Lay-offs and bonus cuts at Goldman Sachs (US:GS) are unlikely to provoke a rush of sympathy for its bankers, but they could signal a better deal for shareholders.
The straitened circumstances have come from a slump in deals and related earnings, following a 58 per cent fall in second-quarter profits to $1.2bn (£970mn) last month. The bank has pledged to take out $1bn in costs, and disgruntled employees may feel that their future lies somewhere else if bonuses don't rebound quickly. Notably, though, the bank increased the level of shareholder returns by upping the interim dividend by 10 per cent, perhaps giving a clue as to what management's priorities for capital allocation are this year. The third-quarter results on 17 October will add additional detail.
Lower fees are not a problem that is exclusive to Goldman Sachs. All the major Wall Street investment banks – including Barclays (BARC) – are struggling with deal activity that is approximately 25 per cent lower so far this year than in 2022, which was in turn well down on 2021. In broad terms, the value of deals across the industry is down about $1tn compared with last year. Further, banks calculate their variable employee reward costs as a percentage of total revenue, so severe cuts in bonuses are inevitable almost everywhere. Finance industry careers blog Mergers & Inquisitions reports that variable bonuses are down 15-50 per cent across the sector.
It is now legitimate to ask whether the exit of so many of its senior, and more expensive, employees – including up to 25 director-level positions in Goldman’s European operations alone – will lead to better times ahead as more motivated and younger associates come up to take their places.
The evidence that a cadre clear-out is a sure-fire way of returning a sense of drive and purpose to a company is mixed, to say the least, when it comes to banks. While in other industries a drive for efficiency means chasing down more leads, or improving processes, for an investment bank it can also mean assuming more trading risk. And the problem is whether the investment banking business model, with its regulatory restraints and an environment where cheap money is but a memory, can adapt when returns are more directly proportionate to risks that are taken.
More salary, less risk
What does seem clear is that there is a link between bonuses and the level of risk that employees are prepared to take on. According to a 2016 IMF paper, 'Is Capping Executive Bonuses Useful?', one key measure is the risk-free rate of return (for an individual banker ie their fixed salary) and the profits that are available through assuming a much higher level of risk.
It is the difference between these measures that determines how much risk they are prepared to take and therefore how much bonus they can earn. The higher the risk-free rate, ie higher levels of guaranteed salary, the less risk they are prepared to take. As length of service so often determines salary levels, older higher-salaried employees could feasibly see less advantage in running more risk than is necessary. In this context, the proxy for a minimum return is what banks can simply earn on three-month US Treasury bills ie short-dated government bonds with a guaranteed rate of return.
Intriguingly, in the period prior to the best returns for dealmaking in 2021, the return on US three-month Treasuries was an average of just 1.5 per cent. By contrast, investors and banks can currently earn a 5.32 per cent return on three-month Treasuries, without assuming any additional risk at all.
In other words, the period that powered profits at the likes of Goldman may be an anomaly linked to the prevalence of cheap money. This is a significant generalisation given the differences between individual banks' divisions, let alone entire organisations. But taken to its logical inclusion, it matters not a jot whether new employees are hungry for success, as the risk premium on top of the safe rate of return may just be too high for investment banks to stomach.
That reality won’t go down well with many trading desks – whose performance on the back of rising bond yields earned decent money – as bonuses here are likely to be cut as well.
This is certainly a view that chimes with increasingly downbeat assessments of the year ahead. JPMorgan (US:JPM) reckons that the total revenue for investment banking across the market in 2024 will be $80bn, two-fifths below the fees earned in 2021. The bank’s own assessment is that further consolidation of investment banking is inevitable so that more costs can be cut.
So where does this leave investors? With Goldman and other US investment banks hovering around a price/earnings ratio of 10, compared with the S&P average of 23, the sector is clearly at a heavy discount. However, investors may have it slightly better in that cost savings tend to benefit the dividend payout ratio because this is based on multiples of earnings. With the outlook uncertain, management is keeping shareholders, rather than employees, sweet by continuing the flow of dividends and buybacks.
