Why Do Wall Street Bankers Get Paid So Much?

Raj Date1

January 17, 2010

It’s bonus season on Wall Street, and the joyous hallmarks of the season here in Lower Manhattan (e.g., crowds in the usually desolate Hermes and Tiffany outlets) are this year accompanied by the decidedly less festive drumbeat of public outrage over banker compensation.

This is, of course, not the first time since the onset of the financial crisis that bankers’ compensation has come under such close scrutiny. But for the most part, and despite the most tinny of ears, the industry has so far side-stepped any major legislative clampdown on pay practices.2  Without question, though, compensation will invite closer regulatory scrutiny in the future.  The Federal Reserve is already working towards better calibrating the impact of compensation practices on bank holding companies’ risk profiles.3 

The Fed’s approach, though, has clearly not satisfied the widespread, and profound, sense that something is desperately wrong with financial industry (and, in particular, Wall Street) compensation.  For example, the past week has seen the FDIC propose calibrating deposit insurance premiums based on banks’ compensation structures -- despite the arguably attenuated connection between the two, and over the objections of two Board members.4  And it seems likely that part of the political impetus for the Administration’s “bank tax” comes from the unseemliness of the bonus dollars about to rain down on Wall Street.5

Policy motives, it would seem, are beginning to shift from the belated and commonplace observation that compensation schemes had invited imprudent risk-taking during the bubble.  Rather, some policy ideas now appear to be grounded, implicitly anyway, in something far more basic:  it isn’t so much how bankers are paid -- that is, the system of incentives and the mix of consideration -- it’s that bankers are simply paid too much.6

A Basic Question:  Why Are Bankers Paid So Well, Anyway?

In some circles, even asking such questions is somewhat heretical.  But, for our purposes, let’s assume that compensation levels, even though they are presumably negotiated between consenting adults, are an appropriate issue for legislative inquiry. 

And let’s concede that, by any rational standard, investment bankers’ pay is astonishingly high.  Indeed, it is especially astonishing because, unlike some closely related professional species like private equity investors or hedge fund managers, investment bankers do not typically even pretend to risk any kind of “co-investment” with their clients or employers.  In the vast majority of cases, Wall Street bankers are simply employees, working for wages.  Really, really big wages.7

Finally, for our purposes here, let’s put aside short-term proposals that might or might not be legitimately grounded in retributive motives8, and focus instead on the more fundamental and longer term question of the propriety of high Wall Street pay.

That more fundamental inquiry should start with a fundamental question indeed:  Why are Wall Street bankers paid so much, anyway?  What are the market structures that enable such stratospheric pay packages?  And, given those market structures, if we sincerely wanted to mitigate the tendency towards huge paydays, without resorting to arbitrary caps, how would we go about it?

It’s (Mostly) Not a Market Failure

There is an instinct among self-described free market adherents to declare obviously unpalatable market-based outcomes to be the result of market distortions -- information asymmetry, or agency problems, or externalities, or government meddling, or some other shadowy villain.

Two of those usual suspects are typically blamed for outsized banker compensation.  The first is a kind of information asymmetry:  it is persuasively argued that bank boards of directors systematically underestimate the risk that executives take on, so they myopically over-reward executive performance.  The second putative distortion is a corporate governance problem that is decidedly not confined to financial services:  senior executives have considerable influence over boards’ compensation decisions; that is, they have a great deal of say on their own pay.9 

As Cambridge Winter Center research has described, board governance problems were especially pronounced at large banks during the credit bubble, as much due to shortfalls in director capabilities as anything else.10  But these governance-related distortions do not, as a logical matter, explain away the vast majority of eye-popping compensation.  The pliability of boards might explain the largesse bestowed upon senior executives, but rank-and-file professionals make prodigious sums as well.  And risk-return asymmetry might help explain proprietary trading desks’ massive paydays, but bankers who do not traffic in risk (M&A specialists, for example) are paid handsomely too.

It’s (Mostly) Not Supply and Demand

But if market distortions don’t fully explain Wall Street compensation levels, neither do straightforward labor market supply and demand dynamics. 

