This Is the End


Markets, Risk and Human Interaction

October 23, 2009

Why Do Bankers Make So Much Money?

A tenet of economics is that in competitive markets there are no economic rents. That is, people get fairly paid for their efforts, their capital input, and for bearing risk. They are not paid any more than is necessary as an incentive for production. In trying to understand the reason for the huge pay scale within the finance industry, we can either try to justify the pay level as being a fair one in terms of the competitive market place, or ask in what ways the financial industry deviates from the competitive economic model in order to allow economic rents.
Do the banks operate in a competitive market?
No one expects competitive levels of compensation when there are deviations from a competitive market. In what ways might the banks – and here I mean the largest banks and those banks that morphed over the past year from being investment banks – fall away from the model of pure competition?
One way is through creating inefficiencies to keep competitive forces at bay. Banks can do this, for example, by constructing informational asymmetries between themselves and their clients. This gets into those pages of small print that you see in various investment and loan contracts. What we might call gotcha clauses and what the banks call revenue enhancers. And it also gets into the use of complex derivatives and other “innovative products” that are hard for the clients to understand, much less price.
Another way is to misprice risk and push it into other parts of the economy. The fair economic payoff increases with the amount of risk taken. If a bank takes on more risk it should get a higher expected payoff. If the bank can get paid as if it is taking on risk while actually pushing the risk onto someone else, then it will start to pull in economic rents. The use of innovative products comes up again in this context. They provide a vehicle for the banks to push risk to others at a less than fair price. Or, they can push the risk onto the taxpayers by hiding the risk and then invoking the too-big-to-fail protections when it comes to be realized. The current “heads I win, tails you lose” debate centers precisely on this point.
A third, and most obvious reason banks might not be economically competitive entities is the organization of the industry. There are barriers to entry. No one can just decide to set up a major bank. And there are constraint in the amount of business any one bank can do. As we have seen with Citigroup, there finally are diseconomies of scale – after a point the communication and management issues make the bank less efficient and more prone to crisis. If there is fixed supply, then the banks can push up the price of their services. The crisis over this past year has made matters worse. If you are one of those still standing, you are a beneficiary of that crisis, which has choked off the supply even further.
Are the workers getting paid fairly for their efforts?
An alternative to the idea that the industry is not competitive is that the industry really is competitive and those who are getting these outsized paychecks are being fairly compensated for their efforts. This comes back to the term we hear bandied about in conversations on banker compensation: talent.
There is no denying there are many smart people in the banking industry. (Though I think from a social welfare standpoint, we might have done better if some of those physicist and mathematicians that populate the ranks of the banks had found greener pastures in, say, the biological sciences). But I don’t buy the notion that there are so many who have the level of talent that justifies tens and even hundreds of million in compensation. I think this level of compensation, and the notion of talent behind it, is the result of the inherent uncertainty in the financial enterprise, one that makes it very difficult to assess talent. Indeed, I think the invocations of talent for money producers in finance are akin to those that, in times past, were set aside for the mystical powers of saints and witches.
Far more than other fields of endeavor, it is difficult in finance to tell if someone is good or lucky. A top trader or hedge fund manager might have a Sharpe Ratio of 1.0 or 2.0. But that Sharpe Ratio is nothing less that a statement that if you get a hundred people trading, a few will do well just by luck. (And it doesn’t matter if that Sharpe Ratio occurred over the period of one year or twenty – though the greater sample size helps, it is still the same point in terms of statistical inference, so a long track record does not get you away from this problem).
How does this tie in with saints and witches? People want certainty, and if they can’t get the certainty they want from the empirical, they fall back on superstition and witchcraft, or at least they used to way back when. In some medieval village, a priest prayed and a supplicant was healed. The odds that the supplicant would have healed spontaneously was whatever it was, but there was more of a sense of certainty to feel that it was the manifestation of healing power.
There were false saints and true saints. The difference between them became manifest over time by how frequently the prayers were answered with affirmative results. Not that any saint had to bat a thousand. Sometimes there were understandable, exogenous circumstances that inhibited the saint’s healing talents from being operative, most commonly a lack of righteousness on the part of the supplicant, occasionally an inevitability, a higher power that overshadowed that of the saint. Maybe the will of God, maybe an unknown, evil curse.
I hope the analogy is apparent. And there is a related one, an analogy to Pascal's Wager. The bank should wager that the talent of its star employee exists, because it has much to gain over time if it does, while if it does not exist, the bank will lose little in expected terms. And in a competitive world, it is even worse if they incorrectly let the talent go for lack of proper compensation, because then some competitor will pick it up.


