Every once in a while something occurs that suggests you're just talking to yourself. Last week I spoke briefly to radio's Marketplace about a short piece I wrote on Wall Street bonuses. From the beginning I felt that Marketplace was trying to get me to say that bonuses were simply too large and that Wall Street "didn't get it." I resisted; the interviewer persisted. And so it went. Then, early this week, the perfectly pleasant interviewer, Kai Ryssdal, brought up the conversation in a short piece on listener letters, saying that I had argued that we had no choice but to give bonuses ("a necessary evil") to Wall Street, because if we didn't, everyone would head off to private equity and hedge funds.
That's not exactly what I said or wrote or think. What I feel about the size of bonuses is exactly as subjective, and irrelevant, as me opining on, say, Tiger Woods' income. All this wouldn't matter much -- it is a very minor dispute -- except that it shows how the feverish pitch of the bonus dispute flattens any kind of serious discussion. What I did say is that a consistent policy, including pressure on bonuses but also increased taxes, capital requirements and regulation, might well drive the best talent, particularly in trading or merchant banking, at large Wall Street firms to less rigorously regulated private equity and hedge funds, shifting the problem, not resolving it. But I certainly never called bonuses a "necessary evil." Perhaps Ryssdal can be excused for drawing the sound-bite-ready conclusion that he did. But there's a larger context here that I now feel compelled to lay out.
The fact is the crisis and its aftermath do raise big questions about the attractiveness of the largest financial institutions to the very best talent. For the past 40 years, these institutions (mostly commercial and investment banks) raced to accumulate more and more capital, creating great competitive pressures while finding themselves caught in a kind of trap. Usually, as institutions bulk up, they swing to playing a volume game, wielding their capital to squeeze out steady streams of commodity profits. This, in many ways, was the traditional commercial bank approach (and the approach long taken by the now-derided Sandy Weill): Bulk up, roll over the competition, but don't take too many risks. Investment banking, on the other hand, was able to live more on the edge. Particularly after shedding their partnerships, these firms, while smaller than the big banks, moved from one new, often opaque, market to the next, harvesting windfalls, then dancing away (hopefully) before either scandal hit, the economy crumbled or the big banks moved in to commoditize the profits.
But as Glass-Steagall gradually eroded, the differences in approach between, say, a J.P. Morgan Chase & Co. (NYSE:JPM) and a Goldman, Sachs & Co. (NYSE:GS) narrowed. The market wanted a combination of stable, big-bank power and profitability and investment banking nimbleness and returns. Institutions grew vastly larger and took on, across the board, much greater risk. And then it all blew apart, probably because those two imperatives were, when lashed together in a single institution or in a single sector, explosive.
Increasing compensation accompanied this multidecade evolution, but it was symptomatic of underlying tensions, not causative. After all, pay was increasing in corporate America at the same time. The notion that bonuses drove this risk-taking is clearly overstated; it accompanied it and flowed from it. Arguably what did fuel risk-taking was the fact that all these institutions had become public companies, and that the market and their shareholders wanted and expected larger institutions to generate stable and high-octane earnings growth. For all of the attention paid to the dangers of cash-based bonuses, the most incendiary link between risk and the markets was the widespread issuance of shares as compensation. And the enabler here was the fact that shareholders and share-incentivized managers had their interest aligned -- in, of course, a very dangerous way.
That said, where are we now? Unlike some observers, I'm not convinced that the administration has been fully captured by the banks and that they are going to be able to return easily to traditional ways, content in the knowledge that they'll be bailed out if they get in trouble. At least over the near term, say five to 10 years, governments here and abroad will apply greater and greater pressure on bank profits, again through taxation, through increasing capital demands and more rigorous regulation; perhaps even some Glass-Steagall-like split may occur. They may not actually break up the big banks, unless they get into trouble again. And they may fail to shrink the size of finance compared to the real economy. But big-bank profitability, and with it the size of bonuses, will be squeezed; or at least it seems that way now. And that in turn will force big banks to opt for one side of the strategic equation or the other: size and commodity profits, or risk and reward. Right now, at least among the big banks, the former seems to be dominant. And why not? The windfall profits that are available to a J.P. Morgan or a Goldman Sachs come from safely skimming off profits from the government's low-interest-rate money. But that won't last forever.
Granted, all this was difficult to articulate on the radio. What I was trying to get at, however, is that eliminating bonuses on Wall Street is not simply a matter of making a fuss one year, then strolling away the next. Because bonuses are symptomatic, the real "cure" is to tackle the underlying malady, which I would argue is the belief that great size and high growth can comfortably be accommodated in a publicly held banking institution operating in global markets. Besides, everyone acts as if the handful of big banks constitutes "finance" or "Wall Street." The truth is, over the past decade or so, finance has effectively been disaggregating, even as a few institutions grew larger. Private capital has proliferated. An ill-thought-out plan to hammer down bonuses on Wall Street, even if you do believe you're dealing with too-big-to-fail institutions, will only shift talent elsewhere. Do we really think that an interest in making large amounts of money has disappeared?
Besides, should we care if talent moves? After all, private capital consists of a bunch of small, non-TBTF firms, right? Well, explain this: How could Long-Term Capital Management be TBTF in the late '90s, but any number of current hedge funds, nascent or real, not pose significant risk to the system a decade of growth later? So what is the plan to deal with firms or funds that may not have the assets of Lehman Brothers Holdings Inc. or Bear Stearns Cos. (although, they may: Consider Blackstone Group LP [NYSE:BX] or Citadel Investment Group LLC), but that have great concentrations of interconnectivity with the rest of the system? How will we know when a dangerous pooling of risk develops? Refusing to acknowledge that there is a large piece of finance that has nothing to do with the big banks is almost the definition of fighting the last war.
Effective regulation is never partial. Regulatory arbitrage persists as long as human nature exists -- and it's a big world out there. We are living with a healthcare system that is so deeply paradoxical and dysfunctional because it suffers from the devil's own combination of public and private incentives, rules, payments, standards. The financial system is similarly tangled in this blend of private and public, from different regulators with different emphasis, with vast numbers of rules, many of which are never enforced, if only because they are anachronistic, contradictory or idiotic. Now, based on an unproven theory that pay was at the origin of the crisis, we propose, based on some crude psychology of money and risk, to layer on an even greater number of rules on a discrete number and class of employee, while ignoring vast swaths of other firms and other players. This strikes me as guaranteed to screw things up even more than they are today, and to set off any number of unintended consequences. But for five minutes those of us who are not wealthy, and who do not receive bonuses, and who feel aggrieved, will get to bask in the glowing joy of self-righteousness.
That's the way this particular issue has gone, as my little conversation on the radio demonstrates. The fact is the country does suffer from increasing inequality of incomes. This is a serious and deepening social problem, but it's not one that's going to be solved by lurching around trying to eliminate the symptoms. We often forget how captive we are of very difficult tradeoffs, some of which play a major role in our current debate: safety and growth; prudence and efficiency; stability and innovation; order and freedom. One way, of course, to deal with the pay problem in finance is to cap compensation on every single soul working in the business, from the smallest money manager to Lloyd Blankfein. That would be effective, but also draconian, dangerous, ridiculously complex and probably unconstitutional. We need finance, we need Wall Street, we need a degree of animal spirits -- though, for all the noise and certainty we don't really have a clue about what the optimal size and shape of the financial sector should be, and we haven't dealt seriously with how to get there. That process has only just begun, but simplifying it down to how I feel doesn't really help very much. - Robert Teitelman
Robert Teitelman is the editor in chief of The Deal.