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Why Financial Pay Shouldn’t be Left to the Market

CAMBRIDGE – Although some financial firms are reforming how they pay their employees, governments around the world are seriously considering regulating such firms’ compensation structures. The Basel Committee on Banking Supervision has recently come out in favor of such regulations, and the United States House of Representatives has voted to require regulators to set compensation rules.

Perhaps not surprisingly, many financial bosses are up in arms over such moves. They claim that they need the freedom to set compensation packages in order to keep their most talented people – the ones who will revive the world’s financial system. So, should governments step back and let financial firms reform themselves?

The answer is clearly no. In the post-crisis financial order, governments must take on the role of monitoring and regulating pay in financial firms; otherwise, the perverse incentives that contributed to the current crisis could easily recur.

It is important to distinguish between two sources of concern about pay in financial firms. One set of concerns arises from the perspective of shareholders. Figures recently released by New York’s attorney general, Andrew Cuomo, indicate that nine large financial firms paid their employees aggregate compensation exceeding $600 billion in 2003-2008 – a period in which their aggregate market capitalization substantially declined. Such patterns may raise concerns among shareholders that pay structures are not well designed to serve their interests.