Employee earnings are set to decline sharply in the investment banking division of RBS.  Future bonuses to be paid in subordinated debt spread over the following 3 years.  Subordinated debt is currently about as popular as a bad smell in a lift.  Hence its even more of a pay cut to be allocated a bonus in sub debt at par when other subordinated bank debt is trading at a big discount to par in the marketplace.  Sub debt has the same downside as equity but no upside as its limited to par. 

Yesterday the Government agreed to pay RBS par for £19 bln of convertible preference shares, which are even further down the capital structure than sub debt.  Technically the RBS B shares are Convertible Non-Cumulative 7% Preference Shares, issued on a 108% conversion premium and automatically callable at 130%; coincidentally the 65 pence call trigger is the same price as the second rights issue of 2008.

RBS will be aiming to buy back the B shares from future retained earnings.  Having 38 bln new shares created is not in the best interests of minority RBS shareholders – so don’t expect RBS shares to trade above 65 pence until all the B shares have been bought back.  RBS would also benefit from buying back subordinated debt in the market if they could buy it back below 50%.  Below this level the profits from cancelling the debt would exceed the Core Tier 1 capital spent on the buyback.  This would therefore be neutral from a Core Tier 1 capital perspective and would also wipe out future coupon payments.  Buying back below 33% would even be neutral from a normal Tier 1 capital perspective.  There are will be even fewer buyers of perpetual subordinated bank debt once they realise that none of this debt will be called until RBS has spent £19 bln of future retained earnings on buying back B shares.

Back to those pressured employees.  We are at the start of a structural change in pay in the marketplace.  More of the company earnings will be retained by shareholders.  This marks the end of the 48% compensation payout ratio.  Will they all leave and go work somewhere else in today’s global marketplace?  A few individuals may leave, especially those whom are already independently wealthy, but for the rest I doubt it as there is nowhere else to go.

In the very long run investment banking will go back to private partnerships as these are the best way of risking capital – when its the partners’ money they pay attention to the risk.  Not quite the same as hedge funds as partnerships are not creaming off 2% of their investors’ money every year come rain or shine.  Boutiques offering corporate finance advice will be set up first as these require little start-up capital.  Risk-taking partnerships will start small and build up their capital by retaining earnings – this will take much longer but at least these partnerships will not bring an economy to its knees if they go bust.