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The Bonus-Driven “Rainmaker” Financial Firm: How These Firms Enrich Top Employees, Destroy Shareholder Value and Create Systemic Financial Instability

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  • James Crotty

    ()
    (University of Massachusetts Amherst)

Abstract

We recently experienced a global financial crisis so severe that only massive rescue operations by governments around the world prevented a total financial market meltdown and perhaps another global Great Depression. One necessary precondition for the crisis was the perverse, bonus-driven compensation structure employed in important financial institutions such as investment banks. This structure provided the rational incentive for key decision makers in these firms (who I call “rainmakers”) to take the excessive risk and employ the excessive leverage in the bubble that created the preconditions for the crisis. This paper presents and evaluates extensive data on compensation practices in investment banks and other important financial institutions. These data show that rainmaker compensation has been rising rapidly, is very large, and has asymmetric properties that induce reckless risk-taking. Since boom-period bonuses do not have to be returned if rainmaker decisions eventually lead to losses for their firms, and since large bonuses continue to be paid even when firms in fact suffer large losses, it is rational for rainmakers to use unsustainable leverage to invest in recklessly risky assets in the bubble. A review of the modest literature on financial firm compensation practices in general and those of investment banks in particular demonstrates that the giant bonuses of the recent past are not efficient returns to human capital – they are unjustified rents. The paper discusses possible answers to the challenging questions: what is the source of rainmaker rents and how are they sustained over time? Answers to these questions can help guide debates over the appropriate regulation of financial markets. They are also necessary inputs to the development of an adequate theory of the “rainmaker” financial firm that can help us understand how these firms were able to maximize the compensation of their key employees through policies that destroyed shareholder value and created systemic financial fragility. To my knowledge, no such theory currently exists. JEL Categories: G01; G24; G10

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Bibliographic Info

Paper provided by University of Massachusetts Amherst, Department of Economics in its series UMASS Amherst Economics Working Papers with number 2009-13.

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Date of creation: Oct 2009
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Handle: RePEc:ums:papers:2009-13

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Keywords: bonuses; investment banks; leverage; financial crisis; perverse incentives;

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References

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  1. Thomas Philippon & Ariell Reshef, 2009. "Wages and Human Capital in the U.S. Financial Industry: 1909-2006," NBER Working Papers 14644, National Bureau of Economic Research, Inc.
  2. Reinhart, Carmen & Rogoff, Kenneth, 2009. "This Time It’s Different: Eight Centuries of Financial Folly-Preface," MPRA Paper 17451, University Library of Munich, Germany.
  3. Gary Gorton & Andrew Metrick, 2009. "Securitized Banking and the Run on Repo," Yale School of Management Working Papers amz2358, Yale School of Management, revised 01 Sep 2009.
  4. Raghuram G. Rajan, 2005. "Has Financial Development Made the World Riskier?," Working Papers id:248, eSocialSciences.
  5. Steven N. Kaplan & Joshua Rauh, 2007. "Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?," NBER Working Papers 13270, National Bureau of Economic Research, Inc.
  6. James Crotty, 2008. "Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’," UMASS Amherst Economics Working Papers 2008-14, University of Massachusetts Amherst, Department of Economics.
  7. Tobias Adrian & Christopher R. Burke & James J. McAndrews, 2009. "The Federal Reserve's Primary Dealer Credit Facility," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 15(Aug).
  8. Michele Boldrin & Adrian Peralta-Alva, 2009. "What happened to the US stock market? Accounting for the last 50 years," Working Papers 2009-042, Federal Reserve Bank of St. Louis.
  9. James Crotty & Gerald Epstein, 2009. "Avoiding Another Meltdown," Challenge, M.E. Sharpe, Inc., vol. 52(1), pages 5-26, January.
  10. James Crotty, 2007. "If Financial Market Competition is so Intense, Why are Financial Firm Profits so High? Reflections on the Current ‘Golden Age’ of Finance," Working Papers wp134, Political Economy Research Institute, University of Massachusetts at Amherst.
  11. Marianne Bertrand & Claudia Goldin & Lawrence F. Katz, 2009. "Dynamics of the Gender Gap for Young Professionals in the Corporate and Financial Sectors," NBER Working Papers 14681, National Bureau of Economic Research, Inc.
  12. Thomas Philippon & Ariell Reshef, 2007. "Skill Biased Financial Development: Education, Wages and Occupations in the U.S. Financial Sector," NBER Working Papers 13437, National Bureau of Economic Research, Inc.
  13. Eric Tymoigne, 2009. "Securitization, Deregulation, Economic Stability, and Financial Crisis, Part II--Deregulation, the Financial Crisis, and Policy Implications," Economics Working Paper Archive wp_573_2, Levy Economics Institute.
  14. Paul Oyer, 2006. "The Making of an Investment Banker: Macroeconomic Shocks, Career Choice, and Lifetime Income," NBER Working Papers 12059, National Bureau of Economic Research, Inc.
  15. Alan D. Morrison & William J. Wilhelm, 2004. "The Demise of Investment-Banking Partnerships: Theory and Evidence," OFRC Working Papers Series 2004fe14, Oxford Financial Research Centre.
  16. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Bonuses & ideology
    by chris dillow in Stumbling and Mumbling on 2009-12-04 12:56:43
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Cited by:
  1. Olivier Godechot, 2011. "Finance and the rise in inequalities in France," Working Papers halshs-00584881, HAL.
  2. Peter Skott & Frederick Guy, 2013. "Power, Luck and Ideology in a Model of Executive Pay," UMASS Amherst Economics Working Papers 2013-01, University of Massachusetts Amherst, Department of Economics.
  3. James Crotty, 2010. "The Bonus-Driven “Rainmaker” Financial Firm: How These Firms Enrich Top Employees, Destroy Shareholder Value and Create Systemic Financial Instability (revised)," Working Papers wp209_revised3, Political Economy Research Institute, University of Massachusetts at Amherst.

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