Ask anyone within the apologencia of the financial services
industry why bankers are paid so much and the stock answer you will receive is
that in a knowledge-based world, talent is the key source of competitive
advantage; and so banks pay the market rate to retain talent and remain
competitive. But with banks across North America and Europe still on central
bank life-support, how well does this argument stack up five years on from the
2007 crash?
The apologists’ answer is to emphasise recent hardships and
the perennial threat of talent flight. In terms of hardship, many
emphasise that talent have lost their jobs and have lower bonuses (than
last year). Others
argue that the shift towards non-cash, deferred bonuses has robbed talent of
its deserved payout because an individual’s pay is now more reliant on the
performance of their company’s stock, over which any one unit of talent has
little control. The 50% tax rate on high earners also pushed talent to
the brink, so that further attacks on their pay could potentially lead to talent
flight to competing sectors in Switzerland, France, Germany, Hong Kong and
Singapore. And that is some threat, if we are to believe Nick
Clegg’s recent assertion that without the tax paid by financial services during
the 2000s, there would be little public sector job growth outside of London (though
we shouldn’t because it is patently incorrect).
For all the made-for-TV, strategic emotion around the loss
of banking talent, are we in danger of becoming paralyzed by the fear of losing
something that perhaps wasn’t really there in the first place? Answering this
question really depends on what we mean by ‘talent’ and how we understand the
relation between skill, performance and reward. Is talent something you have,
or something you demonstrate? And is reward something that reflects your
achievements, or reflects the context within which your achievements take
place? These questions are all the more pertinent at a time when billions,
perhaps trillions, of central bank money is being poured into the UK’s
financial institutions, yet so much still ends up in the pockets of a very
select few. By what metrics might we know ‘talent’? By what achievements might
we award it its name? Perhaps we might gain some insight by briefly looking at
the particular history of the term.
The etymology of the noun ‘talent’ is interesting in its own
right. In its first meaning, dating back to the ninth century, ‘a talent’ was an
ancient weight or a money of account widely used by the Assyrians, Babylonians,
Greeks, Romans, and others so that, for example, a Babylonian silver talent was
equal to 3000 shekels. By the early 17th Century the themes of
measurement, value and field of application were transposed to the realm of
human endeavour: ‘talent’ defined an aptitude for something expressed or implied. Talent was given its name only
in a particular field, where superior skills could be assessed, valued and
valorised.
But like many English words and phrases with such history,
there is blur, overlap and polysemy as the ebb and flow of language carves new
distributaries which divert from the main stem. ‘Talent’ again around the 17th
Century also took on an additional meaning, one with a quasi-spiritual accent.
This second ‘talent’ was used to describe a divinely entrusted power or ability
of mind or body; one that required space and nurturing to flourish. This talent
had no referable field of application, this talent was mercurial and
precocious, embodied and thus inimitable, but also boundless in its
application.
It is this latter ‘talent’ that is now summonsed in the defence
of bankers pay. It is an abstract talent that is not only portable but - like
fairy dust – has the ability to transform whatever or whomever it touches: it
is dextrous and dynamic so that it can be applied to any industry, any field. In
a knowledge-based economy, this is the kind of talent that all organisations
want, and are so desperate to pay for.
This quasi-spiritual definition is particularly convenient
for the apologists of finance. It allows all economic questions to be framed in
terms of the need to provide freedom for and reward god-given talent, and the
important of talent-friendly legislation to attract it to these shores. But evidence
of genuinely portable, transformative talents are rare. Even in the cultural
industries where the uniqueness of talent is perhaps unparalleled, there are
profound limits to its effects when applied to new domains. Take a superstar
like Madonna for instance, despite an illustrious musical career her acting
career has earned her a record five Golden
Raspberry Awards; while retiring sports men and women notoriously struggle
to repeat their successes in other fields, often leading to feelings of social
dislocation and depression.
