Arnold Kling  

Why aren't there more investment bankers?

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David Leonhardt writes,


From World War II through the 1970s, while most Americans were getting solid raises every year, the incomes of the richest 1 percent were doing only a little better than inflation. Since the 1980s, the two groups have switched places. The affluent have received huge gains, and everyone else's pay growth has slowed down. For the last six decades, in other words, the American economy has been much more of a zero-sum game than we might like to believe.

I think that the term "zero-sum game" is probably off. We have absorbed well over tens of millions of immigrants in this period, and my guess is that the economy has been positive-sum for them.

But what all this handwringing about the income distribution is missing is a story about competition. Why aren't the rents at the high end of the income distribution competed away?

I can see how doctors earn rents--there are obvious barriers to entry. And the field of entertainment generates winner-take-all results, in part because being popular makes you more popular.

But a lot of the big money is in finance--investment banking. One would expect more people to go into investment banking and compete away those rents.

The market solution to income inequality would be more investment bankers. Why aren't there more investment bankers?

I am pretty sure that all of my daughters could master finance if they wanted to. Both economic theory and my wife are telling them that they should major in accounting, but none of them will do so. I may be naive, but I suspect that there are a lot of people who could raise their incomes by going into investment banking. They are not prevented from doing so, but they choose other careers as a matter of taste.

This leads to the hypothesis that wealth is becoming more concentrated because fewer people are focused on achieving enormous wealth. My daughters, by not competing, enable the people with investment banking jobs to earn high rents.

In short, the distribution of wealth represents differences in taste. Many people prefer jobs with less income and more of other characteristics.

I think that many people steer away from finance and accounting as a matter of taste. But people who choose different occupations are not all satisfied with simply making their own choice and letting other people make their choices. Just as there are people who believe that it is in bad taste to smoke or drive an SUV, there are people who believe that it is in bad taste to be an investment banker. And just as there are people who want to see government do something to punish smokers and SUV owners, there are people who want to see government punish those who choose high-income careers.

UPDATE: a commenter makes a good point, which is that many investment bankers are not in the top income bracket. It might be that if there were more investment bankers, the more run-of-the-mill six-figure incomes would be competed down, but the incomes of the superstars might remain the same. I don't know enough about what generates the really high rents in the industry to know whether more competition lower down would lead to less spectacular rents at the very top.


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CATEGORIES: Income Distribution



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The author at Half Sigma in a related article titled U.S. Census vs. Arnold Kling writes:
    According to the U.S. Census 2007 Statistical Abstract, 74.5% of college students report that "being very well off financially" is "very important or essential." This is up from 62.5% in 1980 and 36.2% in 1970. More evidence that Arnold Kling's [Tracked on December 15, 2006 2:52 PM]
COMMENTS (30 to date)
KipEsquire writes:

The term "investment banking as a career" is comparable to the terms "health care as a career" or "education as a career" -- you are lumping together far too many and too varied occupations for your thesis to have any potency.

(P.S. Yes I am an investment banker. No I am not in the top 1% of incomes. Go figure.)

cljo writes:

I like your competition point. On the "taste" point, I think it has something to do with the perceived social and political limitations of being an investment banker. For example, I know conservative doctors, liberal doctors, Republican doctors, and Democrat doctors. Most people "know" exactly who an investment banker is. If they are not that person, regardless of their interest in finance, then they move on.

Timothy writes:

It takes a very specific type of person with a bad case of OCD to be an accountant.

David writes:

Maybe if you had a son...? But the people who bad mouth finance probably insist there are no gender-related career preferences.

Mike writes:

Well, I was an investment banker for 2+ years after graduating from Snooty College. The pay was outstanding; the lifestyle was nuts. I averaged well over 110 hours per week during that time; I traveled 3 days per week; I met all sorts of big whigs (Michael Price, The Crown Prince of Luxemborg, e.g.); it was awesome.

But, I wanted to learn more about economics; I wanted to teach others about economics and the real world; I wanted to enjoy some leisure time each day; I wanted to live in a less populated area, etc.

So I spent 5 years getting my PhD at Cornell and taking a cozy teaching job at a college in the rural south.

My income is 1/3 of what it was when I was 22 years old. My students claim I am worse off and irrational. There just wasn't much intellectual stimulation buying and selling asset managers, and securitizing 12b-1 mutual fund fees.

