This month the biggest Wall Street companies reported their quarterly earnings. JP Morgan Chase and Goldman Sachs reported bumper earnings, Citgroup and Bank of America, not so good. But if you leave out write downs on debt, everyone had a great quarter in their capital markets businesses. Billions have been budgeted for year end bonuses.
As could be expected, the issue of Wall Street compensation raised its head again. And this time there is the weight of the federal government behind it. Banks that have taken TARP money will see their executive compensation capped. And the Federal Reserve has suggested that all large banks that fall under its jurisdiction will be reviewed on on going basis to ensure that executive bonuses do not produce risk taking behavior that could put the banking system at risk.
There are several memes that get mixed up in any discussion about Wall Street compensation in the media. Add a lot of emotion from a distraught public and it becomes for a tangled mess where the media feeds the furore but there’s no real understanding of the underlying issues. Let’s see if we can parse the issues out.
These are the issues as they are played out in the media
– Issue #1 – The taxpayer bailed out Wall Street. How can they pay themselves these kinds of bonuses.
– Issue #2 – The rest of the country is going through agonizing pain – high unemployment, pay freezes and cuts – how can these people pay themselves what they do?
– Issue #3 – Their companies have been (and some still are) hemorrhaging cash. How can they pay their investment bankers so much?
I don’t think any of these issues merit any attention from lawmakers. #1 could be argued many ways but at the end of the day, if the bank has taken TARP money and hasn’t yet returned it, the federal government as shareholder with special rights, can do as it pleases. Politics dictates that compensation should be curbed and so it will be. #2 amounts to appealing to a cold corporation’s heart – a futile endeavor. #3 is the company’s call. They have a board and shareholders. If they think that they need to pay top dollar to retain talent, then that’s what they need to do.
In my mind there are two fundamental issues that need consideration. One, is related to risk increasing compensation practices. The second is a larger issue of high, untrammeled growth in the capital markets in the last two decades.
On the first issue, everyone agrees that Wall Street’s bonus bonanzas encourage traders and management to pile on the risk, collect their super size bonuses and when things turn south, leave the shareholders to pick up the pieces. And when things go really really bad, like what happened to the markets last year, let the federal government foot the bill.
What is not clear to me is why the shareholders just stand there and let this happen. The expectation that the bank is too big to fail and that the fed will bail you out, doesn’t explain it. If you were a shareholder in Citigroup and held the stock prior to the crash, even though you were bailed out, you probably lost your shirt on Citi.
I am not sure what the answer to this is. It could be that in the normal course of things, shareholders don’t really exert any influence on the board of the company. Election of board members and votes on CEO compensation, need to see a lot more vigor in the shareholder meetings, especially in the US.
Or it could be that shareholders think they’re smart and will be able to get out before the stuff hits the fan – a variant of what the trader or management thinks – except that the employee just loses her job, the shareholder his savings.
It could be that there isn’t enough disclosure. That Wall Street companies, on the pretext of not revealing proprietary information on trades and investments, is actually throwing a cloak on dodgy, heads-I-win-tails-you-lose schemes.
There could be other things going on that only behavioral economics can explain. Thinking that if everyone has been doing risky trades for so long then maybe its not that risky, is both irrational and perfectly natural.
Whatever, the reason behind it, this nexus between risk and compensation needs to be tackled head on. It is going to be a very tough problem. But not addressing it is not the answer.
The other question is also a big one. In the last two decades, the capital markets have grown much faster than the rest of the economy. The chart here shows that the profits in the US Financial sector went from about 15% of total corporate profits in 1998 to over 40% in 2007. When an industry grows at that pace, the competitive intensity is low and margins are high. The use of technology raises productivity further increasing margins. In the capital markets the only significant cost is the cost of people. When there is no or low downward pressure on prices, compensation has no place to go but up.
But is the ‘natural’ size of the industry as a share of GDP what it is today or what it was two decades ago? Can an industry that essentially allocates capital, and doesn’t really make anything, have such a large share of the GDP? Is there something in the laws of the land that make it so? For instance the credit rating industry, many say, is a creation of legislation and would not have existed at least in this twisted model of today, had it not been for an easy regulatory environment. Are there other such areas that would wilt in the face of an openly competitive field or lower entry barriers?
