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Why do investment bankers get paid so much?
Did you see that the average bonus at Goldman was $622,000 for a year's work? Arnold Kling asks why here, and here, with follow-up from M. Drapier.
The puzzle, of course, is why the supply of investment banking doesn't expand so as to lower price and thus wages, in what appears to be a fairly competitive industry.
My take: The high payments solve an agency problem and align interests, and thus they are relatively invariant to competitive pressures. If Goldman does an IPO, the issuing company wants to make sure that Goldman promotes the issue properly. This means, among other things, that Goldman eschews pure market-clearing prices and instead places the issue in the hands of investors who will talk it up and promote it. For this to happen, Goldman has to care more about its relationship with the hiring, security-issuing firm than about some of its external relationships, namely other groups which would like to buy into the offering at favorable prices but which would not promote it as effectively (NB: this is not the only relevant conflict of interest problem, it is just an example).
In other words, the company doing the IPO has to pay Goldman lots to ensure their loyalty.
Competition for doing IPOs won't much lower the required payments needed to capture the loyalty of Goldman. There could be one million talented investment bankers bidding to do that issue, and ex post the security-issuing firm will still pay the winner large sums to align incentives in the desired manner.
Posted by Tyler Cowen on December 14, 2006 at 08:46 AM in Economics | Permalink
Comments
From The Office http://www.quotesfromtheoffice.com/employees/dwight_schrute/:
"Would I ever leave this company? Look, I'm all about loyalty. In fact, I feel like part of what I'm being paid for here is my loyalty. But if there were somewhere else that valued loyalty more highly, I'm going wherever they value loyalty the most."
Posted by: Jonathan at Dec 14, 2006 9:19:50 AM
The supply might not be as high as you'd expect.
I-banking is notorious for it's incredible demands on the lifestyle of its employees. In my experience (newly-minted MBA here) the banking interview process is not so much about determining whether the candidate has the skills to do the job, since that's quite easy to determine and there is an oversupply of suitably skilled candidates.
Generally a major focus of the process is about trying to test whether the candidate is suitably committed to the job. That they won't just up and quit the first time that a recently-divorced bitter MD terrorizes them into working back-to-back all-nighters (seen it happen).
Since most of the candidates are smart people with other options (i.e. people who are high risks to defect), the group who actually is that dedicated to the job is pretty tiny and rarefied. Notably and regrettably, it excludes most women (who have better sense, on the whole, about work/life balance).
So it is,in fact, quite possible that the group "High honours from a top-10 MBA program and and nearly insane commitment to the world of finance" is small enough to justify the salaries paid incoming (ballpark $200k total comp at an MBA level and $100k for undergrads).
It gets much higher in the upper ranks, because the supply shrinks further at higher levels. Some people burn out. Some people have families. Some people get job offers from even-more-lucrative hedge funds and private equity firms. Some get job offers to work for nice companies with 9-5 hours. Most of the up-or-out "victims" want to leave anyways: if they're doing poorly they're not having fun. The dirty secret is that it's usually pretty easy to get promoted in these places provided that you are sufficiently unhinged that you can put in the lifestyle required. But that is an incredibly high bar.
Posted by: Andrew Edwards at Dec 14, 2006 9:32:39 AM
Important note: GS made most of its money this year on the back of principal investments, not investment banking. So the question is not why aren't there more people in I Banking, but why aren't there more people in trading, hedge funds and private equity. And the answer to the question is: the numbers involved in these areas are growing every day. GS is the largest hedge fund manager in the world, it's private equity funds are a huge player, and as it reduces the number of agency traders it is simulataneously increasing the number of principal traders. To think of GS as a company populated by I Bankers is incorrect. It is literally the worlds largest hedge fund
Posted by: joe at Dec 14, 2006 9:40:32 AM
"...the company doing the IPO has to pay Goldman lots to ensure their loyalty."
Uh...either I missed the explanation or you didn't really offer one.
It seems to me that the best answer to such bizarre disparities of compensation is the "winner takes all" dynamic (you see it with lawyers all the time) is that the marginal cost of going with the "best reputation" is very low. ($150/hr for an attorney versus $500 is trivial when the issue is worth tens of millions) and in CYA terms, well-worth it, especially if one loses..."Well we lost but we hired the very best attorneys."
Posted by: David Sucher at Dec 14, 2006 10:03:18 AM
Yes, GS is more than Investment Banking. The 26,000 include tech, stock loan, and stock research people as well as those previously mentioned. In a good year the hedge fund and other proprietary trading activity yields returns paid out in bonuses that would look like capital gains if structured as a hedge fund.
Also note that bonuses are part of normal compensation. Base salaries often range from 70-150K for people working in Manhattan.
Posted by: John Kunze at Dec 14, 2006 10:20:49 AM
I'm more interested in why this labor isn't outsourced to India or (insert lower-wage, good-education country here)
Posted by: evm at Dec 14, 2006 10:32:29 AM
Investment banking is another case of winner takes most all. Do you want to trust your brain surgery to the second best brain surgeon? Similarly, why trust your IPO to the second best investment banker?
