Tuesday, June 21, 2011

Wall Street Layoffs Due To Pay Raises?!

The New York Times had an article yesterday talking about possible layoffs at Wall Street banks.  Of course, some of the same banks booked enormous profits in 2010 so one wonders if any of them have read the story of Joseph, but I digress.  In the article, the pay raises are singled out as the primary reason why layoffs are necessary.

The story goes something like this:

In the past, a significant percentage of ones income at a Wall Street firm was in the form of a bonus.  The idea was that if the company did well, the employees got an extra piece of the bigger pie and when the company didn't do well, the employees got less.  Not only did this provide an incentive to employees to perform, but it provided a safety net for banks as well.  When times got tough and profits were down (or non-existent), banks did not need to pay out big bonuses, and this automatically reduced their expenses.  Makes perfect sense.

However, in the wake of the financial crisis, many people pointed to these fat bonuses as one of the causes of the imposition of the banking sector.  One of the unintended consequences of this was that the bonus provided employees with an incentive to take excessive risks with other people's money.  After all, if you are getting a big bonus for selling lots of sub-prime loans, you are going to sell loans to anybody with a pulse without considering what it will do to your company's balance sheet.

One of the outcomes of the banking crisis was that banks were pressured to reduce the impact of bonuses on ones compensation.  Now that bonuses were being reigned in, banks compensated (no pun intended) by raising the base salary of employees.  After all, if you wanted to retain talent, you had to make sure that they remained well compensated.  Of course one has to wonder why you would want to retain the same "talent" that flushed your company down the toilet in the first place, but I digress again.

Anyway, the crux of the matter is that now that banks seem to be hitting another bump in the road, bank profits are under pressure.  As with any company, banks look to cut expenses when revenue is down.  However, since bonuses have been replaced by a higher base salary, banks say that they cannot cut expenses automatically by lowering bonuses.  Instead, they say that the only way to cut employee expenses is to lay people off.  In economic parlance, they have replaced a variable cost (bonuses) with a fixed cost (salary).

As a student of microeconomics knows, there are two types of costs:  variable and fixed.  A variable cost is one that grows as you have more sales.  On the other hand, a fixed cost is one that stays the same regardless of your level of sales.  Consider a company that makes shoes.  As the company sells more shoes, it needs to buy more leather since the amount of leather it needs is proportional to the number of shoes it sells.  When shoe sales drop off, it doesn't need to buy as much leather, so its expenses automatically go down.  It is a variable cost.  On the other hand, if you make shoes, you need a factory building, and you might take out a mortgage to buy that factory.  Unfortunately, if shoe sales drops, you still need to pay the mortgage on your factory.  Just because sales go down doesn't mean that the bank will all of a sudden reduce your mortgage payment proportionally.  The mortgage is said to be a fixed cost because it doesn't vary with the level of sales.  Obviously, if you are a business owner, you'd rather have variable costs than fixed costs.

In the Wall Street situation, a bonus is a variable cost because it goes up and down based upon how well the company does.  That makes perfect sense.  However, is salary really a fixed cost like the article says it is?

Of course not.

The truth of the matter is that this sounds like an excuse more than anything else.  Who says that you have to consider a salary to be fixed?  There are many examples of companies which reduced employees' base pay in order to avoid layoffs.  If nothing else, the recession has shown that salaries, too, can be considered to be a variable cost that can be lowered in bad times.  I think the real story is that Wall Street wants to lay people off to save money (nothing wrong with that).  However, rather than coming out in saying "we need to pay people off because we have too many people", "we want to streamline operations", they are implying that they are laying people off because of the way the Government has meddled with their compensation policies.  This is an easier story to sell to the public, especially when you had such a good year in 2010.

The moral of the story is that maybe Wall Street needs to go back to college and retake microeconomics again.  Perhaps that is one of the reasons why they are having such a bad 2011?

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