Tight Cost Control Bolsters Banks' Returns
Byline: Peter Wilson-Smith Editor-in-chief
These may be hard times in the investment banking industry but the initial batch of first quarter earnings figures show that this is an industry quite unlike any other.
Considering that numerous large corporations have been announcing losses, huge write-downs and in some cases even going to the wall, the investment banking industry is coming through the worst downturn in two decades in remarkably good shape. The first quarter of this year has been the toughest period many bankers will have experienced during their working career, yet most houses are still managing to earn returns on equity that many an industrialist would die for during a recession.
Goldman Sachs' annualised return on equity was 15.4% during the first quarter, despite taking a huge hit on a block trade that went wrong. Bear Stearns earned 15.2% and Lehman Brothers came in at 14.6%. These returns may be well below the 20% plus that the investment banks expect to earn over the cycle, but it is still pretty startling in a low inflation environment and at the worst point in the investment banking cycle.
A similar picture is likely to emerge when Morgan Stanley reports next week and the other bulge bracket firms such as Merrill Lynch announce first quarter earnings in a month's time.
The key to this remarkable resilience is cost control.
Having increased headcounts by between 25% to 50% over the past few years and allowed compensation levels for bankers to rise by about 30% a year, most of the industry has reacted swiftly to the downturn. Some have been quicker than others to cut staff, and there is more firing to come. But all have cut compensation levels sharply by an average of 30% to 40% over the past year.
With such a high proportion of variable cost in the form of compensation, investment banks can react much more quickly to business downturns than the corporate sector. Those, such as CSFB, which allowed guaranteed bonuses to erode the flexibility of their cost base have suffered accordingly. …