  1. Rick,

    I agree with your premise. Without a true economic moat, the margins in standard banking appear unjustified. lending money is a commodity business after all. The answer to high upper management pay is that these people are treating their organizations as large out of the money option sales, loading up on risk.

    The risk is ignored by boards etc. as they are blinded by the amazing cash flows and resultant income growth. Any commodity business without a visible or apparent economic moat is mostly likely engaging in some form of temporal assymetric risk. The outliers tell the story. In a commodity business (lending), the cheaters (over risk takers) / without regulations effectively gain market share with cheaper offerings.

    This was long ago highlighted and managed in insurance.

    Structured finance is a tool of risk obfuscation more than anything. Structured vehicles once blessed by ratings agencies become cashflow machines and "turbo jets" which allowed the passing of risk. Again outsized margins in a moatless business are highly suspect.

    Ironically many of those same people would argue the "moat" or skill which placed them above their peers at the time was superiour risk management. My own belief is that superior risk management is not embodied in tools, models or regulation in so much as it is in behaviour and humility. the tools, regulators, peers and models can be wrong for a long time.

    The true test of character is to walk away from "free money" while a crowd rushes towards it. This may mean stepping away from a career as a CEO of a bank, but it is the right thing to do. The recent Brooksly Borne video on PBS is an excellent example of true character and integrity.

    Nick Gogerty

  2. The first question and your discussion of it seem misdirected. We want to know whether financial labor is a competitive market, not whether the financial industry operates in an efficient market. If banking isn't a competitive industry then economic rents could just as easily accrue to shareholders or cartel members other than executive employees and traders.

    So does financial labor operate in a competitive market? Your discussion of the second question suggests one reason it might not: shareholders and directors have deluded themselves into attributing to talent what is actually just luck. Do you think this is in fact the case? That to some degree the best paid finance workers are overpaid (i.e., collecting rents) because (A) no employer can discern innate skill, but (B) there are enough employers who would rather take the risk that some portion of an employee's past performance was luck than risk losing that employee to a competitor who is willing to attribute more skill to past performance? (But shouldn't this happen in every labor market where skill is difficult to distinguish from luck?)

  3. Agree with the broad story but here is one error.

    Sharpe ratio does have its problems but it is not correct that a 20yr Sharpe ratio and a 1yr Sharpe ratio are the same thing in terms of statistical inference. Sharpe ratio and t-statistic (as a standard measure of statistical significance) are proportional by the square root of sample size. Thus, a given Sharpe ratio has more than 4x larger t-stat if it is over the 20yr window.

    Even when it comes to non-normalities / peso problems, the 20yr window has many more chances to see rare events than the 1yr window.


  4. That's right. I have adjusted to post to prevent a misunderstanding.

  5. I'm a confused here.

    What is your actual point about long track records (10+ years) with high Sharpe Ratios (1.0+)?

    Are you saying that it is hopeless to try and identify great hedge fund managers and traders?
    Are you arguing for an entirely different compensation scheme for hedge fund managers?
    Are you saying that there are billionaires in the hedge fund community who have no edge or talent and became billionaires through sheer luck (obviously crooks don't count in this question)?

  6. Well we all know how executive compensation has grown like crazy in the last 25 years (compensation consultants to blame?) and investment banks have a very flat organizational structure. So perhaps it's as simple as: you have to pay the analyst a lot because you pay the CEO $20 million and there's not as much that separates the two as at most companies.

  7. Hi Sir,

    Thanks for explaining a very pertinent notion. However, I don't completely agree with you on the two sub-questions.

    "Do the banks operate in a competitive market?"

    Contrary to your viewpont, I think that banks operate in a market which is as competitive as any other competitive market we can think of.

    For the first point that you mentioned, I find that in the financial sector (FS), the basic premise of perfect competition still holds, i.e. there are multiple sellers and buyers, and all sellers are price takers. In the FS, if a company raises price without improving its product offering, customers can easily switch to its competitors, given the higher mobility of the resources. Admittedly, that doesn't mean the absence of information asymmetries because however the best intentions of sellers, not all clients have wherewithal to understand subtleties of every financial product. And even if they have, they don't always want to expend their energy in doing that.

    Moreover, I think it's wrong to assume that only banks should bear the fallout when things turns bad, whereas clients only reap benefits. Clients, along with the financial institutions, have to bear both rewards and pains of the market, as is applicable in a capitalist economy.

    I don't think that barriers to entry in the banking industry in the US is high, given that there was 8,430 FDIC-insured commercial banks as on Aug. 22, 2008, as per FDIC. And as far huge size of the bank and ensuing (dis)economies of scale are concerned, these are equally applicable to other markets also.

