A Theory of Investment Banking

sounds at least a little like my response to the original post, with less vitriol. it makes me a little proud to have weighed in on a question that caught the attention of writers/bloggers at The Economist.

Power corrupts, ultimate power corrupts even more. And what is more powerful than being on the very tippy-top financially? Yes I screwed up the cliche but I think you get my drift.

It's not JUST the long hours which determines a young worker's advancement up the ranks of investment banking.

If the world does not need more investment bankers, and plenty of people are willing to do it, then that is an excess supply, and their incomes should fall.

This seems like a strange conclusion to me. Suppose that the need for bankers is fixed, let's say at 10 (for simplicity's sake), due to the fact that only so many productive deals can be done. Further assume that those generate $10 in profits, so these are distributed to the 10 bankers, who each get $1. Suppose further that there were only 10 people applying for the jobs (so anyone who wants in can get in).

OK, now let's increase supply of wannabe bankers to 20. So only half get the job--but of the 10 that do, the average wage would be unchanged--it would remain at $1. It seems that a fixed demand implies that wages should remain fairly steady, or am I missing something here? "...world does not need more investment bankers" sounds like a horizontal demand curve to me...

Ack! Fixed demand=verticaldemand curve. Sorry about that, wasn't thinking. I don't think the numerical example changes, though.

I thought about this exact question a lot in the late 1980s when I was the VP of Planning, reporting to the CEO of marketing research firm. The CEO spent a lot of his time on mergers and acqusitions, and he paid a lot of money for the advice of a single investment banker.

Why not replace the one expensive outside advisor with a host of lesser paid outside advisors? From the CEO's perspective, however, he wanted one source of highly qualified advice, not a lot of less qualified kibbitzers.

I think this perspective explains a lot of the vast income generated by investment bankers in the M&A game.

You're right that the constrained resource is talented, experienced investment bankers. CEOs and CFOs, who actually contract the ibank when doing a deal, will only maintain personal relationships with so many people.

On the other hand, I would bet that the number of junior level bankers has increased significantly over the last two decades. Instead of a rainmaker + a junior partner, teams now consist of a rainmaker + a VP + an associate + an analyst. Still, it's curious that banks choose to work their youngest employees 100hrs/wk and pay them double their peers rather than hire 2x the number of analysts. There must be some efficiency to working them so hard.

To understand why investment bankers can make so much, one has to get away from the special characteristics of investment banking and look at all occupations which pay very highly: entertainment stars, sports stars, great authors, etc.

My guess is limited supply. That is why experienced investment bankers make so much and that is why movie stars, rock stars, baseball stars etc. make so much.

It is similar to the partnership model used in consulting firms and law firms. Hire a lot of smart, ambtious raw material, pay them well, and put them through a grinder so bad that only the most ambitious (and sometimes smartest/most talented) stick around for the rewards.

BTW, Liars Poker is not about investment bankers - it is about bond traders/salesman. Still a dysfunctional culture, but a different culture nonetheless. Predators Ball or Barbarians at the Gate gives a better picture of investment banking.

That's like saying there should be more Fortune 500 CEOs, since they seem to make a lot of money.

If you have x number of deals, they aren't going to be better if you have twice as many people working on them.

And if the people are paid a lot, it doesn't mean the businesses are better off with 2x deals.

There are also compensating differentials, since there is much volatility in earnings, when the market turns down bankers get fired in droves, they have to work long hours sucking up to annoying a-holes, and they burn out young.

I think that the reason investment bankers make so much money is embarrassment and status concerns on the part of their employers.

Let us say that you don't have any great money concerns and you are hiring a plumber. Let us say that there are established plumbers in town with fancy trucks and advertising. There is also a hardworking newcomer who charges 50% as much.

What is the upside to you of hiring the new guy? You don't really care that he is going to charge you 250 instead of 500 to unblock your drain.

But now maybe your neighbors in your fancy location look out the door and see the new guy's ratty pickup and think, why is he (you) trying to save money? Is he having financial difficulites?

