Trader Compensation, Risk, and the Banking Labour Market

Abstract

This paper argues that employee mobility in the financial sector can be conducive to excessive risk taking by financial institutions. Excessive risk can result from the need for these institutions to hire from a labour market with dispersed talent. On the one hand, institutions want to hire only talented workers, making sure untalented ones do not seek employment with them. In order to pick only the best bankers, the institution offers a low base salary and high bonuses. These high-powered incentives can lead to excessive risk taking. The paper studies two different labour market models with varying degrees of mobility. On the labour market, banks of different sizes compete for the most talented workers. Larger banks end up hiring more talented traders. However, the competition from other banks endogenously raises the outside options for talented traders, giving rise to a need for high-powered incentives, leading to potentially excessive risk taking. The paper finds that labour markets with high worker mobility are more conducive to excessive risk than those with lower mobility, as the threat of a trader moving jobs raises the compensation that such a trader can demand.