00:00:05
in my paper with Richard Larry from the University of Texas at Austin we try to understand how the specific tasks that
00:00:10
workers and finance perform will affect their compensation we think this is an important topic because the financial
00:00:18
sector is a big part of the economy in the US the financial sector represents 10% of US
00:00:25
GDP also a lot of the money that is flowing through the financial sector and ends up being used to compensate workers
00:00:33
typically a Wall Street firm will use 50% of it of its revenues to pay its workers so there's a lot of money that
00:00:40
is Flowing from the US economy to financial workers and we try to understand how that works so what we do
00:00:47
in the paper is we propose a labor market model where Financial firms compete for the services of a limited
00:00:55
supply of skilled workers and these workers can be as allocated or they can be hired to become traders who speculate
00:01:05
with other firms about the value of an asset or they can be uh hired to create a surplus by finding profitable
00:01:13
investment opportunities so for the first task what they do is a zero sum game they participate in a zero sum game
00:01:22
they help the firm extract Surplus away from rival firms on the other hand if they if these workers are hired to find
00:01:32
investment profitable investment opportunities like finding the next Tesla or finding the next Facebook they
00:01:38
create a surplus for the whole sector and we show in this paper that the externalities that these workers impose
00:01:45
on other firms will affect their compensation and by specifically modeling these tasks like speculative
00:01:52
trading or investment we're able to talk about how the compensation and the employment of workers in finance can be
00:02:01
affected by the investment opportunities the liquidity needs and the trading networks that we
00:02:11
observe so the key takeaway of my paper is that the specific tasks that workers perform in finance will have a big
00:02:21
impact on how firms compete for their services for example take a financial engineer who is hired to find better
00:02:30
ways to hedge interest rate risk so that engineer by innovating by finding that better hedging strategy will benefit his
00:02:40
employer but also all the other firms in the sector who will then be able to to use this strategy to hedge their risk so
00:02:48
when firms bid for the services of this worker when they're trying to compete
00:02:53
for the uh the this worker they're not as aggressive because they know they can
00:02:59
still Ben benefit from the innovation of that worker even though they don't hire
00:03:04
this financial engineer now take a speculative Trader whose job is to take advantage of other
00:03:12
financial institutions right take advantage of the counterparties better value the Securities that are being
00:03:19
traded between his or her employer and their counter parties right now acquiring the expertise of this this
00:03:29
Trad is very important because instead of gaining say $5 million by better valuing the Securities that are about to
00:03:38
be traded The Firm might lose $5 million to that to the firm that employs this Trader so we go from a profit of $5
00:03:48
million to a loss of $5 million so now firms are willing to pay up to $10 million for the services of this worker
00:03:57
first $5 million for the profits that he creates but also $55 million to make sure that this worker is not used
00:04:05
against them that second $5 million amount is what we call the difference premium this is how much you're willing
00:04:13
to pay for a worker to make sure he he or she does not work for one of your counterparties and and use is
00:04:22
competitive competitive advantage against you so that's one thing that's a
00:04:27
key Insight another Insight is has to do with the interactions between different
00:04:33
types of jobs right think of a situation where a firm's counter parties hired a lot of Traders a lot of
00:04:41
good Traders and these Traders are able to trade or value the Securities that your financial Engineers have created
00:04:50
what that means is if you hire Financial Engineers you're going to lose a lot of
00:04:56
the Surplus that these Financial Engineers create to other firms because they have good Traders so what that that
00:05:03
means is that in equilibrium your financial engineer and financial Engineers will
00:05:09
earn less if other firms have hired a lot of smart speculative Traders on the other hand if other firms
00:05:18
have hired a lot of Smart Financial Engineers that means they have created a lot of good Securities that might need
00:05:25
to be traded in the future so the compensation you willing to offer for your Traders will go up if these guys
00:05:33
have hired a lot of financial engineer so not only are two traders who might have this very similar
00:05:40
skills not only are they paid differently but also the compensation of one type of worker will be comp will be
00:05:49
affected greatly by how many workers of a different type are hired by rival firms
00:06:00
first we find that eye compensation for financial workers might arise in cases where only a few firms are competing for
00:06:07
