Business Talk On: Did Europe Just Ban Investment Banking? And More on New Financial Reform

The recent financial reform that has passed / is in the process of being passed falls into that last category of something big happening.
So let’s see what just happened, whether or not the finance industry will survive, and how your bonus will be affected.
What Happened
First, everything here is as of July 14, 2010 in case you happen to be reading this at a later date.
In the US, the House of Representatives passed financial reform legislation that includes these key points:

The government now has broader authority to liquidate insolvent firms.
There are more regulatory and risk management requirements.
There are new limitations on prop trading, derivatives, and PE/HF investing and only 3% of a bank’s capital can be invested in private equity firms and hedge funds.

(And yes, I’m aware of the consumer protection provisions but we’re just focused on investment banking-relevant changes here.)
The Senate is expected to pass the same legislation shortly.
Europe
But if you thought that sounded bad, it’s far worse in Europe – here’s what you got over there:

40-60% of bonuses must be deferred for at least 3 years.
Only 30% of the total bonus can be paid in cash upfront.
At least 50% of the total payout must be in the form of stock.

Ouch.
And yes, you’re reading that right: not only will around 50% of bankers’ bonuses be deferred years into the future, their cash bonuses will now be tiny as well.
What They Thought Would Happen
The European legislation came as more of a shock because there was so much focus on the US and the potentially disastrous consequences there:

Originally, they were going to ban all PE and HF investing by banks.
Originally, all derivatives might have been banned rather than just certain classes of derivatives.
Originally, banks would have had to pay $17.9 billion in fees.

So the final legislation was watered down considerably from these early proposals.
Banks responded by ramping up their hiring efforts.
How This Affects You
In the US, these new regulations are much more worrisome if you’re on the sales & trading side or you’re working at an internal PE fund or hedge fund.
There are no bonus caps similar to what was passed in Europe, so this reform won’t directly impact you if you’re in a front-office investment banking role.
If you’re at a private equity firm or hedge fund at a bank, well, you should now be thinking about your Plan B options.
Technically they can still exist, but 3% of a bank’s capital is very little to invest.
On the trading side, some banks are getting around restrictions by re-assigning prop traders to client-facing flow trading desks instead.
So that’s one possible outcome – although you may still be doing prop trading due to some clever loopholes (more on that below).
And In Europe…
So what happens in Europe with all these bonus restrictions?
The obvious answer is that banks will raise their base salaries to compensate for lower bonuses – but that logic doesn’t quite hold up 100%.
The bonus system works because banks must see what the full year’s results look like before handing out large piles of cash.
If analysts make a $70K base salary and $50K bonus – hypothetical numbers – banks cannot just raise base salaries to $120K to get around these new rules.
They may bring them closer to $100K, but beyond that it’s too risky to make base salaries exactly equivalent without knowing what the full year looks like.
And it’s even worse for the senior bankers who make high 6-figure and 7-figure bonuses – there’s no way base salaries will come close to compensating for those.
All of this also ignores the fact that 50% of your bonus will be deferred for several years – an issue for junior analysts who often leave after 2-3 years.
So What Happens to Bankers in Europe?
Even with significantly lower bonuses, it’s safe to say that no one will go out and get a real job – finance still pays more than anything else.
Instead, more and more talent may migrate to the US, Asia, and emerging markets where pay is higher and regulations are less burdensome.
Got Loopholes?
Of course, there’s also no guarantee that any of this will be implemented as it has been reported.
Maybe the bonus restrictions will only apply to certain bankers or certain groups, maybe they will find another way to pay salaries or bonuses that gets around the restrictions…
There’s always a gap between resolutions that get passed in the EU Parliament / US Congress and the implementation, and with this type of reform the gap will be even wider.
In the US, meanwhile, banks are simply moving traders from prop trading desks to client-facing flow trading desks to skirt around the new regulations.
And even if firms can only invest 3% of their tangible common equity in hedge funds and PE funds, they can take their sweet time selling off their existing divisions.
So it’s safe to say that even with new regulations in place, banks will find loopholes to reduce the impact.
Will It Work?
If you care more about the global economy than banker bonuses (What? Seriously, why are you reading this site?), you might be wondering whether or not these proposals will prevent another financial crisis from happening.
They may help a bit, but overall governments have placed far too much blame on banks and ignored everyone else who played a part in the crisis.
Yes, credit default swaps contributed, but what about predatory lending, people buying houses they couldn’t afford, and the Fannie Mae and Freddie Mac debacles?
These new regulations might lessen the impact of another 2008 meltdown – but does anyone seriously expect the next crisis to resemble this past one at all?
So, What Now?
Other than, “Pay will be down, but still higher than other professions” it’s hard to say much without seeing how these new rules are implemented.
If you’re interested in trading, hedge funds and prop trading firms suddenly look a lot better than large banks.
Few people do PE internally at banks vs. real PE firms anyway, but the same deal applies there.
The European reforms seem the most serious, but you may not want to pack up and leave just yet: they probably won’t be implemented as they appear, there will be loopholes, and who knows how many bankers will actually be affected.
Still, there’s no denying that bonuses are heading south – but did you expect anything different?