Compensating Financial Experts

Vincent Glode is Assistant Professor of Finance at the University of Pennsylvania. This post is based on an article authored by Professor Glode and Richard Lowery, Assistant Professor of Finance at the University of Texas at Austin.

Compensation in the financial sector has been a controversial topic in recent years and has drawn the attention of both the press and financial regulators. Concerns about excess compensation in bailed out financial institutions even led to the appointment of a “Pay Czar” to monitor the compensation of executives and highly paid employees. Since compensation amounts roughly to half of Wall Street firms’ revenues (Office of the New York State Comptroller, 2014), and the financial sector now represents about 10% of the U.S. GDP (Greenwood and Scharfstein, 2013), the question of whether pay within financial firms is appropriate and consistent with good policy strikes us as extremely important.

One particular group of workers who tend to earn extraordinary rewards for their expertise are traders in over-the-counter markets. In our recent paper, Compensating Financial Experts, forthcoming in The Journal of Finance, we investigate the source of apparent high compensation in the financial sector, and how it may relate to the nature of trading activities. We categorize the workers employed by financial firms as those hired to create profitable investment opportunities, which we call “bankers,” and those hired to value and trade these investment opportunities, which we call “traders.” While creating worthwhile investment opportunities increases the total value available in the economy, valuing assets that are traded among financial firms simply provides an advantage to one firm in a zero-sum trading game. We show that the externalities associated with these tasks drives the compensation for the traders above the compensation of bankers.

Since a trader’s expertise improves his employer’s ability to appropriate the surplus in a zero-sum trading game, hiring traders imposes something akin to a negative externality on future trading counterparties (in the sense that the private benefit of such action exceeds its social benefit). This leads to defensive bidding by firms that offer traders what we call a “defense premium.” Without such a premium, the traders a firm targets would be hired by rival firms (i.e., potential trading counterparties) and their expertise would be used against the firm in question.

Workers responsible for creating investment opportunities in the first place, however, do not earn as much as traders. This low wage arises because firms sometimes need to sell the valuable investment opportunities bankers have created. When the counterparty to this sale has significant trading expertise, the sale occurs at a discount. Thus, the counterparty appropriates part of the surplus that bankers have helped create. As a result, hiring bankers is similar to providing a public good and that is why they earn less than traders. Furthermore, as the number of traders employed by trading counterparties increases, the benefit of employing bankers decreases, resulting in even lower compensation for bankers in equilibrium. In contrast, as firms employ more bankers and find more profitable investments, the benefit of employing traders who will later value securities backed by these investments increases, resulting in even higher compensation for traders. Thus, not only are two virtually identical workers paid very different wages when they occupy different jobs, but the compensation of a given type of worker is also greatly affected by the employment of a different type of worker by rival firms.

We also show that, surprisingly, the average compensation earned by financial workers can increases as the supply of workers increases. When more workers choose to enter finance, the proportion who end up employed as traders may increase, and this shift in the composition of workers can lead to an increase in the overall wage, even as the wage of each type of worker falls with greater entry. This result may help explain why average salaries in finance have continued to increase in recent decades despite the flood of workers entering the sector. Our model can also shed light on the apparent reversal in the types of occupations that have been considered the most lucrative over the years.

The full paper is available for download here.

Both comments and trackbacks are currently closed.
  • Subscribe or Follow

  • Cosponsored By:

  • Supported By:

  • Programs Faculty & Senior Fellows

    Lucian Bebchuk
    Alon Brav
    Robert Charles Clark
    John Coates
    Alma Cohen
    Stephen M. Davis
    Allen Ferrell
    Jesse Fried
    Oliver Hart
    Ben W. Heineman, Jr.
    Scott Hirst
    Howell Jackson
    Wei Jiang
    Reinier Kraakman
    Robert Pozen
    Mark Ramseyer
    Mark Roe
    Robert Sitkoff
    Holger Spamann
    Guhan Subramanian

  • Program on Corporate Governance Advisory Board

    William Ackman
    Peter Atkins
    Allison Bennington
    Richard Brand
    Daniel Burch
    Jesse Cohn
    Joan Conley
    Isaac Corré
    Arthur Crozier
    Ariel Deckelbaum
    Deb DeHaas
    John Finley
    Stephen Fraidin
    Byron Georgiou
    Joseph Hall
    Jason M. Halper
    Paul Hilal
    Carl Icahn
    Jack B. Jacobs
    Paula Loop
    David Millstone
    Theodore Mirvis
    Toby Myerson
    Morton Pierce
    Barry Rosenstein
    Paul Rowe
    Marc Trevino
    Adam Weinstein
    Daniel Wolf