Wide-ranging re-regulation of investment banks' activities will reduce leverage, profitability and compensation, says Alan Johnson, an influential Wall Street compensation consultant.
The coming changes will profoundly affect hedge funds and buyout firms as well, Johnson, managing director at New York-based Johnson Associates, told eFinancialCareers News. All activities that depend on financial leverage, whether buy-side or sell-side, are likely to be scaled back.
"Going forward, I think people will be paid less money. I think the businesses will be less profitable," he says.
The driving force behind this notion is the prospect of higher capital requirements. "I've had a lot of clients saying that more capital is going to be put to use. They'll have greater capital charges, less leverage, less different products. All that means less profit, and less profit means less compensation," he explains.
Trading Desks, Hedge Funds to Be Hard Hit
Not all business segments will suffer equally, however. Within sell-side institutions, Johnson says trading desks will "take the biggest hit. There's going to be a lot more capital put against" the exposures that banks take on when trading fixed-income, equities, foreign exchange and other products.
On the other hand, traditional investment banking activities - advisory business and capital markets (issuing stocks and bonds) - will fare relatively better in the new regulatory regime, to the extent they don't require capital commitments.
On the buy side, Johnson lumps together hedge funds and LBO firms as "the next bubble to burst." Both groups juice up returns via leverage, generally in the form of bank credit. Participants have been assuming that when markets eventually recover, credit will flow as freely as it did before the crisis. But that won't happen if re-regulation brings stiffer capital charges for risky loans.
Other industry sources echo Johnson's overall views about future re-regulation impacting leverage, capital, and profitability. However, they differ over how the effects may filter down to various players and sectors.
An Alternative View
"Some hedge funds will have taken a hit, but others will be strong," says Wall Street headhunter Jay Gaines, chief executive of Jay Gaines & Co. "Compensation probably doesn't change that dramatically on a performance basis, in the hedge funds. And if the Street firms are going to compete with the hedge funds for people, that's got to put some (upside) pressure" on compensation, he believes.
Gaines also sees certain traders poised to gain rather than lose influence in the new landscape. "My guess is certain firms like Goldman Sachs might concentrate even more on their own proprietary investing activities," he says. "Goldman has such strength in scientific, analytic, disciplined proprietary trading. No Street firm, and probably no hedge funds, are in that league. So I can't believe that activity will be curtailed. If you're at Goldman, maybe the logic is to revert back to being private and taking bets that you can make successfully."
Tighter regulation of investment banks grabbed the spotlight since the Fed approved requests by Morgan Stanley and Goldman Sachs to become regulated bank holding companies. Those were the U.S.'s last remaining standalone bulge-bracket I-banks after Lehman Brothers sought bankruptcy protection and Merrill Lynch agreed to be acquired by Bank of America.
According to Johnson, the bailout and/or conversion of banks by itself won't reduce compensation. He notes several U.S. and European bulge-bracket institutions already operate as "universal banks" and pay their investment bankers competitively with the standalone I-banks. What will affect profit and pay, he says, is "going forward there will be greater capital requirements and less government-sponsored risk taking." He sees those effects extending beyond the current crisis that is depressing bankers' bonuses for this year and next.
No Simple Escape Route
Can those with curtailed pay prospects escape damage by switching employers? That won't do the trick, in Johnson's view, because re-regulation will have similar impacts among all similarly situated institutions. "Where are you going, where are the high-octane places going to be? I'm not sure," he says.
The only real answer would be to switch to a more promising specialty. On that score, Gaines offers hope. "People who are talented, within a firm, historically they've moved fluidly from area to area, even at senior levels," he says. "Some of the best senior operations people came out of finance. A lot of the best risk people came out of finance. Some asset classes lend themselves to crossing over. A high yield analyst isn't all that different from an equity analyst."