Paycaps As A Bailout: Why Capping Pay Hurts The Recovery


Apparently we’re only a couple hours away from a big announcement from President Hope N. Change about pay caps at Wall Street firms. No one knows what the rules will be, and many suspect that they will be so ineffectual that every company will simply find a quick workaround.

But that’s cynicism talking, which we’re supposed to be past these days. So let’s pretend for a moment that the pay caps will work–that they’ll be applied in some way that actually limits the amount of money people working in finance can earn. What happens then?

Well, in the first place, we’ll find ourselves in a strange world in which competition for talent is severely limited. Instead of bidding up the price for investment bankers, analysts or traders, Wall Street firms will find that they can be more complacent. The competition won’t be able to hire away the best people with the promise of extravagant pay.

This will have the secondary effect of providing moribund Wall Street firms with a huge subsidy. Talent is the biggest expense at Wall Street firms–once you net out bad bets on real estate. Capping pay would create a huge cost reduction. That sounds like a boon for shareholders. Unfortunately, this would have the effect of allowing dead in the water firms to continue on without fear of losing their best performers. This, in turn, might actually encourage Wall Street to further misbehave. If you only have to pay your guys $500,000, you can afford to lose a lot of money without losing your top people. In short, you are taking away a big downside of risky behaviour by financial firms.

It gets worse.  The exit of talented people is typically a signal of financial distress on Wall Street.  For firms with hazy balance sheets, very often it is one of the only metrics available to an outsider who wants to judge a firm’s health. Shares of Bank of America, for instance, seem to be suffering by the ongoing defections of senior executives. Once you max out compensation at five hundred grand, you’ll find that this signal becomes useless.

Overall, this could hurt our economic recovery by limiting the rewards for making smart bets on the companies and sectors that will lead us into economic health. Bankers capped out at $500K will have little incentive to advise firms about how to raise money in troubled economy. Traders will be less active. Basically, we’ll wind up creating a zombie version of Wall Street that will have little incentive to rebuild our economy.

We’re just getting started with this. We’d keep on listing the problems if it were not for the fact that we’re  sceptical that any pay cap would actually cap pay in a meaning way on Wall Street. We’re confident in the ability of financial professionals to find work-arounds for any limit on their compensation. So why go on with the problems of what we expect will be a counter-factual?