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Sunday, November 8, 2009

They must be good, they get more than 100 percent of profits

 Amazingly, the so-called rainmakers inside the big banks and trading houses take home more than the total profits of the company.  From Nancy Folbre, economics professor at the University of Massachusetts, Amherst.
Banker Bonus Rain
By Nancy Folbre
Economix, New York Times
November 2, 2009

Executive pay at seven large United States companies that enjoyed government bailouts has recently been officially regulated and capped by Kenneth Feinberg. But economists are just beginning to explain how top employees came to receive such extravagant rewards in the first place.

Wall Street firms have always been famous for their generous bonuses to managers and traders — their so-called rainmakers. The graph above shows that employee bonuses have actually exceeded the estimated pretax profits of United States securities dealers in many years.

What is especially striking is the high level of these bonuses in 2007 and 2008, years in which profits were negative.

Patterns are similar for individual financial firms, where a particularly large share of revenue is devoted to bonuses. As one article in The Economist asks, “Are investment banks run for employees or shareholders?” Another article warns of “employee capture.”

(The possibility that some owners are being exploited by some employees is apparently far more disturbing than its inverse.)

Much of the justification offered for current pay caps in the United States rests on indignation about government bailouts. As long as companies are not subsidized by taxpayer money, perhaps market forces should be allowed to determine pay.

But do market forces determine pay the way most economists assume?

Many arguments to the contrary are effectively mobilized by James Crotty, the University of Massachusetts economist, in a recent working paper.

Top executives of financial firms often choose the very board members who are expected to monitor their pay decisions.

Investment banking is a demanding job. “Rainmakers” typically work long hours under high stress. Yet the number of highly qualified graduates from top colleges eager to enter investment banking has typically far exceeded the demand. Why hasn’t the excess of supply over demand failed to drive earnings down?

The importance of personal networks and contacts gives rainmakers leverage. As the Nobel laureate Oliver Williamson emphasizes, the threat of withdrawing from or disrupting productive relationships can give employees considerable power. The apprenticeship structure of the job gives senior managers and traders control over their successors.

The very qualities that contribute to success on the trading floor — including aggressive use of technical expertise — may be deployed in joint efforts to reduce competition from new job entrants or to weed out those unlikely to demand super-high compensation.

In any case, highly paid employees in finance earn large premiums compared to their counterparts in other industries — pay differences that persist even when virtually all measurable differences in individual characteristics are taken into account. A recent National Bureau of Economic Research paper by Thomas Philippon and Ariell Reshef describes such premiums as unearned “rents.”

Deregulation made it easier for rainmakers to conceal risks that short-term profits would morph into long-run losses. The oligopolistic structure of the industry — now more concentrated than ever as a result of bank failures and mergers — made it easier for them to collude.

Financial firms are investing heavily in lobbying to block efforts to make the industry more competitive. Their rainmakers are still pretty good at making rain for one another.

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