It is going to be a lean year come bonus time at Canada's securities firms.
For the past few years, compensation has defied gravity. Returns to the owners of securities firms have been steadily falling, while the payouts to those who work there held up relatively well. It couldn't last, yet it persisted longer than seemed possible.
Companies argued that they needed to pay to keep employees. No longer. Nobody is hiring in any big way, reducing the threat of defections. Shareholders can demand a more significant piece of profit. The one number that matters – return on equity (ROE) – shows that bank management has not yet done nearly enough to reallocate returns from employees to shareholders.
The United States is setting the trend. Goldman Sachs Group Inc. cut pay by one third last quarter. That took Goldman's compensation ratio – the percentage of revenue paid out to employees – down to 41 per cent in the first nine months of the year – the lowest since at least 1999. JPMorgan Chase & Co. also chopped pay.
Look for the same trend in Canada as bonus season rolls into full swing after the bank year end of Oct. 31. Management is putting out the word that there is less to go around. One senior banker who has had a pretty good year said management has still prepared him for what he called a "step change" in pay.
ROE measures profit as a percentage of common equity, and from the biggest firms to the smallest, it has slumped to somewhere between soft and terrible by historical standards. The reasons include slow equity markets and regulatory changes that have made some trading activities less rewarding, as well as pay that hasn't moved in step with revenue.
ROE for Canadian securities firms is down by more than half from prefinancial crisis levels. In 2006 and 2007, ROE across the industry was on the order of 22 per cent. In the second quarter, the last for which industry-wide statistics are available, it was 7.9 per cent.
Small firms are lucky to generate any of the "R" in ROE at all. The bigger firms are generally doing better. But they can keep a lid on compensation, safe in the knowledge that smaller rivals cannot bid top dollar for staff. Given what Goldman just did, it's not like foreign firms are going to pay a lot more, either.
Two years ago, the securities division at Royal Bank of Canada paid 42 per cent of revenue out to staff. This year, it is 39 per cent.
Many employees are going to feel it even more than that. Within firms, another change is taking place. The pay structure is increasingly likely to mirror that of a sports team with its payroll limited by a salary cap. Stars take almost all the money and what's left is distributed to role players. The result is a cluster of salaries at the high end, a cluster at the low end and not much in between.
It will likely take yet more restraint to placate shareholders, however. Even with the cuts, returns for owners are still falling. RBC's return on equity in capital markets was 12.7 per cent in the quarter ended July 31. Two years ago, it was 15 per cent.
Goldman posted a return on equity of 8.1 per cent in the third quarter. There was a time when Goldman could easily top 20 per cent.
The long-term implications are also serious for the business unless ROE is revived. Investment banking firms in Canada have been closing shop. Single-digit returns on equity are not going to draw many new entrants to replace them.
Similarly, for someone running a big Canadian bank that owns a capital markets business, why allocate a lot of money to it at this point? Return on equity in businesses such as retail banking and insurance is much higher. Wealth management is less lucrative than those other areas, but also less risky than securities. The result is going to be less investment in the securities business.
Some of this is cyclical. Investment bankers often say the biggest driver of business is economic growth. When that picks up, so will revenue. But some of the issues, such as the regulatory demands, are not nearly as cyclical.
If there is any silver lining in this for bankers it is that they are increasingly paid in stock. What they lose in cash they should get back, in some measure, in returns on equity.
With the pendulum beginning to swing toward shareholders, it's not easy to see it reversing any time soon. Once stockholders get used to having a bigger piece of the pie, they will want to keep it.