Why are financial sector employees paid so lavishly? And why do they tend to act more irresponsibly during economic booms, when their compensation is at its highest?
These are questions increasingly on the minds of critics, whose ranks have swelled since cavalier behavior on Wall Street triggered a global economic crisis in 2007.
Now a study by Philip Bond, an associate professor of finance at the University of Washington Foster School of Business, sheds new light on the subject.
Using sophisticated modeling techniques, Bond and co-author Ulf Axelson argue that the finance sector’s elaborate compensation packages are appropriate—though not necessarily deserved—for work with such serious consequences on other people’s money.
This compensation structure, however, has a downside. It exacts a brain drain on other worthy professions. And it contributes to an increase in lax and reckless behavior during robust economic periods, when impeccably educated and connected financiers are especially confident they’ll land on their feet should they fail.
Wall Street exceptionalism?
Finance sector compensation is generous by any standard. Lofty base pay is often eclipsed by annual bonuses which grow even bigger when the economy is booming.
This is meant to motivate high performance in a line of work that has serious economic ramifications. It also compensates for notoriously long hours, stressful conditions, fluctuating pay and lack of job security. Yet nobody is complaining, notes Bond. On the contrary, securing employment as an investment banker, money manager or stock broker is considered the next best thing to winning the lottery.
And in our explanation,” he says, “they have won a lottery of sorts.”
Landing these dream jobs takes an element of macroeconomic luck. Prior research has found that most finance careers begin straight out of b-school or not at all. And no matter how qualified or connected the candidate, graduate in a bad year and your career is likely to wander away from Wall Street.
All of this depicts the average finance sector employee as talented and well-educated, certainly, but not exceptional—at least not so exceptional as to warrant the sector’s premium pay.
Deserved or not, Bond and Axelson find that premium pay is necessary to motivate performance in jobs that are difficult to monitor and that carry significant moral hazard—that is, one person’s decisions have serious consequences on many others.
This incentivizing may be necessary on Wall Street, but it doesn’t always achieve the intended result.
Specifically, when the economy is booming and the job market is hot, the authors observe an increase in both bonus pay and risk-taking. With the prevalence of outside opportunities, throwing more money at financiers becomes a less effective motivation to work hard for their clients rather than taking shortcuts.
“Employees of the finance sector need to be incentivized because the consequences of them messing up are particularly severe,” says Bond. “But they become even harder to incentivize during booms, when they have lots of options.”
In the paper, Bond and Axelson identify one other significant economy-wide ramification of the finance sector’s ample pay: brain drain.
They find that Wall Street riches lure away some of the best and brightest who would otherwise go into other professions—medicine, teaching, engineering, business, government, for instance—in which their skills might provide greater value to society at large.
Bond allows that the paper’s inconsistent findings do not neatly support the arguments of critics or defenders of the financial sector’s compensation system.
“It can feel like we’re being apologists for bankers,” he says. “But while we do find that the financial sector’s level of compensation is necessary, we also find that its employees are not, on average, as special as their pay would suggest. Attempts to incentivize them with even greater bonuses during booms appear to produce a spike in risky behavior. And, on a broader level, Wall Street pay lures a lot of talent that would otherwise go into other worthy lines of work.”
Still, when they weigh the pluses and minuses of Wall Street’s compensation system, Bond and Axelson conclude that its utility outweighs its harm.
“We believe that an overhaul of the finance sector’s pay structure would result in employees working less hard and messing up more often,” says Bond, “with enormous ramifications.”
Bond adds that the study provides one additional and unexpected revelation. The logic of its model, he says, helps explain the mystery of long-term unemployment that has vexed generations of economists.
Simple economic theory says there should be employment for everyone who is willing to work for what the market is willing to pay.
But this analysis of the job market’s upmost echelon suggests that there is actually a minimum compensation required for people to work hard at jobs that are difficult to monitor. Not Wall Street riches, certainly, but some premium that is necessary and appropriate to incentivize people to work diligently in difficult jobs.
“We didn’t set out to study long-term unemployment,” Bond says. “But in working on the paper, the more we thought about it, the more convincing this seemed as an explanation.”
“Wall Street Occupations” is published in the September 2015 Journal of Finance.