Tony Jackson of the Financial Times has an article tonight on a topic near and dear to my heart, namely the fact that higher capital ratios will not lead investment banks, um, banks, to change their highly profitable “wreck the economy” behavior. He focuses on the role of how the change from the partnership model has turned investment bankers into mercenaries (and one might add, mercenaries willing and able to foment precisely the sort of trouble in which they can then intervene):
In the 1980s, those firms were absorbed into larger quoted conglomerates, whose obligations to shareholders made such swings in profit impossible. So the burden fell on employees, who were axed wholesale in bear markets and re-employed – usually by other firms – in the upturn. This has turned investment bankers into a tribe of mercenaries, ready to switch allegiance instantly for a better offer. That might seem unattractive but it is a rational response to industry conditions.
The resulting individualism, though, can run to extremes. One American investment banker I know, who works freelance on projects for different employers, tells me he regards taking a salary as “demeaning”. He eats what he kills, and is beholden to no one.
At this point, the dysfunction of the system becomes jarringly apparent. Investment bankers trade off the assets and brand name of the firm for which they work. The firm’s owners are entitled to be paid for that.
Peter Hahn, an ex-investment banker who teaches at London’s Cass Business School, says: “These guys say ‘I’ve brought in $10m, so I want $1m.’ But how much risk did they bring in with that? And how much came in because it says Goldman or Citi above the door? These are the hard questions, and they don’t get asked.”
As someone who worked in the industry in the 1980s, Jackson’s take has merit but also misses important issues. It has been disturbing to see how the change from the partnership to the OPM (other people’s money) model has led in a straight line to predatory behavior (a subject we discuss long form in ECONNED). And he is correct that mobility has a lot to do with it, but for more complex reasons.
Many have taken note of the obvious way that partnerships constrained risk-taking: unlimited liability tends to focus the mind. And having the overwhelming majority of one’s personal wealth tied up in a partnership also made the very top producers in the industry immobile, which is what Jackson focuses on.
But the part he ignores is how partnerships also restricted the ability of junior staff to switch firms, which led to the development of strong cultures. Recall that the big prize in the industry was becoming a partner and partners put all the other partners’ capital at risk. Each partner ran a very narrow franchise; the head of corporate bonds had no idea of the risks the head of M&A was taking (yes, a management committee provided oversight, but it was mainly on issues that fell outside of normal daily operations). So effectively, each partner, or group of partners in a profit center ran a franchise under a bigger umbrella.
The pay demands of talented junior staff were kept in line because they also did not have a lot of mobility. Remember, inviting someone into the partnership is a very risky decision. Therefore the firm’s owners will be most comfortable with someone they have observed closely over time, in a variety of business and personal settings. In the vast majority of cases, anyone who switched firms mid-career would be less likely to make partner than home-grown talent (the exceptions would be firms poaching staff in areas where they were weak, or individuals trading down from a more prestigious to a less prestigious firm to get more latitude or a bigger payout). That meant that the junior staff knew they had to build what amounted to sweat equity in order to get a piece of the firm.
Consider how the model has changed. In franchise businesses, the entrepreneur makes an investment to acquire the rights to a franchise, which is governed by a detailed contract. Franchisees often are organized (better by the franchisor, as in cases like MasterCard) into sub groups (regional is a typical pattern) to facilitate the dissemination of new programs and to provide venues for getting franchisee input. But any governance structure has already organized the franchisees so they can pressure the franchisor for more concessions, and in a worst case scenario, revolt (threaten litigation, exit, etc.)
In the old partnership model, younger staff had to earn their way into the franchise and had very limited ability to exit (although there were some firms that had spectacular internal fractures, such as Lehman after Bobby Lehman’s death). In the new OPM model, junior staff can and do switch firms readily, and since the industry has always treated pay as the only measure of worth, the name of the game is simply maximizing one’s bottom line, rather than working in a franchise that one hopes to inherit.
