When the credit squeeze struck last summer, the widespread view on Wall Street and in the City of London was that the five-year boom in investment banking bonuses had come to an end. If large banks had suffered losses, it seemed logical that their highly-paid employees would share the pain. The reality is likely to be more complicated. Though several institutions have not yet reported their results, it increasingly looks as if the bonus pot shared between employees of the world's largest investment banks will be larger than ever before.
Even though several bulge bracket banks have suffered catastrophic losses on investments linked to the US subprime mortgage crisis, many parts of their business enjoyed a record year in 2007. Moreover, not all banks have been equally affected. This has produced some surprising results. Take Morgan Stanley, for example. Despite reporting a huge fourth-quarter loss and raising $5bn in new equity from a Chinese state investment fund, the US bank paid out $16.6bn in compensation last year - an increase of 18 per cent. This pushed the ratio of compensation to revenues - a closely watched measure of cost discipline - to 59 per cent for the year. Most investment banks aim for a ratio below 50 per cent.
But Morgan Stanley is unlikely to be alone. Citigroup and Merrill Lynch, which are both due to report fourth-quarter results this week and have both been forced to seek fresh capital, face a similar dilemma, as does UBS, which is due to inform staff of bonuses later this month. The problem is not just about how to reward good performers in spite of scarce financial resources. Uncertainty over the economic outlook also makes it hard for banks to predict which business areas will be active this year, and therefore which staff they need to keep happy. Some parts of the industry, such as the structured finance desks that created complex fixed-income securities, have been scaled back. But in other areas, such as commodities, banks are still looking to expand and human capital remains scarce.
"The major risk to our business is people. For each vacant seat there are probably only around five people out there who could do it. We're hoping [rival] banks screw up and underpay this year, which could make it easier for us to hire," says the head of commodities at one European investment bank. The challenge is reflected in the variety of ways in which banks have tackled the problem. At one end of the spectrum are those institutions - such as Goldman Sachs and Lehman Brothers - that have escaped large losses in the fixed-income business. For them, the bonus round has been almost business as usual, with top performers well rewarded. Those identified as poor performers will have received little or no bonus - a bank's way of suggesting they should start looking for another job if they do not want to be ignominiously presented with a bin bag and told to clear their desk.
Even so, the slowdown in corporate activity and the weakness in the bond markets has curtailed overall rewards even at the healthier institutions. At Lehman, for example, individuals whose contribution was up 10 times would have seen their bonuses rise about seven times, according to a person familiar with its compensation policy this year. That helped to soften the blow for talented individuals who happen to work in the slower areas of the bank. So a valued employee whose contribution was 10 times less last year might have seen his or her bonus fall only four times.
Merrill's compensation ratio - pay and benefits as a percentage of net revenues - is expected to rise to more than 70 per cent as it seeks to cushion key staff from feeling the pain of the bank's losses. Some observers believe it could exceed 100 per cent if the bank reveals fresh losses on subprime securities. Merrill is believed to have increased its bonus pool for its investment banking division, although not by as much as its revenue contribution rose last year. It is thought to have been brutal with its fixed income division, including staff not directly responsible for losses. UBS, meanwhile, has taken the controversial decision to cap cash bonuses and make up the difference with shares. Executives argue that the bank's depressed share price makes this more attractive than in other years. Nevertheless, UBS's rivals are expecting a rash of senior defections in the next few months.
Coming after a year of losses, it seems odd that so many should be receiving large bonuses. Wall Street's apparent largesse to its staff is hard to square with senior bankers' expectations. Most predict that revenues derived from the US will be flat to down, with Europe flat at best. Growth is being pencilled in only in Asia. Yet even if the investment banks are behaving rationally in attempting to hang on to staff, this year's bonus round is bound to be controversial. The prospect of institutions whose behaviour helped create the current financial crisis continuing to reward its staff lavishly is likely to add to pressure on banks fundamentally to rethink their compensation structures. The crisis has revived the debate about whether investment banking bonuses encourage excessive risk-taking. This argument suggests that traders have a huge incentive to pile on risks because the rewards for success - a large bonus - are much greater than the consequences of failure, which is unemployment.
Writing in the FT last week, Raghuram Rajan, professor of finance at the Graduate School of Business at the University of Chicago and former chief economist at the International Monetary Fund, argued that banks should claw back payments to risk-takers who cream bonuses in good years but whose actions sow the seeds for large future losses. It is an idea that appeals to investment bank managers and is being taken up by some institutions. For example, Credit Suisse each year holds back some of what it pays its proprietary traders, who take risks with the bank's capital. If the traders do well again the following year, the retained bonus is released, plus an extra reward. But if their strategy blows up, they lose the retained part of the bonus.
However, investment banking executives insist the scope for such schemes is limited by intense competition for talented traders, particularly from hedge funds, where the rewards for success can be even greater. They also argue that the current crisis was largely caused by other factors, such as poor risk management and a lack of discipline with capital. "There is an assumption that compensation was the cause of the crisis and I don't think that was the case," says one senior executive. "It is a very competitive market and we don't believe we can change the system."
This is scant consolation to shareholders in investment banks, who are effectively subsidising the payout. Their only consolation is that if the broader business slows down this year, as expected, it will be some time before the bonuses reach such heights again.