Wall Street will be paying near-record bonuses for 2009 and the public is furious, given Wall Street’s role in triggering the recent severe recession. Unfortunately, there is a great deal of misunderstanding surrounding the whole complex topic. This paper attempts to explain the underlying issues comprehensively by giving the facts and the arguments from all sides, as well as expressing a few of the author’s own opinions. For the record, I was a Wall Street investment banker for nearly two decades, primarily at J.P. Morgan, ending in 2008. I now work at the Brookings Institution analyzing government policy related to finance.
This primer addresses the following questions:
- Who are we talking about when we refer to Wall Street?
- How does Wall Street compensate its investment bankers?
- Why does Wall Street use this system?
- Why are so many people so upset about the bonus system?
- How does the bonus system affect risk-taking?
- How do banks counteract perverse incentives in the bonus structure?
- How should the profits resulting from the government’s aid be split?
- What is Wall Street doing to change the system?
- Did firms with “better” compensation structures perform better?
- What is the government doing?
Who are we talking about when we refer to Wall Street?
The highly paid executives on Wall Street are virtually always investment bankers or the top executives of the firms that employ them. Some of them work for Goldman Sachs, Morgan Stanley, and other traditional investment banks. Increasingly, many others work at the investment banking arms of large commercial banks, including J.P. Morgan (distantly related to Morgan Stanley), Citigroup, and Bank of America (which acquired the old Merrill Lynch to augment its own efforts.)
Investment bankers play many roles, most of which relate to arranging deals (“intermediating”) between companies or between companies and investors. Investment bankers arrange mergers and acquisitions of businesses, help firms raise capital by selling stocks and bonds to investors, and assist businesses and investors in trading securities, exchanging currency, buying protection against a rise in interest rates or other financial risks, and similar transactions. Many of these intermediation activities are helped by the bank taking a trading position, such as buying a bond from a seller while looking for an ultimate buyer on the other side of the transaction. Holding inventories of securities to assist these transactions led over time to banks playing a major role in trading for their own speculative gain. (If a bank has traders sitting there anyway, with a good perspective on the market, there is a real financial benefit to using their full trading capacity.) This “proprietary” trading has expanded from a sideline to a major activity of many investment banks.
Investment banks, and the commercial banks with which they are often associated, increasingly also hold large investment positions that are not meant to be traded frequently. Those managing such positions are compensated in a similar manner to traders, but generally operate within tighter risk constraints that may be deliberately reinforced in the bonus process.
How does Wall Street compensate its investment bankers?
Wall Street firms traditionally pay their investment bankers a share of the total revenue garnered by their unit. In aggregate, investment banks usually pay out roughly half of their net revenues as compensation, with some considerable variation between firms and over time. Salespeople selling securities such as stocks and bonds generally receive an explicit commission based on the volume of business generated. Traders, for their part, expect to receive a relatively stable portion of the income they earn for the firm, net of any losses, expenses, and deductions to reflect a cost for the amount of the bank’s capital they had put at risk. Mergers and acquisitions and corporate finance advisors also expect to receive a portion of the fees they earn for the bank, although in that area it can be complicated at times to determine how to allocate the credit for bringing in a deal, since multiple key people may have been involved. Subjective judgments are invariably involved in those areas.
One of the balancing acts for each bank is to decide how much the bonuses will be determined by individual or unit performance and how much by the results for the bank as a whole. Determining bonuses completely on individual performance encourages infighting, a “silo mentality,” and the taking of risks that can be subtly shifted to other parts of the bank. On the other hand, basing bonuses primarily on the bank’s total performance can de-motivate the best performers and push them out to other firms where they will be rewarded more for individual performance, either because a different formula is used or because the firm is small enough that their efforts will have more impact. Wall Street is full of smart, very self-confident people who would rather that their individual performance determines how they are paid. Most banks have settled on an approach that focuses principally on individual performance, but is affected quite significantly by the overall results of the firm.
Another important balance is between paying cash up-front or deferring cash payments over a number of years. When possible, banks prefer to pay much of the bonus money over a period of years and to have the funds invested in the meantime in their own stock. This makes it harder for bankers to leave the firm, since they would usually forfeit the remaining deferred bonuses, and gives them another incentive to look out for the interests of the bank as a whole, since they want the stock to go up. Of course, individual bankers would usually rather receive the cash immediately to use as they wish and to avoid being tied to their current employer in case a better opportunity arises.
Why does Wall Street use this system?
An investment bank can be thought of as an affiliated group of small businesses. The key individuals at most units that perform well could move individually or as a group to another bank and slot right into the existing infrastructure at the new firm. The pages of the Wall Street Journal are replete with such switches during the good times and, to a lesser extent, even when times are hard. Top investment bankers usually are very good at one or more of a few fundamental skills: marketing, providing financial or strategic advice, or taking risk positions. All of these activities, particularly the first two, are aided by the establishment of a strong network of personal relationships. These skills and relationships make investment bankers highly mobile. For an advisor or a sales professional, it means that they can usually take many of their clients with them if they move. For a trader, it means that a wide range of people may be aware of their skills.
It is desirable for both sides to find an acceptable compensation approach. Banks need to retain their good employees and the bankers themselves benefit from operating within the confines of a stable firm. The compromise that has been worked out is to have the bank as a whole retain most of the revenue, but to pay out a large, and relatively stable, slice to the bankers. The banks keep a keen eye on the revenue split at their rivals, in order to avoid systematically losing their best people.
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