To be sure, the supply of qualified candidates for Wall Street jobs is constrained, particularly during the all-too-frequent paroxysms of anti-immigration sentiment.  Bankers must be both numerate and literate, in a way that rules out large swaths of the talent markets that migrate towards engineering, or the law.  And, in general, bankers enter the business at the bottom, which means immensely long and tedious hours for new entrants.  Given the relative scarcity of people with the basic skills and work ethic required, a substantial wage premium should naturally be expected. 

But not this substantial. 

Wall Street staff need not be systematically more numerate, literate, or hard-working than, say, physicians.  Were this simply an issue of supply and demand, the Wall Street wage premium associated with the scarcity of talent should bear some rough similarity to the wage premium enjoyed by doctors.  But it doesn’t.  At equivalent points in tenure, investment banking pays vastly more than medicine.

The Perfect Market Structure . . . for an Employee

The reason for this is that the industry structure of investment banking -- unlike that of medicine or engineering or even the law -- almost perfectly maximizes employees’ ability to capture economic rent.  Specifically, three structural features enable the annual windfalls so characteristic of the industry.

First, investment banks’ clients rarely apply direct pressure on firms to limit banker compensation -- in contrast to, say, insurers’ relentless pressure on doctors’ fees.  Part of this dynamic is fueled by an agency problem:  clients’ decision-makers (like institutional money managers) are very rarely paying their own money for investment banking services.  And, in important markets like equity underwriting or M&A advisory, client executives are not especially interested in finding bargains on what, to them, can feel like bet-your-career transactions.  The plain truth:  no one gets fired for hiring a Morgan Stanley banker to handle an IPO.

Second, the nature of most Wall Street businesses is that, while institutional reputations and capabilities are important, those institutional resources are necessarily brought to bear through the skills and personal networks of individual employees.  Because employees can (and quite frequently do) take their individual skills and client networks to competing firms, as a group Wall Street bankers are able to extract excess economic value from their firms over time.  Compare this to the plight of many engineers, whose value-add is necessarily dependent on tangible and intangible assets owned by their employers.

Third, and certainly most importantly for policy-makers, the sheer size of today’s leading Wall Street firms enables bankers (and, especially, traders) to extract outsized compensation.  When applied to a sufficiently large asset base, even razor-thin marginal differences in talent and capability can mean significant differences in nominal returns. 

Let’s say Adam the senior credit trader is slightly more clever than his rival Bob, and as a result can be expected to gain, over time, one percentage point annually better returns on risk capital.  If his firm only provides Adam with $100 million of capital to manage his positions, his incremental returns over Bob only amount to $1 million per year, and, as a result, his principled argument for incremental compensation would be capped at that amount.  If his firm is ten times larger, and, as a result, is able to stomach a $1 billion capital allocation to Adam, his incremental returns over Bob amount to $10 million.  It is entirely predictable to expect that Adam would seek to capture some fraction of that $10 million for himself.

Ever-larger firms enable employees to scale putative advantages in talent over ever-larger capital bases, and thereby capture ever-larger compensation for themselves.11  And policy-makers have intentionally created a world in which the largest firms have become dramatically larger over time.  Goldman Sachs, for example, ballooned from a $250 billion balance sheet in 1999 to $1.1 trillion by the end of 2007, and even now, after two years of de-leveraging, has more than $850 billion in assets.  In turn, the largest firms create a pricing umbrella on compensation, as second-tier and boutique institutions legitimately fear that they cannot compete without at least coming close to the largest firms’ payouts over time.

The emergence of giant banks might or might not be good for clients, shareholders, or taxpayers; but they are unquestionably great for bankers.

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It might be unseemly, but stratospheric Wall Street compensation is the entirely predictable outcome of rational market actors behaving within an industry structure that is almost uniquely suited to the extraction of economic rent by employees. 

Most of the facets of that industry structure are not especially susceptible to influence or control by policy-makers.  But one facet might be ripe for closer control:  the size of Wall Street’s largest players.  If policy-makers are serious about moderating Wall Street pay, it is yet more reason to evaluate constraints on the size of our largest financial institutions.

