Bonus? You Just Met Us! (Part 1)

Financial institutions and investment firms (to which I will sloppily refer as ‘Wall Street’ here) have been busy tallying the numbers for 2010 in preparation for the annual ritual of bonus payments.  Predictably, there will be some jaw-dropping headline numbers about the size of firms’ payouts and the amounts received by certain individuals; and there will be some uproar from politicians, talking heads, and ordinary people about how such compensation is unjustifiable and probably evil.  Over the next several days, I intend to share some thoughts about the compensation model of Wall Street that I hope will frame the issue in relatively non-judgmental terms, as the pragmatic and moral conclusions one draws from this spectacle will be incorrect absent an objective diagnosis of its root causes.  My general view is that Wall Street’s compensation model exists because clients and investors are willing to pay for it, rightly or wrongly, and that whatever reform one might hope for is a fool’s errand in the absence of meaningful pressure from those stakeholders.  And, more broadly, this model reflects the reality that individuals can generate profits on an enormous global scale, and that our society will (and should) struggle to balance a number of competing values — meritocracy, compassion, liberty, community — in figuring out how to adjust to this reality.

But, first, a small attempt to reframe the narrative of the Wall Street bonus, although one might instead euphemize it as profit-sharing, variable compensation, or simple blood money.   The conventional term ‘bonus’ does not really help Wall Street from a PR point of view, because it connotes something over and above the fair and expected compensation for an employee.  In reality, expectations for bonuses, which may constitute half or more of an employee’s total compensation, are explicitly part of employee’s career decisions.

A better reference for Wall Street bonuses, although at a different scale, would be tips for restaurant servers.  A server would likely not be induced to work just on the basis of his stated wage – it is expected that tips will contribute as well.  His take in tips depends on some factors he can control directly (e.g., his level of service and skill at cross-sales at his tables), some he can influence indirectly (e.g., by exhibiting hospitality and creating a good atmosphere for other servers’ tables), and others totally beyond his control (e.g., whether the economy makes people more or less likely to dine out).  On Wall Street, an individual’s bonus is a function of her personal contribution to the firm’s profitability, her group’s or business unit’s contribution, the firm’s overall results, and other variables such as her political savvy or competitors’ practices.  There may be some mechanisms for pooling tips across tables to mitigate the randomness that comes with table assignments, as banks have multiple business units with different profits and losses.  And I think one can argue reasonably about whether it’s fair that a waiter at Per Se is entitled to the same customary percentage service charge as a diner waiter who “works just as hard” filling orders at a fraction of the check size – just as one might debate the absolute compensation levels on Wall Street relative to, say, the manufacturing sector.

I draw this distinction because narrative matters to our intuitions about fairness.  Take the case of a senior investment banker whose annual compensation is, say, typically $200k of base salary and $800k of bonus.  (I’m making these numbers up.)  She does a phenomenal job and brings in some hugely profitable deals for the bank and its shareholders, but the bank had an awful year because a bunch of traders made bad bets on, hypothetically of couse, mortgage-related securities.  When bonus time comes, perhaps she is only awarded $300k.  From the public’s perspective, it is still outrageous that a struggling bank would pay out any sort of bonus, particularly an amount that is so far above the median income.  From her perspective, however, her wage was unexpectedly cut in half through no fault of her own – a situation not unlike that of displaced factory workers, for instance, but for which the public lacks sympathy because of a sense that she is still “paid enough” already.  Would it be fair for a contractor to finish remodeling your house, only to have you pay half his agreed-upon invoice and escort him outside?  I think the right answer is, “no, except under certain circumstances” and a more constructive debate is whether any of those circumstances obtain rather than whether the overall level of construction costs is too high.  (One such circumstance might be: you would have been forced into bankruptcy if you paid his whole bill, in which case a costly process would have ensued that potentially left everyone worse off – not that I’m trying to find analogies for the financial crisis at every turn…)

I don’t think it’s fair to imagine that Wall Street employees demand ‘lavish’ bonuses because they believe they deserve it for doing God’s work, but rather that they (like everyone) work under certain expectations for what their level of pay will be, and that it’s generally lousy to change the rules after people put in the work that they committed to.  But it is fair to examine critically the myths and realities that drive (total) compensation in the financial sector, which I will take up next time.

Some tidbits in the meantime: the Economist has a fairly reasonable take, and their third point is one of the better arguments in the debate — although I’d note that it doesn’t directly apply to investment firms, which make up a considerable portion of the ‘overpaid’ elite; and I don’t think it goes far enough in examining the way bank employees extract personal rents by virtue of their privileged positions in the economy. This latter point is touched on by RBS’ chairman in this thoughtful interview from the Beeb, although his point is a slightly different one (with which I, generally, agree) — that much of the talent mythology in financial services is, as our friends across the pond might put is, bollocks.

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