Fat City On The Thames

Bonuses at investment firms may shrink profits and boost risk

It's bonus time in the City of London, and at the wine bars favored by hotshot traders, talk of the Magic Envelope fills the smoky air. A 25-year-old equities trader at one upscale hangout says his bonus was three times the size of last year's. He won't say how much he took home, but it was enough to buy a new country house--mostly with cash.

He's not alone. Industry watchers say 400 to 500 City bankers and traders got bonuses of $1.6 million or more. On the whole, the fat bonuses are a sign of the City's health, reflecting the London Stock Exchange's rise to all-time highs in 1996--not to mention the hot merger business. The City earned a record $1.8 billion in merger fees alone last year, compared with $1.5 billion in 1995, according to Philip Healey, editor of the London-based Acquisitions Monthly.

TALENT SEARCH. But some senior bankers and analysts worry that the bonus froth may unduly encourage risk-taking and could even signal a top in the markets. They also fear that competition among banks for prime talent may be getting out of control, making employers vulnerable to a downturn. Fees for many of the banks' products and services, from interest-rate swaps to merger advice, are shrinking as the providers compete fiercely on price. Only by boosting volume can the banks keep up with growing staff costs. "A squeeze could occur if there is any slowdown in growth in the business," says John D. Leonard, European banking analyst at Salomon Brothers Inc. in London.

One reason for soaring compensation is intense competition for talent. In the past two years, several big banks, including Deutsche Bank, Barclays, and National Westminster Bank, have pushed aggressively into trading and other areas of investment banking. Their hunger for staff has driven up salaries and increased the use of so-called guaranteed bonuses, often covering two years or more, to lure people from rivals. Such bonuses lock banks into high fixed costs, and even less profitable institutions must pony up or see experienced hands walk out.

Pay is also rising in London because as high finance grows increasingly global, the City and Wall Street are becoming one big market. Compensation in Britain has traditionally been lower and less bonus-driven than in New York, but now pay scales are converging.

In some cases compensation costs have hurt British banks' bottom line despite the healthy market. BZW, Barclays' investment wing, recently acknowledged that it paid $72 million in "upgrading" costs in 1996. These include, among other things, guarantees for new recruits and buyouts for no-longer-wanted staff, says Barclays Chief Executive Martin Taylor. Such expenses contributed to BZW's 29% drop in operating profits, to $326 million, for 1996. Taylor says that investments in people and systems are necessary for the bank to be competitive in the future and will begin paying off next year.

Taylor may be right. But there are signs of unease about the skyrocketing bonuses. The weightiest came from the Bank of England, which is worried that some incentive schemes, including big lump-sum payments for hitting specific profit targets, may tempt traders to take excessive risks. In an in-house publication, one bank official wrote that huge bonuses might be creating a system of stars, "who may feel compelled to justify their status by taking greater risks in hope of making higher and higher profits."

SOBERING EFFECT. Senior bankers say that behind the BOE's warnings are fears that overpaying and risk-taking could damage the financial industry, aggravating its cycle of booms and busts. In a radio interview, central bank Deputy Governor Howard Davies warned that the bank might set higher capital ratio requirements for banks with risky pay arrangements.

This admonition has had a sobering effect. John R.H. Bond, group chief executive of HSBC Holdings PLC, says he is concerned about "excessive pay" in the City. He also says that HSBC is trying to curtail risk by cutting back on proprietary trading, the dealing that banks do for their own portfolios--an activity inherently riskier than taking positions for clients.

But how much City behavior will change remains to be seen. One top banker remarked that the Bank of England was "like a headmaster warning schoolboys to stop smoking." The City's highfliers aren't likely to pay much attention--at least until the market turns against them.

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