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Banks and brokerages are increasingly under pressure from shareholders to cut pay to preserve returns for investors, and Canada is no exception. But it's likely that employees at this country's independent brokers will feel the pinch a lot more than those at big banks, which may be able to use the situation to their advantage.
The percentage of total revenue that is used to pay staff (known by the shorthand "comp ratio") is in sharp focus at securities firms. In the U.S., there are calls for investment banking firms to cut pay sharply to ensure that more cash flows to shareholders, boosting return on equity from generally dismal to something that's at least acceptable. (Here's a Reuters take on the issue.)
Thomson Reuters even built this handy calculator to show just how much pay would have to fall at banks like Goldman Sachs, JPMorgan and Citi Group to get average return on equity up. To reach an across-the-board ROE of 10 per cent, which is not great but at least approaches what shareholders had come to expect from securities firms, pay would have to fall about 37 per cent at the investment banks. That would take the average comp ratio to 26 per cent from 42 per cent.
The comp ratios are elevated and ROEs depressed because revenue is soft amid a sluggish economy and markets.
In Canada, the country's two largest independent brokerages would also have to cut pay significantly to get near a 10 per cent ROE. Both GMP Capital Inc. and Canaccord Financial Inc. have had comp ratios in excess of 60 per cent in recent quarters, leaving little for profits to create a return for shareholders. Both have reduced their dividends, and shares of both companies have slumped.
Without a significant cut in pay for workers, analyst Sumit Malhotra of Macquarie Group estimates there won't be much of a return on equity at either firm. He estimates that GMP will have a full year ROE of 2.1 per cent in 2012 with a comp ratio that is likely to come in at 62.4 per cent.
Canaccord is forecast to end the year with a 62.2 per cent comp ratio and an ROE of negative 0.2 per cent.
Cut the comp ratios to 50 per cent for 2012 and the ROE jumps to 11.1 per cent in 2012 for GMP, assuming the same revenue and other expenses, and to 8.9 per cent at Canaccord, Mr. Malhotra calculated.
"If you are a shareholder in the independent brokers, at this point it is very fair to ask 'What's in this for me?'," said Mr. Malhotra, who covers both brokerages and the big Canadian banks. "The shares are down 70 per cent from their 2011 highs and the dividend has been cut in half. Yet even with the revenue outlook remaining very challenging, we haven't seen management show that comp ratios are going to be lowered to the point where the ROE profile looks more palatable."
In more normal markets, Canaccord and GMP have comp ratios in the 50 per cent ranges, and their ROEs are well into the double digits.
If global competitors and local independents do trim pay significantly to assuage shareholders, the beneficiary is likely to be the big Canadian banks.
They currently run at bank-wide returns on equity in the teens, and the returns on equity at their securities arms are often even higher. For example, even in a relatively tough market, Bank of Montreal's return on equity for its capital markets unit stood at 18.5 per cent through the first three quarters of the bank's fiscal year. Toronto-Dominion Bank's capital markets ROE was 18.3 per cent in that period and Royal Bank of Canada's was 15 per cent.
So Canadian banks can split the difference. They can cut pay a little bit, knowing that there is only a small likelihood that many in the securities business will jump ship to global firms and independents that are cutting more, and the savings will help boost already solid ROE numbers. But they can also afford to keep their pay levels at a premium to the other firms that are under pressure, and pick up top talent if they want.
"As usual, the banks seem to be in a good spot as far as their broker/dealer units are concerned," said Mr. Malhotra. "They have more diversification – including a ramp-up of corporate lending – to better sustain revenue levels, and with both the globals and the independents likely to lower comp there isn't much of a competitive dynamic to prevent the banks from following suit."