Here is a fun fact. Between 2000 and 2007, the top five executives of Lehman Brothers pocketed $1 billion. At Bear Sterns the top five guys made even more: $1.4 billion over the same period. So on average, each one of these financial geniuses pocketed $240 million, that is $30 million a year, or over half a million dollars a week, or over $100,000 a day for eight years. Not a bad wage for driving your company into the ground, utterly destroying all shareholder value, and bringing the world to the brink of financial disaster.
The conventional conclusion from this abomination is that incentives on Wall Street are skewed. Indeed. Traders call their compensation structure “eat what you kill”. That is to say, their bonuses are a percentage of the annual profit they make their firm. An axiom of finance is the greater the risk, the greater the potential profit. So the easiest way to make big profits is to take big risks. If you are lucky, you pocket your share. If you are not, well, the shareholders take the hit. Nassim Nicholas Taleb (whose Fooled by Randomness is one of the best books on the financial crisis, even though it was published long before the bust) describes one popular strategy as “picking up nickels in front of a steamroller.” Clearly that is a bad idea, unless somebody else gets squashed, and you still get to keep the nickels. If we want to avoid the next financial crisis, we need fix investment banking’s incentive structure: risk and reward must be linked.
An even more obvious, although less conventional conclusion, is that financiers are overpaid. Finance’s function, as all the textbooks tell us, is to transform societal savings into the most productive investments. First of all, it is unclear that most financial transactions even do that anymore. Real investment as a share of GDP actually declined over the past 30 years, while the financial sector exploded in size. A bigger financial sector should translate into larger capital investments. It has not.
Secondly, we as a society seem to be paying over the odds for what should be a simple banking function. In 2006,…