Working Paper: CEPR ID: DP9725
Authors: Thomas Cooley; Ramon Marimon; Vincenzo Quadrini
Abstract: Over the last three decades there has been a dramatic increase in the size of the financial sector and in the compensation of financial executives. This increase has been associated with greater risk-taking and the use of more complex financial instruments. Parallel to this trend, the organizational structure of the financial sector has changed with the traditional partnership replaced by public companies. The organizational change has increased the competition for managerial talent, which may have weakened the commitment between investors and managers. We show how increased competition and the weaker commitment can raise the managerial incentives to undertake risky investment. In the general equilibrium, this change results in higher risk-taking, a larger and more productive financial sector with greater income inequality (within and across sectors), and a lower market valuation of financial institutions.
Keywords: Financial; Corporate Governance; Financial Risk; Income Inequality; Limited Commitment; Managerial Incentives; Partnerships
JEL Codes: E2; G1; G2; G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Transition from partnerships to public corporations (L33) | Weakened commitment between investors and managers (G34) |
| Weakened commitment between investors and managers (G34) | Increased managerial incentives to undertake risky investments (G34) |
| Increased managerial incentives to undertake risky investments (G34) | Greater risk-taking (D81) |
| Greater risk-taking (D81) | Larger and more productive financial sector (O16) |
| Greater risk-taking (D81) | Increased income inequality (D31) |
| Increased competition for managerial talent (M51) | Managers prioritize personal outside value over firm value (L21) |
| Weakened contractual commitments (L14) | Greater risk-taking (D81) |
| Weakened commitments (D74) | Greater share of financial sector output (G29) |
| Weakened commitments (D74) | Lower market valuation of financial institutions (G21) |