Why Bankers Will Continue to Make Just as Much as They Used To

I can understand the brouhaha over banker pay. Bankers make a lot of money. And the seeming unwillingness of the banks to lie low on the compensation front for even a quarter or two makes me wince.

Case in point, this New York Times article: After Off Year, Wall Street Pay Is Bouncing Back

Even as the industry’s compensation has been put in the spotlight for being so high at a time when many banks have received taxpayer help, six of the biggest banks set aside over $36 billion in the first quarter to pay their employees, according to a review of financial statements... If that pace continues all year, the money set aside for compensation suggests that workers at many banks will see their pay — much of it in bonuses — recover from the lows of last year.

Yes, bankers will get paid as much this year as they did before the financial services meltdown.

Another number in the article jumped out at me: "Historically, investment banks have paid workers about 50 cents for every dollar of revenue." This is surprisingly similar to the amount paid to employees of ad agencies and other marketing services firms. It is also surprisingly similar to the amount paid to consultants and lawyers (adjusting for the implied equity-ownership pay in partnerships.)

The headcount-expense/revenue ratio in professional services firms is so universal because the economics of salaries and revenue are linked. We (and the mass media) tend to think of firm revenue being set in one supply and demand market and eexpenses being set in another and firms forming only in that uncommon circumstance where the revenue is enough to support the expenses. This may well be true for companies that make widgets: whether or not the widgets are made is a consequence of whether or not they can be made for less than they sell for.

But in a professional services firm, this is not how it works. The demand for the firm's product is also the demand for the underlying labor, so these demand curves are linked in a simple fashion. The supply curves, obviously, are also linked. Because of this--and the industry dynamic it creates--professional services salaries are the amount left from firm revenue after rent, technology and returns to equity-providers are paid*. Since these other amounts are generally within a small range of percentage of firm revenue, the amount paid to employees will be as well.

If you think bankers make too much money, focusing on how much they are paid will get you nowhere. If they are not paid 50% of firm revenue, they will go to another bank that will pay them that much. If no bank will pay them that much, they will go start a new bank. If that sort of compensation is outlawed at any bank present or future, they will start a bank where they are the equity owners and get paid that much. The money has to go somewhere, and it's not going to go to the providers of capital because the providers of capital to professional services companies have no negotiating leverage.

Taxes would work. In most of the business world, it seems that the highly compensated are paid on a de facto post-tax basis, so if taxes are raised, compensation is raised to correct for it. But this can't be true under my theory of professional services firms. So that's one way.

But I believe that outsize salaries are the result of a market failure, so why screw around with taxes when we should be addressing the market failure itself? I'm no expert here, so I'm not going to expound in detail my pet theories of why banking services cost so much. But in general I think that financial services regulations are far too oriented around who is allowed to provide certain services and how they are licensed when they should be oriented around actually protecting people who need protection. These two things are supposed to be the same, in principle, but they have not turned out that way.

I know it's easier to get the average person incensed over someone's pay than to get them to think about reforming a market--especially a market the average person could care less about--but I guarantee that no matter what the government does, no amount of bluster over how much bankers make will change their pre-tax compensation a single iota unless they focus on why revenue per employee is so high.

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* Yes, I don't believe payments to owners in professional services firms are the residual profits. And why should they be, when the employees can leave and set up shop across the street with almost no need for equity capital? In the implicit negotiation over distribution of revenue, the employees have all the bargaining power. The equity will be paid a fair return, but will not receive any structural increases in revenue. On the other hand, the equity will continue to bear the majority of the variability in profits. This view, while not the standard economic view, has the advantage of being supported by reality. (It also accounts for why non-partner-owned professional services firms tend to conglomerate, but that's another post.)