The Dangers of Investment Bank Franchise Model, by Yves Smith posted on Naked Capitalism

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This is another fantastic Article by Yves Smith, the owner of Naked Capitalism Web Site and Author of the fantastic book Econned. Econned is a book that everyone should read. 

I added a few underlines to things I thought were interesting.

The Dangers of the Investment Bank Franchise Model

Tony Jackson of the Financial Times has an article tonight on a topic near and dear to my heart, namely the fact that higher capital ratios will not lead investment banks, um, banks, to change their highly profitable “wreck the economy” behavior. He focuses on the role of how the change from the partnership model has turned investment bankers into mercenaries (and one might add, mercenaries willing and able to foment precisely the sort of trouble in which they can then intervene):

In the 1980s, those firms were absorbed into larger quoted conglomerates, whose obligations to shareholders made such swings in profit impossible. So the burden fell on employees, who were axed wholesale in bear markets and re-employed – usually by other firms – in the upturn. This has turned investment bankers into a tribe of mercenaries, ready to switch allegiance instantly for a better offer. That might seem unattractive but it is a rational response to industry conditions.
The resulting individualism, though, can run to extremes. One American investment banker I know, who works freelance on projects for different employers, tells me he regards taking a salary as “demeaning”. He eats what he kills, and is beholden to no one.
At this point, the dysfunction of the system becomes jarringly apparent. Investment bankers trade off the assets and brand name of the firm for which they work. The firm’s owners are entitled to be paid for that.

Peter Hahn, an ex-investment banker who teaches at London’s Cass Business School, says: “These guys say ‘I’ve brought in $10m, so I want $1m.’ But how much risk did they bring in with that? And how much came in because it says Goldman or Citi above the door? These are the hard questions, and they don’t get asked.”
As someone who worked in the industry in the 1980s, Jackson’s take has merit but also misses important issues. It has been disturbing to see how the change from the partnership to the OPM (other people’s money) model has led in a straight line to predatory behavior (a subject we discuss long form in ECONNED). And he is correct that mobility has a lot to do with it, but for more complex reasons.

Many have taken note of the obvious way that partnerships constrained risk-taking: unlimited liability tends to focus the mind. And having the overwhelming majority of one’s personal wealth tied up in a partnership also made the very top producers in the industry immobile, which is what Jackson focuses on.
But the part he ignores is how partnerships also restricted the ability of junior staff to switch firms, which led to the development of strong cultures. Recall that the big prize in the industry was becoming a partner and partners put all the other partners’ capital at risk. Each partner ran a very narrow franchise; the head of corporate bonds had no idea of the risks the head of M&A was taking (yes, a management committee provided oversight, but it was mainly on issues that fell outside of normal daily operations). So effectively, each partner, or group of partners in a profit center ran a franchise under a bigger umbrella.
The pay demands of talented junior staff were kept in line because they also did not have a lot of mobility. Remember, inviting someone into the partnership is a very risky decision. Therefore the firm’s owners will be most comfortable with someone they have observed closely over time, in a variety of business and personal settings. In the vast majority of cases, anyone who switched firms mid-career would be less likely to make partner than home-grown talent (the exceptions would be firms poaching staff in areas where they were weak, or individuals trading down from a more prestigious to a less prestigious firm to get more latitude or a bigger payout). That meant that the junior staff knew they had to build what amounted to sweat equity in order to get a piece of the firm.

Consider how the model has changed. In franchise businesses, the entrepreneur makes an investment to acquire the rights to a franchise, which is governed by a detailed contract. Franchisees often are organized (better by the franchisor, as in cases like MasterCard) into sub groups (regional is a typical pattern) to facilitate the dissemination of new programs and to provide venues for getting franchisee input. But any governance structure has already organized the franchisees so they can pressure the franchisor for more concessions, and in a worst case scenario, revolt (threaten litigation, exit, etc.)

In the old partnership model, younger staff had to earn their way into the franchise and had very limited ability to exit (although there were some firms that had spectacular internal fractures, such as Lehman after Bobby Lehman’s death). In the new OPM model, junior staff can and do switch firms readily, and since the industry has always treated pay as the only measure of worth, the name of the game is simply maximizing one’s bottom line, rather than working in a franchise that one hopes to inherit.
Thus OPM players inculcate a very different set of values than those of the old partnerships, that of focusing on the current kill and of viewing client and firm relationships through a cold economic calculus. Should we be surprised at the result? As we wrote in an article, Indefensible Men:

With economic casualties all about, thanks to baleful financial “innovations” and reckless trading bets, the tone-deafness of the former Masters of the Universe is striking. Their firms would have been reduced to sheer rubble were it not for the munificence of the taxpayer—or perhaps, more accurately, the haplessness of the official rescuers, who threw money at these players directly and indirectly, through a myriad a programs plus the brute force measure of super low interest rates, with perilous few strings attached.
Yet what is remarkable is that the widespread denunciations of excessive banking industry pay are met with incredulity and outright hostility. It’s one thing to be angry over a reversal in fortune; it’s one of the five stages of grief. But the petulance, the narcissism, the lack of any sense of proportion reveals a deep-seated pathology at work….

Although the word “entitlement” fits, it’s been used so frequently as to have become inadequate to capture the preening self-regard, the obliviousness to the damage that high-flying finance has inflicted on the real economy, the learned blindness to vital considerations in the pay equation. Getting an education, or even hard work, does not guarantee outcomes. One of the basic precepts of finance is that of a risk-return tradeoff: high potential payoff investments come with greater downside….

Many psychological disorders are otherwise healthy tendencies carried too far, unchecked by other personal attributes. Single-mindedness, drive to succeed, aggressiveness and lack of remorse are useful traits in business, but when do they tip into the psychopathic? In the case of Wall Street, the collective psyche has suffered as important restraints on ego and behavior have eroded.