Think Bankers Are Overpaid? Use Less Credit

These days, Americans are increasingly heard complaining about Wall Street compensation. John Mack, chairman of investment bank Morgan Stanley, is too. Unfortunately, he doesn't see the industry changing compensation levels anytime soon, since competition is only driving pay higher. So what can be done to fix the problem?

Here's Bloomberg reporting on Mack's comments:

"I still don't think the industry gets it," Mack said yesterday during an appearance in Charlotte, North Carolina. "The issue is not structure, it is amount."

He gives an example of why it's so hard to control compensation on Wall Street:

Mack, who retired as CEO of the world's biggest brokerage in December, cited a 28-year-old Morgan Stanley trader whose unit had earned $300 million to $400 million for the firm. After Morgan Stanley offered $11 million in compensation, the trader jumped to a hedge fund that paid him $25 million, Mack said.

If you think that $11 million is already too much for a trader to make, then presumably you think $25 million is bordering on insanity. You could try to diagnose what went wrong here, but it's pretty hard to identify where the buck should stop.

First, Morgan Stanley's motivation for paying him $11 million makes sense: he made the firm hundreds of millions of dollars. He should be paid accordingly. Second, the hedge fund can't really be blamed for upping that offer. If the trader can replicate his previous success, then at $25 million he'd still only be paid a small fraction of what he'd earn the fund. Third, you can't really blame the trader. Obviously if you're doing the same work as a hedge fund as a bank, then why not more than double your compensation?

The problem I see here is that it's consistently possible for a trader to bring in $300 million to $400 million in a year. If this was a sort of one-off payout resulting for some particularly lucky bet, that might be okay. But if it's possible to do this year-after-year, then something's wrong.

Where do the enormous piles of money come from that settle on Wall Street? Some consist of fees for transactions or advisory. Investment profit also plays a part. What has caused these quantities to grow so high over the past few decades? I think credit is mostly to blame.

Think about all of the outstanding debt right now. If all suddenly came due, do you think there's any chance that the world, as we know it, wouldn't crumble? Credit is way overextended. Businesses, banks, consumers and the government are so highly leveraged that it's hardly comprehensible.

As credit continues to grow, Wall Street capitalizes every step of the way. Businesses do debt deals: bankers get a fee; bond traders enjoy transaction costs; bond investors get interest; equity investors get a higher return because the credit brings growth to those firms. Consumers incur debt through a mortgage or credit card: bankers securitize it and take a fee; traders sell the resulting bonds and get a transaction fee; bond investors get interest; equity investors see broad returns because consumer spending increases. Similar logic applies to municipal and sovereign debt. The derivatives market then grows to facilitate all of that credit activity. Credit is the life-blood of Wall Street.

The way you lower profits, and consequently compensation, on Wall Street is by lowering leverage levels. And I don't mean only for banks. I mean for insurance companies, manufacturing firms, consumers -- you name it. If you shrink credit, then you have less intangible credit-based money providing real money to bankers and traders.

I really thought that the credit crisis would be a reckoning for economy. But it looks like the credit markets will shortly be returning to business as usual -- unless we make a choice to rely less on borrowing going forward. That could be regulatory, but it must also be done on an individual level. If consumers live within their means, then they'll utilize less credit. If businesses shift their capital structure to be less reliant on debt, then they will pay less to lenders. And finally, if banks are forced to rely less on borrowed money, then their profits won't be as outlandish. Credit isn't inherently bad, but too much can create dangerous imbalances.

Easy credit makes for high Wall Street profits. Credit got a little harder following the crisis, but only a little. Using less credit is a difficult choice to make, because using money you've actually earned, instead of borrowed, takes will power. It humbles us. Growth would be more restrained, but less volatile. More reasonable credit levels will result in a healthier, more balanced economy in the long-run.

(Image: AMagill/flickr)