Friday, March 25, 2011

By Michael Prowse, Senior Visiting Fellow

“Let me tell you something about the very rich. They are different from you and me” – F. Scott Fitzgerald.

“Yes, they have more money” – Ernest Hemingway.

In 2010, Bob Diamond of Barclays, Britain’s highest paid bank chief, earned $10.9m, roughly 260 times the average UK income. The two highest paid members of his staff earned more than $15m each in salary and bonus last year plus a further $45m worth of shares under past incentives schemes. The average pay of the bank’s top 230 employees was nearly $4m, according to analysis by Megan Murphy and colleagues at the Financial Times*.

Such rates of pay are not unique in the global market for financial services. Remuneration of senior staff would have been similar – probably higher in some cases – at Goldman Sachs, Morgan Stanley, UBS, Credit Suisse, Deutsche Bank and other systemically significant financial institutions.

There is a tendency, especially in the US, to believe pay solely reflects personal effort and ability – and thus is “deserved”. Anyone who raises objections – or recommends tax or regulatory policies aimed at curbing high pay – risks appearing an envious kill-joy.

Yet the truth is more complex. Personal effort and ability certainly play a role. So does good fortune – being in the right place at the right time. But so also do institutional and structural factors that are often hard to discern. Mr Diamond’s pay is not purely a reflection of prodigious personal productivity, still less is that of his top lieutenants. Even if one allows fully for the complexity of some financial tasks, bankers’ pay is still way out of line with that in other, equally demanding, occupations. The public has a right to know why and to demand that something is done about it.

One reason for suspecting bankers are exploiting special advantages is that pay in financial services has not always greatly exceeded that in other sectors. In a detailed analysis of  US financial services Thomas Philippon of New York University and Ariel Reshev of the University of Virginia, show that remuneration relative to other industries has described a U shaped pattern over the past century**.

From 1909 until 1933 the financial sector enjoyed a large (and rising) pay advantage relative to other occupations. But after the reforms made necessary by the Great Depression, the sector’s wage premium began to shrink. The decline of pay in financial services relative to the rest of the private sector continued at a slower pace in the decades following World War Two. By 1980 the wage premium in financial services had all but disappeared: jobs in banking were paid at about the same rate as jobs of similar complexity elsewhere.

After 1980, argue Philippon and Reshev, the forces equalising pay rates went into reverse, rapidly creating a financial landscape similar to that of the 1920s. Once again pay in banking soared relative to that in other occupations. The pay explosion in this one privileged sector, they estimate, has accounted for up to 25 per cent of the increase in overall economic equality since the 1970s.

The study suggests finance, unless heavily regulated, tends to draw away from the rest of the economy. During the middle decades of the 20^th century – the decades of “financial repression” – banking became a normal industry earning normal returns.

Being economists, Philippon and Reshev strive to interpret deregulation positively. They argue that it “increases the demand for skilled workers and unleashes their creativity”. Rising relative pay after 1980 thus partly reflected the growing complexity of finance – for instance the increased reliance on mathematical skills. This drew in talented individuals who, but for the open-ended opportunities created by deregulation, would have exercised their skills elsewhere.

But the authors accept this justification of high pay in finance can be taken only so far. They reckon the average finance worker was 70 per cent “over paid” in 2006; after adjusting for skill differentials and other factors, the premium drops to 40 per cent. This, they argue, represents an upper bound for the “rent” earned in financial services – the windfall that finance extracts from the rest of us, because pay exceeds the levels normal competitive forces would dictate.

In other words, if the G20 could bring about a coordinated 40 per cent cut in bankers’ remuneration across the globe, there would be no net outflow from the profession because, on average, bankers would still earn as much, or more, than their counterparts in other occupations. They would have nowhere to flee to.

For all its merits, the Philippon/Reshev paper probably substantially understates the “excess” pay in financial services, at least at the top end. It is difficult to imagine where, other than in financial services, Barclays’ 230 senior bankers could earn even 60 per cent of the average $4m they earned last year.

