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Slash, burn, cut and trim. With ever increasing regulation and client inactivity, bankers reckon they have hit upon a way of boosting returns. Costs. Investors may find it amazing that it has taken so long for banks to pay proper attention to expenses. Sure the industry was effective at cutting bonuses during leaner years, and would delight in the odd mass cull (only to rehire again). But beyond that, banks paid lip service to a more thorough focus on costs.
The reason for this is that they were too busy making money to care. Nor was there a rational reason to nitpick over cab fares and what the salary for a human resources vice-president should be. That is because the main driver of returns on equity for banks during the boom years was leverage. It still is, but with having to run higher capital adequacy ratios, and with volume growth muted, bank bosses are being forced to look at margins to improve ROEs.
The obvious place to cut costs first is compensation. But how radically do banks have to reduce pay in order to move the proverbial needle? Take Barclays in the U.K., whose relatively new chief executive has made cost cutting central to his turnround plans. Using a DuPont framework, Barclays should be able to spit out a 10 per cent return on equity (ROE) based on about £1.5-trillion ($2.3-trillion) of assets, £50-billion of shareholder equity, £25-billion of revenues and £5-billion of net profits. All else being equal, cutting last year's compensation ratio from 40 to 37 per cent boosts ROE to 12 per cent. To reach 15 per cent, Barclays would need a ratio more like HSBC's 30 per cent, hard with such a large investment bank.
Compensation may not have to take all the load. Using Barclays as an example again, as well as a £10-billion pay bill, it spends £7-billion on selling, general and administration expenses. Surely there is plenty for the consultants to cut there.