Conventional Thinking

In a recent article about the upcoming bonus season on Wall Street, John Reed, a former Wall Streeter and founder of Citigroup, commented: “These guys don’t get it. They are off in a different world.” He was reacting to the news that most Wall Street firms are probably going to give out generous bonuses for a year in which, many Americans feel, the American taxpayer took all the brunt of the financial crisis and the bankers took all of the cash.

But this is what bankers and the financial world does. And has done forever. They give their people competitive salaries and then compensate them at the end of the year with the surplus that they have all contributed to – the bonus. But over time, this end of year surplus has become no longer a “bonus” but, in the eyes of most working in the banking industry, “earned” compensation. When a bonus keeps coming year after year, you come to expect it. And many people who work on Wall Street not only expect on it, they plan on it. I have to admit I was a little surprised when I learned that debt counseling was offered at an investment bank last year, after bonuses were almost cut in half. Turns out, a lot of people had already spent the money that they expected – but would not get – that year.

This compensation structure is so ingrained in conventional thinking, that it has taken some pretty radical moves by governments to get the banking industry to think a little bit out of the box. And to be honest, the US banking industry has not felt compelled to think out of the box at all. [John Reed would agree, I think.] Only Goldman Sachs, a firm that prides itself on being a first mover and leader in the industry, said last month that its top executives would get deferred stock as their bonus this year. No other bank followed their lead. But why would they? Everyone knows that the top 30 executives at Goldman are already billionaires; they can’t possibly care that much whether they get compensated this year or next - as long as they get compensated and keep their roles as leaders in their firm. Banks don’t have any incentive to change their compensation practices either - the only backlash at the moment from handing out big bonuses will be the 24 hour news cycle, during which the banks will get hammered - but their employees will be very happy.

Conventional thinking is completely ingrained on Wall Street. And given the product being sold on Wall Street, it’s not hard to see why. The basic type of financing is loans – that hasn’t changed over the past several centuries – the form of that financing can take many different shapes and flavors, but the essential transaction is the same. And the other is equity – commonly known as public shares in a company, but also a form that can have many shapes and flavors. And derivatives, the things that made everyone swoon, are just bets on the two fundamental products, loans (bonds) and equity. It’s just that the folks on Wall Street make them sound so complicated. (I leave out foreign exchange; that’s a whole different kettle of fish.)

Conventional thinking is ingrained even in the organizational structure of most banks. The pecking order – Analyst, Assistant VP, Vice President, Director, Managing Director – is pretty well known on the Street. There’s not been much to change that over the past several decades, if not century. Conventional thinking is also ingrained business process – the front office owns the business (and its revenues), and infrastructure groups (middle office and back office operations, technology, finance) are the cost centers that align with that business. This silo-ing is conventional thinking about how to run a bank. But the organization ends up providing all the wrong incentives for the business. Here’s the Naked Emperor.

Conventional thinking says that the Front Office is responsible for the profit and loss of its business from front to back – from the time the product is marketed to the time it is sold and settled in the account of the client. That should encourage the Front Office (FO) to work well with the Back Office (BO); it would seem that the FO incentive is to make sure everything runs seamlessly throughout the whole process, and to support all the folks who make that happen. But in reality, that approach has killed the relationship between the Front Office and the Back Office. Because whenever the Back Office messes something up, the Front Office just gets angry. They don’t like the Back Office anymore, because they are keeping the Front Office guys from making money. This is not how you build relationships. It destroys them. And it results in inefficiencies and inequities in the ways the groups work with each other. But this is the way it works on Wall Street. That’s conventional thinking for you.