I don’t know the answers to these questions. But I do know that if the world has a problem with Wall Street traders, bankers and CEOs making tens of millions a year, not just in today’s recession, but beyond as well, we will need to look at taming the industry, not capping salaries. If that’s even the right thing to do. Or possible at all.
People's cost are significant in capital markets for a reason. They needed the same people's genius to turn perceptions (of entrepreneurs / investors) into reality. If the Carnegies and the Mellons and the Rockefellers led the early industry opportunities, the Googles and Amazons of today made it in double quick time thanks to the wizards at Wall Street and they certainly don't curse them – and that's pretty much the way it should be. If anything needs fixing, guess it is the regulatory vigil. Every (in)security is filed with SEC for registration before it is issued to public. For a change, why haven't anyone put SEC on the doc for not blowing the whistle, not even once before the whole damn thing blew up ?
I don't contest the point that compensation in capital markets is higher than other industries because the companies gain from having the smartest people working for them. But that still leaves open questions like –
– How high is high? Once they have crossed the other industries how high does it have to be for it to be serving the purpose of pulling talented people in.
– Why has it grown faster? Comp in capital markets have always been higher. But if in the last two decades it has grown much faster than the average comp (or even avg comp in college educated pop) is that because it absolutely must have the cream of the working population (which I can tell you is not the case at all)? Or is it that the total pie – profits + bonus pool – has been growing like a rocket leaving enough room to satisfy investors and hand out oversize bonuses.
How high? As high as someone is willing to pay. That's something for the hirer to judge. The rule of "caveat emptor" prevails.
Benchmarking compensation practices in financial industry with other industries is like comparing apples to oranges. Financial industry is a high stress industry and you will see it if you take a look at their balance sheets. Other industries have land and building, plant and machinery, patents, stock of raw / finished goods inventory, work-in-progress, cost of production, distribution and logistics etc., to account for as assets (with additions every year) and to provide for their depreciation etc. that blocks a huge proportion of their pre-tax profits from suffering tax knocks. Financial industry has no such tax shelters besides interest on loans that get charged off to their revenue. So there will be a huge surplus left (during the upcycle years) that will face a full tax slap and it is prudent to use it to reward high performing employees generously that can ensure deal pipelines to remain full. The industry runs on the individual, his contacts and his foresightedness much more than the organizational clout and outreach that other industries enjoy.
Basab. I agree with the point that the tremendous growth in capital markets has facilitated the rise in salaries. This is a wonderfully elegant explanation that has the value of being applicable to other contexts.
However, I dont view this growth of capital markets as unhealthy. Permit me to restate the unoriginal (but unpopular) view that capital markets connect people with money (and perhaps no ideas) to people with ideas (and perhaps no money). So, they are key to democracy, like the circulatory system is to the human body — "doesnt make anything" by itself, but facilitate others to do what they want to do.
The use of (Wall and Dalal) street funding to expand microfinance in India, eg. http://online.wsj.com/article/SB12565045494420666… is an uncontroversial feel-good example of the utility of growth in capital markets. Less uncontroversial, but perhaps more impactful, is the role that capital markets played in the boom of the 2000s. Arguably, the world (and certainly the emerging third world) is better off with the boom.
Money was certainly wasted (in 2000, 2008 etc) , and more transparency is certainly needed. But, is there a better alternative?
Radha – I am not saying that Capital Markets don't add real value. Allocating capital where it is most efficiently used is of enormous value to the economy, even though it may be perceived to be just "moving money around". But there is something going on, which is probably regulatory in nature, which has allowed it expand unfettered. For instance, the regulatory framework protects the three credit rating agencies which allows these analyst firms make lots of money on debt instruments when their counterparts in the equity markets make much less in a highly competitive industry.
Sometimes the regulatory structure of an industry can cause it to expand without any resistance. Healthcare is one such example. Is Wall Street another? That's the question
When the Politician , Business man and Market regulator becomes best of buddies , start dining together and nodding head in heartful applause its time to sense the trouble .It then becomes a binge where blind leads the blind .
And in case of Paulson and Greenspan they were part politicians, part businessmena and part market regulators in different Avtars ……what else could you expect ???