After two tough years, most big Wall Street and City of London firms are expected to post higher profits this year. It is early days but average end-of-year bonuses are predicted to rise by about 20% at the larger firms.
But don’t expect a season of unalloyed goodwill. Investment bankers and traders look set to fight over the division of the spoils.
This is because the traders have brought home the lion’s share of revenue at most investment banks. Lehman Brothers is a good example. Its traders are expected to generate half its expected $8.4 billion this year, according to Morgan Stanley estimates. Last year they generated less than a third.
This disparity matters because of the way bonuses are set. When the bonus pool is created with the budget at the start of each year, each division effectively divides its revenues between those belonging to the bank and those available to be scooped by the bankers.
Banks tend to allow M&A and capital markets bankers to keep a bigger slice of the revenues they generate – say up to 30% – because their efforts are seen to have a strong influence on the sales line. Traders get to scoop just 10% of their take because they feed off market flow. A chunk of the total pool is reserved for back-office staff and so on. It is a fairly transparent process. If a division hits its budget, its bankers get paid.
But these broad-brush rules aren’t necessarily a guide to what happens when the money available to be distributed exceeds budget. Then what gets handed out as bonuses becomes a matter for negotiation.
Investment banks do not disclose their budgets to outsiders. But most bulge-bracket firms look to be on course to beat their revenue goals this year. A rough proxy for budgets might be the forecasts analysts made for them at the start of 2003.
Earning over budget In January, Goldman Sachs was forecast to pull in $14.6 billion in revenues this year, again according to Morgan Stanley. The latest forecast is that it will make $15.7 billion. For Lehman, forecasts have moved from $6.9 billion to $8.4 billion. And Merrill Lynch’s have risen from $18.8 billion to $20.5 billion.
Some of this unprojected revenue could, of course, be absorbed in additional non-staff costs. But given that large investment banks tend to target total compensation-to-revenue ratios of about 50%, up to half of any excess could find its way into bankers’ pockets. That would be $2.2 billion of potential extra bonus at these three banks alone.
Only the trading units have contributed to the unexpected revenues. Merrill Lynch, for instance, might have beaten its overall budget by $1.7 billion this year, using our proxy. But its traders brought home all of that and more, beating their budgets by $2 billion. All the other divisions actually undershot their budgets. It is pretty much the same story at Goldman and Lehman.
Although banks claim they aim for market-led performance in paying bonuses, the traders still have an argument for snapping up most of any extra distribution. After all, they made all the extra cash. Isn’t it fair that they should at least be allowed to keep most of it?
The investment banks aren’t likely to go along with this because it would lead to a massive disparity in income between traders and bankers. From their perspective, this would be unfortunate at a time when investment banking was starting to pick up. Right now, most firms are keen to hang on to their top performers in M&A and capital markets.
Banks have tended to manage these disputes in the past partly by appealing to employees to consider the general good of the firm, or by asserting the convention that bankers don’t get paid to the full in the good times in return for getting bonuses in down years.
But such appeals may be less effective these days. After all, investment banks have been prepared to sacrifice staff pretty ruthlessly through the downturn. And traders have before them the memories of 2000, when star investment bankers such as Frank Quattrone earned massive bonuses during the equity and tech boom. There could be some hard arguments ahead.
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