Investment banks and bonuses – what’s going on?

Traditionally large US investment banks have proved to be lucrative places to work.  Very large profits have provided shareholders with attractive dividends and employees with both high salaries and considerable bonuses.  Consider the following statistics.  In 2010 Goldman Sachs set aside $15.3bn to pay its staff both salaries and bonuses, down 5% on the $16bn it set aside the previous year, but still an average of $430,000 each.  Furthermore, total bonus payouts on Wall Street were $20bn in 2012, 8% more than the preceding year; and remember that figure refers to bonuses, so basic salaries are not included.  In 2013 Barclays decided it would be appropriate to set its bonus pool to £2.4bn, an increase of 10% over the preceding year, despite the fact that annual profits at the bank fell by 32%.

 

However, as a recent series of articles, such as the one below from the BBC News website show, revenues and profits at the “bulge bracket” investment banks are suffering.  Bank of America Merrill Lynch reported a fall in income in the third quarter of 2014 and Citigroup announced that profits were 27% lower in the first quarter of 2016 than they had been in the first quarter of 2015.  In 2015 Credit Suisse made an overall loss of $2.92 billion and at JP Morgan profits fell by 54% in the first quarter of 2016 compared to the first quarter of 2015.  In addition, times at Goldman Sachs, nicknamed “Gold mine Sachs” thanks to its generous payments to employees, have turned very tough with a fall in revenues of 40% in the first quarter of 2016 compared to the previous year. Overall, the picture for these banks is not good in terms of profits or revenues.

Many readers will now be very concerned about the fate of the employees in the investment banking divisions of these firms.  Will they continue to enjoy the salaries and bonuses they have come to rely upon to support their lifestyles?  Well, no-one at Goldman Sachs needs to worry too much.  The management have decided to set aside $2.66 billion for its bonus pool in the first quarter. That worked out to an average of nearly $73,000 per employee for the first three months of the year.  At the end of 2015 JP Morgan also decided it would leave its bonus pool roughly unchanged from 2014, despite falls in revenues and profits compared to the previous year.

This flies in the face of economic theory.  Bonus payments at all sorts of firms are designed to solve a dilemma known in economics as, “the principal-agent problem”.  It occurs when an actor in a transaction, the principal, pays another actor in a transaction, the agent, to carry out some work on their behalf.  The problem comes if the principal has different objectives in undertaking the work from the agent.  Consider a situation where your boiler breaks down in the middle of winter and you call a plumber to fix it.  In this case you are the principal and the plumber is the agent and the work is the repair of the boiler.  Your objective is to have the boiler fixed as quickly and cheaply as possible but the plumber’s objective is to make as much money as possible from the repair.  You may find that the plumber carries out work which is not really necessary, or claims that the boiler cannot be repaired and quotes for the replacement of the boiler, when in fact the fix is simple and cheap.  This occurs because the plumber wants to maximise his profits and so has different objectives to you.

In the context of an investment bank the principals are the shareholders, who want the bank to operate as profitably as possible, and the agents are the employees.  Employees’ objectives might include having an easy life, taking unnecessary risks in trading activities for the thrill of it and leaving work early to go and play golf.  None of these will maximise profits.  In order to keep the agents’ objectives aligned with those of the principals a bonus payment is made to the agent but theory suggests it should be very closely aligned to profit, otherwise it is useless.  Therefore, if a loss is made there cannot be a bonus and any fall in profits should lead to a commensurate fall in bonuses.  The evidence from bulge bracket US banks suggests that bonuses are not being used this way.

It can only be concluded from all this that, as in many other areas, the labour market theory and the labour market practice in the area of bonuses don’t seem to be the same.  Nevertheless, it probably does not concern employees in the financial services industry too much.

BBC News online article here:

http://www.bbc.co.uk/news/business-36083324

 

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