The phrase that explains why investment banking pay must plummet

Goldman Sachs pays well, but it doesn't pay nearly as well as it used to. Average compensation per head at the bank is on track to reach $425k this year, but in 2007 the bank paid an average of $661k. It's the same story elsewhere: UBS paid its investment bankers CHF475k in 2008 and is on track to pay CHF350k in 2013, for example.

Worse, and as yesterday's banking report from McKinsey & Co highlighted, pay is likely to fall further in future. Compensation costs are falling, but the costs of technology and infrastructure are rising. Technology and infrastructure costs are inflexible: banks have to keep spending on them if they want to stay in the game. Something has to give. And that thing is compensation.

Accordingly, as banks look around for ways of targeting reduced compensation more effectively, they are focusing on new concepts. The words from McKinsey's report that should strike fear into every thinking investment banker are, 'seat value.'

McKinsey says:

'The next stage is to better identify value created by incremental profits generated, rather than the “value of the seat” of the underlying franchise, with pay-out ratios recalibrated accordingly....A disproportionate fraction of value created goes to producers, with insufficient differentiation between true value creation and the “value of the seat.”

From now on, therefore, banks need to differentiate between the revenues that a monkey in a seat could generate and the revenues that an intelligent banker in the same position might bring in. Pay should be based upon that differential. It's about distinguishing alpha from beta, says Jon Terry, compensation consultant at PWC: "How much of the profit generated by an individual is due to the franchise of the firm and how much is due to personal franchise and personal ability?"