Why are financial industry paychecks so big?
The answer is simple, and it is the one Willie Sutton is supposed to have offered when asked why he robbed banks: “Because that’s where the money is.”
Those who want to do something about bringing that pay down ought to focus on why there has been so much money in the financial sector in recent years. It should be no surprise that people in that business wanted to be paid a lot; the surprise should be that there was so much money to go around.
For whatever reason, the money was there in recent years as never before.
The government estimates total financial industry profits each year, and it is easy to compare them to the size of the economy. In the six decades from 1929 through 1988, those profits averaged 1.2 percent of gross domestic product — and never went above 1.7 percent.
Then they shot up in the 1990s and went up further in the current decade, peaking at 3.3 percent in 2005. Even now, the figure is higher than it ever was before 1990.
Why were those profits so high? And did society get its money’s worth out of them? If those surging profits reflected the financial industry’s success in helping the real economy, we might be jealous but not contemptuous. You don’t hear a lot of carping about how Bill Gates and Steve Jobs became so wealthy.
There is no doubt that the allocation of credit — a primary function of the financial industry — is a crucial function, particularly in an economy undergoing change. If the finance business has done a great job of that, of directing money to where the new opportunities are, then there is no reason to begrudge them their wealth.
Unfortunately, there is little evidence that the financial industry’s success has done much for the rest of us. Capital was not well allocated during the recent bubbles, to say the least. The fact we had bubbles testifies to that.
Moreover, Robert Barbera, the chief economist of ITG, points out that in the middle of this decade there was a surge in borrowing by the rest of us — households and nonfinancial businesses — that was much larger than the simultaneous growth in the economy.
The last time that happened, he points out, was in the late 1980s, just before the previous banking crisis. Perhaps he has found an indicator that a systemic risk regulator could use in a coming cycle.
But saying the success of the financial sector has not been a godsend to society does nothing to explain why it occurred.
Let me suggest a few contributors to that success:
HIGHER CHARGES It is not just all those fees you have noticed on your credit cards and checking accounts. Much more important is the growth of the hedge fund industry.
The people who managed money for institutions a generation ago charged fees that seem tiny by today’s standards. Now hedge funds normally charge a management fee of 1 percent of total assets, plus 20 percent of profits. Those fees swell financial industry profits. To generate investment returns high enough to justify those fees, hedge funds use a lot of leverage. That borrowed money creates financial industry revenue.
CONCENTRATION “In 1990, the 10 largest financial institutions had 10 percent of financial assets in the United States,” says Henry Kaufman, an economist and author of a new book, “The Road to Financial Reformation.” “Last year, the figure went over 60 percent.” He points out that bid-asked spreads are rising in some markets, which will raise profits for the market makers, and that fees for underwriting securities are also rising.
DERIVATIVES AND COMPLEXITIES Richard Bookstaber, a former hedge fund manager and risk manager whose 2007 book “A Demon of Our Own Design” warned of the crisis that soon erupted, suggested in his blog last week that banks profited from “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.”
EVADING TAXES AND RULES Many of the financial innovations of recent years were not designed to increase operating profits for customers. Instead, they sought to avoid taxes, or make accounting statements look prettier, or get around regulations seeking financial safety. At their worst, they boiled down to an offer to charge a customer a dime for letting him evade 20 cents in taxes. Such transfers do nothing for the larger society.
EXCESSIVE RISK-TAKING The banks took more and more risks in recent years. Some they pushed out to others via derivatives that often were badly priced. But others were kept. When things went well, the profits rolled in. When they went badly, we got to bail them out.
(The profit numbers the government uses, by the way, are a version of operating profits. They don’t count big write-offs, which would seem quite unreasonable if it did not turn out that bankers did not need to count them either. Bailed out, they could return to collecting big paychecks.)
If those are the reasons for the profits, then perhaps regulatory attention should focus on the causes, not the effect. Rather than have a pay czar try to determine fair compensation for bailed-out banks while others can do as they please, Congress could look at changing the environment that produced this mess.
One way to do that is to encourage more competition. The impulse last year to have bigger banks take over failing big banks now looks exactly wrong, even before remembering that the regulators thought Citigroup and Bank of America were good acquirers with solid balance sheets.
The new regulatory system also needs to force banks to hold a lot more capital, and it needs to keep them from using tricks to take the same risks while appearing to need less capital. If the regulators can do that, it would reduce bank profits by tying up capital. One Wall Street executive I know suggests that would, in turn, bring down compensation by stimulating shareholders to demand more of the profits for themselves.
Mr. Kaufman argues that to prevent further socialization of the financial system, there simply have to be fewer banks that are too big to fail. He thinks such institutions should face more stringent regulation, and be barred from certain activities. If they want to do those things, they can find ways to split up or shrink.
Customers can also be empowered. Forcing most derivatives onto exchanges would increase the number of people who would be in a position to trade them, and probably bring better pricing for customers. One reason there are so many custom derivatives is that banks have persuaded customers they are cheaper, which is absurd. They can argue that because the banks do not force companies to put up cash when the value of a position declines. That should change. The banks could still lend the needed margin, or course, but by separating the credit and pricing functions customers would know more, and possibly get better deals.
Some such ideas were in the Obama proposals, but they are being watered down by intense bank lobbying. Some legislators who loudly denounce bank pay seem unwilling to do anything about the actual causes.
If policy makers want to bring down bank pay, they should do something to make the industry more competitive, and to assure that no one expects the taxpayer to again pay all the costs if the industry blows up again.
Floyd Norris comments on finance and economics in his blog at nytimes.com/norris.