Today’s economy seems rife with problems. The current unemployment rate is just above nine percent, and it will not decrease anytime soon.
People resent the irresponsible behavior of the bankers responsible for the crisis.
Making matters worse, people are angry at enormous investment banker salaries. Investment bankers at Goldman Sachs earned an average annual salary of $600,000.
Shocked at the high numbers, many people are pushing for heavy taxes on investment banks. There is a lot of literature already out there about why excessive taxing of banks and investment banks is a bad idea.
Instead, it is useful to consider exactly why investment bankers deserve the high salaries they receive.
Investment banks are financial institutions that help companies issue new stocks and bonds.
The first of three key functions investment banks undertake is to serve as an underwriter.
As underwriters, investment banks help companies issue new stocks and bonds.
This is particularly helpful for new companies as the investment bank will advertise and market a company and its securities to potential buyers.
Here an investment banker must demonstrate talent in being able to correctly evaluate the price of a security so that it will enter the market in a way that it can be successful.
Similarly, an investment banker in this situation must serve as a marketer in pitching and selling a stock.
Fulfilling underwriting responsibilities at an investment bank is thus very difficult.
Investment banks also help companies by other companies and help companies merge with other companies.
This task is called mergers and acquisitions. Investment bankers must research their client company’s potential profits from these deals.
Similarly, they advise clients about which deals to make and what price to pay for these deals.
Here, investment bankers must analyze a variety of economically relevant economic factors in order to produce very important information for their client company.
The third major task of investment banks is to buy and sell securities. Naturally, this requires in depth economic evaluation of securities. In all three of these roles, one can clearly see the challenging responsibilities of an investment banker.
One of the biggest reasons that investment bankers get paid as much as they do is contained within the role of serving as an underwriter: reducing adverse selection.
It is difficult for a new company to go public because people do not have a track record to judge the company off of.
As a result, people do not know how to value the stock. Here, asymmetric information, in which the public at large does not know a lot about a new company, is harmful to the new company.
The public, fearing that new companies are bad and will want to sell their securities at inflated prices, are unwilling to buy securities from new companies. Investment banks work to reduce this worry.
Investment banks research the firms they underwrite and make sure that the stocks those firms put out are correctly priced.
Invest banks also make sure that the firms are sound. Investment banks put their own reputations at stake when putting out securities.
People have faith in securities underwritten by a prestigious investment bank like Goldman Sachs.
If Goldman Sachs started to underwrite securities, people would have less faith in Goldman Sachs.
Thus, if an investment bank underwrote many bad securities, people would be less likely to trust and use it.
Due to the importance of reputation, investment banking is a concentrated industry. Part of the reason underwriting earns investment banks so much money comes from the reputation of an investment bank.
It is easy to want to attack investment bankers in this day and age. That said, they serve an important role, and by and large, they deserve the money that they make.
