Can we criticise banker pay?

25th September 2012

The case for the prosecution is that excessive rewards for risk taking helped create the necessary conditions for a collapse as increasingly large bets failed to pay off. Furthermore they contend that bank bosses conspired to keep wages high in their firms in order to justify their own inflated incomes.

In response, a number of commentators have argued that these companies had to pay the going rate for quality employees for fear of losing them to rivals. As such pay levels were set by the marketplace and employers were obliged either to meet them or face dire consequences.

What does the market do to wages?

In most industries competition helps both to keep wages for talented individuals above average but also acts to constrain them when they become dilutive to profitability. This is because in a genuinely competitive market firms are competing not only for the best employees but also on price. Following this logic, if you can produce higher quality goods at a lower price than your competitors your business is likely to thrive.

For individuals this means that those people who are able to drive innovation or who are most efficient at their job are highly prised. To recruit or retain these people employers will have to pay a higher price than for the average worker, but not so high a price as to counterbalance the productivity gains.

So just as the market helps boost the salaries for talented workers so too it should help restrain them from becoming too high. If employees are being paid more than a company can sustain either wages will have to fall, the number of employees will have to be cut or costs will have to be passed on to consumers. Although the latter may appear preferable, it runs the risk of undermining the cost advantage that a firm may have held by testing the price tolerance of their consumer base.

These feedback loops theoretically ensure that companies remain dynamic and are able to shift their behaviour to meet current market conditions. They should also imply that if a company is overpaying its staff then markets will ultimately punish it either by shareholders pulling their money out or consumers refusing to buy overpriced goods.

Banks as the last workers collectives

The economist and journalist Anatole Kaletsky once dubbed the banking system "the last workers collectives" as they appeared to be one of the few sectors that redistributed large portions of their earnings back to staff. His characterisation is echoed by Hugo Dixon, the founder and editor of Reuters Breakingviews, in his latest post:

"During the bubble years, pay in the financial services industry went through the roof. It wasn't just for the stars either. Fairly ordinary middle-ranking bankers raked it in. Even after the bubble burst, pay has taken a long time to come down. The 2007 bonus round was a record. Although pay was reined in after Lehman Brothers went bust in 2008, it rebounded the following year."

Dixon calls for banks not only to reduce pay in line with falling revenue but to go even further – cut the proportion of revenue devoted to staff salaries. In doing this he is suggesting that the market in which bankers are operating has become dysfunctional. That is, it can no longer be assumed that banker pay can effectively regulate itself.

There are two lines of argument for why this should happen:

First, pay at banks has risen faster than returns to shareholders. This means that those who put money into the business to allow it to grow are seeing their potential return diluted as those within the banks award themselves a larger portion of the profits. As the crisis forced the government (read taxpayers) to become a major stakeholder in a number of these institutions the problem has become all the more prominent.

Secondly, excessive pay erodes the ability of banks to adjust to sudden market shocks. By paying out revenue rather than holding some back in reserve increases the reliance of large banks on implicit state protection. Were these firms to be hit by another crisis the too-big-to-fail problem will ensure that governments are once again obliged to recapitalise them at a significant cost to taxpayers.

Counterpunch

Not everyone is convinced by these risks. The blogger Epicurean Dealmaker has responded to these criticisms by suggesting they ignore the self-correcting mechanisms of the marketplace.

"If you want to run an investment bank, you have to hire and retain investment bankers, whether you are profitable or not, and you will pay the going rate in that labor market. Since we are fungible factors of production, if you cannot afford to pay us what your competitors will, we will leave and you will be unable to generate any profits at all. You might as well shut down."

He claims that these types of businesses will have spent a great deal of time (and money) evaluating how to get the most out of their employees. This helps explain, he says, why so much of the compensation packages offered to investment bankers comes in the form of deferred pay. By holding back pay and stock options these payments both offer incentive to continue to work hard and reason to stay with the company.

The blogger suggests that most bankers would accept lower overall pay if it was 100% cash as it would give them greater flexibility in their career and predictability of earnings.

Evaluating the evidence

One of the main questions that need to be answered if we are to evaluate which side of the debate carries more weight is whether there can be genuine competition between large financial institutions.

On the face of it there are plenty of competitive pressures on even the largest investment banks. The problem is that these can have perverse effects on pay if the management of a company believes that they enjoy the implicit protection of a sovereign.

If a company is allowed to operate as if it cannot fail then it has a positive incentive to offer pay packages at a premium to market rates in order to attract talent, even if this poses a risk to the company's financial position. This creates a de facto bidding war for employees without having t
o increase prices or cut costs elsewhere.

The results can have an impact on wages not only at the top but also in how they are set at the bottom. As Dixon suggests, the pay differential over equivalent positions was not confined to the boardroom or senior executives in investment banks.

Of course, it is possible that the bankruptcy of Lehman Brothers has helped to undermine some of the confidence in a too-big-to-fail model. Indeed such a theory may help explain falling pay at investment banks and why we have witnessed a recent uptick in shareholder activism over remuneration.

Yet in the aftermath of the crisis we should be wary of assuming that markets are always and everywhere rational.

 

More on Mindful Money:

It's the debt based economy, stupid

In defence of financial journalists

Banking connections – the more there are, the greater the risks

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