These status things must mean a lot to well off people or no one would buy a Rolex. I think they mean even more in the context of mergers and aquisitions.

When you look at IB hiring out of b-school, there is an interesting trend: better looking people get hired, often over seemingly more talented people. My friends in IB often say that the analyst or associate job is more sales than anything else. Some portion of the rent capture by investment banks is a product of asymmetrical information and sales.

B.S.
I will take the case of M&A to elucidate the point:

Statistically proven: More than 90% of acquisitions are failures or fail to generate value.
Good question to ask is what is driving the M&A business? Pressure on companies to perform --> No organic growth> Regulatory constraint + desire of market control (monopoly,oligopoly etc)>Easy solution viz Acquisition. 2-3% commission in M&A deals of higher than billion dollar means a fortune.

Another demonstration: look at the main actors of KKR, Blackstone, and Carlyle.The best example is some ancient british royalty sitting in board of directors of 3i. No surprises- these are well connected people and they dispose an arbitrary power.

The point is we are dealing with a private club / interest group (invitations only). This extends from CEOs to bankers to Govt officials (the hailed Wall Street to Washington route). They are there to cash in their advantages. Similar is the case of management consultants.

Now look at another stuff: the recruitment criteria for top IBs and consulting firms - they are looking for smart individuals who have this inherent sense of insecurity and who keep on making more and more efforts. Its a pyramid of power/ money where the seniors make the juniors believe that they can at one moment belong to that much vanted "private club" . Analysts keep on trying in this modern slavery only to be used by the giants. The stick of meritocracy is only valid till the extent wherein employees of these companies can have a sincere belief that its not a pure political game.

The reason for limiting number of investment bankers by the seniors in those companies is basically a market control. This might be called a monopsony in the labor market.

Steven Vickers writes:

"Ack! Fixed demand=verticaldemand curve. Sorry about that, wasn't thinking. I don't think the numerical example changes, though."

Yes, the demand curve is vertical. But that changes everything. With a vertical demand curve, the demand is fixed in terms of quantity, not revenue. If you add supply, the price (in this case the salary of investment bankers) falls.

This is the clearest case of efficiency wages I've ever seen. And if you want a good account of an investment banker's life, I suggest you read Monkey Business.

Monkey Business, by John Rolfe and Peter Troob, is a very entertaining book about two entry level i-bankers who decided not to stay in the industry.

Prof. Kling-

Right, I understand that. I'm just not sure that supply-demand graphs are that illustrative in this case, particularly for the higher-end salaries, in the same sense that I don't think it wouldn't explain a great deal of the market for, say, top NFL quarterbacks--there's too much individual variation.

If the world does not need more investment bankers, and plenty of people are willing to do it, then that is an excess supply, and their incomes should fall.

Why don't the salaries of NFL football coaches plunge?

They are paid millions of dollars. Yet the world needs only 32 of them, and there has to be far more than 32 people who are capable of doing the job and who would be willing to line up for it at that price (and do).

I always thought bankers were paid a lot to preclude the temptation of using their knowledge of on-going deals for personal monetary gain. That's why they would not hire 2X the number of analysts at 50K each, because 1/2 analysts may be tempted to buy the stock of a future acquisition target, etc.

I early economics courses there is often an example of a supply curve for farms. It is noted the most efficient and successful farm will make a large economic rent because the marginal farm sets the price.

An economist should easily recognize the fallacy in looking at that one highly profitable farm and concluding "if farming is this profitable, there should be more farms".

Looking at the money people at Goldman make and asking "why aren't there more i-bankers?" is a similar error. They are not the i-banker at the margin.

There are indeed hundreds of smaller less successful i-banking operations, some of whom are earning fairly marginal returns on their efforts.

As I mentioned on the Economist website:

There seems to be a fair bit of talk about IPO's when in reality, investment banks have a much wider revenue stream.

Having said that, Hank Paulson, I believe, mentioned a few years ago that 80% of GS revenue comes from 20% of the bankers (or traders). He was most likely being nice- it may be 90/10.

