Tears on Wall Street

January 24, 2012

There were tears not only on Wall Street but in London and other financial centers around the world as investment bankers opened up envelopes telling them what bonuses they had earned in 2011.  None were more distressed than traders at Goldman Sachs where the average pay check per employee was $292,397 for the first nine months of 2011, compared to $370,056 the previous year.  There were also tears in London as Ed Miliband and David Cameron turned up the pressure on British banks to cut back on bonuses.

Ever since the 1970s, investment bankers have paid themselves substantial bonuses, leading all other sectors of the economy.  What did they do for their money? According to former Citibank CEO Walter Wriston, they were grossly overpaid, describing them as the “guys who get between the wall and the wallpaper.”  In the current economic environment, Wriston’s observation couldn’t be more apt.  With money cheap, the job of investment bankers has never been easier. But, based on banks’ profits, they are doing nowhere as well as they did before the global financial crisis.

One reason is that many investors got burnt by the complex deals put together by the likes of Goldman Sachs. These included the use of exotic derivatives that, as it turned out, neither the bankers nor their clients fully understood. That was 2007, when not only rich investors had good reasons to weep but so did mom-and-pop investors who saw their pension funds destroyed. No longer able to set up complex deals, investment bankers have had to find more honest ways to generate profits.

If one incident exposed the greed epidemic in the financial sector, in 2008, AIG paid out $165 million in bonuses to employees in its financial services division—the very same division that had nearly bankrupted the company and had to be saved by taxpayer bailout.  According to Nell Minow, a shareholder activist, “These guys are doing more to destroy capitalism than Marx.” She went on to say, “I believe that what we’ve seen recently is a corporate takeover of the capitalist system, to the benefit of certain actors in the system and to the detriment of everyone else”.

The root of the problem is the cozy relationship between board members and top management within investment banks. Board members are supposed to represent the interests of shareholders, yet they are often appointed by the CEO, who, knowing that the board’s job is not to rock the boat, happily sign off on large bonuses. One reason for this congenial arrangement is that the system does everything it can to work against genuine shareholder democracy.  For example, with pension funds, managers seldom bother taking an active role in looking after the interests of their members, even though they usually control large shareholdings.   As the economist John Kenneth Galbraith said, “The salary of the chief executive of the large corporation is not a market award for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself.”

Rather than being the epitome of capitalism, the system is closer to organized kleptomania.

Returning to Goldman Sachs for a moment, its rule of thumb in doling out “bonuses” is that they should represent around 50% of profits. The system has nothing to do with incentives for performance and everything to do with being a thinly disguised profit-sharing system with executives rewarded in good times but suffering little in bad.  On the other hand, investors—the capitalists of the system who put their money at risk—find themselves sharing the upside but not the downside.

The knee-jerk reaction is to say that shareholders have only themselves to blame. On the other hand, the law does everything it can to make sure that the real owners of corporations have little say in how they are governed, the very betrayal of the capitalist system.

Adam Smith foresaw this situation. He warned business owners that once they handed control of their company over to directors, they should to expect “negligence and profusion.” The very self-pity that we see today as bonus checks are sent around shows how little investment bankers care about looking after the interests of their shareholders.

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