So let’s be more grown up about it. Talent is not fairy dust
and skill and expertise have a very specific context within which it is best
applied. That doesn’t discount the possibility that specialised skills can make
large differences in niche areas, which may justify large rewards. But that
then means we need some kind of activity or operating measure to gauge the
presence or absence of ‘talent’.
In banking arguably the most appropriate operating measure
of any banker’s skill is the return on assets figure: ‘how much net return can
you generate from the assets you purchase or create’? Here, the figures are
illuminating. The table below uses the 2011 results for Barclays (though we
could have used other years and other banks). It shows that in its capital
markets arm where the best paid bankers work, Barclays Capital, actually shows
a disappointing return on assets – lower than Barclaycard, their retail arm and
‘other’ activities. Furthermore it tells us something of the precariousness of the
monestised asset values from which elite bankers draw their high pay. Barclays
Capital makes more pre-tax income than any other segment and roughly 50% of the
group total, but it does so by stacking an astronomical £1.16 trillion of
assets onto the group balance sheet, which was 75% of the group total (and staggering
only a little less than UK GDP, which was £1.44 trillion in 2011). Here the
value of BarCap’s assets would need to fall a mere 0.25% to completely wipe out
the segment’s pre-tax profit; 0.5% to wipe out group profits; and 3.5% to wipe
out its profits and Core Tier 1 Capital (valued at £43,066m).
As we know, the value of these assets do fall and when they
do, the repercussions for other stakeholders are dramatic. The table below
presents a stakeholder analysis of the top 6 UK banks from 2001-2009. It
presents the cumulative average gains for the state (tax income received and
direct bailout expense) for shareholders (capital gain/loss and dividends) and
for the workforce (staff costs) across the five institutions. The bailout figures do NOT include the
bailouts of Northern Rock (£25bn, 14 Sept 2007) and Bradford and Bingley (£42bn
29 Sept 2008); or emergency loans to HBOS & RBS October 2008 (totalling
£62bn); or special liquidity scheme/credit guarantee scheme (£500bn in total);
or asset guarantee scheme 24 Feb 2009 (£325bn). The shareholder figure is for
total capital gains/losses and dividend payouts and does not measure returns to
shareholders owning shares in 2001. So this figure, if anything, understates
the diverging fortunes of different stakeholders.
It would be difficult to credit those bankers at the heart
of the leveraged, CDO boom ‘talented’ by these graphs, even if they do have an
impressive record of educational attainment. In the same way that I would struggle
to justify the same term myself if, despite any apparent intelligence and
skill, I chose only to teach my students through the medium of mime and blew my
departmental budget on powerful hallucinogens which led me to perform demented shamanic
rituals on the ashes of my unmarked exam scripts. Talent must be recognised in
a particular context, and if the results disappoint then you have to raise
serious question about whether those skills are appropriate for that industry, whether
high pay is merited, and whether we should be thinking of these people as ‘talent’
at all.
If talent should be judged by performance, and performance
is disappointing, how do we explain the endurance of high pay norms then? It
may simply reflect two key industry features: i) the revenue earning capacity (NB
not profitability) of an industry or field and ii) the number of other charges
and claims on that revenue stream. The best paid UK academic will always
command a lower price than the best paid UK banker, not because the banker is
better in some market for abstract talent, but because a university has an
externally imposed revenue ceiling (student quotas, the resources available
from funding bodies etc) and a range of administrative, teaching and research
costs which mean claims on revenues are distributed amongst the many rather
than concentrated amongst the few. Similarly, a graduate with an engineering or
physics PhD will be differently remunerated depending on the industry in which
he or she chooses to work. Those skills may add equal value in manufacturing or
finance, but they will be more generously remunerated in finance because there are
a relatively smaller set of claims on that quantum of revenue. The central
claim of our 2006
book still stands: high pay is a function of position, not necessarily talent.
The real reason elite bankers are paid so much is because
they are a small group of interconnected individuals close to a big till.
This ‘big till’ and its attendant high pay norms are a dead
weight loss. A dead-weight loss refers to a situation where an
implied subsidy or some other distortion leads to an allocative inefficiency.
