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Wall Street is clearly going to cut bonuses this year, and next year does not look promising either. But financial industry types have not given up the hope of an eventual return to a system based on taking 50 per cent of revenues for the annual bonus pool.

Personally, I am sceptical about that for a couple of reasons.

First, that tradition is a relic of Wall Street’s former partnership model, under which senior executives in banks took real capital risks in return for having first cut of the revenues. If those banks suffered in downturns, the people who profited at the top of the cycle had to accept a lot of financial pain.

The tradition has been partially replicated by paying annual bonuses in equity that vest over three or more years. But that is not the same as having all of one’s wealth tied up in equity in a private partnership, a hefty disincentive to excess risk-taking.

One thing we already know is that traders and bankers have been earning large bonuses based using close to zero-cost capital and very cheap wholesale funding. But the cost of both capital and funding for banks will be higher in future.

The corollary is that it will be far harder for such banks to provide shareholders with an adequate return on capital while allowing employees to take 50 per cent of revenues. So the bonus pool is bound to be squeezed.

Second, banks in Wall Street and the City have been held to ransom in the past few years by employees who said they would leave and go to a hedge fund if they did not get the full bonuses they had demanded. Some of them are still saying so.

But those hedge funds (and private equity funds) were being financed and encouraged by banks, using the aforementioned cheap capital. We are seeing a large shake-out that will eliminate a lot of alternative employers for disenchanted bankers.

I think all of this is bound to lead to a bonus squeeze. Will that damage Wall Street banks? Not if one believes the article in the New York Times this morning by Dan Ariely, a Duke university behavioural finance academic, who found that very big bonuses can make a person more stressed and less efficient at his or her job.

November 20th, 2008 in Finance | Permalink