Goldman Sachs' profits recovery and associated bonuses have unleashed a wave of populist outrage. Described in Rolling Stone magazine as "a great vampire squid wrapped around the face of humanity", the investment bank has become a focal point for anger over what politicians claim to be a "privatise profits, socialise losses" industry in urgent need of strict regulation.
Last week's report on pay by New York State Attorney-General Andrew Cuomo added to the sense of injustice. Almost 5,000 employees at banks that received troubled asset relief program funding received bonuses of $1m or more last year. Goldman Sachs paid the highest proportion of its staff big bonuses, with more than 200 getting at least $3m.
The banks retort that such payments are entirely necessary to retain staff. Morgan Stanley's finance chief referred to a "war for talent" while justifying the bank's decision to pay employees an eye-watering 72% of revenues in the second quarter. The owners of the business and providers of capital (otherwise known as shareholders) appear to be silent on the issue.
The tension between capital and labour continues, even though the philosophical battle between capitalism and socialism seemed to be resolved in favour of capitalism. The Soviet Bloc collapsed and extreme socialist parties in the western economies have been largely ignored by the electorate. China has adopted a hybrid form of market-based autocracy.
Investment banking as a socialist endeavour
However, the central tenet of capitalism is that the bulk of the rewards of production goes to the providers of capital, not labour. On this basis, investment banking is one of the world's greatest socialist endeavours.
Bob Crow, general secretary of the UK's militant railway trade union, the National Union of Rail, Maritime and Transport Workers, could learn a thing or two from the ability of banks to reward labour ahead of capital.
A recent catchphrase of David Cameron, leader of UK's main opposition party, "sharing the proceeds of growth", rings hollow when you consider how revenue was redistributed during the credit boom.
Virtually every division of every investment bank saw record profits in this golden era. After such a era of plenty, they should have finished 2007 awash with surplus capital and able to sustain the most serious severe downturn with limited pain.
Yet, as we know, the entire industry came close to collapse. When you examine how the proceeds of growth were shared, it is not difficult to see why.
Employees were paid ahead of shareholders
Taken together, Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers saw their shareholder equity increase by $41.8bn in the five years to 2007. Yet compensation totalled a staggering $226.4bn.
The worst offender on this metric was Merrill Lynch which paid employees 21.5 times the increase in shareholders' equity, followed by Morgan Stanley on 17.1 times. Goldman Sachs was the most parsimonious with 2.4 times.
Perhaps it is no coincidence Merrill Lynch lost its independence while Goldman Sachs retained its.
Outside the pure investment banking sphere, JP Morgan was so unaffected by the financial crisis that it became the industry's white knight, mopping up Bear Stearns and Washington Mutual. What was JP Morgan's compensation multiple? A mere 1.14.
The investment banking industry likes to argue that the ratio between revenue and compensation should be 50%, to retain sufficient talent. Yet this is far in excess of the typical 20% performance and 1.5% administration fee, charged by oft-criticised hedge funds.
It is worth adding that hedge funds' 20% profit share does not directly go to the employee responsible for the return but to the management company, which might give half of that to the trader.
In the case of an investment bank, shareholders both own the management company and provide the investment capital. Paying 50% of the returns achieved to would-be rainmakers compares deeply unfavourably with the 10% offered by hedge funds.
It beggars belief that shareholders should ever have allowed such rewards to go to banking teams, while becoming exposed to record levels of leverage at the peak of the cycle.
Profits used for compensation instead of capital buffers
To sum up, shareholders allowed employees to have free puts on earnings. Profits, which should have been used to build up capital buffers, were siphoned off and put into compensation. Because it was based on returns on equity with no adjustment for risk, banks had every incentive to increase returns through leverage. Shareholders should have only paid for risk-adjusted returns, not risk taking.
We have seen the first signs of what is to come, in the wake of government-backed bank rescues.
The Turner report in the UK has proposed a threefold increase in the capital requirements for proprietary trading. Governments are seeking to ensure compensation is deferred and subject to clawbacks. Leverage will be discouraged and penalised.
Shareholders may end up benefiting from this trend, as leverage falls and margins grow. As has been the case in other recoveries, reduced competition will further boost the bottom line. Bank margins are back to peak levels and they are likely to stay there for some time.
Equity markets are nobody's fool. When the banks drove up returns through leverage in the last cycle, they responded by derating them. Conversely, we should expect stock price multiples to expand to historic highs as banks start to deliver.
Habits die hard. It may well be that compensation levels will go straight back up, as recovery takes shape. But shareholders will have no complaints if returns are not artificially inflated by leverage.
In the last cycle, shareholders gave up too much of the rewards and were left holding the risk. With appropriate oversight and regulation, capital should belatedly earn its reward.
This article first appeared in Financial News.