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OPINION

Macaskill on markets: Banks need their own inflation index

Wage inflation leads to substantial cost increases at major Wall Street banks.

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Jamie Dimon took a characteristically dismissive approach to the impact of wage inflation on JPMorgan’s cost base when he delivered the firm’s full year results to investors in January.

“We want to be very, very competitive in pay,” said JPMorgan’s veteran head. "There’s $1 billion in merit increase. There’s a lot more compensation for our top bankers and traders and managers, who, I should say by the way, did an extraordinary job in the last couple of years delivering this stuff. We will be competitive in pay. If that squeezes margins a little bit for shareholders, so be it."

Dimon returned to the theme later in his quarterly earnings call with analysts, saying that chief executives should not be “cry babies” about wage inflation, and that cost rises were not factoring into JPMorgan’s growth plans.

“Please don’t say I’m complaining about wages,” Dimon said. “I think wages going up is a good thing for the people who have the wages going up. And businesses simply have to deal with changes in prices. It hasn’t stopped us from doing anything. Zero. None. Nada. We’re not cutting back on growth plans or bankers or markets or countries because there’s some wage inflation.”

Shareholders were not impressed by this approach at JPMorgan or other Wall Street banks that announced substantial cost increases alongside 2021 revenue totals that in many cases were at record levels.

JPMorgan’s share price fell by over 5% after its fourth-quarter and full-year results were announced, while Goldman Sachs saw a bigger dip, with a stock fall of 10% in the wake of its own annual numbers.

Unwelcome attention

Goldman drew unwelcome attention for unrest among its junior bankers when a leaked slide deck about working conditions by disgruntled employees went viral last March.

Goldman, like other Wall Street firms, pledged to improve the environment for young employees, and later in the year was dragged into substantial wage hikes for starters as big banks competed to hire and retain talent.

Improved conditions for junior bankers accordingly helped to drive up costs in 2021, including a surprising rise in compensation and benefit expenses of 33% in the fourth quarter on an annualized basis, in the period when senior managers typically exert downward pressure on costs ahead of year end.

Another contributor to Goldman’s employee cost inflation was a reported special one-off stock payment to partners on top of their scheduled bonuses. Similar schemes have been put in place for top staff by other firms.

This trend could be interpreted by shareholders in a number of ways. It could be an indication that upward compensation pressure to stem potential defections by employees is a feature, not a bug, of the current inflationary backdrop for banks.

The payments could also be a sign that senior bank executives are taking advantage of a historic market bull run that may be coming to an end in order to effectively cash out some chips.

The rise in employee compensation costs for investment banks in 2021 was fuelled by strong performance in sectors such as M&A, where deal making was at a historical high, and IPOs, which also saw record volumes. These are the least automated areas in a modern bank and the most reliant on the performance of experienced individual bankers. A shift back towards a greater weighting of markets revenues as a proportion of total income could help cost control efforts and the management of wage inflation.

The rise in employee compensation costs for investment banks in 2021 was fuelled by strong performance in sectors such as M&A... [those] most reliant on the performance of experienced individual bankers

Bank chief executives such as Goldman’s David Solomon said on their earnings calls in January that 2022 is starting with a healthy pipeline for deal making, including M&A. But weakness in global equity markets in January could stall some of these deals, while increasing activity for the sales and trading staff in the markets divisions at banks.

The fall in technology stocks in the US in January was accompanied by a series of daily records for equity options volumes, for example, and the prospect of multiple US Federal Reserve interest-rate hikes is driving heavy trading in bonds and fixed income derivatives.

Markets staff are paid by performance in the same way as investment bankers who work in M&A. But technology can improve productivity in trading and threaten experienced staff with redundancy – in that they know some of their existing functions can be automated, if not in the sense that they may be at threat of dismissal.

Banks routinely promote their efforts to increase trading efficiency by improving their deployment of technology. However, this is extremely difficult for outside analysts or investors to evaluate.

Goldman can plausibly claim that its SecDB risk management software and related client services under the Marquee brand have a superior track record to similar technology-based initiatives by its direct peers on Wall Street, for example. But it is harder to demonstrate how the firm will perform compared with non-bank competitors such as Citadel Securities or Jane Street in generating trading revenues from relatively low-touch businesses.

And Goldman’s total technology spending is unlikely to move beyond half of the roughly $12 billion that JPMorgan is currently spending annually. Goldman will always be outgunned on a total technology budget basis by bigger universal banks.

That places Goldman and other banks in a quandary, where it wants to stress to analysts and shareholders that it will keep making productive investments while trying to control its overall cost base.

“One area that you should expect us to continue to invest in is across technology and engineering expense,” Solomon said on Goldman’s quarterly earnings call in January.

Some aspects of the banking sector’s cost inflation may be transitory, to use the adjective that has been officially retracted by Fed chair Jerome Powell as the way to describe the upward pressure on prices.

“I think it’s probably a good time to retire that word and try to explain more clearly what we mean,” Powell told Congress at the end of 2021, before preparing a campaign of rate hikes for 2022 with the air of a zealot converted to the cause of inflation busting.

Fresh benchmarking

Some aspects of bank expense inflation, such as competition for junior staff, might well prove to be transitory. Concern about inflation seems likely to remain a drag on bank stock prices in the near term, nevertheless.

It might therefore be a worthwhile exercise for bank leaders to commission some new inflation indices from their own employees, who rarely miss a chance to create fresh benchmarking tools that might appeal to clients.

British food writer and campaigner Jack Monroe recently celebrated what she hailed as victory in pressing the country’s Office for National Statistics to broaden its headline inflation index and better reflect the impact of price rises on ordinary families.

It should not be beyond the wit of highly paid bank analysts and structurers to devise indices that cut out certain types of “good” inflationary pressure, such as productive technology spending by banks, while underweighting the impact of cost rises such as compensation for bankers.

Anyone who came up with a convincing bank inflation index that pointed to transitory upward pressure on overall expenses would surely be in line for an above-average bonus in early 2023.

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