The social cost of runaway bank pay

By Christopher Swann
August 18, 2009

If only the economy were bouncing back as fast as banking compensation.

Even as the first anniversary of the collapse of Lehman Brothers draws near, bankers and traders are now grabbing a larger share of their institutions’ net revenue than they did during the boom years. The leading U.S. banks are on track so far this year to pay their employees $156 billion — more than in sunny 2006.

Politicians have focused mostly on whether the bonus structure can be changed to discourage bankers from making reckless bets with their shareholders money. But a bolder solution to excessive banking pay is necessary. It starts with a simple question: Are bankers paid too much? The answer is a resounding yes.

Everybody enjoys a bout of cathartic outrage over the pay of reality TV personalities and sports stars. At root, however, we must accept that these salaries are determined by the free market. The same is not true of investment banking.

Even those banks not currently financially dependent on the largesse of the federal government clearly benefit from an implicit guarantee. Governments of every political hue have clearly demonstrated that they are unwilling to let large institutions fail. This enables financial institutions to take risks that a toothpaste manufacturer could not. Bankers took full advantage of this subsidy before the crisis and are starting to do so again.

A report by London-based Smithers & Co., while issued before the crisis, shows how that dynamic continues to work. Smithers found that the median nominal return on equity in banks towered above those in other sectors.

“With higher leverage than other industries they could achieve 20 percent returns compared to an average of 8 percent elsewhere,” Andrew Smithers said in a telephone interview. The downside of the banks’ high returns is high risk, much of which is born by taxpayers. This has become more dangerous since offsetting regulations limiting risks were dismantled.

The opaque nature of the business also makes it easier for financial professionals to capture a “wholly disproportionate share from the returns in the productive economy”, says Paul Woolley, an academic at the London School of Economics who set up the Center for the Study of Capital Market Dysfunctionality.

Before the crisis, financial services peaked at around 40 percent of total corporate profits. “Financial services are by far the largest item in most people’s budgets,” Woolley says.

Since the fees are hidden or opaque, however, this causes little resistance. For example, various layers of management fees reduce by at least half the gross returns that investors
would otherwise reap from equities. (Research by Kenneth French at the University of Chicago suggested that investors spend about $100 billion a year trying to beat the market.) Consumer financial products are seldom more transparent.

Nor, Woolley argues, do the activities of the financial sector add as much value as they claim. The boast, for example, that financiers funnel savings to their most productive use is overdone. As fund managers compete to beat the market they are often forced to follow trends. This momentum trading causes an over-allocation of capital to frothy sectors — as seen during the Internet bubble.

Realizing that as a society we overpay for financial services is the first step. The second is proper regulation. A study by Thomas Philippon and Ariell Reshef for the National Bureau of Economic Research concluded that the premium paid to bankers compared with similarly qualified workers in other fields gradually disappeared after the introduction of strict banking regulation in the 1930s.

The premium — between a third and a half — only returned after these controls were relaxed in the 1990s. Forcing banks to hold enough capital to pay for their own risks is the key. A powerful Consumer Financial Protection Agency in the U.S. could also ensure that financial professionals are not being overpaid simply because their products are difficult to understand.

Woolley also makes a strong case for a Tobin tax on transactions — reducing the wealth-destroying churn of financial assets.

Excessive banking pay is a social ill. The sector has long sucked in far too much of society’s brightest graduates — putting them to tasks which often have little social value and at worst are parasitic. Politicians should not regulate bank pay directly. But lower compensation for bankers will be a sign that regulatory reform is working.


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