My cohort at my bank all make well into the 6 figures now - and there are a few stars. I do not believe more entry at the bottom will prohibit the stars from making a killing. I really do find investment banking analagous to golf before and after Tiger Woods. More bankers leads to more aggressive tournaments where we see the winners getting even richer relative to their productivity differences. I suspect you'd see a lot more innovation too - this is the part I regret from leaving Wall St. For example, our group was the first group to securitize mutual fund fees. We extended that business into Canada. When I left, I was working on selling a guaranteed investment vehicle to institutional clients (earning about 8% per year) where we would take on all of the long-term investment risk and any returns beyond 8%. I suspect you'd see a lot more of these products developed, even into the retail sector. You would see creative investment banking for small businesses (e.g. we helped a small gold range securitize their driving range fees). I don't see the finance world as zero sum at all, I think competition might intiially slow wage growth at the entry level, but that the industry would explode further with more people.

randy writes:

It's because in getting hired, it is always "who you know" not "what you know". We don't even sort of live in a meritocracy. I don't think that getting into investment banking is such an easy endeavor Arnold.

Chris writes:

Mu understanding has been that the very top of income brackets are populated, mostly, by people that sold their business in the previous year.

If you filtered out the one year gains I wonder what the "inequality" would look like.

US writes:

Endowments don't matter at all?

aaron writes:

Is it at all possible that the people who are likely to do these lower paying jobs are simply breeding faster than people in high income professions.

And, as productivity goes up, are as many of these lower income jobs necessary?

greg writes:

It's nearly impossible to land a job in IB unless you have industry contacts or graduated from a top-tier university. I don't know why you think it's so easy to land a high paying job right out of college--it's not.

aaron writes:

"It's because in getting hired, it is always "who you know" not "what you know". We don't even sort of live in a meritocracy. I don't think that getting into investment banking is such an easy endeavor Arnold."

I agree with rand to a point, who you know will help to get interviews. But more importantly, it's about being smart, having a personality that is agreable to the company you're courting, and having a communication style that is agreeable to the company/industry as well.

aaron writes:

And I-banking has a couple year hazing period. Starting salaries are only about 70-80k (I'm guessing) with typical 90+ hour weeks to basically be a glorified, overly dedicated secretary or personal assistant. You're looking at $16 an hour and a high cost of living and lots of taxes for atleast a year before you start making real money. I was willing to do it back when I graduated (unfortunatly that was when the job market evaporated), but now I think I'm too old to put up with that bullshit.

jaim klein writes:

There are many trades that have almost no entrance barriers and are not regulated, and offer the possibility of high income, yet you dont see young people crowding the door. Selling anything on commission offers illimited income, good salesman earn very high incomes, and every employer will take in good salesmen. Investment bankers's job focuses in selling financial products and services, and basically there are no entrance barriers. The best have no relevant university degrees at all. But few people has the dedication and disposition to persist in these jobs. I had for one had the opportunity and lasted only one year.

Matt writes:

I wonder what role declining schools plays into this. In high finance, as with high powered law firms, (or brain surgery!) they want the best people doing all the important work. That's why people have to work 100 hours. Wouldn't they prefer to work 50 hours? In most industries, 2 people working 50 hours are more productinve than 1 working 100. Some fields are different.

My understanding is that if you generate enough business to add to the firm, they keep you. IBs will fire employees they don't want before bonus time so they can give bigger bonuses to the employees they do want. That either means they can only keep a fixed number of employees, because their profit is relatively fixed, or it's because the other employees are not the best.

jaim klein writes:

There are many trades that have almost no entrance barriers and are not regulated, and offer the possibility of high income, yet you dont see young people crowding the door. Selling anything on commission offers illimited income, good salesman earn very high incomes, and every employer will take in good salesmen. Investment bankers's job focuses in selling financial products and services, and basically there are no entrance barriers. The best have no relevant university degrees at all. But few people has the dedication and disposition to persist in these jobs. I had for one had the opportunity and lasted only one year.

jaim klein writes:

Matt said "My understanding is that if you generate enough business to add to the firm, they keep you." Yes, that is what I was trying to say above. To generate business is to sell. It is a very necessary and well paid job, but I found it depressing.

agent00yak writes:

I didn't think they fired you, from what I understand (Somewhat limitted, because I'm on the buy side outside of NYC) is that they zero you. AKA, your bonus is going to be zero and will be zero until you find a new job.

Half Sigma writes:

This post is complete and utter bull. Investment banking is a clost profession that doesn't let people in, even if they want in and even if they are extremely knowledgeable about finance.

Mike writes:

yes, I agree that the barriers to entry at an investment bank (or hedge fund or merchant bank, etc.) are high because they recruit nearly exclusively at the top schools. However, we just had a student hired by Lehman Brothers because of the persistance of our faculty and career office in getting her in their face (she's really bright).

