NEW YORK (Reuters) - Wall Street banks facing dwindling trading volumes may find that they have just one option left to boost profits: paying less of their revenue to many of their employees.
Major banks like Goldman Sachs Group (GS.N) and JPMorgan Chase & Co (JPM.N) have already started laying off traders, but all the big firms will likely also pay lower bonuses to the employees that remain.
The shift reflects a change in the balance of power between investors who supply capital to Wall Street firms and the traders who use the capital. Investors may be getting the upper hand as regulations choke off the productivity of some employees.
“The only way to operate profitably in a low-revenue environment is to reduce expenses, and that comes down to compensation,” said David Dietze, chief investment officer at Point View Financial Services in Summit, New Jersey, which owns Goldman shares.
Banks have typically paid a large chunk of compensation in the form of a year-end bonus. These payouts, which ran to millions of dollars for top staff, became a hot-button issue when the government bailed out banks at the height of the financial crisis.
Trading has become less profitable for Wall Street banks. The U.S. financial reform law signed in July limits the amount of money that banks can put at risk in financial markets. The law also forces some lucrative trading markets to move onto exchanges, instead of being brokered by Wall Street firms, cutting into a key source of revenue.
At the same time, new global capital requirements are raising trading costs by forcing banks to hold more money as a cushion against losses.
With revenue under pressure, cutting costs can be a crucial strategy for boosting profits, analysts said.
By cutting jobs and paring compensation, “the banks are sharing the cost of (regulatory change) between employees and the shareholders,” said Brad Hintz, analyst at Sanford C Bernstein in New York. “That’s probably a fair way to do it.”
Some traders have already received pink slips. Bank of America Corp (BAC.N) is cutting 20 to 30 employees who traded for the bank’s account, while JPMorgan Chase & Co (JPM.N) recently told about 20 commodities traders to find new jobs.
Hedge funds evidently need fewer traders, too. D.E. Shaw & Co., the third-biggest hedge fund in the world, has cut 150 staff, or 10 percent of its workforce, a source said last week.
“There’s less capital being put at risk, and that means you don’t need as many traders,” said Roman Regelman, a partner at Booz & Company’s financial services practice in New York.
That trickle of layoffs could become a torrent at the beginning of next year if financial markets are slow for the next three months. Banks typically clear risk from the books toward year end, but last year’s fourth quarter was unusually slow, and this year’s may be as well, analysts said.
“My guess is the big cuts, the real reductions, are a January event,” said Hintz. Analyst Meredith Whitney estimated in a report at the end of August that between 40,000 and 80,000 -- or 5 to 10 percent -- of U.S. securities and investment jobs could go over the next 18 months.
A sign of the turning trading environment came when Jefferies Group JEF.N reported last month that third-quarter profit halved from a year earlier as investors wary of an uncertain economy kept away from trading.
Some banks evidently are already getting ready to pay less of their revenue to employees -- Goldman has set aside just 43 percent of its revenue for compensation for the first two quarters. The historical average on Wall Street is around 50 percent.
A recent presentation by Moody’s Investors Service analyst Peter Nerby showed that banks’ returns on equity can recover to pre-crisis levels if they pay only about 40 percent of their revenue to employees.
Two hedge fund managers noted that if banks all cut their compensation levels and return to their pre-crisis levels of profitability, valuations for the stocks could rise. Most banks are trading at around one time their book value now, which could rise closer to twice book value, they said.
Of course, while the prospect of higher valuations is attractive to bank investors, most are also aware that banks’ key assets are their employees, Point View’s Dietze said.
Earlier this year, banks rushed to hire investment bankers and traders after paring back severely in 2009.
Now many banks are cutting jobs. To the extent they are hiring, it is largely in areas that use less capital, such as investment banking. Citigroup Inc (C.N) recently hired a team of energy bankers from UBS UBSN.VX, reportedly offering millions to lure them from the Swiss bank.
Banks and funds are adapting to a new reality, where huge trading gains -- and the payouts for the traders behind them -- are relegated to the history books by regulatory change and shifting risk appetite.
“We have too many traders that have been trained to be aggressive, now they need to be more thoughtful, more focused and more flexible,” said Booz’s Regelman. “The supply and demand equation has fundamentally changed.”
Reporting by Elinor Comlay, additional reporting by Dan Wilchins, editing by Matthew Lewis