Wednesday, November 28, 2007

Why does banking pay so well?

Superb article from Martin Wolf in the FT:

He starts with the question: "Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid?" and goes on to suggest the answer is "banking takes high risks. But the public sector subsidises this risk-taking. It does so because banks provide a utility. What the banks give in return, however, is gung-ho speculation.".

The key point is that (Wolf again; I can't put it any better): "banks benefit from sundry explicit and implicit guarantees: lender-of-last-resort facilities from central banks; formal deposit insurance; informal deposit insurance (of the kind just extracted from the UK Treasury by the crisis at Northern Rock); and, frequently, informal insurance of all debt liabilities and even of shareholders’ funds in institutions deemed too big or too politically sensitive to fail... if things go well, shareholders earn exceptional returns. If they go badly, the downside cannot exceed their equity. Beyond that point, creditors and government share the losses."

This goes a long way towards explaining why bankers are paid so well: during times of profit, banks can pay out crazy wages and bonuses. However, the government guarantees Wolf alludes to above in effect put a lower bound of zero on remuneration: bankers don't ever have to pay back earnings (i.e. receive negative wages), no matter how thinly capitalized their industry or how bad their decisions turn out be. Wolf again: "...a run of profitable years in which shareholders receive high returns and employees are handsomely rewarded. Then comes the year of the locusts ...since they do not receive negative pay, they are able to keep their earlier gains."

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