    "Are the workers getting paid fairly for their efforts?"

    I agree with you all who get hefty paychecks in the FS are not deserving. Perhaps. this is due to fact it's very difficult to differentiate between real and fake talent. However, this problem with varying degree has persisted in every sector for many decades.

    And some (or many) time companies don't even bother to look at performance before doling out hefty bonuses or promotions, as suggested by a famous study done by Fred Luthans et. al. in field of the Organizational Behavior.

    In the study, Fred Luthans et. al. answered a question "Do managers who move up the quickest in an organization do the same activities and with the same emphasis as managers who do the best job?". And answer to question, as per study, was that social managers were more successful than effective managers in terms of promotion, salaries and perks. I guess anyone who has worked in any company must have observed this.

    So, I believe that the financial industry is only a model of the whole system, and it just manifests the problems that plague our system.


  8. Rick:

    I'm a little confused and I'd appreciate your assistance.

    Could you please compare and contrast financial industry profitability/compensation with those of Major League Baseball, the National Football League, the National Basketball Association, and the entertainment (movies/television) industries?

    All of the industries that I mentioned have excessive returns (or potential returns) and compensation structures throughout their business that many would consider excessive (even more than investment bankers). Each of those industries benefit, as part of their business models from government beneficence, (as opposed to the finance industry, which, aside from insured deposits, has had to bear regulatory COSTS in their business models - but, of course, needed assistance to prevent the collapse of the financial system).

    I really don't understand how network anchors can complain about banker salaries with a straight face. The news tends to be a loss business for the networks (part of the social bargain to pay for their monopoly of the airwaves), but anchors are paid quite well, more than one could seemingly justify from their contribution to society (and from a supply/demand perspective).

    In fact, while the banking industry is a critical component of the world economy, the other businesses don't exactly add to society (not like physicists, medical researchers, etc. anyway). You can't conduct scientific research these days without functioning financial markets.

    I know that the Government (and, therefore, we as taxpayers) had to invest TRILLIONS to fix the problems in the financial markets. It should be pointed out, however, that ALL OF SOCIETY benefited from avoiding the cataclysm that would have resulted from a failure to act (not just the financial institutions). Nor were financial institutions the only culprit in the creation of the problem. There was complicity from home buyers, mortgage brokers, regulators, and elected officials in the creation of the bubble.

    Willingness to endure the massive trade deficits and budget deficits also was a major contributor. China owns our bonds because they needed to both keep their currency low and sterilize the funds from exports to avoid inflation at home. We became addicted to their cheap products and they were our willing dealer as we borrowed, and spent, and let our industries die.

    I'm not arguing against free trade, but that was a MAJOR contributing factor because of the impact on the yield curve - leading investors to seek yield in the riskiest places (and made them willing to believe that 90% of a pool of sub-prime mortgages could support a AAA rating).

    I'm interested in your thoughts when viewed from that perspective.

    You might find it interesting that the minimum NFL salary in 2009 is $310,000. The minimum salary for a Major League Baseball player this year was $400,000. The NBA has a graduated schedule, depending on years in the league, with the minimum for a rookie in 2009-10 of $457,588; $736,420 for a second year player; up to $1.35 million for veterans with 10 or more years in the League.

    Those are the minimum salaries for THE BENCHWARMERS!.

    When compensation of most people is considered from a "life isn't fair" perspective, it will seem outrageously high (or, as in the case of teachers, low).

    I hope you are doing well and I look forward to your next book (it's been to long since the last).

    Yours truly,

    Larry Loeb

  9. I highly recommend reading Fool's Gold by Gillian Tett if you want to know more about credit derivatives, how it began at JPMorgan as well as how it became a devilish instrument to make huge profit on subprime mortgage.

  10. Larry,

    Your sports analogy does not really work here for a number of reasons:

    1) It's much easier to distinguish talent in sports. After watching a player for a year, you know whether the player is good vs. lucky. After a year of returns it's hard to distinguish alpha from noise in finance.

    2) There is little agency / monitoring problems in sports. A better analogy may be that you have a bad or mediocre player who gets paid millions because they have tremendous influence on the board that manages the team.

    3) Football players actions do not cause or contribute to a meltdown of the whole economy requiring trillions in bailouts.

    You seem to be supporting both the bail-outs and the salaries, which makes no sense. What would stop me as a banker from writing out of the money puts and receiving a bonus, and getting a bail-out when the put gets in the money?


