Inequality and Moral Hazard Rents in the Financial Sector

Ashwin Parameswaran over at Macroeconomic Resilience:

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.

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