Critics of Wall Street pay sometimes say that the overall level of compensation is so high that it encourages risk taking, irresponsible trading, and arrogance. Surprisingly, however, any attempt to lower pay at Wall Street firms is likely to have the perverse effect of making firms take on even more risk.
Recall that yesterday we demonstrated that the incentive structure of compensation on Wall Street was not an important factor leading to the financial collapse of 2008. Traders at Wall Street firms were not taking on too much risk because of the bonus incentives, they were taking on too much risk because they misunderstood the riskiness of mortgage backed securities.
Still, critics of the enormous amounts of money paid to bankers, traders, analysts and advisers on Wall Street insist there is a serious problem with the high level of compensation, regardless of the structural incentives. There may be some truth to this. Unfortunately, the alternatives would be likely to make the risk of bank failures even higher.
How could reducing pay on Wall Street increase the risk of institutional failure? To understand this we need to understand that the root of high pay on Wall Street is the enormous amount of money made by Wall Street firms. Reducing the share of revenues going to compensation will not eliminate the revenues, it will just redistribute them.
The beneficiaries of the redistribution will be the shareholders, who will see their equity in the company grow and dividends fatten. How will shareholders react to this situation? They will demand that investment banks take on more risk.
Raising the shareholder return for risk-taking will raise the demand for risk-taking. They will pressure management to engage in even riskier trading and lending strategies, because of this shift in expected return for the risk.
This outcome will occur even if the reduction in pay on Wall Street is accomplished through a massive tax hike. At first glance, a tax hike on Wall Street pay would seem to divert money from bankers to the Treasury. But, of course, this inefficient use of firm capital would not long be tolerated. Instead, firms will reduce cash compensation in favour of more tax effecient schemes, including diverting more money to shareholders and paying employees with shares.
Importantly, shareholders have very limited downsides when firms take excessive risk. Their losses are capped at the price paid for of the shares, which means that they will respond to any increase in the amount of reward received for a given level of risk by demanding more risk.
Ironically, attempting to reduce Wall Street pay may wind up creating the very dynamic–rewarding excessive risk taking–that some critics think caused last year’s near death and actual experiences.
This isn’t to say that some reforms–such as changing the mix of compensation paid out in bonuses and salaries–won’t do any good. They very well might. But those who think the real key to financial stability is lowering the overall level of compensation haven’t thought there program through.
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