It was Adam Smith who proclaimed that the butcher gives you meat not because he gives a flying potato that your wife makes an excellent beef stew, but rather its his own personal desire to be able to feed his own family that he sells his meat.  He might love his job, but I can assure you he did not take it because he wanted to fulfil his part in the economics of our society.  He wanted to get paid, and it just so happens that chopping up dead animals brought home enough money that he’s happy to continue doing it until he's killed enough animals to set some kind of record.

But how much money the butcher makes is simply a function of supply and demand.  As the only butcher shop in town with nothing close by and residents yearning for fresh meat the butcher will likely make a “killing” (pun intended) simply because there are no alternatives.  However, the moment townsfolk start seeing the butcher rolling around in a Mercedez you’ll start to see other butcher shops open up as it’s appeal as a very profitable business starts to spread.  This in turn will drive down prices (as supply is more readily available).  That’s basic economics.

To illustrate how the above example differs from banking we need to alter the scenario above in one small way – we need to create a large barrier to entry.  Imagine in the scenario above the town now had 5 butchers, but the cost of opening up your own butcher shop was enormous and Government regulations made rules about opening up a butcher shop incredibly complicated.  The results would be obvious – those 5 butchers will remain the only places to purchase goods in the entire town.

The interesting problem the butchers now face is how much money to charge for a pound of beef.  While logic might dictate they will continually lower their prices so that customers choose their store over the store across the street, and in many competing businesses this is indeed the case.  The problem, however, is that these butchers may realize their product is actually indistinguishable from their competitors (they are both selling the same beef), and that the towns folk will actually need to buy it from someone at some point.  If they competed aggressively with each other you’d see the prices drop dramatically, but if instead they got together and agreed that the price for beef should be $100 / lb, townsfolk would have no other option (no other suppliers) but to pay the outrageous prices, and they’d simply divide their business sporadically across the 5 butchers in town.

Bringing the analogy back to banking, you can see how banks can get away with charging so much for various services – simply because they know if you go across the street you’re going to get the same charges, so their “pitch” for your business is that you happen to be in their bank at that very moment.  When a PC-user and a Mac-user sit down to discuss why they’ve chosen their particular computer brand they could argue extensively the pros and cons of each, but you’ll never two people argue over why Bank of America is the better bank over Chase.  They are indistinguishable.

Understanding why banks and other financial institutions make so much money is only part of the equation.  Because the barriers to entry for a bank are so enormous it is almost impossible to start your own bank without public financing (going “public” and being listed on the stock market), virtually all banks are public.  This means they have shareholders and investors who, in exchange for buying a piece of the company, will receive a share of it’s profits in the form of dividends as well as enjoy an increase in the price of their share should the bank perform well.  Having shareholders also means the huge profits the banks are pulling in is also going back into the public sector, minus the money going into the bonus pool and employee salaries.  Here’s where it gets interesting.  For the banks they are only competing with other banks, so they have no need to drop their fees and reduce their profits to be competitive (as shown above), but public investors having a wide range of choices for where to invest their money.  With banks pulling in so much money they become a natural choice for investors, but basic economics shows that banks don’t need to be the very best choice from investors in order to keep shareholders happy, they just need to be competitive with the other choices offered to investors.

This means that if a bank was normally going to return a 30% return on investment to shareholders but the market was only returning 8%, the bank could still give 21% of that profit to itself and still beat the market (by returning 9% back to shareholders).  Any easy way for banks to return more money back to shareholders would be to cut salaries in half, but there is no reason for that because financial institutions almost never short of public investment.

So what specifically helps raise these salaries of bankers to catastrophic levels?  Firstly, the banks themselves are enormously profitable due to lack of competition amongst themselves and the barriers to entry for other, new banks.  Secondly, because shareholders are still willing to give them money because they are competitive with other industries in terms of return on investment, and finally because the excess cash that doesn’t go to the shareholders has to go somewhere.

You’ll notice skill set and hard work haven’t been mentioned.  They are incredibly important but the fact is that is only a small portion of why the salaries are so skewed.