Therefore, talking about average bonus levels may be a bit misleading.

The average salary figure is somewhat misleading. A lower level managing director at Goldman could receive a $3 million bonus, while a higher level vice president at Goldman might make $300,000. Less than half the company is a v.p. or above. and MDs are fewer than 1 in 20.

Becoming an MD at Goldman takes intelligence, hard work, experience, who-you-know, and a clean track record. It is much easier being accepted at Harvard or Stanford than it is to be appointed an MD at Goldman. One of my friends (who is an MD at Goldman) is a lawyer with superlative people skills and derivative product intelligence, along with the credit and legal grasp required to win deals from other top bankers.

These types don't grow on trees. They number in the hundreds, not the thousands.

Mr Juggles writes:
"Instead of a rainmaker + a junior partner, teams now consist of a rainmaker + a VP + an associate + an analyst. Still, it's curious that banks choose to work their youngest employees 100hrs/wk and pay them double their peers rather than hire 2x the number of analysts. There must be some efficiency to working them so hard."

Efficiency is key. An analyst that is just starting is easily 3x slower than an analyst that's had a year of experience. And to acheive the efficiency of the experiences analyst, the new analyst must put in the hours to get the experience.

As to the question of why there aren't more bankers, I think the answer lies in the fact that leaving the office at 2AM every day or pulling two all-nighters in a row is simply not a viable options for many, many perspective workers. That itself is enough of a barrier to entry to limit the supply of qualified bankers

It is in the interest of those already in the industry to limit the number of new entrants. Select the best and get rid of the rest. It makes little sense for firms to expand beyond the cyclical expansion and retrenchment that the industry is subject to. It makes much sense for new firms to form, but new firms would have a difficult time drawing business away from established firms without a track record.

It amounts to leverage, when you have potentially a billion dollars of earnings at stake would you fire a $10 million dollar CEO (or investment banker) in whom you have confidence and replace him with someone who you know less about for $5 million?

Your question "Why aren't there more Investment bankers" contains the false premise that there is a small number of investment bankers. There are in fact a great deal of them. They exist in all shapes and sizes from those few that make unheard of amounts of money to those that make nothing and have to leave the business. They exist at major firms, minor firms, brokerage houses, banks, boutiques and as independents. They exist in the major financial capitals and in cities all over the country. They specialize in all different industries and company shapes and sizes. I have always thought it to be one of the most economically efficient businesses as the measure of success is how much revenue you generate.

I admire all the market analysese that have been posted, I really do. The problem I see is that some still seem to believe in perfect markets (using graphis, vertical demand curves, etc.)

Would it be so hard to accept that we can explain the oligopoly by two simple terms. Capital (the most important barrier to entry) and patronage (the ultimate barrier to entry).
GoldmanSachs is simply massive, meaning they have less incentive to leave anything on the table due to their economics of scale in investment banking. As well, companies may be more easily trusting of them as their IPO service provider due to their ability to pick up the tab in the event of the coincidence of high % being witheld and overpricing.
Secondly, patronage. Do I really need to explain this? It's kind of how Haliburotn gets military contracts and how if you work for Boeing you've probably worked in the Pentagon, and vice versa.

Too much analysis. What ever happened to Occhums Razor anyways?

There is no need to re-invent the wheel here. As several comments have indicated, IB salaries are closely related to the peculiar economics of superstar salaries in many professions. Sherwin Rosen wrote some seminal articles on this topic, of which a very accessible verion can be found at http://www.geocities.com/valencia_aaup/The_Economics_of_Superstars.html
There is also an interesting book on this topic by economist Robert Frank called "The Winner-Take-All Society: Why the Few at the Top Get So Much More Than the Rest of Us."

After reading this work, one would be tempted to rephrase the "All men are created equal" dictum of the U.S. Constitution to "All people are created with talents which are lognormally distributed, but let us set up social rules as if we don't know ahead of time where each on of us will fall in the distribution of talents."

