mutual fund

Profits

For Andrew Haldane of the Bank of England, banks since 1900 earned profits typically not very different from those of other industries. But between 1986 and 2006 profits rose to extra-ordinary levels, rewarding all managers, whether competent or just plain lucky. His explanation? The banking industry, in search of profits and in response to increased competition, took the gamble of dramatically increasing leverage, thereby exposing the entire financial system to systemic risk.

During the golden era (1986-2006), competition simultaneously drove down returns on assets and drove up target returns on equity. Caught in this cross-fire, higher leverage became banks’ only means of keeping up with the Jones’s. Management resorted to the roulette wheel. Source: Haldane speech doc.1402; see also an article by Preston of the BBC.

Wages

This increase in profits resulted in management salaries and bonuses soaring well above the levels typical of the past. Floyd Norris of The New York Times  cites a study by two American professors, Thomas Philippon and Reshef Ariel, who attribute much of the increase not just to deregulation, but also to the inability of the regulatory system to keep up with the changing financial system.

“In retrospect,” the authors write, “it is clear that regulators did not have the human capital to keep up with the financial industry, and to understand it well enough to be able to exert effective regulation. Given the wage premium that we document, it was impossible for regulators to attract and retain highly skilled financial workers.”

Related questions

The Economist cites a study of the venture capital industry doc.1403 by American professors Leslie and Oyer, and concludes that the real puzzle is that, after 20 years in which private equity has dominated the takeover landscape, there is still not enough evidence to determine whether the industry delivers any economic benefits. In another financial industry, mutual funds, profits and economic benefits are similarly hard to reconcile.

Standard & Poor’s publishes regularly (see the most recent published in August 2009 for the USA and for Canada ) studies (known by the initials SPIVA) which invariably show that highly paid actively managed fund managers find it very difficult to beat the performance of passively managed funds. So how does one justify their high fees?

Canadian banking

In Canada banks and their regulators openly boasted of having avoided the credit crisis by having banks which were better managed, more stable and more responsible than those elsewhere in the world. But what is now being explained is that this may be due less to the world-class beating quality of their management, than the (involuntary) contribution of Canadian consumers who, more than almost anywhere else in the world, have been a source of cheap, stable bank financing in the form of retail bank deposits; see an article (or a PDF version here doc.1404) by two American economists, Huang and Ratnoshy.

The quality of executive compensation controls does not appear to be an alternative explanation. The fact that the CEOs of several major Canadian banks, at the worst of the crisis, had to voluntarily choose (because of the embarrassment?) to forgo their bonuses leaves us wondering about the controls on remuneration of senior management. How is it that the bank boards had authorized bonus plans that, in the absence of charitable action by senior management, would have paid out huge bonuses in the midst of one of the worst financial crises since the Great Depression?

Occupational prestige

How did ordinary citizens react to a dramatic run-up of banking profits and compensation, followed by a major financial crisis, in their perception of bankers? A Harris Poll released this year on the relative prestige of 23 different occupations placed bankers and brokers among the five lowest ranks, a level that has changed little in 30 years.

Conclusion

As we slowly work our way out of the recession, it will be interesting to see if the profits of bankers, bankers' salaries and the costs charged to investors, return to historical levels, or rather to the exceptionally high levels of the years 1986 to 2006.