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1 Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.   The Cambridge Winter Center is a non-profit, non-partisan think tank focused exclusively on U.S. financial services policy.

2 Recall last year’s media attention to AIG’s bonus payments, and the House’s subsequent, abortive “TARP Bonus Bill”.  See Raj Date, Outrage Abhors a Vacuum, Cambridge Winter Center (March 22, 2009), available at http://www.cambridgewinter.org/Cambridge_Winter/Archives/Entries/2009/3/22_OUTRAGE_ABHORS_A_VACUUM.html, accessed Jan. 13, 2010.

3 Federal Reserve Board, Proposed Guidance on Sound Incentive Compensation Policies, 74 Federal Register 206 (Oct. 27,  2009), pp. 55227-55238, available at http://edocket.access.gpo.gov/2009/pdf/E9-25766.pdf, accessed Jan. 13, 2010.

4 FDIC, Incorporating Employee Compensation Criteria into the Risk Assessment System, 12 CFR Part 327 (Jan. 12, 2010), available at http://www.fdic.gov/news/board/2010Jan12ANPR.pdf, accessed Jan. 13, 2010.

5 The “Financial Crisis Responsibility Fee” proposed by the Administration would assess a 15-basis point fee on non-deposit liabilities, and would apply to firms with more than $50 billion in assets.  By definition, then, the fee would hit hardest those banks that are large and disproportionately fund themselves in the capital markets -- that is, the biggest Wall Street firms.  See Fact Sheet on the Financial Crisis Responsibility Fee (Jan. 15, 2010), available at http://www.whitehouse.gov/sites/default/files/financial_responsibility_fee_fact_sheet.pdf, accessed Jan. 17, 2010.

6 With characteristic bluntness, Barney Frank, the Chairman of the House Financial Services Committee, this week made that implicit notion explicit:  “There is clearly an overwhelming public justification for the regulators restraining incentive or banning incentive structures that incentivize excessive risk. Now we’ve gotten that, and I want to help put some public attention on that. But the question of the amounts is also a relevant one.” House Financial Services Committee, Press Release (Jan. 13, 2010), available at http://www.house.gov/apps/list/press/financialsvcs_dem/press_01132010.shtml, accessed Jan. 14, 2010.

7 Junior associates at major Wall Street firms routinely earn multiple six-digit sums; junior managing directors should, in most years, make well into seven digits; senior executives and the heads of groups or trading desks will not infrequently earn into eight digits.  Historically, most of that compensation, particularly at more senior levels, has been delivered in year-end bonuses.  See generally Douglas J. Elliott, Wall Street Pay:  A Primer, The Brookings Institution (January 11, 2010), available at http://www.brookings.edu/~/media/Files/rc/papers/2010/0111_wall_street_elliott/0111_wall_street_elliott.pdf, accessed Jan. 14, 2010.

8 For example, Rep. Peter Welch of Vermont has introduced a bill in the House that would apply a 50% tax to bonuses by TARP-aided banks in excess of $50,000.  Wall Street Bonus Tax Act, H.R. 4412, 111th Cong. (2009), available at http://www.gpo.gov/fdsys/pkg/BILLS-111hr4412IH/pdf/BILLS-111hr4412IH.pdf, accessed Jan. 17, 2010.

9 See generally Lucian A. Bebchuk, Testimony Before the Committee on Financial Services of the U.S. House of Representatives, Hearing on Compensation Structure and Systemic Risk (June 11, 2009), available at http://www.house.gov/apps/list/hearing/financialsvcs_dem/bebchuk.pdf, accessed Jan. 14, 2010.

10 See Raj Date and Holly Scott Atallah, The Failure of Bank Board Governance, Cambridge Winter Center (Oct. 5, 2009), available at http://www.cambridgewinter.org/Cambridge_Winter/Program_A_files/bank%20boards%20100509.pdf, accessed Jan. 17, 2010.

11 Recall Sherman McCoy’s wife, in The Bonfire of the Vanities, explaining her bond-salesman husband’s job to their daughter:  "Just imagine that a bond is a slice of cake, and you didn't bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that."  In today’s market, bigger firms mean bigger cakes, bigger slices, and bigger crumbs.