The popular zeitgeist seems to be that we need to put a cap on Wall Street bonuses. However, I believe that everyone is missing the point. The real question is why banks are so profitable that they can give out huge bonuses at all. What should a company do with huge profits? Isn’t it more egalitarian in some sense to give it to the employees rather than the shareholders?
So why are banks so profitable? I can see at least three possible reasons. The first is that banks have very large fluctuations in revenue so in up years they reap huge profits but then they lose a lot in down years. However, since the government bails them out when they go down, they have an effective ratchet so that they only make money. The second is that the people on Wall Street are just so much smarter and talented that they just create more wealth. The third reason is that Wall Street banks have an effective monopoly.
So let’s break down these hypotheses. The first one probably has some merit because these banks take highly leveraged positions so that they can make a lot of money. If you borrow and bet big then you’ll win or lose really big. Getting bailed out whenever you lose sure comes in handy as well. I can’t fully buy the second explanation. I’m sure the people on Wall Street are very smart but I doubt that they’re a lot smarter than people in Silicon Valley, big pharma or academia, which are all less profitable (especially academia). A physicist on Wall Street can easily make (at least in the hey days) ten to a hundred times more than a full professor at a prestigious university but there is no way she is ten times smarter. Now some would argue that the professor may lack some personality traits that are necessary for success on the street (or they are unaware that they could be making more money) and that may be partially true but I think there are plenty of aggressive smart quantitative people that are not taking in huge bonuses. While the likes of Warren Buffet and George Soros are simply better than everyone else, their talents are nonalgorithmic and not what the big banks use to make money.
That then brings us to explanation three. There must clearly be barriers to entry and advantages for being big that the banks enjoy. If there were no such advantages then their would be more firms and more people on the street eroding the profitability. Microsoft does so well because it is a monopoly. The big three US car companies only did really well when they were an oligopoly. Google has an effective monopoly (except in China).
So what exactly are these barriers? Well I think one is that the fixed costs of doing business on the street are pretty high so being big gives you a definite edge. Small entities simply can’t compete because they lack the infrastructure, personnel and capital. Now, if the advantage increases as you get larger then you end up with a classic winner-take-all network. The firms that have a slight edge get bigger, which amplifies their advantage and that crowds out the weaker firms. Being big also allows you to make bigger bets. Repealing the Glass-Steagall Act, which separated commercial banking from investment banking, also gave an advantage to banks, because they had access to even more capital to leverage into even bigger bets. There is probably some collusion between the big banks as well to keep other firms out. Hence, it seems to me that if we want to curb Wall Street excesses then reducing bonuses is not the answer at all. That may be the only fair thing taking place on Wall Street. What we really should do is to re-institute Glass-Steagall and eliminate the monopoly power the banks have.