Opinion: Wall Street Compensation and Bonuses - BEFORE Watching Inside Job

I heard about the Oscar winning documentary, Inside Job and wanted to write a post on what I think is its main focus before and after I watched it.

Compensation on Wall Street is has been the envy of many, but recently the become an more of a debate. Here are some of my views on the issue starting with a blast from the past!

Liar’s Poker Lessons On Wall Street Pay

One of the most controversial topics in banking is compensation. In Liar’s Poker, Michael Lewis claimed to be asked, “Why investment banking?” during an interview at Sheason Lehman and he ignorantly replied because he wanted to get rich. Lewis latter learned the correct answer was to say he liked the challenging environment and working with great people in the job, but by then he had unfortunately already chosen sales and trading. The topic of compensation, bonuses, and performance was brought up consistently throughout the book. Lewis earned one of this highest bonuses when the company was having one of is worst years. After Warren Buffet was convinced by John Gutfeund to bailout the company, Solomon decided to pay out its highest bonuses ever. The situation of compensation at Solomon holds similarities to Wall Street today.

Given the sub-prime fiasco and the resulting billions of dollars in government loans to banks, the general public has become more interested in banker’s pay. Especially since since after the bailouts, banks have earned record earnings and banker’s record bonuses. Liar’s Poker made arguments for:

  • Performance based bonuses: Incentives should be aligned between the firms profit and the employees profit. A compensation committee and pay limits are not effective. Also, it doesn’t hurt to loose the bottom 5%, or punish risk, as Goldman Sachs does every year. 
  • Management should understand the details: Since mangers get paid way more than their employees. That means their responsibilities should include looking at the big picture like William Rineere, but also overseeing their employees activities to prevent a Nick Leeson (Barings Bank) situation. 

If both of these factors are incorporated into a banks culture the chances of its success increase. Furthermore, it is important to note that other factors like employee talent, monopolies in a banking service, and economies of scale also matter, but this is a post on compensation. 

Personal Take On Wall Street Pay

As an aspiring investment banker myself, I recently got asked by a friend what my opinion on bonuses. When I think about banking, I think about two things “art and science”. At the lower levels of the firm (e.g. analysts and associates) employees create models, research, and pitch books. The grunt work needed to complete bring in clients and keep them happy. As a result, investment banking analysts learn the fundamentals of the “science” while getting paid big salaries compared to their peers out of college. What is often forgotten is that the average 60K base comes with having to work 100 hours per week for 52 weeks (no holidays), bringing their hourly wage down. Check out the sensitivity table below courtesy of www.mergersandinquisitions.com.

McDonalds vs. Steve Schwarzman

Note: Let’s be realistic, no banker is going to get $0 in bonus and work 140 hours every week; however, this does demonstrate how a McDonald’s crew worker earning $7.81 per hour (www.glassdoor.com) puts the bankers salary into perspective. Also, the salary of McDonald’s worker doesn’t include the 2x (depending on the location) amount for overtime after 40 hours a week. 

After rent, taxes, paying back student loans, and food the banker saves very little and works a lot. 

At the higher levels (e.g. vice president and managing director) banker’s salaries are highly correlated to the amount of business they bring in and how well the bank is doing. For their talent in mastering the “art” of building relationships they get compensated accordingly. There are situations where it can take 5 years for an MD to earn a six figure bonus.

Other departments like sales and trading and brokerage branches are already performance based at most banks. Since bonuses are heavily relied on, and performance is the way these are earned, incentives are allied. The bonus process motivates and increases productivity in the industry, mean more industries should learn from and adapt the compensation structure in finance, not fight it. 

Political Arguments Around Compensation

Obama and Congress have been criticized for not curbing banker’s salaries. The main issue lies in the fact that the government had to bailout several large banks, and therefore feel that banks should have been suffering not profiting. A negative externality of this event is that the compensation issue has been unfairly vilified. The focus should be directed at banks that are too “big to fail” and banking managers that don’t have their client’s and bank’s best interest at heart. Compensation wasn’t responsible for the financial crisis, it don’t need to be reformed.

Conclusion

Banks that have solid compensation structures align incentives with performance, and as a result, will continue to thrive in attracting talent. Bonuses are a popular scape goat, but “don’t hate the player, hate the game”. There were systematic problems in banking regulation and oversight that caused the financial crisis, and the issue of compensation wasn’t one of them. After all, as Lewis said after the bonus meeting, “No amount of money seemed like enough.” To work the amount of hours junior banker work for the pay they do, greed isn’t a sustainable motivator. At the end of the day, a successful banker has to be passionate about the work.

Can’t wait to watch the film and post about it soon.

My Reaction to Freakonomics (The Movie)

I recently saw Freakonomics the documentary. I heard great things about the best selling book and have been meaning to read it for a while. In fact, the book was the subject of one of my presentations in 7th grade; but I only read Sparknotes to complete it. Finally, after seeing the movie, I can speak about the book more knowledgeably. Alright, enough personal information, let’s jump into the key takeaways Steven Levitt and Stephen Dunbar formulated.

Firstly, statistics can be mathematically correct, but their interpretations are still subjective. As my Biology teacher says, “Correlation doesn’t mean causation”. This topic is commonly explained in lower level economics and political science classes. The premise of research in these subjects is to differentiate the two and find true causation. A good example illustrated in the movie examined the causes of the decreased crime rates in the 1990s. A prominent newspaper claimed the causes could have been politicians (e.g. Rudy Giuliani, Bill Clinton,…), increasingly effective policing tactics, and better family values. However, Levitt pointed to abortion being the main cause of decreased crime. By eliminating unwanted pregnancies, children who weren’t wanted didn’t grow older.

Similarly, this principle also hold true when valuing a company. As many practicing accountants will tell you, the dollar value of a company is a subjective number. That is why companies hire investment bankers to come up with a valuation range and negotiate for the best price.

Secondly, incentives matter. By studying human incentives, we can create games in which to manipulate them in beneficial ways. For example, Steven used his daughter’s potty training as an example. A piece of candy used to reward her for correctly using the toilet. This method was very effect for the first week. However, the problem with incentives is that people exploit them in two ways: through free riding and adapting to the game. The Levitt’s daughter got so good at using the toilet that she could control her pee to maximize the amount of candy she received. Nevertheless, the lesson still holds true. Mapping successful game processes out can allow researchers to find incentives that do work and apply them to other games. This process is commonly known as gamification.

Another way the game developer can understand the process more intricately is to get involved when conducting research- “put yourself in the subjects shoes”. This is the third point I took away from the film. Researchers can define incentives in more details if they experience or “think like” the subject.

There were a few other cases I thought were worth noting. SPOILERS: For example, how a person’s name dictates their success (it doesn’t), whether or not to trust your real estate agent’s offer (keep your house on the market longer), and corruption in the world of sumo (the competition process matters). Even with all of the terrible acting, the movie was thought provoking. Personally, I found the information on research methods useful in picking my next paper topic. Moreover, I enjoyed the authors’ insight into several gamificaiton cases.

In the future, I plan on reading Super Freakonomics and checking out the NY Times Freakonomics Blog. Maybe they will come out with another movie and save me the trouble.

Just kidding. I’ve changed.