Interesting article in this week’s Financial Times, highlighting comments made by Larry Fink, founder of investment giant BlackRock. Apparently, Fink criticized the “luxurious” returns reported this quarter by a number of Wall Street firms (taking particular aim at Goldman Sachs). With less competition, Fink observes, the remaining firms are taking advantage of market conditions to charge huge fees for services. This includes profiting from the very rich spreads (the difference between the bid and the ask or buy and sell quote on a stock or bond) on even the most basic of trades. Mr. Fink added that he is seeking ways to reduce those spreads and save his client’s money.
Bravo! While we recognize Mr. Fink is clearly a player, this is about the first time we have heard someone go on the record as thinking about the client and not the bonus pool! In fact, the financial community forgot about the client some time ago. The biggest culprits continue to be the investment banks, almost more for historical reasons than anything else.
In the good old days, investment banks were partnerships. The capital of the institutions belonged to the partners, and they were able to allocate it to the deals they wished to see done. They could choose the risks they wished to take and those they did not wish to take, and they would put their own capital at risk to fund the chosen deals. At the end of the year the partners got together to decide how to distribute profits, including how much would be reinvested back into the firm. Generous payouts in the good years and sometimes no payouts in the bad years—that was the norm. In general, salaries were on the low side, but bonuses could account for 75 percent (or more) of an investment bankers annual compensation.
When the size of the deals got so big no firm could go it alone, we started to see syndications: A number of institutions would join together to fund a deal. Then the commercial banks lobbied to get into these markets and, in the 1990s, were finally allowed to do so. With everyone in the same game, there was now real competition for talent, and the commercial banks adopted the compensation structure of the Wall Street investment banks. In hindsight, this was really the wrong decision, something that became clear with the next evolution in the financial markets. Before this shift, bankers were paid decent salaries and were offered long-term careers at their institutions. Bonuses were paid but represented a percentage of a banker’s salary, not a multiple thereof.
Once the commercial banks were allowed into the game, with significantly more capital than most than most of the privately held investment banks, the private firms couldn’t afford to stay private to stay in business, so they went public. This development refigured the landscape. Investment bankers were no longer partners with a capital stake in the business; they were employees, playing with someone else’s capital. In a partnership, what you pay out and what you reinvest is clearly your prerogative. You are the owner and the investor. Once you have become a public company, however, two very important things change: 1) The money you put at risk is not yours, and 2) You don’t own the business anymore; it belongs to your shareholders.
With this transition, the approach to risk management also morphed. When playing with someone else’s money, you just don’t take it as seriously. During the good years, nobody seemed to care, as there was so much money to be made. When the markets turned, however, it became apparent that the old compensation model for the private investment banks really doesn’t work. I will grant that hiring and keeping smart people is an expensive proposition, but I would also argue that it is becoming a ridiculous expense, one that is coming out of the pockets of the clients of the investment banks (and those clients’ shareholders) as well as the shareholders of the investment bank. The cost of doing business in the investment banking world has been thus driven way out of proportion.
This is not benefiting the people who are providing the risk capital as much as it is benefiting the intellectual capital, the executives who may not even be stakeholders in the venture. We must work to change the fundamental model used for compensation in the investment banking community and seek to drive down the cost of doing business for the clients these institutions serve. We should also encourage shareholders to take a much more active role in keeping management mindful of good and fair business practices. Some very thoughtful suggestions relative to compensation have been chronicled by Franceso Guerrera in his FT column this weekend, “Banks can show they understand restraint via salary packages”. Thank you, Mr. Fink and Mr. Guerrera, for the reality check.