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