Thus OPM players inculcate a very different set of values than those of the old partnerships, that of focusing on the current kill and of viewing client and firm relationships through a cold economic calculus. Should we be surprised at the result? As we wrote in an article, Indefensible Men:
With economic casualties all about, thanks to baleful financial “innovations” and reckless trading bets, the tone-deafness of the former Masters of the Universe is striking. Their firms would have been reduced to sheer rubble were it not for the munificence of the taxpayer—or perhaps, more accurately, the haplessness of the official rescuers, who threw money at these players directly and indirectly, through a myriad a programs plus the brute force measure of super low interest rates, with perilous few strings attached.
Yet what is remarkable is that the widespread denunciations of excessive banking industry pay are met with incredulity and outright hostility. It’s one thing to be angry over a reversal in fortune; it’s one of the five stages of grief. But the petulance, the narcissism, the lack of any sense of proportion reveals a deep-seated pathology at work….
Although the word “entitlement” fits, it’s been used so frequently as to have become inadequate to capture the preening self-regard, the obliviousness to the damage that high-flying finance has inflicted on the real economy, the learned blindness to vital considerations in the pay equation. Getting an education, or even hard work, does not guarantee outcomes. One of the basic precepts of finance is that of a risk-return tradeoff: high potential payoff investments come with greater downside….
Many psychological disorders are otherwise healthy tendencies carried too far, unchecked by other personal attributes. Single-mindedness, drive to succeed, aggressiveness and lack of remorse are useful traits in business, but when do they tip into the psychopathic? In the case of Wall Street, the collective psyche has suffered as important restraints on ego and behavior have eroded.
And it is not at all obvious how to turn the clock back on this development.
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This is a very insightful post but I feel that many of the NC posts are solely focusing on the recent financial meltdown and the failure of economists to notice what Joe Public could see way down the rail tracks.
What is less discussed is the root cause of the original decade of stability & economic boom which fueled the rise of mercenary traders using “Other Peoples Money”. Where did all this money come from? where was the wealth creation for all this? We all know the answer, it is on the labels on our clothes and on the back of the goods we purchase – Made in China/Vietnam/Indonesia etc etc. The massive increase in the global workforce is the root cause. 100’s of millions of willing workers, debt free workers (c’mon, if you didn’t have any debts or mortgage to pay would you need such a big salary, would your boss, would everyone in the chain for each product you buy?).
We cannot change this and until transport costs from the other side of the world become uneconomic and/or the debt chain in the far east matches that here in the west then we just have to work out a new way of living, within our means.
Such is life.
Well, you asked for it…:-), and needless to say I differ with your assessment.
You need to read my book. You cannot do a discussion of why we had the crisis in short form, the seeds were sown in the decade after World War II.
I really don’t see the difference between the two of you. If it wasn’t for cheap labor and positive productivity, wouldn’t all that debt that was created produce wage inflation and price inflation instead of asset price inflation?
This topic dovetails nicely into the issue that banks don’t want to hold onto anything and take their profit over time.
This does make investment bankers mercenaries because the profit they made last year can be leveraged to derail the very entities they just profited from.
“And it is not at all obvious how to turn the clock back on this development.”
I don’t think that’s even possible. But that doesn’t mean it’s permanent either. Wall Street, like many power structures ultimately rely on something else to support it. That something else is the government and society at large. It’s relationship with society is parasitic, and thus, Wall Street must do what parasites do – extract from the host until the host dies. In nature, parasites find another host, Wall Street won’t be so lucky.
During the Great Depression, Wall Street was paralyzed because the US Gov’t chose to (naively?) liquidate, liquidate, liquidate… and the gold standard was also restrictive. And so, the parasite’s strength was sapped, and it was easier to tame: Glass Steagall, Pecora, etc… Such regulations can only be applied to a wounded beast. We don’t have that, yet.
Today we have a monetary system that is easily expandable (to a degree) and it keeps the parasite well fed, while the host (society) loses all strength. Nothing will stop this parasite but its own destructive behavior. Why? Because it’s own power is the only thing strong enough to bring itself down. There is no other power equal to it. It is an unrivaled power.
I hate to say it, but no grassroots movement or “good government” era can exist to tame this thing until this thing, this wildfire, burns itself out on its own. And then we rebuild.
