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Editor's Take: Bonuses as a % of returns on capital are bad news for bankers

12 August 2008

Sarah Butcher, Editor

UBS’ plan to link bankers’ payouts to returns on capital is likely to hammer bonuses lower than ever. Even worse, it may well catch on.

UBS announced the new bonus arrangements today, along with its quarterly results. In the words of the Financial Times, ‘compensation in the three distinct operations of equities, investment banking and fixed income, currencies and commodities (FICC) will be measured by each individual operation’s return on capital.’

We spoke to one of the architects of the new pay arrangements, who says they’re a new thing - not only for UBS but for any big investment bank.

However you look at it, bonus prospects at UBS aren’t good. But using returns on capital instead of revenues or profits to determine future payouts will probably ensure they stay bad for a long time.

According to UBS’s latest quarterly results , net income as a percentage of average attributed shareholders’ equity in its investment bank was -7% in Q2. CreditSights analyst Simon Adamson, says historical returns were more like 15%.

If return on capital formulae are used to calculate bonuses industry-wide, the outcome will almost certainly be structurally lower bonuses for everyone.

According to Adamson, some investment banks achieved 25-30% returns in the years preceding the crunch.

However, most banks are now moving to raise more capital, and regulators may yet call for still more stringent capital requirements. Even if profits eventually recover, therefore, returns on capital will not.

And if bonuses are allied to returns on capital, they will suffer the same fate.

Comments (6)

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• Should be pretty good for M&A bankers though

  Wolf 12 Aug 2008

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• I would not mind going for such a scheme but this new measure will certainly kill some of the innovativeness & nature of the investment banking world, which will certainly be the downside.

  Big Swinger 13 Aug 2008

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• the arguement is not clear. why would bonusses go down if they are related to return on capital? what is the difference between bonusses calculated as a percent of individuals profit vs bonusses calculated as % of return on capital? In many areas, for e.g. trading, return on capital is non-sensical term.

  AK 13 Aug 2008

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• Profits and return on capital should be reasonably well correlated - unless the amount of capital allocated to a business increases faster than profits. Regulatory pressure to increase capitalisation may result in banks allocating more capital to businesses in the long term. Under this model, this would have a detrimental impact on bonuses,

  Sarah, Editor, eFinancialCareers 13 Aug 2008

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• the arguement is not clear. why would bonusses go down if they are related to return on capital? what is the difference between bonusses calculated as a percent of individuals profit vs bonusses calculated as % of return on capital? In many areas, for e.g. trading, return on capital is non-sensical term.
  
  AK 4 days ago
  
  
  Correct me if i'm wrong but if i'm not wrong - when a trader or sales trader puts in a trade, they require credit lines - these so called credit lines take up capital - ie a trade you put in is deriving someone else in the same bank of another money making opportunity.
  
  So technically what the bank is pushing for is - yes you can do a deal but make sure it's a deal that is going to be more than what the cost of fund for the bank will be - and yes it also means that even though you see absolute returns coming in you may be seeing a negative return - which means sometimes its better not to do anything at all than to do something that you're not quite sure of.
  
  this ROE way of assessing trading/sales trading has been around for some time in some banks.

  ST 17 Aug 2008

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• ST is right and the scheme to link bonuses to ROC is industry best practice. Any monkey can use a credit line to do a revenue generating trade, but if it doesn't exceed the cost of funds, it shouldn't be done (unless there's a strategic benefit that should be justified with a business plan) because it doesn't add value. It's the value add that drives bonuses at any decent listed company.

  dvamva 06 Sep 2008

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