Investment Banking: Counting John's Money

In the next two articles I’ll look into the investment banking industry – a certain ‘due diligence’ on my side as a Bocconi graduate. Today, I’ll discuss salaries of investment bankers, and a few days later I will present to you my view on the challenges the industry faces. We shall have some fun.

Let us get back to John. He’s now an analyst at some European investment bank. A nice promotion for John since last time I mentioned him, huh? He earns around 50,000 euros per year, which is around 4,200 a month. John then pays a horrendously high European income tax that nearly halves his monthly earning. He thus ends up with 2,200-2,500  euros/month net of all tax.

Dear reader, do you want to be in John’s shoes? Let’s see. As an investment banker, he rarely works less than 60 hours per week. In fact, if he worked this little, he’d be considered that guy in the corner who plays his solitaire when no one is looking. John is actually a good worker, and works 70 hours a week, which is an average for the industry. In February, year’s shortest month, he will work 280 hours. His effective salary (net of tax; who cares about the before-tax salary when no one ever really receives it on hands?) is thus 9 euros (roughly $12) at most.

This is not even double of what a McDonald’s cashier Bob receives for his ordinary job working a 40-hour week and daily receiving his meal from the hands of Ronald McDonald. The only one left to speak to John is the vending machine down the hallway. Finally, and it may be important for many of us, an investment banker hardly manages to have a social life of his own.

John is clearly better off when he receives his bonus. John’s bonus will typically amount to 10-50% of his yearly income. But don’t forget, we’re in Europe. Probably the guy’s name isn’t actually John, more like Johannes or Giovanni, but that’s not the point; another thing is that the European taxation system will kick in and take half of his money again. If distributed evenly over the entire year, the bonus amounts to around +1050 euros/month. This translates to roughly +3.7 euros to his hourly salary. In total it is at best 13 euros/hour ($18/hour).

Let’s round it up. Over at least 4-6 years, John paid thousands for his education, did one or a couple of internships and only stepped into the job market at the age of 23-26. He received the most low-paying job in an investment bank. He works inhumanly long hours, has barely any social life by the age of 25-28 and, if the bank does exceptionally well, earns just 2-3 times as much as a McDonald’s cashier does on an hourly basis. I’ll throw in some personal touch on this and ask, Is it something to live for? I’m sure some are getting excited at this. A popular vision is that it’s good as a starting point. My only open question is, why do you think you’re at a starting point when you’re already 25-28? Life can’t observe inflation forever.

The topic is absolutely interesting as most of us weigh picking up their careers in investment banks. As I said, I’ll return to the industry shortly after I publish this. I promise I’ll be less nonconformist in my next article, as I will speak of the challenges for the industry, since there’s evidence the industry has changed in the last 1-3 years. Let’s speak about that one of these days.

On Europe and Its Banking Industry

First of all, I’d like to use these first lines to thank everyone. Your recent words of support and encouraging evaluations have inspired me on continuing with the blog.

Special credit goes to the love of my life, who’s shown passionate interest and given me the strongest support in what I’m doing here. Additionally, I thank my family, friends, classmates, professors, and other ‘fellaz’ for their sincere words of encouragement. I also thank all the ‘silent’ readers, because I can still see all your names in my pageviews statistics... Just kidding, I only see your country and the browser you used. And your home address with a picture of you.

Without all of you, guys, the time I’m spending here would be, putting it mildly, a bit less worthwhile. So thank you!

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Plunging into the fascinating and incredibly exciting world of finance now. Yeah.

I recently had an honor to meet Josef Ackermann, CEO of Deutsche Bank. He was visiting Bocconi earlier this week with a speech on the state of Europe’s banking industry today. If someone is to listen up to, he is the one. Head of one of the 5 largest banks in the world, Ackermann is also a member of the supervisory board of Siemens, a member of the boards of Royal Dutch Shell and Zurich Financial Services, as well as an honorary professor of several European universities and a welcomed speaker at large international conferences like the World Economic Forum.

When this man isn’t happy, you know things aren’t right. Ackermann confirmed his worry that the banking environment in Europe has become more troublesome than ever. I developed and further researched some ideas he presented, and came up with the following conclusions on Europe’s economy and the banking sector.

