The perception that financial professionals earn more than people in the non-financial world is not wrong. Interestingly, however, there was a long period in the 20th century where this was not the case.
Every child knows: Bankers earn a lot. They actually bring back home much more than someone else with a comparable job outside the financial sector. But what drives this difference? Is it because bankers create so much economic value? Or are bankers just reckless people, better in getting the best deal possible for them?
The history of the wage differential between financial and non-financial professional sheds some light on these questions. Philippon and Reshef looked at the historical time series, and the graph below neatly summarizes their findings:
The dotted line shows the relative wage of financial professionals. It is compared to a benchmark wage in the non-financial private sector given by the thin grey line. The figure highlights two facts. First, wages in the financial sector were much higher between the 1920s and the 1940s, and after the 1980s. Second, and even more interesting from a contemporary viewpoint, is the complete lack of wage differential between the 1940s and 1980s. During this time, a banker used to earn roughly the same as a person employed in the private non-financial sector. How can this pattern be explained? It actually is related to the regulatory framework in place at the particular periods in time.
Failed Banking Regulation Before the Great Depression
Before the 1930s, there was an asymmetric regulatory framework in place. Stringent banking regulation did not yet exist. Still, the Federal Reserve – introduced in 1912 – supplied the banking industry with liquidity guarantees. As government guarantees induce a moral hazard problem, this situation of guarantees without effective regulation calls for trouble.
Unconstrained by regulations, bankers took on risky bets, as they felt safe given the guarantees. They made a killing while the music was still playing. This development ignited the roaring Twenties. But as we know by now, one day the music stopped playing, and it all ended in tears: the Great Depression of the 1930s.
The experience of the Great Depression led to a policy change. First, the guarantees were redesigned and Federal Deposit insurance was introduced. This time, the government did not make the same mistake again and combined the added government guarantees with a stringent regulatory framework; symmetry was finally established.
Government guarantees prevented panics on financial markets, but bankers were effectively prevented by banking regulations to abuse these guarantees. Hence, the industry was unable to extract excessive profits and wages during this time.
Failed Banking Regulation Because of the Digital Revolution
The digital revolution that started in the 1970s unsettled the delicate balance between banking regulation and government guarantees. With new information technology, bankers suddenly found countless ways to circumvent banking regulations while still relying on government guarantees for their risky bets. And with this, the wage differential between financial and non-financial professionals was re-introduced.
Today’s wage differential between bankers and non-financial professionals thus points toward a fundamental problem. It can neither be explained by the generation of economic value in banking nor by reckless behavior. They key lies in outdated institutions. Banking regulation does no longer work in a world that is organized around information technologies. To cope with the challenges of our financial system in the digital age, we need a paradigm shift of a similar magnitude to the one after the Great Depression.
"Hi Mark, we provide a detailed account how financial innovation was used to circumvent banking regulation in our book, the End of Banking. Have a look at it.".
"Some detail on just how technology allowed the entire financial community to circumvent regulations would be appreciated. I am sure that there is a lot more to it than that.".