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This month the biggest Wall Street companies reported their quarterly earnings. JP Morgan Chase and Goldman Sachs reported bumper earnings, Citgroup and Bank of America, not so good. But if you leave out write downs on debt, everyone had a great quarter in their capital markets businesses. Billions have been budgeted for year end bonuses.

As could be expected, the issue of Wall Street compensation raised its head again. And this time there is the weight of the federal government behind it. Banks that have taken TARP money will see their executive compensation capped. And the Federal Reserve has suggested that all large banks that fall under its jurisdiction will be reviewed on on going basis to ensure that executive bonuses do not produce risk taking behavior that could put the banking system at risk.

There are several memes that get mixed up in any discussion about Wall Street compensation in the media. Add a lot of emotion from a distraught public and it becomes for a tangled mess where the media feeds the furore but there’s no real understanding of the underlying issues. Let’s see if we can parse the issues out.

These are the issues as they are played out in the media
- Issue #1 – The taxpayer bailed out Wall Street. How can they pay themselves these kinds of bonuses.
- Issue #2 – The rest of the country is going through agonizing pain – high unemployment, pay freezes and cuts – how can these people pay themselves what they do?
- Issue #3 – Their companies have been (and some still are) hemorrhaging cash. How can they pay their investment bankers so much?

I don’t think any of these issues merit any attention from lawmakers. #1 could be argued many ways but at the end of the day, if the bank has taken TARP money and hasn’t yet returned it, the federal government as shareholder with special rights, can do as it pleases. Politics dictates that compensation should be curbed and so it will be. #2 amounts to appealing to a cold corporation’s heart – a futile endeavor. #3 is the company’s call. They have a board and shareholders. If they think that they need to pay top dollar to retain talent, then that’s what they need to do.

In my mind there are two fundamental issues that need consideration. One, is related to risk increasing compensation practices. The second is a larger issue of high, untrammeled growth in the capital markets in the last two decades.

On the first issue, everyone agrees that Wall Street’s bonus bonanzas encourage traders and management to pile on the risk, collect their super size bonuses and when things turn south, leave the shareholders to pick up the pieces. And when things go really really bad, like what happened to the markets last year, let the federal government foot the bill.

What is not clear to me is why the shareholders just stand there and let this happen. The expectation that the bank is too big to fail and that the fed will bail you out, doesn’t explain it. If you were a shareholder in Citigroup and held the stock prior to the crash, even though you were bailed out, you probably lost your shirt on Citi.

I am not sure what the answer to this is. It could be that in the normal course of things, shareholders don’t really exert any influence on the board of the company. Election of board members and votes on CEO compensation, need to see a lot more vigor in the shareholder meetings, especially in the US.

Or it could be that shareholders think they’re smart and will be able to get out before the stuff hits the fan – a variant of what the trader or management thinks – except that the employee just loses her job, the shareholder his savings.

It could be that there isn’t enough disclosure. That Wall Street companies, on the pretext of not revealing proprietary information on trades and investments, is actually throwing a cloak on dodgy, heads-I-win-tails-you-lose schemes.

There could be other things going on that only behavioral economics can explain. Thinking that if everyone has been doing risky trades for so long then maybe its not that risky, is both irrational and perfectly natural.

Whatever, the reason behind it, this nexus between risk and compensation needs to be tackled head on. It is going to be a very tough problem. But not addressing it is not the answer.

The other question is also a big one. In the last two decades, the capital markets have grown much faster than the rest of the economy. The chart here shows that the profits in the US Financial sector went from about 15% of total corporate profits in 1998 to over 40% in 2007. When an industry grows at that pace, the competitive intensity is low and margins are high. The use of technology raises productivity further increasing margins. In the capital markets the only significant cost is the cost of people. When there is no or low downward pressure on prices, compensation has no place to go but up.

But is the ‘natural’ size of the industry as a share of GDP what it is today or what it was two decades ago? Can an industry that essentially allocates capital, and doesn’t really make anything, have such a large share of the GDP? Is there something in the laws of the land that make it so? For instance the credit rating industry, many say, is a creation of legislation and would not have existed at least in this twisted model of today, had it not been for an easy regulatory environment. Are there other such areas that would wilt in the face of an openly competitive field or lower entry barriers?

I don’t know the answers to these questions. But I do know that if the world has a problem with Wall Street traders, bankers and CEOs making tens of millions a year, not just in today’s recession, but beyond as well, we will need to look at taming the industry, not capping salaries. If that’s even possible at all.