It is usually used by neo-classical economists to describe the distorting
effects of taxation, minimum wages etc on a free market. It has even been used
by bah-humbug-ers
to describe the net losses of gift-giving at Christmas. But here it could be
used to describe the effects of a bailout guarantee on the unit value of elite
labour. Bank bailouts have had two effects. First they have kept banks on life
support and allowed the continued payment of high fees to elite workers, when
by rights banks should be cutting costs and writing down debt. Second, with QE,
central banks have reduced the costs of capital to banks, allowing them to ramp
spreads on their outstanding and future loans – thus providing funds to both
recapitalise and maintain pay norms, while passing on costs to their customers
(as well as taxpayers and the public sector). This would not happen in any
other distressed business, where the workforce would immediately bear the brunt
of adjustment.
The big till is underwritten by government and central banks. But what are the social returns? The social dividend is limited by problems of insider claims and opportunity costs. On the former, for example, the generally accepted view of the mutual fund
industry is that actively managed funds pay more for their stock
pickers than those passive funds who simply buy the index, but that active
funds underperform passive funds (eg Gruber 1996). Further studies suggest that
net returns to investors are negatively correlated with a fund’s expense
levels, which are generally higher in actively managed funds (Carhart 1997). In
purely economic terms, this means that talent is overpaid on a marginal cost
basis: the skill of active stock pickers may allow the fund to generate superior
gross returns, but they incur higher costs from transactions, information and
pay, so that net returns to investors are lower. Put in the language of
‘claims’, this is the same as saying that any benefits which might accrue from
more accurate stock picking are captured almost entirely by insider talent
working within actively managed funds. The same may also be true of activities
like high-frequency trading which involve eye-watering sums spent on algorithm-builders,
code-writers and telecoms infrastructure which improve
latency by milliseconds and give traders manning the war machines of
finance fleeting advantages. Returns on individual trades may be marginally
higher, but those gains are largely claimed by insiders within the bank. Outcomes
for markets are as yet unclear
because it is open to all kinds of socially
useless wargaming, while returns to investors appear modest and may
disappear quickly. And, as Knight
Capital’s investors can attest, it may leave your capital exposed to
unforeseen software malfunctions and other unanticipated interactions in
complex systems – the likes of which Charles Perrow has
discussed.
If the higher returns that accrue from modest or superior
performance are captured by a small number of insiders, then we need also to
think about opportunity costs. That is – if those skills were applied to
another area of the economy, would they improve the national economy relatively?
If, rather than spending their time writing code for high frequency trading,
the same skilled engineers and mathematicians developed new software for high
tech manufacturing or green technologies or some other high skill, technology
intensive industry, would they produce more jobs, more spin-off activities,
more economic multipliers etc? I have no data or study to answer this question
(and it is a complex one because HFT clearly creates its own demand for
high-tech telecommunications investment), but my hunch is that on balance, they
may well do. Skilled workers would undoubtedly be paid less in other
non-finance industries, even if their net economic contribution were greater. Is
high pay in finance therefore more a market distortion rather than a sign of an
efficient market for talent?
It seems that the ‘market for talent’ metaphor is
inappropriate when explaining high pay in banking. Activity performance by any measure
has been poor, which suggests that whilst these individuals clearly have
skills, they cannot be considered ‘talent’ in many instances. Similarly high pay
is only possible because the industry is heavily subsidised and operates in a
permissive, lightly regulated environment. Their talent is not ‘bid up’ due to
its scarcity nor its transformative power. Even at the peak of the boom surveys
like that conducted by Deloitte found that only very small numbers of CFOs
within financial services claimed there was an ‘inadequate’ supply of talent
(defined as “high potential individuals likely to excel in finance”). With such
a thing in mind, perhaps the role of the banking institution is not to put a
ceiling on elite bankers pay, but rather to put an implicit floor under it by
sanctioning certain high risk, high volume, low return activities and creating
positions which allow a select few insiders to value skim for considerable
personal gain?
Stanley
