UBS has been forced to do a horrible thing to its investment bankers

Something nasty has happened at UBS. As we were first to report last week, the investment bank has increased salaries for its investment bankers. In an industry with strict cost controls and volatile salaries, this can only end badly.

Since the start of 2013, UBS has had a stated cost target of 65% to 80% of revenues in its investment bank. In the first quarter of this year, it performed well and costs came in at 65% of revenues. UBS's investment bankers therefore have some leeway - but not much. If investment banking revenues fall more by more than 20% from this point, costs will need to be cut to meet the 80% maximum target.

It's unfortunate, therefore that UBS's investment banking revenues have historically proven very volatile - even before the decision to pull back from large areas of fixed income.  In the first quarter of 2012, for example, revenues at UBS's investment bank fell 40% year-on-year. In the fourth quarter of 2011, they fell by 33% year-on-year - even before the Kweku Adoboli rogue trading incident.

It's equally unfortunate that two thirds of the cost base at UBS's investment bank is eaten up by compensation and that the bank had already been pulled up for having inflexible personnel costs - even before the latest salary hike.  UBS was one of the first banks to increase salaries dramatically in 2009 and has one of the highest proportions of fixed to variable compensation among European banks according to analysts at SocGen. In 2012, UBS said 38% of compensation costs for its 'key risk takers' took the form of fixed salaries. However, the Swiss bank has also committed to a programme of hefty bonus deferrals in which 60% of all bonuses in excess of CHF250k are deferred, with 30% deferred over five years. The need to pay these deferred bonuses from the past will further restrict room for manoeuvre on costs when revenues fall at UBS in future. Together with higher salaries, harsher, faster layoffs are the inevitable outcome.

UBS declined to comment on the increases in its pay, which reportedly range from 9% to 25%. However, senior UBS bankers we spoke to said they were surprised. One purported to be, "astonished." Another said it made no sense given revenues at the investment bank are so volatile. "UBS already has very high fixed compensation costs," he said. "By increasing the fixed cost base, you're removing the flexibility to cut pay when revenues fall. You're also reducing the incentive for bankers to work hard."

Andrea Orcel, CEO of UBS's investment bank, had little option but to hike investment banking salaries, however. The European Union's bonus cap is fast approaching. Although the cap won't affect pay until 2015, it will be applied retrospectively to compensation for 2014 said Jon Terry, a partner in the reward and compensation practice at PWC. "If banks are going to increase salaries in time for 2014, they will need to do so this year," Terry said.

UBS may be the first investment bank to do its employees a disservice. It's unlikely to be the last.