How the bailout feeds bloated banker pay
Rising pay in the finance sector in the wake of the global financial crisis is no surprise and is driven partly by the government’s bailout itself and the underwriting of banks that are too big to fail.
News that some financial firms benefitting from government largesse actually increased the share of revenue they pay their employees sparked a lot of outrage but more heat than light.
The good news is this new bulge in pay may not be sustainable.
The bad news is it will probably only be stopped by further regulation, regulation which may never come.
To understand what is going on you need to understand the economic concept of “rents”, essentially the extra money a given individual or industry is able to extract from its clients above what it would be able to if there was perfect competition.
A monopoly will charge a very high price for goods or services because, well, they can. Needless to say economic rents are not a good thing, unless of course you are in receipt of them.
Workers in financial services have been huge beneficiaries of economic rents in recent years. They sell products which are complex and poorly understood by clients. They have been very lightly regulated, and it has been hard in many areas for start ups to compete with large firms and drive down prices.
A study by economists Thomas Philippon of New York University and Ariell Reshef of the University of Virginia found that about 30-50 percent of the extra pay bankers get as compared to similar professionals is attributable to rents. <http://people.virginia.edu/~ar7kf/papers/pr_rev15_submitted.pdf>
In other words, banking is able to overcharge its customers and bankers are able to capture a huge portion of that for themselves. Why? Because they don’t face enough competition, their products are too complex for clients to be able to understand and bargain effectively, and crucially because regulation allows for this state of affairs.
Rising complexity, in my view, has probably been fuelled at least in part because it drives margins and tilts power away from bank clients and shareholders and to employees.
“The more complicated the product the easier it is for people to hide the risks,” Reshef said in an interview.
The study shows that excess pay in banking is very closely linked to lax regulation, as opposed to higher productivity or early adoption of technology.
Relative compensation in finance in the early part of the last century peaked not in 1929 before the crash but several years later just before the more stringent regulations kicked in. Relative compensation began to climb again in the 1980s as deregulation happened and rose like a rocket since 1990.
WHAT JUST HAPPENED??
The economic crisis, far from undermining circumstances that allow for rents and excess pay, has in some ways cemented them.
One area of complexity, asset backed finance, has been eviscerated but many others still sail on relatively unaffected.
Most importantly, the doctrine of too big to fail has confirmed and reinforced the superior market position of those banks and investment banks which still survive.
The U.S. has essentially made it known that the current players will not be allowed to fail. These banks had an advantage already based on their size, that advantage is now greater and carries an implied government guarantee.
Ladies and gentleman, this is your banking recapitalization program: an unfair playing field. I might be able to swallow that as the economy needs a banking system. But, if you believe Reshef and Philippon’s data, a goodly part of the essentially unearned money that should be going to recapitalize the banks is ending up instead overpaying the bankers.
It is true that part of the reason banks are paying their best people so much is that a tectonic shift in banking will place a higher premia on the most talented. Fair enough, but only if we see a shrinking pool of compensation money being tilted towards a smaller elite.
The rise and rise of the rents extracted by bankers from the economy will only really be stopped by government intervention, since, given we have a system of bank insurance, it only really can exist with government connivance.
You could make good progress controlling excess compensation and banking rents by placing limits on size, by taxing complexity (which after all hasn’t really served us well), and by limiting the use of leverage within the parts of the system that can make a call on the taxpayer.
If you look at the Great Depression, this process will take about four years. We’ve not made a very encouraging start.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )