Wry & Dry

Bankers reel in the dosh. Why?

W&D dined with a delightful client during the week.  The client opined as to why bankers (i.e. investment bankers, etc) earn much more than people of similar qualification/ experience levels.

In the interest of science, W&D has done the research.  And, as it were, contra Ms Gillard, the science is not settled.  However, there are a number of themes.

W&D should disclose, as if he were a parliamentarian disclosing financial interests (but before being found out), that he was once a 'merchant banker' - the forerunner to today's investment banker.  But pleads that this was the early and mid 1980s, before the financial-compensation regime exploded.

And, in any case, W&D worked hard for the money...

But, back to the issue.  As the research of Philippon and Reshef* showed, and can been seen from the chart, the compensation of US financial executives, broadly defined, leapt in the mid 1980s and then raced away from other sectors after 1990. 

This extra-ordinary divergence, called the 'financial premium', was, and is, largely driven by excessive compensation at the top of companies**.  

At the top of a Wall Street investment bank, base compensation is, sort of modest, about $350,000 p.a.  Of course, the cream is in the bonuses, which in a good year comfortably exceed $2m.  Plus. 

Bankers wages

The 'financial premium' is now extraordinary.  Source: Philippon and Reshef (2006) 

W&D won't bore readers with more data.  Please accept the facts.  Or just go down to any Socialist-Left demonstration and hear a rawer, ruder version of the facts.

The question is why isn't this market efficient? 

1.  Regulation/ de-regulation

This is the main reason.

Before the 1930s there was an asymmetrical regulatory framework. Then came the Wall Street Crash of 1929.  And the industry became more tightly regulated.  Government guarantees prevented financial panic, but the separation of banks and investment banks meant that it was difficult to extract excess profits.  A sense of symmetry returned.

This changed with the de-regulation of the financial markets in the 1980s.  But the government guarantees (either implicit or explicit) remained - hence the moral hazard.  Risks were taken, knowing that, generally, the profits would remain privatised and the losses would be nationalised.

Blend this with technology that allowed bankers to capture arbitrage profits (i.e. taking advantage of price differences in two different but related markets) and to circumvent regulation and the recipe for excess profits and hence excess financial markets' compensation was born.

Overlay this with the massive lobbying ability of financial institutions to guide regulators and lawmakers to look after Wall Street and the situation has returned to asymmetry.  

2.  Size of deals

The size of transactions (i.e. mergers, acquisitions - M & A, etc) has exploded, but the commission rates remain the same.  A $5b deal at 1% is a mere $50m in fees.

In 2015, the total of M & A deals was $4.3 trillion.  There were 9 deals valued at $50 billion or more and 58 valued at $10 billion to $50 billion.  Goldman Sachs advised on $1.6 trillion of deals, J.P. Morgan $1.5 trillion and Morgan Stanley on $1.4 trillion.

These profits don't trickle down to senior executives, they deluge down.

3.  Low non-compensatory overheads

There are no factories, machines, supply chains.  Just a few people and an office, as it were.  Plus some technology.  That's why operating margins are so high.

4.  Barriers to entry

You cannot quantify the reputations and relationships of the people.  It can take 20 years to get to a position of serious trusted adviser.  Quite a barrier to entry.

5.  No-one, in this industry, wants lower fees

The gravy train is massive.  7% on IPOs and 1% on mergers & acquisitions when little risk is taken.  But no-one wants to gain market share by lowering fees.  That would be seen to be offering a lower quality service.  When undertaking massive transactions, company executives want the best advice for which the shareholders can pay.

For the bankers, it is far better to differentiate on other grounds.

6.  Information

With all the disclosure that is now required, everyone knows what everyone else earns.  And no-one wants to be paid less than than he/ she believes is merited.

W&D just looks at the law cases about people suing to get greater compensation.  It is always about what other people got paid in a similar role, not what was merited by the value added or the role.

No justification

At the end of the day, W&D senses that the financial premium cannot be justified by added economic value (similarly to the fees enjoyed by directors of inert Australian companies - 17 of the 20 Leaders, for example - but that subject has already been addressed).

But it remains. 

*The Quarterly Journal of Economics Vol 127, Issue 4, Pp 1551-1609.

** This has been confirmed in a number of other studies.  See, for example, Ken-Hou Lin, The Financial Premium in the US Labor Market: A Distributional Analysis, Social Forces, Vol 94, Issue 1, Pp 1-30.

# Source: Dealogic.