It's 5 p.m. on the last Friday in June, and six young bankers are gossiping over pints of warm beer at the White Hart Pub in London's financial district. Michael, a fund manager who does not want his last name revealed, is weighing an offer from a competing bank that would double his annual salary and guarantee his bonus for two years. He figures the total package comes to $400,000 a year. Michael, 32, says he'll probably make the switch and use his first bonus to buy a house in the country.
Investment banks from London to Hong Kong are on a madcap hiring spree in a race to build up their asset management, corporate finance, and emerging-markets expertise. The goal is to make sure they have a place in the top tier of global investment banks. The trend is terrific for employees like Michael. But whether it's good for shareholders, or ultimately for the banks themselves, is another question.
BROKEN LINK. While investment banks are paying exorbitant salaries and bonuses, clients are squeezing them from the other end. Fees are falling for a range of services, from handling Eurobond issues to managing privatizations to selling derivatives. At the same time, investment banks' noncompensation expenses are on the rise because of rapid overseas expansion. The result: Among global investment banks that make figures available, average pretax margins have fallen from 30% in 1980 to 11% in 1995, and return on equity in the same period has plummeted from 51% to 13%. "The traditional link between profitability and employee remuneration is getting broken," complained Barclays Chairman Andrew R. Buxton in a recent speech. As the parent of investment bank BZW Ltd., Barclays has a keen interest in keeping a lid on costs.
True, most investment banks reported healthy earnings increases in 1995 and are issuing glowing reports about the first half of 1996. Much of the optimism is due to the booming U.S. equity market, record levels of mergers and acquisitions, and the revival of emerging markets after the 1994 peso crisis. But booms don't last. Warns Matthew Czepliewicz, a European banking analyst at Salomon Brothers International Ltd.: "Investment banks are operating on a wave of euphoria right now."
Managers of European investment banks are following Wall Street's lead on salaries and bonuses, which they formerly scorned as excessive. Now they're outpaying even the U.S. white-shoe firms in an effort to grab scarce talent. Rising compensation has always made up the lion's share of most investment banks' overall costs. But while banks have gone on raids before, this time entire teams are being recruited.
Deutsche Morgan Grenfell, the investment banking arm of Deutsche Bank that last month hired 60 Latin American equity specialists away from ING Barings, is just one example. In the past year, DMG has hired 250 senior-level staff from other banks. Although an equivalent number of staffers left, the new people are paid far more. In the past year, DMG has added $500 million to its fixed-cost base, most of which is compensation. Analysts expect that figure to rise to $650 million by yearend.
TOO GENEROUS. In another famous incident, Hongkong & Shanghai Banking Corp. recently hired a team of 10 disgruntled fund managers from Credit Suisse Asset Management. Credit Suisse claims HSBC offered bonuses to the defectors for every client they brought over with them, but HSBC denies the charge. Credit Suisse successfully sued HSBC in Britain's High Court to stop its ex-employees from contacting clients for 12 months. Still, the raid was a blow to Credit Suisse, which has lost 1,000 clients since the team departed. This and other problems are behind the reorganization announced on July 2 aimed at boosting the bank's competitiveness in a cutthroat environment.
U.S. investment banks continue to set a bad example of overgenerosity. From 1980 to 1994, compensation as a percentage of net revenue rose by 44% at U.S. investment banks, according to Michael A. Flanagan, an analyst at Philadelphia-based Financial Service Analytics Inc. Total compensation fell in 1995 when interest rates rose, the bond market swooned, and the peso collapsed, forcing banks to retreat from emerging markets and lay off trading and sales staff. But by late 1995, most had resumed their frenetic pace of hiring, only to find that they faced a shortage of qualified people. The solution? Offer a better package than the competition. If that doesn't work, guarantee bonuses.
That used to be anathema--after all, a bonus is supposed to be an incentive to performance, not something taken for granted. But these days, says James P. Hickman, a London headhunter with Russell Reynolds Associates, guaranteed bonuses are no longer unusual. The practice disturbs even some of the bankers who touched off the bidding wars. Rudi Mueller, chairman of Union Bank of Switzerland's London investment bank, calls the system "out of hand." Yet UBS was one of the first European banks to recruit aggressively in London, although it says it has never guaranteed a bonus.
Perrin Long, an investment bank analyst in Darien, Conn., says shareholders until now have been complacent. But he warns that once interest rates start rising again, as is expected to happen later this year, initial public offerings will taper off, M&A activity will dry up, and banks' profits once again will fall. This time, many investment banks will be saddled with higher fixed costs, such as guaranteed multiyear bonuses, that they can't shed quickly. Perhaps that's when shareholders will begin to scream.