Misthos, you said this:
‘Today we have a monetary system that is easily expandable (to a degree) and it keeps the parasite well fed, while the host (society) loses all strength. Nothing will stop this parasite but its own destructive behavior. Why? Because it’s own power is the only thing strong enough to bring itself down. There is no other power equal to it. It is an unrivaled power.’
Your express a very palpable sense of defeatism. Dfeatism is based on the deception promoted by the financial class, that this system is the best possible and that overthrow of the system will result in catastrophe. Although change and rooting out corruption from the system will be painful
and difficult, let us remeber that the the financial system is a system created by people, so it is a system that can be changed by people. the United States still has the Goverment apparatus by which change can be affected. The only thing that is lacking is focus and will in the population, in part because they are still relatively comfortable and entertained, in part because we have MSM spouting the lies of the financial priesthood. Our work is to open the eyes of people, to realize how they have been decieved. It will be hard work, but certainly possible. Defeatism is neither warranted or useful.
I don’t know. I think I’m being realistic. As JK Galbraith once said:
“All successful revolutions are the kicking in of a rotten door.”
The door is far from rotten. The chance for populist change was the Fall of 2008. It didn’t happen. Wall Street got stronger and richer. That doesn’t stop me from posting comments on various blogs, or from running my own blog to increase awareness. But let’s face it. We’re just eggheads that discuss this, and that’s where it ends.
That’s not to say what we’re doing is pointless. I think there’s value in it for when the time comes to rebuild, as they did after the Great Depression.
The system will only change when a larger crisis hits it. It will change due to its own mathematically unsustainable nature. Were it to change due to some “enlightenment of the masses – it would have happened by now. Only a larger crisis that knocks down Wall Street, and unfortunately most of us due to 40 plus years of malinvestment, will resolve this.
It’s not defeatism, it’s understanding power structures. The masses win not because the elites were outwitted – I can’t think of an historical example of such a case. The masses win because the elites screw up. They haven’t screwed up… yet. But they are sowing the seeds of their own demise. Arrogance does that.
All we can do is sit back, grab the popcorn, and watch and discuss.
The Epucuriean [sp!]Dreamer had a post on this probably a year ago. “Let a thousand investment banks bloom” and had the basic premise. Investment banks should be relatively small partnerships that can fail.
But you are right to note that the odds of this reform happen are nil.
There is a huge bias towards getting bigger to tap into the too big too fail system.
Not to mention the larger your partnership is the more secure it is — if you want, look at the plight of the legal system which maintained the partnership model. 1) Lawyers are infinitely more depressed and prone to alcoholism than bankers (not to mention the population as a whole) and 2) Law firms are forming into bigger and bigger partnerships/organizations.
PS.
The government might have been naive about liquidation but a deep, deflationary depression that would require 25% unemployment seems a pretty steep price to pay to control banks…
“The government might have been naive about liquidation but a deep, deflationary depression that would require 25% unemployment seems a pretty steep price to pay to control banks…”
I say it is unavoidable. When the banks ultimately fail, and global trade relationships are re-aligned, they will take down much of the artificially created FIRE economy and its jobs with it (including those mega law firms).
And so, unemployment will skyrocket. In a perverse way, Greenspan was right when he said the stock market IS the economy.
It gives me no pleasure, but in my more clear-eyed moments I see things pretty much the way Misthos does. I just can’t articulate it quite so clearly.
Plus, I am a bit more of an optimist, but at this point I don’t believe government will stop it; I think if anything is able to stop the beast devouring us and itself, it will be some kind of third-party group comprised of fed-up, screwed-over business leaders.
I recently saw where the “elite” felt a closer kinship to each other around world than their countrymen. I imagine Wall Street has no more allegiance to the U.S. than the mills did to New England or the Carolinas, or the manufactories to the rust belt. When we’re drained, they’ll set up in Shanghia or Hong Kong. Good Night, USA.
To gain a better understanding of the kind of mind that you describe, I suggest reading this article: ‘The Psychopathic Influence’
the controlling psychopathic faction of a society (the financial elite), will recruit lower-level psychopaths to do their bidding. These lower-level deviants naturally seek employment in law enforcement, security, the military, politics, or other positions which they believe will offer them power.
