The Say on Pay debate is heating up on Wall Street where government financed (or bailed out, if you prefer) institutions are gearing up for bonus time again. So, here’s the question: Is Wall Street pay merited or a sign of fiscal irresponsibility? Grant Thornton’s David Weild, the well-known former head of a major investment bank, former vice chairman of NASDAQ, and chairman of Capital Markets Advisory Partners, a capital markets think-tank, offers some thought-provoking pointers.
Directorship: What is Wall Street thinking when it pays these huge bonuses in this economy?
David Weild: From Wall Street CEOs down to the business unit heads, they are smart enough to understand the social and political implications in their pay decisions. Yet they are bound by their business instincts to think first about one thing: “How do we retain our key talent.”
Essentially, every manager of every investment bank goes through an exercise every year of:
1. What are competitors saying they will pay comparable staff (firms need to know this so that they can assess the risk of keeping/losing an employee)?
2. Who are my key franchise-maintaining performers/producers and how do I have to pay them to ensure that I keep them?
3. Who are the people that if they leave, won’t adversely impact our franchise? (typically, you take money that you might have paid to these folks and make sure you take care of the key talent).
4. Even if the corporation lost money this year, what lines of business were highly profitable where if we don’t pay up to keep these people we will lose them to the competition?
D: What about those who appear to take advantage of the latest short-term financial dislocation? Derivatives being the latest in a long line.
D.W.: When new businesses emerge on Wall Street (for example, mortgage-backed securities in the ‘80s, high yield in the early ‘80s, derivatives in the ‘90s) there are a limited number of qualified professionals, margins are fat, the market is growing and everyone competes for this talent. Demand exceeds supply. If a firm undercompensates key talent, the business goes into decline and the cost to shareholders is higher than if they had paid higher competitive compensation to begin with.
However, a new product may have these dynamics for only a decade or so and the talent then oftentimes needs to find a new career. When we see a market dislocation, such as occurred during the S&L Crisis over a decade ago, or the Credit Crisis of 2008, it is a signal that prompt attention is needed – the opportunities created can be enormous however short-lived but the risks may be equally large and often unknown. The economy needs this combination of outsized opportunity to attract the capital flows and talent needed to develop it effectively. Then, effective risk management is needed as a counterweight to staunch the potential economic wounds.
D: Is Wall Street ever guilty of overpaying?
D.W.: Yes, there are plenty of times when firms try and buy talent to build new businesses and in that process they overpay for people. There are plenty of instances where a lot of money gets spent on salespeople, traders and bankers and the firm’s shareholders never make a dime – it could be because the plan was flawed to begin with (there have been plenty of financial supermarket ideas that hoped to get synergies from cross-selling insurance and brokerage products which never worked out – AXA-DLJ, Prudential Insurance-Bache Halsey Stuart Shields, Travelers Insurance-Smith Barney – but firms didn’t know they wouldn’t work out until after they made the investment). Or, it could be that the plan is underfunded and the firm can’t stay the course. Or, it could be that the market turned against the strategy, as it sometimes does (think about how trading spreads were crushed in the equities business by decimalization or how retail brokerage commissions were disintermediated by online trading).
D: How should we look at Wall Street compensation then, what factors should be considered?
D.W.: The fact that pay is so high on Wall Street ignores the risks and the lack of longevity/stability for professionals. Doctors and lawyers, frankly, have much lower career risk. I say this for three reasons:
1. Wall Street is extremely Darwinian. They hire the best. Eighty hour weeks for young bankers are the norm. The stress of trading is the stuff of legends.
2. Turnover/purging of professionals is extremely high. When I was at Prudential Securities, I once calculated that, after 10 years, I was the last of 30 professionals that remained. I made it another 4 years before there was a change at the top – reporting lines were changed and I was caught in the political purge that ensued. Market cycles are very ugly on the downside with mass terminations not uncommon. Staff is arguably compensated for a total lack of job security with high pay.
3. Enormous amounts of money are at stake. To hire and retain the best, you need to pay competitively. Goldman Sachs has hired and retained the best and pays the most and of the large firms has arguably performed the best.
4. Rampant age discrimination. The law protects older employees from disproportionate firings. However, the law does not require that older people get hired proportionately. As a result, the likelihood that anyone will make it to 50 in an investment bank or senior trading role is low in comparison to other businesses.
D: The bottom line?
D.W.: Pay is high on Wall Street because it needs to be. The right way to control it is not to regulate pay but to regulate risk taking. Then, consider related issues like the all important transaction incentive, and, above all, increased transparency. The market can do a better job of fixing the economy than the government but for that to occur, economic incentives must be better aligned with long-term public interest. Consider, for example, how unsustainable teaser rates and no-money down mortgages created dangerous economic incentives. Similarly, allowing market participants to package and sell securities without retaining any risk or responsibility for these instruments fomented full blown systemic risk. Taking profitability out of supporting small capitalization equities depresses the entrepreneurial economy by undermining the functioning of the IPO feeder system to the public stock markets.
We need better-informed legislation and regulation to create proper incentives, checks and balances. The bottom line: Put the carrot in the right place but keep the carrot.
David Weild is a senior advisor at Grant Thornton and Chairman of Capital Markets Advisory Partners, a capital markets think-tank. He can be reached at: David.Weild@GT.com