One of the consequences of Joe Nocera’s move to the NYT op-ed page is that his column now appears on the same day as that of Andrew Ross Sorkin. Which can sometimes result in a great lesson on the difference between how Wall Street is viewed from the outside and how it is viewed from the inside.
Nocera devotes his column today to Basel III, which is of course fantastic—he’s quite right that the fight over capital standards is much more important than any wrangling over Dodd-Frank, or derivatives, or the Consumer Financial Protection Bureau. Capital is crucial, it’s insufficient at present, and Nocera’s right that asking too-big-to-fail banks to hold as much as 14% of their assets as equity is a very good idea.
(One point I’d add: these capital standards have to be progressive, a bit like income tax. The last thing we want is a situation where too-big-to-fail banks have an incentive to get even bigger, on the grounds that if they’re going to be socked with the highest capital surcharge anyway, they might as well just get as big as they possibly can. So my suggestion is for the SIFI surcharge to range between 3% and 7%, giving banks an incentive to shrink and thereby get a lower rate.)
Nocera also links to the smart analysis of Anat Admati, who explains that there’s no good reason for banks to minimize the amount of equity they hold:
JPM’s overall funding costs, averaging the required return on the various debt claims it issues (some of which might decline if JPM is better capitalized) and the required return on equity, need not change just because more equity is used.
In other words, it’s a really bad idea to encourage banks to minimize the amount of equity they have, or to look at banks’ profits solely as a percentage of their total equity, rather than in relation to their entire funding structure. If you want to look at profitability, then return on assets is a much smarter place to start than return on equity.
Which brings me to Sorkin:
Wall Street is facing a new reality that it has yet to come to grips with. “Return on equity,” perhaps the best metric for considering the health of the Wall Street, fell to 8.2 percent in 2010, according to Nomura. That is down from 17.5 percent in 2005, before the crisis.
By comparison, total compensation has hardly fallen at all. At Goldman Sachs, for example, compensation and benefit expenses fell 5 percent in the first quarter… And its annualized return on equity fell to 12.2 percent from 20.1 percent in the period a year earlier.
Andrew is, simply, wrong on this. Return on equity is not “the best metric for considering the health of the Wall Street”, precisely because it makes equity seem like a bad thing which should be minimized, rather than a good thing which should be maximized.
More generally, looking at total compensation as a percentage of total equity is rather silly. What direction does Sorkin want that ratio to move in? He seems to think it a bad thing that it’s going down—but isn’t a world where bankers are less overpaid and equity is more abundant exactly what we want?
Sorkin’s bigger point is that higher base salaries (to make up for lower bonuses) are “perverting Wall Street’s calculus during periods of weakness.” Which rather forgets that Wall Street’s calculus was pretty perverted before. The current system is definitely an improvement: it forces banks to hire people for the long-term value they create, rather than for the short-term quarterly profits they can generate before cashing their eight-digit bonus checks and quitting for a life of leisure.
And, since when is this a “period of weakness” for Wall Street? Hasn’t the banking sector been wallowing in cash dropped from Ben Bernanke’s helicopters for the past couple of years? This is a period of strength for Wall Street, and the biggest banks are making record profits. If they’re firing people, maybe that’s a good sign that they reckon they can get by without employing quite as many of America’s best and brightest. And that in turn is a development to be welcomed, rather than criticized for its perversity.
Felix Salmon is a financial writer, editor, and podcaster. A former finance blogger for Reuters and Condé Nast Portfolio, his work can be found at publications including Slate and Wired, as well as his own Substack newsletter.