to shareholders is shrinking faster.
One reason: Banks use what may be the wrong gauge for determining compensation pools for a firm. Namely, they look at compensation as a percentage of net revenue, rather than considering it in terms of profit. That approach emphasizes revenue growth rather than profitability, which is the more important measure for shareholders.
The result is that employees may be getting more, and shareholders less, of what are in many cases lessened spoils. Market upheaval, lower levels of trading, increased regulatory requirements and caps on leverage have led to far lower, in some cases single-digit, returns on equity. That is a far cry from the 20%-plus returns investors had gotten used to back in the boom days. This piles the pressure on banks to find new ways to grow or cut costs such as compensation.
One way is to reconsider the basis for compensation. "Will the Street have to adjust? Yes, it will," says Bernstein Research analyst Brad Hintz. He adds, though, that while some executives and analysts have long argued for other measures, compensation based on revenue has stuck. So change won't happen quickly.
Indeed, the big fear among banks is that changing how compensation is calculated, and so lowering the payout pool, could mean an exodus of star employees, destroying franchise value. Firms also point out that they use a number of measures to determine overall compensation. And not all compensation is bonuses; an increasing share of pay now comes from salary or deferred payments in the form of restricted stock that vests over a period of years.
That said, a look at results for some big Wall Street players shows that shareholders could be better off under a different approach. Consider if compensation were based on pretax profit before banker pay and excluding gains or losses due to changes in the value of a firm's own debt. And assume, say, that half went to employees and the other half to shareholders.
In that case, compensation for investment-banking and trading units at J.P. Morgan Chase JPM 1.52 % and Morgan Stanley MS 1.35 % would have been about 6% and 29% lower, respectively, in the first nine months of 2011, according to Wall Street Journal calculations. At Goldman Sachs, GS 2.32 % which doesn't break out pay expense for individual business segments, compensation for the firm as a whole would have been about 28% lower based on this approach.
Such reductions in compensation would clearly be painful for employees. But they would mean higher earnings for shareholders. At J.P. Morgan, which also has large commercial and consumer banking operations, the impact of such a shift in compensation would have been most muted. The resulting difference would have theoretically meant that diluted earnings per share for the first nine months of the year rose 28.5%, against 2010, compared with an actual increase of 25.7%.
The impact would have been more dramatic at Morgan Stanley and Goldman, which both saw EPS decline year-over-year during this period. At Morgan, the EPS decline would have been shaved to 6%, compared with an actual fall of about 33%. Goldman, whose results were dragged down by a third-quarter loss, would have seen its 71% EPS decline cut to 33% if the compensation expense were lower.
With the struggle between employees and shareholders looking likely to intensify, banks should reconsider their starting point on pay.
Write to David Reilly at email@example.com
Corrections & Amplifications
The impact would have been more dramatic at Morgan Stanley and Goldman, which both saw EPS decline year-over-year during this period. At Morgan, the EPS decline would have been shaved to 6%, compared with an actual fall of about 33%. An earlier version of this article incorrectly attributed the impact to J.P. Morgan instead of Morgan Stanley.