Alas, that is not very pithy. And John Rawls hadn't written his "Theory of Social Justice" at the time the Constitution was written. But I would recommend that people who are concerned about the issue of inequality due to superstar salary dynamics read both Rosen/Frank and Rawls for useful insights into the fundamental economic and ethical issues that are involved.

A lot of this discussion is mistaken. Much of Goldman's huge profit this year came from its proprietary trading division (who trade the firm's own account), NOT from the investment banking division (which did okay, but not spectacular). Goldman's proprietary traders successfully predicted the moves of the oil and natural gas markets, and made some huge bets in China which paid off.

"I think you have to come up with a story about barriers to entry. One plausible story that occurs to me is that some highly-remunerated aspects of investment banking require experience. For example, if a corporate client is involved in a megabucks merger, the client cannot afford a mistake. So the client would pay a premium to have an experienced M&A (mergers and acquisitions) team."

It isn't about experience, it's about contacts. Goldman has the buy-side connections to place a huge deal, and so you go to them and give them a few percent (trivial when you are raising billions) rather than a small bank with lower fees. To a lesser extent, having the Goldman brand on a deal makes it more marketable than having another top bank, which would be more marketable than a regional or niche bank.

"The scarce resource in M&A is the experienced investment banker. The barrier to entry is that you cannot get experience without doing big deals, and you cannot do big deals until you get experience."

The scarce resource is someone who knows an industry inside out, and can identify which mergers or acquisitions or expansions to propose. General deal experience is not that much of a component once people reach a certain minimum level.

"My favorite inside account of investment banking is Liar's Poker, by Michael ("Moneyball") Lewis."

Try "Monkey Business" by Rolfe and Troob if you want to get a real no-holds-barred account.

Arnold,

You are incorrect that the scarce resource in M&A is the experienced banker. The scarce resource in M&A is the achievable deal. And the main barrier to entry in investment banking is the trust of the client.

You must remember that the parties of a contemplated transaction have an enormous interest in maintaining confidentiality. They typically share extremely pertinent business information which, if used for competitive purposes, could destroy one or both parties. Since the upside of equity is unlimited, there are no financial means to compensate for such a loss. (Many such legal agreements have language to this effect, i.e. that monetary damages would be insufficient to protect against potential loss.)

Thus bringing two parties together to discuss a deal is a very difficult and demanding responsibility. The parties have everything to lose and only relatively intangible gains to be made if an agreement is reached. It's remarkable that any deal is contemplated given this level of risk.

All that said, the truth is that investment bankers really aren't compensated very well. Others in these comments have noted that junior bankers aren't paid as well as it might seem given the 100+ hour workweeks that are typical. From a Partner's perspective, however, one might spend six months working on a transaction, only to have it fail. At the senior level most banks work to at least some extent on an "eat-what-you-kill" basis, meaning if you don't make fees, you don't get paid. This is an enormous risk to take. Imagine investing your entire paycheck for six months into a stock only to have the company go bankrupt! This is why you don't see 60-year-old investment bankers. The dumb ones fail, and the smart ones use it as a stepping-stone to find other, more rewarding careers.

Why do some professions or fields paid more than others anyway? I mean investment banking is just an extreme example, there are many cases where a profession has continually paid much more than the average wage. I can understand a short term supply demand issue raising wages as we wait for more people are trained up, but over the long run shouldn't each profession earn the same, assuming the same intellectual demands? Lawyers are paid more than doctors, doctors earn more than engineers and so on.

One idea I have is to do with rent seeking, the existing members of a profession are the ones hiring and deciding the pay of the next generation - if they drive for cheapness by hiring lots of people and paying them low wages, this is likely to put pressure on their wages. It happens because the owners (shareholders) are not the ones hiring. This need not be conscious - professions rationalise by talking about the right stuff, and limiting the schools they recruit from.

But what limits the rent seeking (i.e. why not take 100% of the rent), and why are some professions better at rent seeking than others?