Are investment banks run for employees or shareholders?


 

Banks and bonuses

Going overboard

Investment banks have a long history of providing huge rewards for their employees and managers at the expense of shareholders returns.  This fact has been studiously ignored by regulators, legislators and even shareholders themselves for various reasons over the years.  In large part, this is because the returns that the banks have made are so massive that no-one wants to really question the way these returns are achieved.

Now that the major shareholders in many of these institutions are the taxpayers of the banks’ home countries perhaps now would be a good time to take a detailed look at who stands to gain most from the banks’ apparent return to profitability.

In “Going overboard” (The Economist July 2009) the paper asked whether investment banks are run for the benefit of the employees or shareholders:

As business booms once more, rather than reward their owners with an extra big chunk of profits, most investment banks seem likely to favour their employees again. In the case of Goldman Sachs, shareholders received $4.4 billion of profits during the first half of this year while staff were allocated $11.4 billion in pay and bonuses, equivalent to about half of the firm’s net revenues.Banks defend their model by arguing that they have to pay top dollar to secure the best employees, who maximise profits for shareholders. If they paid less, profits would be lower. For Goldman there may be some truth in this.

In the first half of 2009 shareholders still earned a healthy return on equity of 19%. And over the decade to the end of 2008, even though cumulative compensation was double profits, return on equity averaged 20%. Furthermore, since a chunk of bonuses are paid in stock and staff cannot sell their shares immediately, their interests are to some extent aligned with those of shareholders.

There are several holes in the industry’s argument, however. One is that when investment bankers owned the banks themselves, partners demanded higher returns on their equity than public shareholders now get. In the three years before the bank floated in 1999, Goldman partners earned returns on their capital of about 50% each year.

More importantly, the industry-wide practice of paying out about half of net revenues to employees looks a lot less palatable for shareholders once mediocre or bad banks are taken into account. This is a risky industry: two of America’s five big stand-alone investment banks collapsed during the crisis. And when things go wrong employees do not always take their share of the pain.

aka F*ck You! Pay Me!

Lehman Brothers made losses in the two quarters before it collapsed yet continued to accrue a compensation pot not far off the levels of 2007. Shareholder returns over the entire cycle look a lot worse when the failures are included. Lehman paid out $55 billion to employees in the decade to the end of 2008. Shareholders earned cumulative profits of zero, including the loss of all of their capital when the firm failed.

Banks pay low dividends, and when they get into trouble the capital that shareholders have retained in the firm typically gets wiped out.  Employees have taken money out of their firms each year. It may be time for the owners of banks to mutiny over the bounty.

Image & Article Copyright © The Economist Newspaper Limited
Advertisements

Feel free to add your comments here

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s