John Kay, economist and chair of the Government review of equity markets and long term decision making [PDF; and it's long!], was speaking to the Edinburgh University Business School, ostensibly on “Why are financial services so profitable?”, but essentially discussing remuneration in financial services. (This may because the answer to the original topic is a quick “they’re not!” – profits from the boom years were wiped out in the crash of 2007 and the ongoing global financial crisis: the profits were illusory).
The standard economic model of wages is that workers receive the same as their marginal unit productivity (I think!). The article in Wikipedia explains it better than I could… A big problem with this model is that it is very hard for organisations to know what the marginal productivity actually is. In large corporations through to the smallest business employing people, whilst the theory might say this is how wages are calculated, my guess is that actually no one knows. What is the marginal productivity of a waiter, a bar tender, a bank teller – or the CEO of a major company?
Kay discussed three different economic theories to explain real remuneration patterns and income distribution, each of which comes from different economic and political assumptions.
The first is that what may be perceived as excessive wages reflect political power and rent seeking. Economic rent the amount paid for a resource in excess of the amount to get that resource into productivity. In the example Kay used, the amount that Wayne Rooney is paid by Manchester United is probably far more than the minimum that Wooney would need to be paid to get him to play football: the difference is because ManU have to pay this excess to stop him moving to another club, who might pay more: in an open market, those other clubs bid up the price. (Kay may have been a little premature on this specific point, though the principal stands…)
The economic power in this case is with Rooney; similarly, successful bankers can threaten to move to another employer – or even another country. They could work anywhere – they have highly transferable skills – and their employers might worry that if they don’t pay their high salaries, they would lose access to the bankers’ skills. (I am not so sure that this threat is a problem now that much of their success has been proved to be illusory.)
The second model Kay covered is what he called “the estate agent problem”. The economics of estate agency is, according to Kay, curious: the rate of fees is generally static, with competition not acting to drive down prices. Estate agents generally charge the roughly the same fees as their competitors. This is because users want to pay for the best service; no one want to pay for an ok, but cheap, estate agent (let alone a bad but dirt cheap agent!), since the benefit accruing from paying a bit more for an excellent agent would far outweigh the cost.
Banks therefore pay for the quality they perceive they receive. They don’t want to pay for a mediocre performance when they believe they can pay a bit more and get excellent performance. Similarly, no board of directors is going to hire a CEO or MD they believe to be average: they will all want the best, and their recruitment firms will help – and bid up the price. But it is doubtful how much difference CEOs can actually make. Luck has an awful lot to do with their success or failure, as do the people they hire.
(Recruitment agencies and remuneration consultants have a lot to answer for, too. All firms want to be seen to be good payers – management roles, at least: job ads often describe roles – firms – as “top quartile pay”; I don’t think I have ever seen a role described as “bottom quartile pay”, though of course 25% of jobs, and firms, must be! Remuneration consultancies produce regular reports showing the market rate for specific jobs, which firms expect to have to pay to get the people they want – and the market rate inflates each year as firms adjust their rates to stay with the market.)
The third issue Kay identified is that of “bezzle“, a word coined by J. K. Galbraith to describe the undetected amount of corporate fraud. Before the fraud is discovered, the victims believe themselves better off than they are. Prior to the global financial crisis, we all thought we were better off than we actually were, because of those non-existent banking profits. As someone said (attributed to Nassim Nicholas Taleb), “we borrowed from the future, and now the future wants it back!”
Until a fraud is discovered, we are all better off! (Kay has writen about the global financial crisis in terms of the bezzle.)
The asymmetric information between financial institutions and their customers – that is, just about everyone – and between fraudsters (call them bankers, fund managers… people who are claiming their bonus for no special performance) and institutions are able to make excess profits. Until of course they get found out. Clearly, even though they have been found out, a great many still think they are worth it.
There was a discussion about how better to align reward and performance – locked-in long term share options, maybe – and perhaps a more apposite debate on the kind of people we want running our companies. This last is important. The traders who do the jobs in banks may do so precisely because they are attracted to the high risk, high return environment. Whilst we might benefit from people with less risky approaches, they are unlikely to be attracted to those jobs. Similarly, the CEOs we appoint might actually be wrong for the job – but less aggressive, flamboyant people aren’t going to apply. And what board would appoint a wall-flower against an alpha male bull? Maybe we get the management we deserve.
I’m not sure if any of this really explains extravagant remuneration and the bonus culture that has been laid bare by the crisis. Maybe it is simply greed, and people gaming the system: trying to get as much as they can.