A recent study by Kaplan and Rauh (h/t Tyler Cowen) confirms what a lot of us suspected anyway: the dominance of Wall Street (bankers, hedge fund managers etc) at the very top end of the income distribution. The presence of bankers at the top end of the income distribution is not surprising - A large portion of this blog has been devoted to the subject of how banks extract significant rents from the implicit and explicit support provided to them by the central bank. It is not surprising then that a significant proportion of these rents flows directly to bank employees. But as Megan McArdle notes, this does not explain the significant presence of hedge fund managers in this list. After all, hedge fund managers do not directly benefit from any state guarantees, implicit or explicit.

The SuperStar Effect?

It is clearly possible that there are many "superstars" in the hedge fund universe who generate genuine alpha and deserve their fat paychecks. But then the question arises as to why the prevalence of such superstars has increased so dramatically in recent times. One explanation may be the increased completeness of markets in the last quarter century which enables hedge fund managers to express a much more diverse range of market views in an efficient and low-cost manner. But this must surely be negated by the reduced supply of easy arbitrage opportunities and the increased competition amongst hedge funds.

Hedge Funds as an Indirect Beneficiary of Moral Hazard "Rents"

Megan McArdle rightly dismisses the role of tax policy on pre-tax compensation of hedge fund managers. But just because hedge funds do not directly benefit from a state guarantee doesn't mean that central bank policy towards the banking sector is irrelevant in determining their returns. For example, in my post analysing the possible strategy that Magnetar followed in its CDO investments, I observed that Magnetar essentially chose a trade with a positively skewed distribution. As I noted then, it is not a coincidence that Magnetar chose the other side of the trade that was preferred and executed in significant size by bank traders i.e. severely negatively skewed bets such as the super-senior tranche. As I have discussed many times, this demand for negative skewness is driven by the specific dynamics of the moral hazard problem in banking, often exacerbated by the principal-agent problems that exist even between different levels in banks. Therefore, the "alpha" that Magnetar generated would likely not have existed if it were not for the skewed incentives faced by bankers which in turn were driven by the rents they could extract from the state guarantees provided to them.

Economic Rents flow to the Strong

The example of Magnetar merely illustrates a more general principle that is often ignored: the ultimate beneficiary of any economic rent may be far removed from its initial beneficiary. The final distribution of rents is determined by many factors, most critically the competitive dynamics of the industry in question. In the context of our financial sector, the rents flow initially to the banks but are ultimately distributed between bank shareholders, employees, creditors and their clients/counterparties. The specifics of this distribution depends upon the bargaining power of each group and crucially the bargaining power of each group is uncertain and dynamic. So at the height of the economic boom when both equity and debt capital were cheap and plentiful, it is likely that a large portion of the rents was captured by employees, clients and counterparties such as Magnetar. Correspondingly, during the comparatively uncompetitive banking environment that emerged post the bankruptcy of Bear Stearns and Lehman, more of the rents could flow to the capital holders.

It is instructive to examine a couple of instances where the differing competitive dynamics result in dramatically different distributions of the rents flowing from socialized finance. The same moral hazard argument that I have made repeatedly for the banking systems in the United States and the United Kingdom applies in an even stronger fashion to the banking system in Germany which is dominated by a multitude of state-backed institutions. Yet Germany is one of the most unprofitable banking markets in the world - the ultra-competitive nature of the market means that almost all the rents flow out of the banking sector to their clients (depositors and borrowers such as the formidable Mittelstand).

Fix the System, Don't Blame The Individuals

I have used the language of games and intentional agent adaptation above but the same outcome could easily arise simply via the various groups reacting to local incentives or even via selection mechanisms arising from principal-agent dynamics - Indeed I have argued that active deception on the part of economic agents is unlikely to be selected for. All of which which implies something that I have repeatedly emphasised on this blog: Fix the system, don't blame the individuals.