I'm not particularly wealthy, but I've just retained one of the biggest and most expensive IP law firms to prepare patent applications for some inventions I've devised. The cost of possibly doing it wrong is way way more than the cost of hiring the very best.
Posted by: Trey Tomeny at Dec 14, 2006 10:43:43 AM
"Did you see that the average bonus at Goldman was $622,000 for a year's work?"
I don't think this is true. An article I read stated:
"...Goldman set aside about $16.5 billion for salary, bonuses, and benefits for its 26,000 employees. That averages to more than $600,000 a person."
So the amount is not the average bonus, but rather compensation that also includes salary and benefits.
Posted by: Colin at Dec 14, 2006 10:58:48 AM
Andrew Edwards: Note that there appears to be a huge range in the demands made by different I Banking divisions, and no obvious relationship between variation on that range and variation in performance.
It isn't clear at all why the I-Banking lifestyle should be so grueling. It makes little sense to say that the compensation is to overcome the rational reluctance of prospective I-Bankers to being tortured if there isn't any good reason to torture one's workers in the first place.
Posted by: michael vassar at Dec 14, 2006 11:07:54 AM
I'm with Andrew, at least in part. Compensating differentials for what seems to be a truly awful way to live your life.
Posted by: josh at Dec 14, 2006 11:12:40 AM
Investment bankers make so much money because they have an anti-competitive cartel.
And the link explains why the investment bankers have such a grueling work week. It's part of maintaining the cartel.
Posted by: Half Sigma at Dec 14, 2006 11:19:01 AM
Screwing the little people is almost always a profitable enterprise.
Out here in the field, thousands of half-trained brokers are churning away
Grandma's retirement money so Wall Streeters can get rich.
Ah, I love capitalism!
Posted by: save_the_rustbelt at Dec 14, 2006 11:28:59 AM
This post on the subject is interesting
http://www.halfsigma.com/2006/12/investment_bank.html#more
Posted by: michael vassar at Dec 14, 2006 11:45:03 AM
"Out here in the field, thousands of half-trained brokers are churning away Grandma's retirement money so Wall Streeters can get rich."
Stock brokering is really a completely different business than investment banking, but they often fall under the umbrella of the same company because of vertical integration.
Stock brokers spend most of their day trying to talk people into opening accounts or churning the accounts they already have. So you are paying the full service broker for the "service" of annoying you with sales calls.
Why does anyone use a full service broker at all? Either because of assymetry of information (they don't realize they are being ripped off), or becuase the full service broker makes them feel like a big shot, and the emotion of feeling like a bigshot makes it worth overpaying for the service.
Posted by: Half Sigma at Dec 14, 2006 12:21:13 PM
I'm sorry but I work in the industry in NYC and this is not the best explination. The link above from Half Sigma is more accurate. The industry is mostly peopled with those who are high on the bell curve for aggressiveness and intelligence. If some feel they aren't getting their "fair share" of firm's profits then the can and will leave to start a competing firm.
Though this is a major reason for limited competition it isn't the only reason. The CYA (cover your a**) issue mentioned is certainly a factor. If you are doing a new offering - debt, equity, hybrid, etc. - and something goes wrong then you will get fired if you hired a small no name firm to do the deal. You won't get fired if you hired Goldman Sachs. But likely Goldman Sachs et al got to where they are because they don't get things wrong very often.
Relationships and connections also play a big part in determining success in the business, which is difficult for others to replicate.
Unfortunately I don't work for GS but at least they set a benchmark that everyone else will have to at least come close to now. I work for a European competitor that has a March fiscal year end so I will have to wait 2 more months to find out what I got.
Posted by: asiequana at Dec 14, 2006 12:34:40 PM
Prior to the last 5 years, investment bankers were most often chosen for their all-star analysts, not their investment bankers, who take the lion's share of the commissions. To become an all-star analyst, one must have significant ties to the main players in their industry, something that is hard to compete on. It is nearly impossible for any new players to enter the high-profile investment banking industry, so the new entrants compete with each other for smaller deals. In turn, the main players in the bulge bracket often compete with each other, but never ever over fees. In the late 90's, access to all-star analysts, and kickbacks of other IPOs drove business to investment banks.
For more information read "The Seven Percent Solution," Hsuan-Chi Chen and Jay R. Ritter, Journal of Finance, Vol. 55, No. 3 (June 2000), pp. 1105-1131 - http://bear.cba.ufl.edu/ritter/publ_papers/The%20Seven%20Percen%20Solution.pdf
Posted by: Rg at Dec 14, 2006 12:39:03 PM
"I'm sorry but I work in the industry in NYC and this is not the best explination. The link above from Half Sigma is more accurate."
Thanks for the compliment!
The CYA (cover your a**) issue mentioned is certainly a factor. If you are doing a new offering - debt, equity, hybrid, etc. - and something goes wrong then you will get fired if you hired a small no name firm to do the deal. You won't get fired if you hired Goldman Sachs. But likely Goldman Sachs et al got to where they are because they don't get things wrong very often.
This is an example of the marketing economies of scale inherent to big firms. Personally, I doubt that it's true that Goldman Sachs is less likely to make mistakes than a small boutique firm, but as long as people have an instinctual inclination to place more trust in the big company, you can be sure that the salesmen (aka investment bankers) will play up that fear.
