RegBlog

RegBlog

The Effect of Income Disparity on Financial Regulation

| Jun 18, 2014 | Analysis

As Occupy Wall Street protesters descended on Zuccotti Park in September 2011, the use of the phrase “income inequality” on major news networks, cable, and in leading newspapers grew four-fold. That same year, amid criticism that financial executives pocketed huge bonuses while shareholders faced losses, the Securities and Exchange Commission (SEC) adopted “say on pay” rules, letting investors vote on executive compensation. And in a speech in December 2013, President Barack Obama called income inequality “the defining challenge of our time.”

NYSEWhat about a different kind of pay gap—that between the financial industry and their regulators? What is the magnitude of that gap, and could it have adverse consequences for financial regulation?

In a forthcoming paper, Steven Schwarcz of Duke University School of Law demonstrates that a two-to-one income disparity exists between financial industry employees and their regulators. He argues that this pay gap impedes the ability of administrative agencies to hire competitively, thereby creating an information asymmetry between industry and regulators that may trigger failures in agency rulemaking, monitoring, and enforcement. Schwarcz says that while reducing the income disparity between industry and regulators would be a politically strenuous endeavor, potential solutions do exist and the United States would do well to consider them.

The Bureau of Labor Statistics (BLS) reports that federal government employees, who are paid in accordance with the General Schedule or the Executive Schedule overseen by the Office of Personnel Management (OPM), receive twenty-five percent lower pay on average than private sector workers in comparative positions. Collating data from BLS surveys, USAJOBS, and the Office of the Controller of the Currency (OCC), Schwarcz finds that a much wider income differential exists between financial regulators and members of the industry they regulate. For example, entry-level Federal Insurance Deposit Corporation (FDIC) employees make $51,630 on average and senior policy analysts start at $145,757, he says, while entry-level investment bankers had a median annual salary of $90,560 and high-level financial managers earned $160,900 in 2012.

Schwarcz emphasizes that these figures do not account for a popular form of compensation in the financial industry: options and bonuses. The Office of the New York State Comptroller estimates that Wall Street bonuses averaged $139,940 in 2010. With bonuses much rarer and more modest within the public sector, Schwarcz notes, senior financial regulators would earn $147,757—as noted above—while their private sector counterparts would pocket $300,840, amounting to twice-as-high compensation for the financial industry over regulators.

Schwarcz contends that this two-to-one income disparity impedes administrative agencies’ efforts to hire the best recruits, thereby leading to an asymmetry between regulators and the financial industry. In fact, a 2002 report by the General Accounting Office (GAO) in the wake Enron’s collapse and the SEC staffing crisis found that “inadequate compensation is the primary reason employees leave the agency.” All other things being equal, Schwarcz notes, people will always choose a job offering greater pay. He then asks, what are the circumstances under which the best financial employees would self-select lower-paying positions at any stage in their careers?

Schwarcz uses the Public Service Motivation (PSM) framework to assess how human beings would make such job decisions. PSM, which posits that public employees act out of a desire to promote the public good, suggests that financial regulators would actively choose to earn less in order to work in public service rather than the private sector. However, empirical evidence has demonstrated that the theory does not always translate into practice, says Schwarcz. Although a study by former Secretary of the U.S. Department of Commerce and current chancellor of the University of Wisconsin-Madison, Rebecca Blank, has found that workers with higher levels of experience and education are more likely to self-select into the public sector, recent research suggests that PSM would be insufficient to overcome the two-to-one income disparity, according to Schwarcz. For example, a study by Gregory Lewis of Georgia State University shows that individuals who value income and would rather work for the public sector are more likely to work for the private sector. The Cornell Happiness Study finds that individuals are more likely to choose a higher-paying job with longer work hours than a lower-paying job with reasonable work hours.

Schwarcz argues that the income disparity therefore triggers an information asymmetry between financial regulators and industry arising from a difference in employee abilities and intellect. In turn, that information asymmetry could have adverse consequences on agency rulemaking, monitoring, and enforcement. Without a clear understanding, Schwarcz says, regulators may not only implement inadequate rules but also misinterpret the financial innovations altogether, issuing potentially harmful rules. Absent a clear grasp of financial products, regulators may be unable to monitor them effectively, contributing to information-based market failures. Finally, lack of resources, staffing, and expertise may impede a regulator’s ability to enforce highly complex rules and regulations.

Several ways to decrease the information asymmetry exist, says Schwarcz, but they are not without their own problems. For example, the United States could follow the example of the Monetary Agency of Singapore (MAS), which pegs its salaries to those of the financial industry. While the International Monetary Fund (IMF) has argued that MAS’s strategy has enabled it to attract and retain top regulatory talent, thus establishing Singapore as a financial center, Schwarcz says that the U.S. financial industry may simply respond by raising private salaries to exceed any public sector raises.

Another way to reduce the information asymmetry, Schwarcz says, could involve increasing standardization of financial products or paying third parties to reduce the asymmetry. Pointing to the Dodd-Frank Act’s clearinghouse requirement, however, Schwarcz argues that because third parties, like clearinghouses, also concentrate risk, such standardization may inadvertently act to increase systemic risk.

Increasing regulatory specialization is yet another solution, says Schwarcz, but it is imperfect. He points to the Financial Sector Assessment Program (FSAP)—in which the World Bank brought together a team of specialists to diagnose problems within the financial system—to illustrate that the ability of teams to capitalize synergistically on individual expertise fades over time. Perhaps simply accepting that ex ante financial regulation cannot alone prevent financial failures and focusing more resources ex post is the way to reduce the information asymmetry, says Schwarcz.

Reducing the two-to-one income disparity between financial regulators and the industry they regulate is a politically challenging task, Schwarcz concludes, especially in a period of growing concern about budget deficits and growing federal debt. However, he argues that the existence of information asymmetries between regulators and industry is an arena that needs greater focus, so that future financial crises can be avoided.



Tagged: , , , ,

    Related Posts