Investment Banking Pay Structures: What are shareholders paying for?

It is a well known fact that Investment Bankers, traders and salesmen are some of the most highly paid professionals on God's green earth. Even the near collapse of the global financial and economic system has not succeeded in burying multi year guaranteed contracts or multimillion dollar paychecks.

One question that I seem not to have answer to is: why are investment bankers and traders so highly paid? Yes the hours are crap and job security should be described more in the lack of it. But do investment bankers work harder than Resident Doctors, I really don't think so. Is the job security any worse than that of military or police officers, whose careers - and indeed lives - can be easily terminated by a posting to a war zone or a chance encounter with a trigger happy bandit. So we cannot justify the outsized pay by citing job insecurity or hazard, so what drives investment banker pay?

Another often cited rationale for astronomical pay is that traders often make so much money for the company that they are guaranteed a cut of the profits - sometimes as much as 50% - as compensation. However, a bigger question that needs to be answered is who made the money in the 1st place, the trader or the Bank?. Will the same trader have been able to make as much money if he had been working for a lesser name, without access to teams of research analysts, structurers, systems people and access to real time trading flows?. Will Andrew Hall - the Citi energy trader to whom a $100 Million paycheck is due - have made so much money if he had been working for some nameless XYZ securities firm?. I seriously doubt it!. A lot of his success can be attributed to the stellar cast that Citi has been able to amass to support his efforts. He has access to the best systems, the best analysts, a far-reaching and global informal information gathering network and a whole lot of other things. So if a lot of an investment bank's success is attributable to teams of people working in concert, why are individuals then as richly rewarded as they currently are in Wall Street and the City of London?.

Let me clear, I believe that the capital markets play a very central role in ensuring the proper functioning of the world's economy. Without capital markets and the work being done by the often maligned bankers and traders, we would all still be economic cavemen. Without bankers and traders, excess capital will accumulate in one region of the world or country while other opportunity-rich regions remain starved of capital. That being said, the skills/knowledge required to be a successful investment banker/trader are neither exceptional nor scarce. Though some bankers/traders invented options, swaps and other mind bending derivatives, the truth is that the bulk of investment bankers - including many that earn million dollar bonuses - just originate and process deals. The mental aptitude required for investment banking is not on the same page as that required to be a world class poet, a Nobel prize winning physicist, brain surgeon or a Fields medal winning mathematician. Investment banking does not require or demand "out of this world" skills and as the British City Minister said "Derivatives traders and others are not footballers and should not be paid as if they are". Well said!

Although I don't support explicit pay caps for bankers, because I believe it is an example of an externality that can impair markets and unduly stifle innovation. However, the current global downturn should not be allowed to go to waste, shareholders and chief executives have a chance to force through tough pay reform measures while the financial jobs market is still soft and this has to start from the bulge bracket investment banks. Bulge bracket investment banks - such as Goldman Sachs, Morgan Stanley etc - should actually pay out the least bonuses rather than be industry leaders in terms of compensation packages. They need to develop compensation models and systems that strip out the portion of their firms' revenues and profits that are franchise/reputation driven and those that are employee initiative driven. The truth is that if Goldman Sachs pitches for 10 capital raising mandates, it would get at least 2 or 3 due to its market reputation and global coverage, even if the banker(s) making the pitch(es) is(are) near completely clueless!. It is therefore not very smart to reward a banker for free-riding on the bank's reputation in this manner.

I think bankers' compensation are business decisions that are best handled by shareholders and not by governments. However, shareholders need to be aware that the current compensation models need not be cast in stone and like any discerning buyer they must demand to know exactly what value/"alpha" they are getting from the bonuses they are paying the bankers and traders that work for them.