Banks can potentially come to an implicit understanding about how much to pay employees, says David Ross, a management professor at Columbia Business School.
"It's just common sense that you have to keep an eye on what your competitors are paying," Ross says. "If the leaders are going to pay MBA students X amount, it is hard for other banks that want to compete to pay much less."
Some of the largest banks like Goldman Sachs Group Inc., Morgan Stanley, Citigroup Inc. and Bank of America Corp. recently decided to cut compensation, Bloomberg News reported. Morgan Stanley capped cash bonuses at $125,000 while Goldman Sachs slashed discretionary compensation more than its 26% plunge in revenue.
Ross uses the example of two neighboring delicatessens. One owner decides to raise the price of a cup of coffee at his store then waits to see if his rival follows. Over time, the price of a cup of coffee at both inches up. Each owner could lower prices and undercut the other, but is unwilling to do so because it would cause both to be worse off.
The same idea applies to investment banking giants setting compensation for their employees. Companies could pay far more than others to attract the best talent but doing so drives up costs and cuts into profits.
The status quo is difficult to maintain as it takes only one player to offer significantly more in compensation to lure the start, Ross says. But the system becomes easier to sustain with fewer players and during tough economic times, he adds. For example, banks are not currently hiring extensively, so there is less of a threat that dissatisfied employees at companies like Morgan Stanley will quit.
"Wall Street had a bad year so there is pressure not to pay as much," Ross says. "But this won't continue forever."
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