One way to make money providing financial services is to charge an explicit fee, commission, spread, etc., where the customer knows what she's paying you. Another way is to structure a product to be profitable to you in expectation, in a way that is not transparent to the customer. You can mix and match, but stereotypically, you make less money when the customer knows what you're making than when she doesn't. Because you're probably making more than the customer wants you to make. You are overpaid, is what I'm saying here, and your customer either does or does not know it.
This is fairly obvious,1 and so banks often prefer non-transparent businesses to straightforward fee-based businesses. Here is a delightful Financial Times article about banks trying out that theory on their own employees:
After cutting the pay of traders, bank executives in the US are manoeuvring to reduce their payroll for a 50,000-strong army of brokers who sell stocks and bonds to retail customers. ...
Wary of losing people and assets, the executives are focusing first on less transparent ways of improving their ratios of remuneration to revenues.
Advisors are paid for selling investment products on a transparent “grid”, where, for example, Morgan Stanley’s advisers take 28 per cent of revenues below $220,000 and 47 per cent of revenues of $5m and above.
But banking products, such as mortgages, are not paid on the grid. All of the brokerages are pushing more loans, which should improve compensation-to-revenue ratios.
Ha! The thing about fee- and commission-based investment advisory services is that brokers can tell how much their clients are paying -- that is, how much money they're bringing in for their employer -- and can demand their share. And because clients are pretty portable -- they tend to like their brokers more than their brokerages -- the brokers have a lot of bargaining power to capture the clients' value.
On the other hand, who knows how much a bank makes on a mortgage? It is an impenetrable mystery.2 Or at least, it seems to be an impenetrable mystery to retail stockbrokers.3 If they can't tell how much their bank is making from their work, they can't know how much their share should be. So their share can be less.
This is a neat little tale of brokerage tricks being used against brokers. But it's also a neat reversal in another way. One complaint that you sometimes see -- from, e.g., McKinsey -- about banking pay is that the connection between pay and revenue generation is too vague, which allows the revenue generators to be paid too much.
The idea is that it's hard to actually know how much most bankers and traders are worth: You might have brought in a $20 million fee, but if the bank just took a guy off the street and handed him your business cards, he might have brought in the same fee. It's hard to untangle the value of the franchise from the value of the person representing it. And, since banks are socialist collectives run for the benefit of their employees -- since the employees are effectively negotiating against the bank's pile of cash, and are better informed than the pile of cash -- this lack of transparency is good for the employees. They get to take credit for things that really belong to the franchise. Such is the theory.4
But, as this little brokerage story shows, that's not always true. Some employees really can figure out how much value they create.5 And sometimes the banks try to make the link between pay and revenue vaguer, so they can pay the employees less, and keep more for the shareholders. Or for the investment bankers and traders and executives, but still. Banks using revenue-attribution vagueness as a way to reduce pay does seem like a change.
By which I mean it's intuitive, and sort of a cliché, but it is not by any means always true. It is often true, which is why derivatives businesses -- priced by edge -- tend to be more profitable than, like, cash equities trading for two cent commissions. But profitability is probably set more by competition than by transparency. Plenty of fairly complicated derivatives are actually priced pretty tightly because the custom is to bid them out and a lot of banks compete for them; plenty of transparent fee-based transactions are stubbornly generous because the custom is for everyone to charge the same amount. Initial public offerings all seem to cost 7 percent, and mergers and acquisitions advising remains a great business.
2 Ha, no, I mean, it's not hard at all, especially in a world where most mortgages are securitized with Fannie Mae or Freddie Mac, you can do the math pretty easily. I guess private-wealth clients tend to take out jumbo mortgages but presumably those aren't, you know, vastly less profitable.
3 Oh I kid. Seriously it is not only harder to quantify profitability (especially if you keep the loan in portfolio, you can't book your profit up front; the loan has to perform for 30 years), but also harder to quantify responsibility for that profit. If you're a broker and you bring in a commission, you built that. If you're a broker and you bring in a mortgage, there are underwriters and credit officers and other mouths to feed, and it's harder -- or at least less driven by custom -- to know how to split up the revenues.
4 And it's obviously true at least a lot of the time. Certainly my ability to bring in millions of dollars of fees for an investment bank had more to do with the bank than with me, and I was not the only (nor most profitable) person for whom that was true.
5 Like Paul Taubman. Who runs his own bank for the benefit of himself, so it's all good.
To contact the writer of this article: Matt Levine at firstname.lastname@example.org.
To contact the editor responsible for this article: Tobin Harshaw at email@example.com.