The increased completeness of markets means that banks and hedge funds can implement almost any payoff they desire. Attempts to make markets less complete are futile and any attempts to do so can and will be subverted by economic agents. In such an environment, the system will evolve to a state  which maximises the rent extracted from "insurance commitments" by the central bank or other state agencies. To deny this is to assume that economic agents are omniscient as well as angelic. Even angelic agents who only possess knowledge of their local incentives rather than the bigger picture will act no differently from what I've sketched out above - An economic system that demands such omniscience on the part of its agents contradicts the very essence of a decentralised market economy.


nick gogerty

this reminds me a bit of Greshams law in terms of bad behaviour crowding out good.

Frank Palmieri

Your blog was recommended to me by Rajiv Sethi, and I have to say I really enjoy reading. However, I'm just wondering whether or not you consider non-monetary costs to taking on risky strategies over extended periods. It seems as though you make every agent out to be a maximizer of log wealth as opposed to those which must make marginal trade offs that often times involve transactions which are non-monetary (social acceptance, pride, recognition, social responsibility). If you want to say that natural-selection creates agents which value absolute wealth over other things I might tend to agree, but in that case, it certainly is the people as well as the system which should be changed. For example, Goldman Sachs prided itself on prudent risk management. AIG, as well, prided itself on risk management. After the crises the reputation of these two institutions were maligned severely. While perhaps making millions of dollars would mean you no longer care about your companies brand, its survival, or your reputation as an individual (I wouldn't know) I get the feeling that these types of non-monetary costs are, in fact, of high value to agents. I think you would need to create a framework to analyze this marginal trade off as opposed to looking explicitly at the monetary gain from taking part in such strategies, otherwise it may come off as conjecture as opposed to real analysis. Of course we would never know, but an analytical framework would at least give a consistent approach with which to be able to judge this type of moral-hazard and how it affects agent behavior. Also, while you anecdotally cite the Magnetar trade, are these strategies consistent of all Fund managers within the list? This is not to say you are wrong. I was just curious as to other possibilities or explanations, especially given that fact that it is often the problem that we only look at the monetary incentives.

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[...] of the Day September 25, 2010 frank112916 Leave a comment Go to comments Inequality and Moral Hazard in the Financial Sector – From Macroeconomic [...]


Frank - I'm glad you enjoy reading the blog! To answer your questions, I don't assume that agents deliberately try and maximize wealth. The core of my evolutionary approach is the folowing: selective forces such as principal agent relationships and the Hayekian spontaneous order that arises from agents acting on partial and dispersed knowledge and incentives will drive the system towards a state that maximizes the extraction of the moral hazard subsidy even if agents do not deliberately intend to put on moral hazard trades - longer explanation here https://www.macroresilience.com/2010/01/01/moral-hazard-a-wide-definition/ . In fact, it is likely that the agents who rise to the top genuinely believe that they are doing the right thing and that they are deceiving no one as I explain here https://www.macroresilience.com/2010/02/17/natural-selection-self-deception-and-moral-hazard/ . This is what I was trying to explain when I mentioned that in a complete market ( i.e. In the language of selection, the universe is sufficiently diverse ), you need all agents to be "omniscient angels" for the system not to arrive at this state of maximum extraction sooner or later. This of course explains why most people at the centre of the crisis claim that they weren't doing anything wrong and I believe them! Hence my insistence that we need to change the incentives. On your point that other hedge funds may not have followed such strategies, it is of course true and Magnetar was just an illustration. On a broader level, exploiting commitments such as the Greenspan Put has been as profitable as the TBTF subsidy but that is a different post! My point is that all such commitments will eventually be extracted for all they're worth by market players and its not surprising that a large chunk flows to financial market participants that deal closely with banks. You won't find any argument from me that a lot more empirical work is needed on all these topics but that's probably a lot more work than a blog post!

Tito Costa

Ashwin, thank you very much for sharing such insightful posts on your blog. I found you via @interfluidity.

Doc Merlin

I suspect that regulatory arbitrage plays as large a role as moral hazard rents.

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Tito - Thanks for reading! Doc Merlin - A large proportion of regulatory arbitrage is aimed at subverting regulations that try to mitigate the moral hazard problem.

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