  11. This comment has been removed by the author.

  12. Athletes are in the entertainment business; their pay is derived from what people pay to be entertained. Athletic performance may or may not matter; charisma and public notoriety are also valuable to the employer. The leagues are also monopolies.

    Bankers? Well, there are similarities.

  13. Finance and sports aren't really comparable because the wages in sports are almost entirely supported by people with essentially full knowledge of costs and products paying a price to voluntarily watch high-level sports. I disagree with the government/public subsidy of sports teams, but you have to realize that people pay the price to see the Red Sox because they want to see good baseball. You can see that people place a value on watching the best players because cheap/free baseball is widely available at high schools, colleges, and minor league stadiums.

    In finance, I'm comfortable with the compensation of hedge fund managers because it's similar to the sports model (wealthy people are willing to pay a premium for what they see as the best, in spite of cheaper alternatives such as Vanguard). I have more of a problem with institutions that have captive uninformed customers or institutions that compensate executives on arbitrary standards and then need bailouts because of inadequate retained capital.

  14. Rick,

    What percentage of these "bankers" are actual in sales. They have titles like "senior account executive" or "product specialist" but they are working with customers to sell products. It is difficult to assess correct compensation for a lot of sales jobs.

    Did the realator who sold a $10M house do $600k worth of work? Probably not, but would the house have sold 6% less without their work?

    Does the software salesman deserve 2% of revenue because of his talent, or did he just fill out some paperwork for a customer that had already decided what he was going to buy?

  15. Ironic that what we really need is a lot more banks and bankers to enable more competition. Best way to do this would be to make it much easier to be a bank, i.e. a whole lot less regulation, capital requirements etc. If politicians want bankers to have lower salaries they should remove much of the regulations, and let competition (battle) commence. Oh, but instead they want more regulation. Lovely!

  16. Rick,

    I would disagree with you on one major point. I think the reason traders and bankers are overpaid is that one can be so precise about the dollar value of their efforts. It's not at all clear to measure exactly what the value of one IBM programmer's work is, but at the end of the year you know exactly how much P/L to credit a trader with.

    This makes the market more efficient in that a trader can "prove" his value.

    Of course, people underestimate the effect of luck on trading results, as well as the possibility that the trader may be taking huge "tail risk" and the value of the seat at the trading desk--which should belong to the firm and not the trader.

  17. Rick,

    On your part about talent driving banker compensation, I think that analysis pertains more to trading than IBD. Why do MD's in IBD get million dollar bonuses? Because they have the human capital (i.e. networks) to source deals. In M&A advisory there's hardly any risk to the firm and for capital issuances the bank's balance sheet is leverage, but that's hardly risky compared to prop trading.

    Speaking strictly to the IBD side, I would say that it is competitive - you've seen legions of rainmakers leave TARP banks for boutiques because of the TARP restrictions and the uncertainty the government has created. In that business, it's much more the relationship with the banker rather than the brand of the bank that pulls these deals.

  18. Yes, I am thinking more about trading, but some of this related to IBD, too.

    IBD somehow managed to argue for a percent of the deal rather than an hourly fee, which makes the lawyers who work side by side with them understandably disgruntled. I think it could have easily been set up to be an hourly pay scale.

    That no one is willing to drop their fees or go hourly suggests either barriers to entry (which I mentioned in the post) or limits to competition by price.

    One argument I have heard is that just as someone will go to the best heart surgeon he can find when his life is at stake, so a CEO will go to the best investment banker when his role and business is on the line. But I have two thoughts on this. One is akin to what I was writing regarding saints and witches. How can you say one is so much better than another. The second is the heart surgeons don't charge based on a fraction of the patients wealth.

  19. For those of you in the Bay area, swissnex San Francisco is holding an event in which Peter Bossaerts, professor of finance at the California Institute of Technology, explains what economists mean by the term "competitive markets," what the markets are theoretically supposed to do, and where they fail. He’ll also evaluate whether or not eBay, the New York Stock Exchange, the real estate market, the Over-the-Counter credit derivative markets, and other institutions are really instances of "competitive markets." Bring your laptop to participate in hands-on demos of market behavior.

    More info:

  20. Rick,

    On the topic of percent of deal vs. hourly billing, I agree with you to some extent. I would say though, that the reality of corporate finance-related fees is somewhere in-between a flat percentage and hourly billing. The reason I say that is that firms typically use a downward sliding scale for fees (i.e. 2% of EV for deals under 25MM, 1.5% for 25-50MM... 0.2% of 10B plus etc.). So you would see fees go from 0.5M for a $25M EV deal to about 5M for a $1B deal. Banks run a fairly tight ship compared to other large corporations and so understandably, a more complex deal warrants a higher fee - and I guess you could also factoring more reputational risk on higher profile deals. Another aspect to consider is that a lot of times the deals will fall apart and that these % fees are mostly completion based. Divided out divided out to an hourly basis among all the guys who worked on it, it might turn out to be minimal.

