The Bonus-Driven “Rainmaker” Financial Firm: How These Firms Enrich Top Employees, Destroy Shareholder Value and Create Systemic Financial Instability
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
|Date of creation:||Oct 2009|
|Date of revision:|
|Contact details of provider:|| Postal: Thompson Hall, Amherst, MA 01003|
Web page: http://www.umass.edu/economics
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Raghuram G. Rajan, 2005.
"Has financial development made the world riskier?,"
Proceedings - Economic Policy Symposium - Jackson Hole,
Federal Reserve Bank of Kansas City, issue Aug, pages 313-369.
- Philippon, Thomas & Reshef, Ariell, 2009.
"Wages and Human Capital in the U.S. Financial Industry: 1909-2006,"
CEPR Discussion Papers
7282, C.E.P.R. Discussion Papers.
- 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.
- Carmen M. Reinhart & Kenneth S. Rogoff, 2009.
"Varieties of Crises and Their Dates,"
in: This Time Is Different: Eight Centuries of Financial Folly
Princeton University Press.
- Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, number 8973, 06-2016.
- 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.
- Reinhart, Carmen & Rogoff, Kenneth, 2009. "This Time It’s Different: Eight Centuries of Financial Folly-Preface," MPRA Paper 17451, University Library of Munich, Germany.
- 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.
- Gary B. Gorton & Andrew Metrick, 2009.
"Securitized Banking and the Run on Repo,"
NBER Working Papers
15223, National Bureau of Economic Research, Inc.
- Gary Gorton & Andrew Metrick, 2010. "Securitized Banking and the Run on Repo," NBER Chapters, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
- Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
- 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.
- James Crotty, 2009. "Structural causes of the global financial crisis: a critical assessment of the 'new financial architecture'," Cambridge Journal of Economics, Oxford University Press, vol. 33(4), pages 563-580, July.
- James Crotty, 2008. "Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’," Working Papers wp180, Political Economy Research Institute, University of Massachusetts at Amherst.
- 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.
- James Crotty & Gerald Epstein, 2009. "Avoiding Another Meltdown," Challenge, M.E. Sharpe, Inc., vol. 52(1), pages 5-26, January.
- Steven N. Kaplan & Joshua Rauh, 2010.
"Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?,"
in: Corporate Governance
National Bureau of Economic Research, Inc.
- Steven N. Kaplan & Joshua Rauh, 2010. "Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?," Review of Financial Studies, Society for Financial Studies, vol. 23(3), pages 1004-1050, March.
- 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.
- 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).
- 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.
- 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.
- Michele Boldrin & Adrian Peralta-Alva, 2009.
"What happened to the U.S. stock market? accounting for the past 50 years,"
Federal Reserve Bank of St. Louis, issue Nov, pages 627-646.
- 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.
- 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.
- Reinhart, Karmen & Rogoff, Kenneth, 2009. ""This time is different": panorama of eight centuries of financial crises," Economic Policy, Russian Presidential Academy of National Economy and Public Administration, vol. 1, pages 77-114, March.
When requesting a correction, please mention this item's handle: RePEc:ums:papers:2009-13. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Daniele Girardi)
If references are entirely missing, you can add them using this form.