From the Summary:
A small portion of the population have a psychological makeup which is much different than most. They are completely aware of their difference. They also know that most people are not aware of this profound separation. The difference includes an emotional deficiency, accompanied by a lack of remorse, which allows them to operate outside of standard moral boundaries. They are able to conceal this difference to some degree and usually appear to be generous and friendly.
They consistently engage in antisocial behavior which includes destroying people’s lives, in order to feed their inflated egos. During this process they frequently enjoy mocking their targets, which they see as weak, or are envious of. They will inflict pain upon others for no reason other than the enjoyment of doing so. They span all levels of society….
Psychopaths naturally gravitate toward positions of power. Many historical atrocities were caused by psychopaths. An organization or nation under a psychopathic influence will become saturated with its sickness. It will exhibit these destructive traits, from the upper levels, down to the smallest village.
http://www.thehiddenevil.com/psychopathy.asp
The major task of the Bush43 administration was to entrench such persons throughout the government, in a stranglehold, to service the finance and trans-national corporate sector.
GATT empowered these parasites to bulldoze any government protections of citizens.
“And it is not at all obvious how to turn the clock back on this development.”
Agreed it’s not obvious how to put the evil genie back in the partnership bottle. Could be tried by law I guess, but would probably be fought on constitutional grounds, or the “right to eat what you kill(with other people’s bullets)” grounds. Then there is nationalization, but having a great, big Fannie doesn’t sound that great either. The first thing that would happen is Timmay would point out the need for a GS1500 pay grade (to be competitive with foreign banking, of course), Congress would approve it, and that would just propagate thru the rest of the government compensation.
But it’s pretty straight forward to have the regulators start doing their jobs again and make the banks move away from legalized book cooking, take write offs, etc… Then the Fed should raise interest rates and take away their free money. These are top down moves which will obviously decrease the size of the bonus pool.
Making white collar crime illegal, and prosecute for it certainly would help. You can’t spend all that money very easily if you are in jail (buying roses for your date is unheard of). Also eliminate the practice of corporations indemnifying their management from fines levied due to management’s actions would go a long way towards making rule of law more democratic. Wouldn’t we all like to have a corporate logo pay our fines and/or do jail time for us? Or the modern internet version might be “My Bad Avatar” ?
But I think the free market should have a role in this too, unless the free market is totally brain dead. By now most bankers should know that “eat what you kill” many times is another banker. The other less sophisticated epicureans, say institutional and government investors, and even lowly dirt eating individual investors, have gained quite a bit of knowledge and experience lately about these financial products and deals being peddled. You would think they’ve lost their appetite for the shenanigans. How will the hunter-gatherer function if the prey left the hunting ground? Assuming Ben stops screaming “eat me” at the top of his lungs, of course.
“And it is not at all obvious how to turn the clock back on this development.”
End the idea that all NEW medium of exchange should be demand deposits created from debt (meaning all new medium of exchange should be borrowed into existance).
Start the idea that all NEW medium of exchange should be currency.
Curious thing time, it’s one way. What’s needed here is a trip to a nice little black hole and thence foward with a nice big bang into a new universe. We could begin by nationalizing the primary dealer banks and dispense with QEx. We could begin by prosecuting the fraud that brought us to this place.
We could also ban use of the word “talent” to describe anything that occurs as part of the banking, finance or securities analyst occupations.
These individuals may indeed have talent, however, in some other area. In that regard, a “talented” banker is not an oxymoron. They may be talented photographers, piano players or stand up comedians or karoke singers. Really.
This law would be hard to enforce though. I would say “efficient” might be a good substitute, if people would cooperate.
An “efficient” banker — that makes sense to me, as it politely doesn’t specify the source of the efficiency — maybe family contacts or B-school beer buddies or golf buddies or some form of idiot-savant-like numeracy. Or even better, maybe “driven”. A bit bland, to be sure, but there’s a connotation there that captures the hysteria and malignity of the single-minded pursuit of wealth, but in a restrained way that only hints at the vacuus soullessness while leaving it politely unmentioned.
ho ho cuss
Humans are social critters.
Changes to the culture alter human behavior.
Economists, IMVHO, need to bring a lot more social psychology into their analyses, and I’m really glad to see this topic being discussed.
