Monday, February 02, 2009

How it Got There

People were asking in Hoy's Friday post how the Wall Street bonus structure came to be. I caught myself writing a long, boring post about it (how novel). I scrapped it and here's the reduced version.

Bonuses used to be directly tied to commissions and/or percentage of profits, depending on what your role was. If you had clients, you got a cut of the commissions. If you played with the firm's money, you got a cut of profits. Hedge funds exploded in popularity largely because the traders at the fund tended to get paid well regardless of the fund's performance, with a combination of commissions and profits.

But firms began consolidating as they got bigger. Keeping track of which individual was responsible for which commissions or profits became onerous. So the methods were combined into a bonus pool which was split according to the more macro views of group profits. If group A made 60% of the profits and group B made 40%, then the pool is split accordingly (after the manager takes his cut). Then the individual managers of those groups take their cut, and determine who in the group deserves how much. From an accounting, and accountability, perspective, this makes more sense in a large firm. It also helps makes sure that the junior guy doesn't get completely shafted by a greedy head trader who refuses to acknowledge their contribution.

So, since commissions can be in the tens of millions of dollars per year for a single book, and profits can be in the hundreds of millions for a group, bonus pools can easily be in the millions or tens of millions. When split multiple ways, often based on seniority or the desire to keep someone from jumping ship, it makes a strange kind of sense for one person to make millions in bonuses.

The problem is the sense of entitlement that comes along with it. "I made $10 million last year, why shouldn't I make it again this year?" People forget what the definition of "bonus" is.

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