1-15-2010

Investment Banking Comeuppance Interrupted

What really has everyone so upset about the bonus situation?   It’s obvious that something is not right about a system that supports moral hazard. It’s also obvious that in this specific regard, there is an asymmetric risk-reward architecture associated with large American banking institutions. The process gives big banks incentive to take a lot of risk with their balance sheet to try to create bonus pools, and when it works, they get paid obscene amounts. When banks lose money because of that risk, the government steps in to bail out the system. The banks quickly restore themselves and get back to the business of, again, manufacturing profits from risk. When I was a bank analyst in the mid-1970’s, banking was a different business. The net interest spread told the story. Banks borrowed at one cost, and lent at another cost. A margin was created. This margin, applied to the quantity of earning assets, told the whole story. I had a really simple job trying to figure out where bank earnings would fall out, relative to the interest rate environment, forecast, and what part of the business cycle we were in. This has changed as banks’ trading departments have become dominant pieces of the puzzle. Banks can leverage up dramatically, borrowing against government securities and deploying sophisticated bets in order to manufacture revenue. An obscene portion of this revenue is then paid out as compensation. The shareholders are given justification in that, “we can’t operate without the best and brightest and we have to pay this to get them.” Therein lies the rub. This is simply not true. This is what the country is really upset about. The country is really upset because they thought the banks were going to finally get their comeuppance. Hundreds of thousands of people in the United States have gone to the best business schools. Most of these people are really smart. They work at jobs in Fortune 500 companies. They work at jobs in small companies. They work at government jobs. They have no chance of ever receiving a million dollar bonus. They know they put in less hours than an investment banker, but they still work hard and are smart. Tens of millions of other people in the United States are smart and work hard and they earn less than one hundred thousand dollars per year. They can’t comprehend the greed and avarice at work in the banks.  The population at large has held back its disdain of over-sized compensation while the economy was on a roll. After experiencing the worst recession since the depression that was clearly brought on by excesses in the financial system, they believed it was time for the bankers to get their comeuppance. The Congressional hearings one year ago when top bankers were drubbed by members of the House of Representatives may not have been fair, but it reinforced that it was time to for bankers to become accountable for their greedy actions.  Low and behold, one year later, taxpayers have bailed out the banks. Bonus pools are huge. The issue of paying in stock or cash has been trounced out like it’s a penalty to the bankers. Most citizens are getting bonuses in cash OR stock. Many people are still out of work. Not only haven’t the bankers received their comeuppance, they are laughing at a system that is so stupid that the only penalty that is being applied to them is a small, very small, TARP make up tax that will be spread out over time and partially passed along in costs to customers.  No wonder the public is really annoyed. Representative democracies move VERY SLOWLY, but VERY SURELY. We haven’t heard the last of this. Re-regulation is not only in the wind, but coming down the pike. When it hits, it won’t be fair and it won’t be pretty, but it will be effective in handing bankers their comeuppance.  

Fred S. Fraenkel
Vice Chairman and
Chairman of Investment Policy
Beacon Trust Company

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