    On the equity side, it's usually a flat % of the offering but I think that's fair because that reflects the balance sheet risk (since there isn't much of a difference in terms of time spent putting together say a 10M offering vs. a 100M offering). Versus laywers, I think it's fair as well. Yes there's more paper work, but they don't do too much value-added work for most deals. A lot of the stuff will be menial tasks that almost could almost be automated (title searched etc.).

    As for the surgeon analogy. I totally get what it's trying to say, but I would have to say it's incorrect. M&A advisor's don't charge based on wealth (i.e. how big the company is) - they charge based on the deal size, which is analogous to how complex the job is - whether that is a single bypass surgery or a qudruple bypass. While I don't know for sure, I would expect that the more complex surgery to be much more expensive since it requires a lot more resources.


  21. I think what Rick is trying to say is give me 2%/20% of the lifetime earnings of every baby I deliver - it's the same as RJR buying the annuity that was Nabisco. I don't think it is just the deal - it's the cashflow and I would like a piece of the cashflow of every patient I see whose life I save.

    Unfortunately, I don't have the market power to price my labor that way, i.e. is it market power that allows bankers to price their labor so high? It is a commission business that has over time grown to the disadvantage of our 401(k)'s at a minimum.

  22. Hello from Russia!
    Can I quote a post "No teme" in your blog with the link to you?

  23. In answer to the last comment:

    I am happy to have you link to my post or quote from it. Also, you can send me the link at, since I will be curious to see it in a Russian outlet.


  24. The Supreme Court is going to hear a variant of this issue in Harris v. Jones.

    "They will throw a spotlight on fund fees and on the debate over whether market competition--if it truly exists in the fund industry--is enough to regulate retail fund fees. They will also draw attention to fund boards and their effectiveness in policing fees."


  25. Might I suggest that anyone seriously interested in exactly what banks do and how credit distorts the market read the paper:

    The Capitalistic Renaissance

  26. First I think it was Jesse James who was asked why he robbed banks, said "that is where the money is".
    The folks that want money go to where the money is. Bakers get fat, bankers get rich.
    The biggest problems with it is they were able to shift risk off of themselves and onto the ME! the god damned PISSED OFF TAXPAYER!
    AIG SHOULD HAVE FAILED. Solomon and Citigroup should have gone bankrupt! Let them feel the full force of the risks that they took.
    The boards and officers of the companies be personally sued by the stock holders they ripped off. Then they would have earned the big paychecks when they win. Now they just pay a premium to the big 2 political parties and get off with a bailout when a problem arises. They give themselves raises because they knew enough to pay off both sides in the election. This has nothing to do with Capitalist markets and everything to do with payoffs and bribery. How many people in the Bush and Obama admins worked for companies that got bailout? TOO MANY!
    How many will get cozy jobs afterwards? TOO MANY! I don't mind them reaping the rewards if they are going to pay the price for losing.
    FREEDOM to win or lose.

  27. Our perspective is that "information asymmetries" traditional and (maybe) manageable in merchant banking/institutional transaction where caveat emptor is accepted.

    We would propose however, that as the nations wealth, and especially that of the massive Boomer retirees, comes to dominate the capital markets, globally, we are entering an era of "insti-individual" markets.

    Not having a strong, institutional counter-party and predominantly "retail" customers, shifts informational asymmetries quickly to breeching fiduciary duties, bad faith and fraud.

    You can NOT apply traditional merchant banking business models/practices to people's life saving - or their home equity. The social fabric is threatened.

    Couple of historical fables:
    - I read the early, growing Greek cities and democracies were severely challenged when they expanded in Asia Minor. An acute problem, which they solved by banning traders from the agora, was the ME traders lied doing business. The traders took "info asymmetry" as standard business practice! Something the Greeks hadn't experienced before!
    - It is said that Hitler came to power mainly because of the social disruption caused by the German governments inability to pay the WWI veteran's pension benefits. Hence hyper-inflation.

    Human nature hasn't changed much and NEVER mess with retiree's pensions - economic security = Teabaggers.

  28. Perhaps an intelligent thing to do would be to tie banking executive pay to our national economic well being. When the economy is good, they get a "good" pay check. When the economy is booming, they get a "booming" pay check. Hence create the incentive to reward nationally beneficial behavior and to punish nationally damaging behavior.


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