What is not hard is getting some job on Wall Street that could lead to big bucks later on. For example, there are lots of jobs at bond rating agencies, bond insurers, research firms, etc. that work with the big investment banks. From what I have observed, if a kid really wants to make it happen, "who you do not know" is not really a barrier to entry.

Bob writes:

Mike is right; connections make it easier to get into investment banking or money management, but that's it. There's a huge incentive to hire super-bright people and nonperformers are weeded out ruthlessly no matter who they know. The closed doors story is BS - most of us just don't want to pay the price (going all the way back to majoring in physics or engineering rather than psychology or political science). Which was Arnold's point in the first place.

Dan writes:

I think the focus on IB is missing the point, in that it is focusing on the "poorer" members of that upper 1%. The story actually has been driven more by the ultra high incomes (the upper .1%, for sake of argument) which has been created by a culture of corporate back-slapping. Top executives serve on various corporate boards and make the case for higher executive salaries, which helps them make the case for their own salaries to increase at their stakeholder positions. Thus, the income bracket is becoming increasingly top-heavy. One can compare the ratio of top executives' salaries to average employee salaries in the US versus other industrialized nations to see how our income disparity is increasing faster than elsewhere.

dearieme writes:

"Rents" you call them, rather than wages. I dare say you're right, but would you care to justify your description?

Chris writes:

As I understand the current tax law, the highest marginal tax rates for capital gains are lower than income taxes. This would certainly create an incentive to try list more income as "capital", and thus be subject to lower marginal tax rates. For very high income earners, this would be a sure win. Not sure of the evidence on this matter, however.

Chris

Steven Vickers writes:

Investment banking is a clost profession that doesn't let people in, even if they want in and even if they are extremely knowledgeable about finance.

This doesn't make a lot of sense to me. Wall Street firms exist for the same reason other firms, to make money. They're not going to systematically shut the doors on individuals who could bring the firm millions in revenue.

Now it certainly is true that banks recruit primarily at the top schools, which makes perfect sense--it costs a lot of money (both direct and lost wages) to send people on the road to interview, so if you're going to have better luck at Harvard than Big State, it's a pretty rational decision to concentrate on Harvard.

I also think that Mike and Bob are absolutely correct--while State U grad may have a harder time starting out, if he or she did well in school and in work for a few years, and nails the GMATs, he or she is likely to get into a good business school and then generally the undergrad school is largely irrelevant, just like high schools are irrelevant to college grads.

In short, you can believe that investment banks are willfully leaving millions (or billions) of dollars unearned through simple bias, or you can believe that when successful businesses operate in the same way, there's usually good sense for that. Note I'm not saying they're perfectly efficient, far from it, but successful businessmen aren't generally going to ignore people just because they want another Yalie working beside them.

Aidan writes:

I don't believe the "taste" theory. There are a lot more accountants and insurance workers than investment bankers and that is clearly not employee preference or because of any distaste for finance or number work.

I am a math and numbers person. I currently program business and financial software for a nice living but if there were good odds of attractive career opportunities, I would readily switch paths and take whatever classes are required. And I don't think I'm at all unusual in this regard.

Horatio writes:

IB is winning over many scientists, mathematicians and engineers. About a quarter of the people in my cohort of physics grad students plan to work in finance after completing their Ph.D., or earlier if they can get an offer. Starting salaries are ~200k including bonus and they go up quick.

AJ writes:

A: All of life is just choice and consequence

B: All of life is about victimization and oppression: who is doing what to whom and who has what power.

Most of politics may be sorted by where or how much you apply A paradigm and where you apply B paradigm. Most people are not all A or all B. Libertarians and economists tend to look at many more parts of life through the A lens. Media, (cuurent) liberals, academia tend to look at more of life through the B lens.

Lord writes:

Also don't forget, in these areas it is up or out. Either you advance by promotion or you have to find new employment and large numbers of entry level people are weeded out before they ever earn that much.

JoshC writes:

The doors to investment banking are not closed. I went to a state school and did not have the connections. I graduated with a 3.93 GPA in finance and was persistant enough during my interview process to get the job. I have a great high paying job that bore no relation to the school I went to. I made my own contacts and followed them up to get my interviews. Not knowing the right person is a great excuse for those who couldn't land a good job. The reason people make a lot of money in this industry is becasue there is no room for error and millions of dollars, if not billions depend on the quality of the work you do on each and every deal. They bonuses are based on deal volume so the more quality deals you bring and participate in the more you can make. Yes there are tough hours associated and that is one of the things that weeds people out. If this industry is not for you then you will know it quick.

Steve Sailer writes:

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, 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.

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