The national economy, and those of us wholive and work in that economy, are subject to destruction by financial forces for only ONE reason.
They control the nation’s money system, and they use that control to their certain advantage as a matter of business.
The national economy is at risk because it’s good for business for those who control the money system.
Hello.
Earth calling.
We the people of the United States own and control the monetary system of our national economy.
To own and control that monetary system is what the War of Independence was about – it was fougfht for the reaqson that England would not allow the Colonies the use of their monies.
So, we got the right to control the issuance of our currency by way of Revolution.
It has already been done.
It’s time to wake up and smell the roses.
Congressman Dennis Kycinich has introduced the Bill that is going to take it back.
To save the national economy from being destroyed ass a matter of business.
Hello, America.
The National Emergency Employment Defense (NEED) Act of 2010.
http://kucinich.house.gov/UploadedFiles/NEED_ACT.pdf
It’s the money system that’s broken and insolvent.
We need a new money system.
The Money System Common
best way to ruin the economy
reward reckless, dangerous behavior with huge salaries and and never allow those taking such risks to fail or to have to take losses without government assistance. .
allowing calculated risk taken by small or medium size businesses, or by individuals to be destroyed by the reckless, then doing everything possible to resuce the reckless while doing everything possible to crush the middle class and small to medium size businesses.
Then have all those reckless individuals get in line for lunch at the white house, then go directly to the white house employment line.
Lloyd’s of London was run with unlimited liability private capital for over 300 years until around 2000 US pollution liabilities caused the market to look to “limited liability” capital. The market worked on a “subscription” basis where a risk would be shared by tens or even hundreds of “syndicates.” The responsibility for decision-making was thus diffused through the market. It is hard to understand but there is peer review (through a parallel market) rather than internal horizontal review by internal bureaucracies. This actually allowed for a truly “innovative” market. By contrast, the “limited liability” insurance companies are constrained by regulators as well as internal bureaucracies as to how they could deploy their capital.
The insight has always been (whether at Lloyd’s or in the US capital market) that a true “risk-taker” needs to be focused on the risk by putting his/her own personal fortune at risk. All of the internal reviews and “compliance” simply cannot be a substitute for such focus.
A subsidiary issue is the loss of “relationships” between those involved. This allows for a “give and take” over time where bad deals are replaced by good deals in order to keep a market and an alternative alive. This is more in line probably with the interests of those who are in for the “long term”. However, now the focus is more “transactional” where deals are done and stand alone. There really is no “relationship” in the old sense of the word.
In a sense, when it comes to true risk taking, the pure “free market” advocates have it correct except that they ignore the distorting effect that the government subsidy of “limited liability” status has on the marketplace. The resulting regulatory response to curb the externalities caused by the subsidy only then serve as justification for the bailouts.
the 500 pound elephant in the room is that US banks were having to compete against Deutsche Bank, Union Bank of Switzerland, Societe Generale, Mizuho, and all of the international banks, which never had any Glass-Steagall and some of which (China) are owned by the government.
IE, US financial industry has had to undergo ‘globalization’ just like every other industry. And when our precious US laws got in the way, they were run over with a truck. Just as labor laws and environmental laws have been destroyed by globalization (the economists euphemism for giving children cancer and torturing employees is “cheap labor”), the US financial laws were destroyed by globalization.
If Citigroup was not allowed to grow, then Deutsche Bank would have bought it. Same for the rest of the banks. . . we saw a taste of it as sovereign wealth funds and foreign banks poured money into Morgan Stanley and others in 2007-2008.
It is time to realize that the law in one country doesn’t mean anything, when globalized corporations can race to the bottom. John Thain, when pondering a merger with UBS, was told ‘[you know, youd have to move to Switzerland if this happened]’, and he responded without a pause that he would have ‘[no problem]’ living there. I cant remember where i saw this, but probably Crash of the Titans (Farrell) or maybe The Sellout (Gasparino)
IE, the true ‘internationalists’ did not come from the socialist movement, they came from the bowels of the capitalist heartbeat and the ‘efficient market theory’, which posits no countries and no nationalism. It is like the opposite of One Big Union that Woody Guthrie sang about. One Big Corporation has become much more of a reality.