I am throwing a line of thinking out in the hope of getting reader input. I put a post up a couple of days ago on looting and am still puzzling the question.
I believe that deregulation led to looting, in the Akeloff/Romer sense, that people at Wall Street firms were overpaid relative to the true, properly risk reserved earnings of the business.
The problem is that the mechanism is more complicated than the sort that they and later Bill Black discussed, that of CEO level pilfering (well, save maybe in the case of the Fuld and Gregory at Lehman, although they were badly self-deluded as opposed to criminal in intent. I personally think they were criminal in action, that the accounting was fraudulent, but they somehow rationalized it).
What I believe happened is this (very crude story line, but I am highly confident, to use that old Drexel chestnut, that his pans out):
1. Wall Street firms got big, both as banks started invading their turf (and banks big to begin with). This meant greater spans of control. In the old days, anyone who was running a meaningful profit center was a partner, and there were few enough partners that the management committees could keep on top of them. But as firms got bigger, you had important profit sources that did not have an expert at a higher level running them. They might have some general knowledge of a business, but not specific knowledge.
2. Trading became more important as a profit center relative to other activities due to (gradual) erosion of profits in other areas thanks to deregulation.
3. Rising popularity of hedge funds gave top traders (proprietary traders) a ready exit, plus set a new high pay bar
4. Other boats in trading land rose pay-wise due to 3. Other big producers could always exit to another firm, if not set up own firm.
5. Even if non-prop traders who are “producers” in theory can be replaced, in practice having top guy disappear, taking key people with him, is a bad position to be in. You do lose momentum, you even risk control failures on the desk. If the book is big and active, they do have management hostage. Particularly in new, specialized areas, it would take time to poach someone from another house to fill the gap. (A big issue here is I am not sure how to define who might be able to hold the firm hostage. The head of any major trading desk might fit the bill; not sure who else ought to be included).
As a result of 1-5, middle level (meaning MD but not executive level) employees were effectively able to extort management. Think of what would happen in a nuclear reactor if the staff who knew how to run it could go on strike. So collectively they were able to get themselves overpaid, often in the form of getting to run bigger risks than they should have (ie, the payout norms may on the surface not have change, in terms of ratio of pay relative to apparent production/profitability, but if you are running much bigger risks, you’ve increased your personal top line to the detriment of the enterprise).
And the top level guys had reason not to question it because:
1. Fighting it would risk having the firm appear less profitable, talent would exit
2. Firms were now public, incentives and pay badly skewed towards short term incentives.
3. Competition in many markets based on league tables, meaning market share
I have spoken to some experts who believe this fact pattern to be true, but as of 2-3 years ago could not prove it.
I believe that this probably cannot be established in a rock-solid fashion without having access to internal data (and policies), but I wonder whether readers can point to any anecdotes or case examples (in the public domain, say in Institutional Investor, The Deal, other industry publications) supporting the logic chain above.