Vidya Mahambare: Overpaid bankers?

A new research says workers in financial industry earned wages above their skill premium

A new research says that workers in the financial industry earned wages over and above their skill premium.

It is commonly perceived that salaries and bonuses in the financial sector are too high relative to pay scales in other industries. The ongoing financial crisis has once again brought this issue to the forefront. Indeed, recent research by Ariell Reshef and Thomas Philippon concludes that between the mid-1990s and 2006, those in the financial industry earned 30 to 50 per cent more compared to workers with comparable skills in other industries*.

Using industry-level data from 1909 to 2006, the authors construct a proxy series for wages in the financial sector relative to other industries, controlling for education, skills and even innate ability of the individuals. The difference between the benchmark series and the observed relative wage is what they call excessive relative wage. The paper documents that from 1909 to 1933, workers in the financial industry earned a premium. From the mid-1930s, this wage premium continued to decline and by the late 1970s, wages in the financial sector were on average similar to wages in the rest of the economy. After 1980, it once again started drifting up, and by 2006, workers in the financial industry attracted a 50 per cent premium over their counterparts in other industries.

 

Interestingly, the skill intensity in the sector also exhibits a U-shaped pattern over the same time period. After being a highly skill-intensive industry up until 1933, the financial sector became relatively less skill-intensive in the interim period. That is, financial jobs were relatively more complex and challenging than non-financial jobs before 1930 and after 1980, but not in the middle of the sample period. What factors explain this U-shaped pattern observed both in wage premium and in skill requirement?

The paper identifies changes in the regulatory environment as the main cause. The periods of deregulation of the financial industry coincided with the rise of new industries in the economy with high growth potential such as electricity and railroads in the 1930s and information technology since the mid-1990s. Finding optimal ways to finance new firms is a difficult and complex task. New firms are difficult to value because they tend to use new technologies or new business models. Similarly, pricing such risky debt is much more challenging than pricing a relatively safe security such as government debt. As a result, the skills required to perform such jobs were in great demand during these time periods. Therefore, a logical explanation for the wage premium could simply reflect increased demand for highly-skilled labour.

However, according to the authors, workers in the financial industry earned wages over and above their skill premium. That is, neither the skills nor the complexity of the work involved accounts for the observed pay differential. In this sense, the commonly held belief that the financial sector experts are “overpaid” seems to be justified. However, what the paper does not address is the question whether this premium can be justified by the social returns generated by these professionals. For example, financial innovation in general tends not only to improve the efficiency of the financial markets but also that of the economy by improving the allocation of capital as well as the risk-management process, and by lowering the cost of capital. Thus, the benefits to the society may outweigh the costs. Unfortunately, there is no definitive answer as to what the social value addition of this sector is.

In sum, this study highlights two important facts that are relevant to the current debate on regulation of the financial industry. One, tighter regulation is likely to lead to an outflow of human capital from the financial sector. Indeed, highly skilled labour left the financial sector in the wake of the regulations that were put forth following the Great Depression. Skilled labour moved back into industry once these regulations were relaxed. It is clear to see that excessive regulation would result in the outflow of skilled labour and would inhibit the R&D and innovation activities which are critical for improving productivity. This does not, however, mean that there should be no regulation, but rather what we need is effective regulation. Two, following the crises of 1930-1933 and the on-going episode, regulators have been blamed for lax oversight. With hindsight, it is clear that regulators did not have the human capital to keep up with financial innovations and exert effective regulation. Given the wage premia in the private sector, it is becoming increasingly difficult for regulators to attract highly-skilled manpower. Therefore, regulators’ salaries must be competitive with private-sector wages.

*”Wages and Human Capital in the US Financial Industry, 1909-2006.” Thomas Philippon and Ariell Reshef, NBER Working Paper 14644

The author is senior economist with Crisil.The views are personal.

vmahambare@crisil.com