The Labor Market for Bankers and Regulators

The following post comes to us from Philip Bond of the Department of Finance and Business Economics at the University of Washington, and Vincent Glode of the Department of Finance at the University of Pennsylvania.

The financial industry is heavily regulated. Whether it is in terms of spending or number of employees, financial regulation represents more than a third of all business- and industry-related regulation in the United States (De Rugy and Warren, 2009), even though the financial sector only contributes to 10% of the country’s GDP. However, many commentators express grave doubts about the current efficacy of financial regulation. For example, The Economist published a 2010 article entitled “Finance’s other bosses” in which it asked: “Does it really matter who is in charge of the regulators? The grunt work of supervision depends on more junior staff, who will always struggle to keep tabs on smarter, better-paid types in the firms they regulate.”

Overall, the notion that, on average, the people who staff financial regulatory agencies are less skilled than the people they oversee doesn’t seem very contentious—though of course there are many individual exceptions. In our paper, The Labor Market for Bankers and Regulators, forthcoming in the Review of Financial Studies, we seek to understand the economic forces responsible for this pattern.

The main point we make in our paper is that there is a strong—but perhaps surprising—economic force that naturally leads to a market outcome in which financial sector regulatory staff are less skilled than the people they regulate—or more colloquially, why bankers are smarter than regulators.

The starting point of our paper is to take seriously the idea that—ignoring pay differentials—regulatory jobs are better than banking jobs. In particular, we take seriously extensive survey evidence that many people derive satisfaction from public service, along with the widespread notion that working for organizations such as the SEC is an excellent way to build human capital.

Of course, pay differentials between bankers and regulators are very large. But we show that this can be a natural consequence of regulatory jobs being better jobs than banking jobs—regulatory agencies can still attract staff even with lower compensation, because potential employees find the jobs attractive.

But regulatory jobs being better jobs than banking jobs also has a second and more surprising implication, namely that it leads higher skilled workers to become bankers rather than regulators. The easiest way to illustrate this is with a simple numerical example. Workers either have high or low skill. High-skill workers add $600K of value to banks, while low-skill workers add $300K. Competition among banks will bid up compensation to $600K for high-skill workers and $300K for low-skill workers. However, since regulatory jobs are perceived to be better, workers are prepared to accept a pay cut, say $150K, to work as regulators rather than as bankers. So a regulatory agency would have to pay $450K to attract high-skill workers, but only $150K to attract low-skill workers. In other words, a regulatory agency would have to pay three times as much to attract workers who are only twice as good. Consequently, the regulatory agency “prefers” to hire low-skill workers.

It is important to understand that the regulatory agency may never explicitly express a preference for low-skill workers. The forces described lead to a labor market equilibrium in which regulatory agencies offer $150K to workers, and banks offer $600K to high-skill employees and $300K to low-skill employees—or alternatively, offer base salaries of $300K, with an additional $300K available through performance bonuses. Confronted with these job-terms, all high-skill workers view the financial cost of becoming a regulator as too large to bear—even though they would prefer to be regulators if pay were the same. In contrast, low-skill workers find the financial penalty acceptable, and some of them become regulators. Meanwhile, a regulatory agency may very well complain that high-skill workers are just “too expensive”—by which it really means that the cost of employing a high-skill worker isn’t justified by the improvement in productivity.

In our paper, we generalize this simple example and show that, in equilibrium, the better job attracts the worse workers. This idea has a couple of important implications. First, the complaint that regulators are less skilled than bankers is misfounded—not because it is untrue, but rather because it is the natural consequence of regulatory agencies making optimal hiring decisions with limited resources. Redirecting resources to hire the most skilled people would only reduce the overall efficacy of regulation. Second, and related, the fact that regulators are less skilled isn’t a consequence of limited regulatory budgets: an increase in budgets would lead to more regulators, but wouldn’t reverse the skill-differential with bankers.

So far, we have focused on skill and pay differences. But regulatory jobs also differ in a third dimension, namely that they offer much less performance pay. The same forces that explain skill and pay differences also explain this third difference. An old economic argument states that the only way for firms to attract the most skilled workers exclusively is to include contract terms that workers dislike, but that—critically—less skilled workers dislike more than more skilled workers. Performance pay is exactly such an example. So the best workers get contracts with performance pay, while other workers do not. Because the most skilled workers become bankers, this means that banking contracts feature performance pay, and regulatory agencies offer “safe” contracts with guaranteed pay and retention.

The full paper is available for download here.

Both comments and trackbacks are currently closed.