Explaining Wall Street Bank Compensation Rates

For reasons that aren’t entirely clear to me here in the United States there’s an enormous temptation to confuse money with virtue. It might be due to our Calvinist heritage or wishful thinking. However, as it says in Ecclesiastes:

I returned, and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.

High compensation isn’t due to virtue or intelligence or hard work. It’s due to the forces of supply and demand and/or the ability to manipulate them via the power of government and maybe some good luck. That’s it.

When I read Robert Samuelson’s explanation of the high compensation rates of Wall Street bankers:

The explanation for Wall Street’s high pay lies elsewhere. Most of us are paid based on what we produce or, more realistically, what our employers produce. By contrast, Wall Street compensation levels are tied to the nation’s overall wealth. Investment banks, hedge funds, private equity firms and many other financial institutions trade stocks, bonds and other securities for their own profit. They also advise mutual funds, pension funds, endowments and wealthy individuals on how to invest and trade.

There’s a big difference between annual production and national wealth. In 2007, the year before the crisis, annual production (gross domestic product) equaled almost $14 trillion. In the same year, household wealth was $77 trillion (5.5 times production); that covered the value of homes, vehicles, stocks, bonds and the like. Eliminating nonfinancial assets (mainly homes) cut wealth to about $50 trillion (3.5 times). Deducting household debts from financial wealth pushed net worth to $35 trillion (2.5 times income).

People who are trying to protect or expand existing wealth are playing for much higher money stakes than even hardworking and highly skilled producers. That’s the main reason they’re paid more. Similar percentage changes in production and wealth translate into much larger gains or losses in wealth — up to five times as much based on the crude math above. Many lawyers enjoy the same envious position of being paid on the basis of wealth enhancement or protection. They’re involved in high-stakes mergers and acquisitions, estate planning, divorces and tax planning. On average, partners in the top 25 law firms earned $1.3 million to $4 million in 2008, reports the American Lawyer magazine.

I can only look at it with a bit of skepticism. When bankers’ compensation rises when the national wealth is rising that explanation looks pretty good but how does it explain bankers’ compensation rising when the national wealth is flat or has dwindled as much as it has in the last couple of years shouldn’t the compensation of Wall Street bankers go down?

I can’t recall when I first heard this alternative explanation but I do know that I heard it at least thirty years ago and I heard it from a banker. Think of banks as rooms full of money and bankers as covered with glue. Some of it is bound to stick to them as they pass through. Basically, the money is there and the rules allow it.

Bigger rooms means more money in them which in turn means that more sticks to the bankers passing through. If you’re genuinely concerned about bankers’ compensation, there’s a ready solution: smaller rooms. Or you can change the rules—government regulations—that are the glue that allows the money to stick to the bankers. Use caution since the rules you change might well destroy small, local banks that didn’t have much to do with the financial crisis while merely being an inconvenience to the guys that put us in the soup.