Roy Smith On Investment Banking, Compensation & Greed

Former Goldman Sachs partner and current NYU finance professor Roy C. Smith wrote a lengthy piece in the weekend edition of the Wall Street Journal entitled, "Greed Is Good."

In his extensive piece, Smith paints the more complete and fair picture of the old Wall Street, a/k/a investment banks, compensation structure, in order to raise some warnings about the effects of the recent compensation caps, and predict some structural changes.

Among other points, Smith notes that many- perhaps thousands- of well-paid investment bankers at Bear Stearns and Lehman lost assets, jobs and companies. This, too, is part of the risk-taking environment which produced such lavish bonuses over the past few decades.

Smith also does a great job tracing the evolution of investment banking from when all of the firms were private partnerships. He, as I have done, notes the entry of commercial banks into traditional investment banking turf as the beginning of the end of the sector.

My mentor at Chase, Gerry Weiss, had predicted this years in advance. As the less-adept, more ham-handed commercial banks began to underwrite securities, margins shrank, volumes had to increase and instruments had to become more opaque in order to justify spreads and maintain revenues and profits.

Eventually, everybody levered up, and the once-private investment banks, having mostly gone public with the deregulatory "Big Bang" of the 1970s, mostly used other people's money to run much more risky businesses, while paying themselves healthy bonuses in good years.

Smith points out, with which I agree and have also stated, that the logical consequence of the recent vaporization of publicly-held investment banks, is a return to boutique, private partnership investment banking. The compensation caps really won't, by themselves, cause talent to leave the commercial banks for the private investment banks.

But they will set a tone that will probably trickle down. And, anyway, investment banking at a commercial bank simply isn't the same as doing it at a pure investment bank, even with the abolition of Glass-Steagal.

Smith endorses the practice of making large compensation payments vest over some years, in order to make them conditioned on continued profitability. Again, a topic on which I have written, in one form or another, for years. Specifically, I've recommended that large components of senior executive compensation be tied to outperforming the S&P500 over a five year period, in arrears. Thus, if performance lags, the payment in any given year for the prior five-year period shrinks. This is the sort of idea now gaining currency in the remaining publicly-held institutions having to grapple with this dilemma.

I like Smith's sense of history. He notes how the regulatory backlash to the 1920s and market crash of '29 resulted in relatively low financial services compensation until the 1980s. Which, by the way, was about the time the previously-privately-held investment bank partnerships began to swell with public money and pay more lavishly.

On the subject of the systemic risks taken by most, if not all, of these banks, which eventually came home to roost via mortgage-backed CDOs and such, Smith and I agree that, in the future, it's likely that such risk will be minimized only by the existence of many smaller investment banks, rather than a few large ones.

Even now, as I discussed with a Morgan Stanley employee at a social function this past Sunday, quite a few large hedge funds and private equity shops, not to mention the explicitly-identified boutique investment banks, stand ready to re-enter the riskier areas of underwriting and trading in the coming months and years. As private firms, they have no shareholders ranting at annual meetings, need justify their compensation to no external parties, and can only grow at the rate at which their private capital allows, plus judicious borrowing.

As Smith notes, the industry will reinvent itself, and, in fact, already has. My various posts about Blackstone and other private equity shops noted this as far back as the 2007 IPO of that large private equity enterprise.

In truth, as usual, what we see happening with compensation, regulation and risk management of the remaining former-investment banks-cum-commercial banks, Goldman and Morgan Stanley, and the crumbling commercial banks, Citigroup and BofA, is simply the tidying up of the worst-performing, hind-end of the sector. The better players and their capital departed those publicly-held firms over a decade ago, the better to ply their trade in stealth and away from excessive governmental intervention.

Though he didn't write that, I believe Mr. Smith would agree with me on that last point.