Regrettably, Philippon and Reshev do not address one of the central issues in banking reform: the extent to which the expansion in the scale and complexity of the financial sector in recent decades has served social as well as private purposes. Is the growth of  derivatives and other complex instruments akin to the development of new techniques of brain surgery (which benefit patients as well as surgeons), or have the banks created what amounts to a sophisticated chain of casinos, operating on the standard gambling principle that customers, on average, must lose?

In a recent speech, Adair Turner, chairman of the soon-to-be-dismantled British Financial Services Authority, again voiced doubts about the social utility of much financial activity***.  As a former investment banker he finds the sheer scale of modern finance puzzling. Why has it grown so fast relative to other sectors? Since 1977 daily foreign exchange trading volumes have increased 234 times, yet over the same period the broadest cash measures of economic activity have grown only by a factor of 7.

Are all those trades socially necessary or are many of them effectively bets from which financiers make money at the expense of the rest of society? Is the massive increase in the complexity of financial products made necessary by similar increases in the complexity of the real economy, or is it a screen thrown up by the financial industry to disguise their “rent” extraction?

If there were no market distortions, pay rates in financial services could not diverge substantially from those elsewhere. It is not easy to identify the multiple sources of competitive distortions but Philip Augar, a former investment banker, is surely right to emphasise the significance of asymmetrical information.

Super profits in investment banking, he argues, arise “from a business model that gives banks in general and investment banks in particular the best possible view of global economies and markets”****. The larger a bank, and the more diversified its sources of financial information, the greater is its relative advantage.

Bankers can earn exceptional rates of pay only because the broader society provides a complex array of supporting institutions. The point is not merely that demand for services from the non-bank private sector – individuals, companies and pension funds – is essential for their business. In addition to being part of an inter-dependent private economy, banks depend heavily on the public sector.

Commercial banks could not function without a central bank, a sophisticated legal system, and officials capable of conducting monetary and fiscal policies; all of which is itself impossible without political institutions and their supporting bureaucracies.

Nor could banks meet their human capital needs without relying on publicly subsidised universities. It takes an entire society to create a first-rate bank.

Since the broader public realm ultimately creates the opportunities that bankers exploit, it has the right, through its elected representatives, to change the terms on which they transact so as to reduce their excessive remuneration, thereby fostering a fairer distribution of income and wealth.

So far, governments have largely ducked the pay issue. After banks caused the worst recession since the 1930s, they have merely imposed weak restraints on the way bonuses are paid – basically restrictions on the portion that can be paid in cash immediately. But deferring payment, and changing its form, will not necessarily reduce total remuneration.

If nations try unilaterally to enforce arbitrary limits for bonuses or overall pay, the outcome is likely to be disappointing for two reasons. First, if banks continue to generate above average returns, senior staff are likely to find ways to get round legislative curbs on bonuses. Second, bankers are internationally mobile and jump ship at the first sign of pay restraint. Thus when Swiss regulators cut UBS’s bonus pool by 80 per cent at the height of the 2007/09 crisis, the bank lost thousands of staff to competitors that did not face similar constraints. Bonus cuts led to a similar haemorrhaging of staff at Royal Bank of Scotland, according to FT reports*.

Economic efficiency, fairness and social harmony demand a reduction in bankers’ stratospheric pay. But policies will be effective only if two conditions are met.

Action must be globally coordinated – and no initiatives are likely to work unless implemented on Wall Street which, as Mr Augar stresses, still dominates global investment banking. Secondly, the underlying structural causes of large banks’ super profits must be tackled – for instance informational advantages, oligopolistic market structures, opaque barriers to entry and so forth. In practice, removing competitive distortions will requiring the breaking up of many systemically significant institutions.

*“Ahead in the clouds”, Murphy, Jenkins and Baer, Financial Times, March 14^th

** “Wages and Human Capital in the US Financial Industry: 1909-2006”, NBER Working Paper, 2010

*** “Reforming finance: are we being radical enough”. 2011 Clare Distinguished Lecture in Economic and Public Policy.

**** “Only global action can curb bonuses”, Financial Times, January 11^th.