Sunday, February 28, 2010

The Flawed Compensation System in Investment Banking

Here's a good article from the prolific Edward Harrison that explains the differences between conventional corporations (including commercial banks) and the big Wall Street firms relative to how people are compensated and who's really calling the shots on risky decisions. In the Wall Street firms (Goldman Sachs, and the now-departed Lehman and Bear Stearns), the top execs are often clueless about the risks their firms are taking (which is a major problem, of course), and you have much lower level people pulling off hugely risky deals. If they win, their payouts are huge. If they fail, they get fired, but just move down the street to another firm. This is why we can't give the same protections to Wall Street that we give to commercial banks. They should be allowed to take risks, but not with government backing. That's what the proposed Volcker rules are all about.

From Mr. Harrison's article:

Corporate hierarchies

In a normal corporate environment, there is a strict hierarchy in which those at the top earn more than those at the bottom. In order to rise to the top (and earn the salary and huge bonus – I might add), one needs to be considered successful. And that means putting in years of effort for which one receives performance reviews.

If you do well on these reviews, you might even receive accolades, awards and so on – the point being you are a rising star with talent. So you get promoted. “The way you’re going, you might even rise to CEO one day!” That’s the kind of praise you might hear. So the whole hierarchical apparatus is designed to align high achievement with other external signs of success: good evaluations, promotions, more money, more responsibility, more underlings, larger budgets, awards, and accolades and so on. All you need to do is look at an org chart and you get a pretty good sense of who’s supposed to be the stars. And by the way, this is how it works in commercial banking as well.

Investment banking hierarchies

But, that’s not how it works in investment banking at all. When one deal or a series of trades can mean billions in profit, even a relatively junior person can have influence on the bottom line far beyond what her title suggests. This is certainly true in the advisory business, but it is even more true in trading – especially proprietary trading, a major reason that proprietary trading is inherently risky and would be restricted under the Volcker Rule. By the way, this is also a major reason that investment banks that are public companies and not partnerships are risky companies with notoriously poor managers.

A slovenly 32-year old junior trader with terrible social skills, zero management ability and no one reporting to him can make millions of dollars a year. He’s the guy you read about in the newspaper making three times the CEO’s salary. He’s the guy that all the other firms are trying to poach. And he’s the guy that used to be referred to admiringly as a “big swinging dick.” You don’t see that at Acme Incorporated. That’s what I mean when I say it’s all about the money. You learn very quickly in investment banking that status is not all about the titles, it’s more about the money.

Read any account from investment banking like Predator’s Ball or Liar’s Poker you will quickly notice that even the higher level guys are driven to earn a lot of money, not only for the money itself but for what that money says about their status and value relative to their peers.

You can read his full article on Seeking Alpha here.