Marketing economies of scale do represent a barrier to entry for small firms. One of the reasons why the good salemen will stick around with Goldman Sachs and live off the massive bonuses. Goldman Sachs gives them a better deal than what they would get trying to compete.
Posted by: Half Sigma at Dec 14, 2006 12:46:24 PM
A meeting I had got cancelled so I will mention another relevent detail. A business school professor I had stated that if you want to go into finance join a marketing department because most capital is deployed via retained earnings as determined by the marketing department for new products or services. Whereas in finance all of the products are commodities and therefore what you are really doing is sales. I tend to agree with this.
As such sales jobs, at least in well run firms, link pay to how much you sell. The great thing about sales is there is a direct link between your actions as an employee and the success of the firm. At the end of the year you can say to your boss, "I brought in X amount of sales. If it wasn't for me you wouldn't have met the guidance you gave investors."
I learned the value of paying salespeople well early on. When I was young a family friend quit his job as a salesperson for a mid-sized industrial cleaning equipment company. The guy was so good at what he did that he directly brought in half the firm's revenue and his comp one year including his bonus was more than the owner. Of course the owner wasn't happy that an employee made more than him so he cut his employee's bonus in half. My parent's friend quit and went into sales for a different company in a different industry. He continued to be succesfull as well and the firm he later worked for started doing much better. The firm he left, which had been growing quite nicely, began to languish and didn't really grow that much afterwards and later the guy had to sell to a competitor because he was having difficulties competing with that firm which was a little bigger than his.
Posted by: asiequana at Dec 14, 2006 12:51:22 PM
Not mistakes in the sense that you misplace a decimal but a mistake in the sense that you weren't able to place the whole deal or the pricing was less than the issuing company thought they should have gotten. Which is obviously determined by scale and relationships.
Posted by: asiequana at Dec 14, 2006 12:58:58 PM
you weren't able to place the whole deal or the pricing was less than the issuing company thought they should have gotten. Which is obviously determined by scale and relationships.
I bet that the other Wall Street firms wouldn't cooperate with an upstart competing firm that was not playing but the anti-competitive rules, such as by, gasp!, offering lower prices.
Wall Street successfully punished Google for not wanting to play by the rules. Googles IPO went off a lot less than if they placed it through a big investment bank and gave them their "proper" 7%.
Posted by: Half Sigma at Dec 14, 2006 2:14:53 PM
The closer one stands to the vortices of cash flows -- the more money one makes.
Posted by: Varangy at Dec 14, 2006 2:18:01 PM
Some of these comments (and, as far as my non-economist brain can tell, Tyler's argument) do not differentiate between profits to the firm and employee pay. I find Andrew Edwards's "search for the unhinged applicant" persuasive, but it brings up a new question, Why must these people work so hard? Why doesn't the firm simply invest more in a stringent system of monitoring? My guess is that there must be some sort of indivisibility going on, but not working in the industry, I'm at a loss as to what that could be.
Posted by: mike at Dec 14, 2006 2:44:43 PM
I'm more interested in why this labor isn't outsourced to India or (insert lower-wage, good-education country here)
Someone from the hedge fund D.E. Shaw told me their fastest growing office is in Hyderabad where they now have several hundred employees. The number crunching and research components of finance are in the process of being outsourced while the sales and relationship maintenance aspects will have to remain in New York and London where all the money is.
Posted by: Ricardo at Dec 14, 2006 3:55:40 PM
Of further interest on the outsourcing thing, India isn't as cheap as you would think. Indian Institute of Management in Calcutta claims and annual average offer of Rp981,000 or around $22,000 for their MBA grads. They also claim the top end is around $200,000. This is in a country with an annual per capita GDP of less than $700. Some of the recruiters are Merrill Lynch, UBS, Lehman, ABN AMRO, Barclay's and JP Morgan.
Posted by: asiequana at Dec 14, 2006 4:10:26 PM
The $622k is not very meaningful, because there's no obvious way to break it up between back office, support, sales trading, prop trading, pure investment banking, etc. But I think there are really two questions:
1. Why do senior investment bankers make outlandish amounts? This is the question answered by winner take all, CYA, barriers to experience, ivy league networks, collusive fees, etc. And note that even these numbers are dwarfed by many hedge fund or private equity professionals.
2. Why do junior investment bankers (within a few years out of college or b-school), who are still making double or triple or more what their classmates make in other careers, face more competition?
To me the second question is much harder to answer. Brutal work hours are part of it, but not the whole story. Many corporate lawyers, for example, spend more time in a much more difficult grad school environment and work just as hard to make less in the first few years. I was a banker out of college (no longer) and had this conversation with many friends who took other tracks. I think the best synthesis of their answers that I can offer is (1) banking is more cyclical and therefore carries more risk of getting fired (true) and (2) finance just looks harder from the outside than it really is, and there are many very smart people who never cross the gap of thinking of themself as a "numbers person."
But neither of these feels very satisfactory to me either, so I would be curious what others think.
peter
Posted by: Peter at Dec 14, 2006 5:17:21 PM
