This blog has no consistent mission statement or goal and hopefully will stay that way, outlining both the problems with the finance industry and the inconsistencies with anti-finance arguments. At the same time, it became apparent during the first month of writing that there existed a large body of content in a gray area consisting of things everyone within finance believes are unarguably true, but even reporters that have been covering the industry for 20 years do not. As an example, the fact that the industry is designed as structure to generate transactions, with all of the media appearances and research reports functioning as a Marketing Department roughly analogous to that at Frito-Lay, remains hidden from most investors and commentators.
That is all to preface a terrific post by The Epicurean Dealmaker (TED) over the weekend which, in 500 words, blithely defenestrates a well-intentioned academic study attempting to link CEO pay to risky management decisions. TED’s point is that CEO pay is largely irrelevant to the discussion. The real question is how much commission revenue was generated by department heads, a number that frequently exceeds CEO annual pay, and whether this formed a catalyst for risk-ignoring behavior. In my experience, it definitely does.
I want to extend the argument a bit further to propose that investment bank revenue is a net position of between 10-20 smaller “bubbles”, for lack of a better term, composed of each component of Capital Markets. Each sub-department of an investment bank – Equity Trading, Equity Sales, Investment Banking, Bond Trading, Structured Products, Prime Brokerage, Prop Desks etc - forms one of these components.
To backtrack briefly, one of my former global investment bank employers used Revenue per Employee as the primary measuring stick for departmental budgeting, and at first this seemed a remarkably unsophisticated, blunt tool. Over time, however, it became apparent that the system had one extremely profitable outcome – it got human assets into areas with rising revenues and profits extremely quickly. (The other interesting side effect is that by not distinguishing by salary – an admin counted against you equally to a higher-salary skilled person – it kept the number of support staff to a minimum.). At any given time, staff and budget were being removed from departments with declining revenue and added to those with rising activity.
It is very rare for all departments within Capital Markets do be doing well at the same time, and this is the primary source of bonus time animosity and a vicious form of political skullduggery that would make the Tea Party look like, umm , a tea party. . The multi-gazillionaire Masters of the Universe bond traders of the late 80s were the miserable also-rans of the mid-90s. The Structured Product departments that were a major driver of profits starting ten years ago are doubtless shrinking rapidly as I type along with the death of the CDO market. The profitability of the investment bank operations overall, and thus CEO pay, is the net position of the success or decline of each department.
TED more or less covered this, only written better. The part I want to emphasize though, is the way in which all of this structurally encourages asset bubbles. Because, if CEO pay is based on the net profits from all departments, the commission revenue from each separate department is clearly not. Remember that finance generates revenue primarily through the number and size of transactions, not successful investments or the course of markets. The key point here is that nothing generates transactions like asset bubbles. The more money that comes in, the more commission is generated, the more staff get allocated, the more product/ideas get generated, the more money all of those staff make in bonus. The big money attracts big talent, people eminently able to invent new ways to exploit the trend.
Importantly, this hypothetical department is generally not exposed to a potential bubble’s inevitable collapse, outside of lower commission revenue and staff cuts, so they will wring every ounce out of that bubble they possibly can. After all, market tops are notoriously hard to call and Soros himself has noted, through his Theory of Reflexivity, that all bubbles go on much longer than anyone thinks possible. We’ll jump off that bridge when we get to it – the legal department can take care of the lawsuits down the road. The department head, who might have made $10s of millions over the course of the rally, could likely care less about getting fired after all is said and done if it makes management happy.
So TED is entirely right – the place to look for excessively risky decisions is not the CEO, who is responsible for overall profits and cleaning up any mess than results from excess bubble stoking, but the individual commission-incentivized departments generating the highest profits. Risk Management is essentially the process of standing on the tracks in front of the money train which is, to say the least, a politically unenviable position in any organization. For regulators, always fighting the last war, by the time they even start sorting out the whos and whys and where all the money went, the bubble has moved to a new department. Current candidates for this phenomenon include the lending operations under ETFs and funky methods for I-bankers to raise capital for banks ahead of Basel III deadlines.
I suspect that, although the process described above is Fisher-Price elemental for any finance employee with rudimentary observational skills, it will come as a surprise to many outsiders as an example of the Interloper “gray area”. The interesting question for me is, given the literally thousands of reporters and commentators on the financial industry, why this remains so.