October 10, 2008 6:17 pm

A pause for repentance, or the end of big bonuses?

Gordon Brown, the UK prime minister, says that he is upset at the bankers whom his government has been forced to bail out. “I am angry – I am angry at irresponsible behaviour,” he said this week. “The days of big bonuses are over.”

Mr Brown is not the only politician to demand restraint from bankers in return for taxpayers’ cash. The uproar that has followed announcements of bail-outs in the US, UK and elsewhere has led to politicians telling bankers off like schoolchildren.

To which, the whispered reply from those at the back of the class on Wall Street and in the City of London is: “Yeah, right.”

Investment bankers have endured years of criticism about “fat cats” and the “trader’s option” – that they take millions when things are going well and leave the losses to shareholders. It has never dissuaded them from carrying on as before.

This time, investment bankers know that they will have to make short-term sacrifices. The chairmen and chief executives of banks that have relied on public money to remain in business will not be taking bonuses for 2008, unless they have taken leave of their senses.

Those below them know they may also have to demonstrate some public spirit. The market is already dictating that. This is usually the time of the year when bankers gain guaranteed pay offers to move to other investment banks, but there is little largesse on offer now.

“I think banks may be very strict on bonuses this year, particularly if the chief executive has stepped up and said he will not take one. It is a matter of accountability. They must take some hits, like the rest of the world,” says Jeanne Branthover, head of financial services for Boyden, a New York headhunting firm.

After a decent period of mourning – a year or two – most expect things to return to normal. Half of a bank’s revenues will again be placed in the annual bonus pool and shared out according to how much each banker or trader has brought in. The top revenue generators will once more earn $10m to $50m a year.

I am not so sure. We are in the biggest financial crisis since 1929 and the implications of that have not yet dawned on this generation of investment bankers.

It comes down to this: using your wits to trade with others’ capital has been very profitable over the past decade. Capital was so cheap that anyone at an investment bank who knew how to make money with it could take half the proceeds.

This crisis has shown that bankers were taking excessive risks with their shareholders’ capital and that a lot of the revenue was illusory – it has been followed by multi-billion dollar write-downs. It has also shown that capital and liquidity are more precious than banks came to think.

So the real risk-adjusted return on capital of a lot of investment banks has been zero at best. Bankers have been walking out of the building with all the industry’s profits.

Capital will now be more expensive for banks to obtain and they will be unable to afford the extraordinary tithe that their employees have taken out of revenues each year. Sooner or later, that brutal financial fact will be inescapable.

Bankers know there is less cash to go around and that public assistance comes at a price. The US government, for example, has attached conditions to its $700bn bail-out package that would heavily increase the tax bill for participating banks that pay tens of millions to senior executives.

Many expect the compensation bill to go down for a time because fewer people will have jobs and the market for average performers will slacken. “I don’t think we’ll see what we saw in the last five years – outrageously large bonuses for people who are not superstars,” says Ms Branthover.

Deep down, however, bankers do not expect the crash fundamentally to alter the way that Wall Street works. Barclays, which bought the US investment banking arm of Lehman Brothers when the latter collapsed, has been negotiating bonus packages to retain top employees.

The banks say they have no choice because the best bankers and traders could, despite all the turmoil in markets, leave to get a new job with a hedge fund or private equity fund instead. Even amid a crisis, good performers have the upper hand in bonus negotiations.

Perhaps bankers should pause to think about this. There is no question that hedge funds have offered some refugees from investment banks the chance to make tens – or, in a few cases, hundreds – of millions of dollars. But we do not yet know how many of these funds will be left when the markets calm down.

Furthermore, it has become obvious to every investment banker that there is a considerable value in working for a big, well-capitalised institution. Not only is it less likely to collapse but it has a greater chance of being bailed out if it gets into trouble. A big share in a hedge fund is worth nothing if the fund founders.

The logic of the way in which the world is evolving is that there will now be two kinds of Wall Street employer: safe and decently paid or risky and highly paid. Banks will be more regulated and less profitable places to work, where bonuses are lower. Those who have both the talent and the risk appetite will take their chances elsewhere.

It will take time for this to sink in, given that the good times went on so long. But those who expect a pause for repentance followed by a return to business – and bonuses – as usual may have a shock coming.

john.gapper@ft.com

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