Banking Compensation

The front page of today's Wall Street Journal features yet another article on the bonuses being paid to bankers at institutions recently bailed out, or essentially owned, by taxpayers. For those of us who aren't collecting these bonuses this is either infuriating, mystifying or simply mind numbing. It may be helpful to step back for a moment and look at why banking can be such a lucrative profession. Consider the following example:

Bob over at Silverman Slacks is setting up a deal to sell a package of derivatives to a group of hedge funds. An average investment banker should be able to get $1B for these securities. However, because of his superior acumen, drive, reputation, persuasiveness and network of contacts, Bob can do 0.001% better than the average I banker. In most industries a 0.001% advantage is insignificant. However, because of the scale of the transaction involved, in this case that 0.001% advantage translates into $1m in additional profit for Silverman. Or at least it would, if not not for the inconvenient fact that Bob understands the significance of his 0.001% edge.

In order to prevent Bob from taking his 0.001% advantage over the road to Morbid Stansted, Silverman has to cut Bob in on the additional profits his superior abilities generate. Assuming that Bob can reliably generate $1m in additional revenue on $1B deals then Silverman, assuming management is rational and the market for "talent" is competitive, should be willing to pay Bob $999,999 per deal. If they don't, Morbid Stansted will. With this kind of a compensation package Bob doesn't have to pull off many $1B deals to reel in a multi-million dollar bonus.

Wall Street types, who almost never suffer from a surplus of modesty, like to claim that they earn extraordinary bonuses with extraordinary performance. This is complete rubbish. The scale of transactions on Wall Street amplifies the effect of even incrementally above average performance. Meanwhile the personality driven nature of the business ensures that the rewards from those incrementally above average results flow disproportionately to the "talent" that provided the incremental advantage.

Note that this incremental advantage doesn't have to come in the form of higher profits for the banks. Incrementally lower losses are just as valuable. This is why banks are compelled to pay huge bonuses even when their results don't seem to merit it.