The importance of Europe as a world’s financial center is eroding. Let’s look at some numbers. Back in 1999, 44% of the world’s top-25 banks were European. Europe was less exposed to the dotcom crisis and looked as a safe place for investment, as the leading economies were approaching the creation of a common currency, the euro. As of January 2012, only 16% of the world’s top-25 banks were from Europe, while the others were replaced by the banks from China and Brazil.

The number of European stock exchanges fell to 2 in the list of the world’s top-10 stock exchanges by market cap, while some of those previously on the list were replaced by China, India, and Brazil.

On top of that, European economies have been largely stagnant over the past couple of years. GDP growth in Germany was 3% in 2011, and is forecasted at the level below 1% for 2012. France, UK, Italy, and Spain only grew at 0.01-0.07% in 2011, while the growth contracted in Eastern European economies which are traditionally faster-growing ones.

Politics is sending conflicting signals to economy. It all started with the credit agencies (but hang in there – they’re not the ones to blame). They gave the legislators worrying signals that some economies, if not reformed, may have troubles meeting their obligations. In practice it means two things. One is that debt levels have to be reduced. The other is that yields on the existing sovereign debt will need to be increased, thereby increasing taxation and/or decreasing quality of public services.

What would you do as a European politician? That’s right, you’d go to banks and take their money. One completely… odd idea was the transactions tax proposed recently. Not only would it dramatically decrease banks’ earnings; it would also alienate many investors away from an already stagnant Europe.

Another reform, already enacted, is the requirement for banks to increase their Tier 1 capital ratios to 9%. The idea is to increase banks’ reserves and the quality of their portfolios. The outcome is, as evidenced by Ackermann, that banks need to resort to narrower business models and concentrate on core-activities. Additionally, as European sovereign debt is not anymore risk-free, banks are hurrying to de-leverage their portfolios and revise the risk profiles.

Apart from bad signals to economy, there are good ones as well. The problem, however, lies in the poor interaction of these pieces of legislation among themselves. EU politicians should agree on a strategic rather than an opportunistic approach to problem-solving within the Union.

Finally, the banking sector is getting less profitable. This is caused entirely by the above-said. As a result of de-leveraging and retraction from non-core activities, banks’ profit margins are shrinking. In the recent years, the industry has seen rapid shifts of individual market shares. Since many parts of legislation have yet to be enacted, we are probably going to see some more of these shifts in the industry very soon. For this reason, let me postpone discussion of this third point until sometime in the future, when the trends become evident.

Stick around until then. And I’m off for a cup of good Italian coffee.

Driving Forces of Business Consulting Today

What do you call someone who, when mentioned a 7 o’clock meeting, will ask, “AM or PM?” Or someone who can spell the word ‘paradigm’ and actually know what it means? That’s right, a business consultant.

Drawing on my experience of working at a consultancy, I find the picture below so true (sorry to some of you who saw it already, it just perfectly fits in the subject). Additionally, here you can find some other witty ‘observations’ made on consultants I found on the web.

Management consulting firms started appearing in the previous century and were initially focused on general management and technology advisory services. Glass-Steagall Act and subsequent banking sophistications of the mid-20^th century triggered a new wave in the development of the consulting industry. This gave rise to industry-specific consultancies, such as tax-, HR-, operations- and other specific ones. Later it went even deeper, as the rise of industries (such as aviation and IT) brought forth those respective consultancy firms.

The business environment of consultancies today seems to be quite saturated. Some major companies like GE, Toyota, and Lufthansa have their own consultancies providing services within their respective groups as well as to other firms in the industry.

The 21^st-century business consulting is now a whole industry which increasingly has to face new paradigms (no, I just can’t escape using this word in this context). From the conception of the industry until today, the paradigms (or driving forces shaping the industry) for consulting businesses around the world have shifted. Therefore, let me discuss some of the new driving forces I came up with which form the consulting reality today.

The original business focus has become harder to maintain over time. One reason for this is increased competition. From 5 consulting firms with over 1000 employees in 1980, the industry grew to well more than 150 such firms today. As to the industry consultants which are typically smaller firms, the aviation industry alone has over 15 well-defined consultancies just in Europe.

Another reason is that project types have changed and grown in scope. That said, clients search for consultants who are able to present comprehensive project treatment. Instead of providing one service per project (say, a growth plan), a consulting company is expected to spill the service over to other branches of a client’s firm (say, advisory on operations optimization and implementation thereof). The former ‘big 8’ merged into the ‘big 4’ to expand their services and strengthen the existing arms (audit, tax). For this same reason, the cohort of smaller industry-specific consultants eyes widening the offered services.  One example is a German construction consultancy, which extended their services from construction advising to airport master planning.

