Hugo Dixon

Is Goldman Sachs rebasing compensation at a lower level? For the second quarter in a row the investment bank’s compensation ratio has been only 43 percent. In the past, Goldman paid out around 50 percent of revenue to staff. For ordinary mortals, the numbers are still staggering: on an annualised basis, $545,000 is being set aside for each of the firm’s employees. But it does look like Goldman may finally be listening to its critics.

At the end of what was a blow-out first quarter, it was unclear how to interpret Goldman’s relative parsimony. The bumper results meant Goldman could still accrue huge sums for employees despite the lower-than-normal percentage rate. One senior executive said then that it would be reasonable to increase the accrual ratio only if trading in subsequent quarters was poor. Well, the second quarter was rotten. But the ratio didn’t budge.

Part of the explanation seems to be that Goldman has understood how past greed contributed to its recent public relations disaster. It would have been insensitive to jack up the accrual rate just days after paying a $550 million fine in connection with Abacus, a dodgy structured product it sold investors in the boom. Goldman’s failure to show restraint on pay this time last year helped sow the seeds of the backlash inflicted on the industry at the end of 2009 — leading to a UK bank bonus tax which is now costing the firm $600 million.

Sceptics will argue that Goldman will revert to type as soon as politicians take their eyes off the ball. There will certainly be a strong tendency to do so. But new regulations are being introduced around the world which will hardwire more restrained compensation practices: cash bonuses will be smaller and traders will have to repay bonuses when the profits behind them prove unsustainable. Beyond that, it will be down to shareholders to lock in lower pay — with the flipside of higher earnings and dividends.

By Hugo Dixon and George Hay

What’s a bonus really worth? Under new European rules, bankers will see part of their bonuses retained, another chunk deferred and some may also be clawed back. The present value of a $1 million bonus could be cut to less than $800,000, according to Reuters Breakingviews calculations.

The starting point is how much the banker gets immediately in cash. The new rules specify that 40-60 percent of the bonus must be deferred for three to five years and at least half of the non-deferred portion must be non-cash. That means there’s a maximum of 30 percent upfront cash. But for bankers on big bonuses — and $1 million would presumably be in that category — at least 60 percent must be deferred. The cap on upfront cash, therefore, is 20 percent, or $200,000.

The next step is to see how much cash the banker will get in future. For our big swinging dick, the deferred bonus is $600,000, of which as much as half, $300,000, can be paid in cash. This sum, though, has to be discounted to reflect the risk of a clawback for bad performance and the delay in receiving it. Assume there’s a 5 percent risk of clawback each year and take a 4 percent discount rate for the time value of money. Over a four-year period, that shrinks the banker’s $300,000 to $213,000.

Now look at the non-cash half of the bonus. The immediate portion, $200,000, will be paid in the form of contingent capital — a debt-like instrument that converts into equity in a crisis — which cannot be cashed in for an unspecified period. The deferred $300,000 is likely to come in the form of common shares.

Bankers are unlikely to find either form of non-cash terribly appealing. Not only is there the risk of loss; its value is much less certain than cash. Assume therefore that two discounts, each of 5 percent a year, are applied. If the contingent capital has to be held for two years, it is worth only $165,000. The shares, which are deferred for four years, have a present value of $205,000.

Tot it all up and the banker’s bonus has miraculously shrunk to only $783,000. Most ordinary people will still think that’s a lot. But bankers will undoubtedly feel hard done by.

EUROPEAN BANK BONUS CALCULATOR:

Pop in your expected headline bonus here, make some assumptions about how much will be non-cash, what proportion will be deferred and various discount rates. Our calculator works out the bonus’ real value to you.