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Taking the Alpha Out of Finance
26 January 2009
Would the world be better off if most financiers weren't such alpha types?
Do we really need our bankers to be among the smartest, best-educated people around? Or, would society as a whole make out just fine - even be served better - if the finance sector were populated by and large by run-of-the-mill individuals?
Bankers' compensation is in the news again. Lately the focus of attention seems to be shifting from how to punish bankers' excesses, to a more two-sided conversation about long-run consequences that might flow from the seemingly inevitable turn toward stiffer government oversight of financial activities.
In a research paper dated December 2008, NYU's Thomas Philippon and University of Virginia's Ariell Reshef examined a century's worth of data on bankers' pay and found that regulation was one of three major drivers. Increased regulation discourages innovation in finance, in turn removing financial institutions' incentive to pay up to get the best and brightest talent. Thus, the paper's authors conclude, "Tighter regulation is likely to lead to an outflow of human capital out of the financial industry. Whether this is desirable or not depends on one's view regarding economic externalities."
What is your view? Are bankers overpaid? (Philippon and Reshef's paper asserts that they are.)
More important: If more and better oversight does narrow the gap between compensation in finance vis-a-vis other sectors of the economy, is that a winning scenario for everyone except bankers? If the most creative, talented, hard-driving minds stop crowding into financial occupations - thereby bringing about a simpler and less innovative financial sector - will society as a whole be unambiguously better off?
Answering a question with a question:
How large is the intersection between these two sets of people with the talent and ability to, with appropriate education and training, perform at "best and brightest" level in finance:
(1) those who are overwhelmingly motivated by money, for whom the difference between a $200,000 annual income and a $2 million annual income will affect their career choice, and, in order to earn the higher amount lead them to live workaholic, highly materialistic lives, possibly sacrificing health, happiness, and family; and
(2) those who find themselves intellectually challenged, fascinated, and self-actualized by working in finance?
I'd say there is considerable overlap, and the latter will still choose to work in finance even if the financial reward is less.
Maybe all the money being paid out in recent years even selected more in favor of the first group, so finance in fact attracted a lot who were NOT the best and brightest, just the most willing to sacrifice for top pay -- and who collectively made a vast set of shortsighted, catastrophic decisions.
George Lenard 26 Jan 2009
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