their services right when there's only a few firms in the sector trading Securities they only a few of them can
00:06:15
hire these Traders so in most models you will say well that's bad for the workers
00:06:20
lower compensation When there's less demand for their services but since a lot of the compensation that we observe
00:06:27
in our model comes from the externalities it actually helps the traders to have few firms trading or
00:06:34
competing for their services and the reason is that if there are only a few firms then the externalities are greater
00:06:41
and the defense premium is greater M leading to high compensation for Traders the opposite can be said said about
00:06:49
these Financial Engineers if there's if there are very few firms that are looking to hire their their U the these
00:06:57
Financial Engineers the externality that they impose on these firms are big and therefore there's very little
00:07:04
compensation for them their compensation is low now there's the other surprising
00:07:11
fact too and it is that when there's more entry in the financial sector when
00:07:16
there are more workers who want to work in finance we might have com the average
00:07:22
compensation paid to these workers go up and the reason has to do with the allocation of workers how workers are
00:07:30
assigned to different tasks take the extreme example where a firm first needs to hire a final engineer to design a
00:07:39
security and then everyone else that this firm hires will end up being assigned to the trading task to
00:07:47
speculative trading so now if there's only one worker being employed by that
00:07:52
firm that one worker is a financial engineer okay and earns the lower compensation but but then everyone else
00:08:00
afterwards starts making more money because these new workers that are hired by The Firm are imposing negative
00:08:08
externalities on the firm so we start with only one worker making a low salary and we keep adding more workers who
00:08:16
benefit from this this defense premium overall as the supply of or or as the number of workers increases we have
00:08:24
higher average compensation our model helps us understand a few recently documented empirical facts
00:08:35
about compensation and finance first we know that top Wall Street firms tend to pay their uh interest rate option
00:08:43
Traders about twice as much as they pay their foreign exchange option Traders this could be puzzling if you only uh
00:08:51
thought about the skills that these guys bring to the table but our model highlights the the role that trading
00:08:58
comp concentration can can play for this difference right the interest rate option Market is a lot more concentrated
00:09:06
than the foreign exchange option Market therefore we should observe that the traders of interest rate options should
00:09:14
earn a higher defense premium and a higher compensation than foreign exchange option Traders the other thing
00:09:21
that our model helps us understand is why we've seen in recent decades an increase in the average compensation in
00:09:28
finance this despite the the the many people who have entered this sector so we have a lot of graduate students or
00:09:36
undergraduate students who enter the market yet the compensation keep going up the last thing is is kind of a more
00:09:44
broad uh kind of a broader takeaway as and it has to do with the fact that our model highlights our
00:09:51
compensation might not necessarily be linked with the social value that is created by a worker or by a task so some
00:10:00
tasks might be underpaid undercompensated like Financial Innovation and some tasks might end up
00:10:06
being overpaid or overcompensated in equilibrium task like speculative trading and this might help people
00:10:15
understand how to uh better regulate or better uh think about the compensation that is offered in the
00:10:26
market we carefully consider the tasks that that Financial workers perform for their firms right unlike in other
00:10:33
Industries where most workers produce help the firm produce Goods the the workers in our in our
00:10:41
model they trade Securities which imposes negative externalities on other firms or they find uh new Financial
00:10:49
Innovation they identify new Financial innovations that will create a surplus for all sector and the fact that we
00:10:55
model these interactions among firms allow us to uncover the effect of externalities on
00:11:02
compensation in a model without externalities or where we don't model the we don't look at the interactions
00:11:09
across firms we will see all workers with the same ability level making the same amount of money but in our model we
00:11:18
have externalities among firms the firms when they bid for these workers when they try to hire them they consider
00:11:24
these externalities as part of the equation and in the end what we get is that workers who impose negative
00:11:31
externalities on other firms the the speculative traders who are are part of a zero SU game they are they earn more
00:11:39
money they make they they have a higher compensation than the financial Engineers the bankers and the other
00:11:47
types of workers who impose positive externalities on the firms that failed to hire them
00:11:55
[Music]