Industry standards are getting increasingly scalable. Although typically business consulting is thought to be hardly scalable, in the recent years competition forced many consultants to implement result-based fee structures. In order to succeed in having their proposals accepted, consultants need to pledge to achievement of pre-specified results in order to qualify for payment. This paradigm drives to the third one, which is:

Traditional business structures may need to undergo changes. Under the new industry standards and client expectations, consultancies not only need analysts and consultants, but also ‘executors’. This can mean a shift from a traditional ‘matrix’-structure consultancies to ad hoc teams and project-specific working groups, as already practiced by some industry consultants. This can also imply the necessity for consultancies to team up with a common goal of project risk sharing.

These and other driving forces are important for a consultant to bear in mind. The industry is quite vibrant and is almost destined to evolve. Therefore, if you ask me several years from now What the driving forces of business consulting are, I’ll probably give you a different answer.

The Law Humanity Defies

John had a great day and was paid a large bonus at work. He took the money, brought it to the bank, and deposited it on his account. The bankers cheered. They knew exactly each dollar deposited means to the bank 5-10 dollars in extended credit. The bank kept some small part of John’s deposit, and lent out the rest to another institution. That next institution deposited the money in yet another bank, and the latter did the lending again. At the end of the day, everyone was happy; John and the bankers all drank beer that night.

They all enjoyed the blissful ignorance until the news came that, all else being equal, the house prices all over the country fell simultaneously, and it became extremely beneficial for everyone to buy houses. John and all the non-financial institutions immediately rushed to the bank where they deposited their money. The bankers didn’t see that coming and apparently didn’t have enough reserves to cover the immediate demand. But since they’re bankers and they know life tends to treat them well, they didn’t worry much, and called another bank to borrow federal funds. However, the bankers soon recognized that all banks in the country were experiencing the same problem and didn’t have enough cash on hands. The banks called the Fed, the lender of last resort. Suddenly, an asteroid came out of nowhere and hit the Fed’s building so that the printing press was destroyed. That really gave the bankers heebie jeebies.

They called London to borrow money from there. But the British bankers said they were indeed gobsmacked, as their national bank’s printing press was attacked by evil clowns and went out of order. In fact, for some absolutely random reason, no printing press functioned in the world that day. Then people started trading their commodities in order to get the worth they were entitled to. In very economic terms, the aggregate world demanded access to what is called M3 money supply (in very human terms, it’s ALL the money one can think of). Too bad only M0 was available, that is, printed currency plus coins, and there were just not as many commodities as their assigned value.

(http://news.goldseek.com/GoldSeek/1231778551.php)

It wasn’t too long until our friend John realized that everyone was entitled to more than his or her assets were actually worth. The world’s aggregate net worth  just didn’t cost that much! John very soon discovered that paper greenbacks were worth just the paper they were printed on. One way to drive at everything’s fair value would be to go back to barter trade, that is, trading goods for other goods. Or one could trade for gold, since everyone throughout the world could have a relatively easy access to it. But even if all the gold in the world were to circulate as our currency today, there STILL wouldn’t be just enough gold to match our net worth, since the world’s net worth increased 30+ times from what all the gold cost when the US abolished the gold standard in 1971.

Humanity thereby went against the nature and the laws of physics. Any physicist will admit what the bankers do is nonsense, since, according to the law of conservation of energy, NO energy can appear out of nowhere. ‘Nowhere’ is exactly where our money and assets come from. Put it this way, nothing in the world can physically cost more than the world itself; otherwise, how can one pay back?

I told my fiancée about this, and she actually called me out on it. She asked, Why is it bad? This is a truly interesting issue to discuss, so I must thank her for the contribution. In fact, I’ll let you leave your opinion.

Is it good or bad that the value of things is inflated? Is it good or bad to have a never-ending business cycle and inflationary tendencies? It’s highly unlikely for this story to unfold in reality, and it’s more likely that John will get his money anyway. But how are we so comfortable to live in the world where the value is created out of thin air and continues to grow in volume at a rapid velocity? My view is that this system is unsustainable in the long run. The physicists will agree. Apparently, the bankers are driven by other laws we’re not aware of.