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Finance and Labor

Final Report Summary - FINLAB (Finance and Labor)

The main achievements of the project consist in addressing two important questions: (A) How does the operation of the financial system affect overall labor market outcomes and individual careers? (B) How does in turn the functioning of the labor market affect corporate decisions regarding capital structure and risk-taking?

Regarding question (A), the project’s main results are that (i) the association between financial development and employment growth is not monotonically positive, as it vanishes for credit/GDP ratios in excess of 100%; (ii) when credit expands beyond a critical threshold, banks take increasing risk, including systemic risk; and (iii) growth and systemic stability are also affected by the structure of the financial system, namely the size of the banking system relative to equity and private bond markets, bank-biased financial structures being associated with more systemic risk and lower economic growth.

At the level of individual employees, the project has shown that the materialization of financial firms’ risk has non-negligible “scarring effects” on the careers of employees. Asset managers working for hedge funds liquidated after persistently poor relative performance suffer demotion coupled with a significant loss in imputed compensation. Such scarring effects are absent when liquidations are preceded by normal relative performance or involve mid-level employees, so that they appear to stem more from reputation loss than to bad luck. Moreover, the materialization of aggregate risk stemming from financial crises appears to have made finance careers far less attractive in the last two decades: especially in asset management, entry-level positions dropped, the risk of demotion and of pay reduction rose, and returns to education declined, together with the education level of employees.

Regarding question (B), the project’s results show that the functioning of the labor market has important effects on key corporate decisions, but that these effects crucially depend on the design of various aspects of regulation.

One relevant and hitherto neglected piece of regulation is the protection afforded under bankruptcy law to employees’ versus creditors’ claims, and specifically on their relative seniority in liquidation and the balance of their rights in restructuring. The project has established, both theoretically and empirically, that employees' rights in bankruptcy affect corporate leverage, and does so differently in financially unconstrained firms, which can use leverage strategically in wage bargaining, and for financially constrained ones: stronger employee seniority increases the leverage chosen by the former, while it reduces it for constrained firms.

The generosity of public unemployment insurance, instead, contributes to shape firm decisions regarding the allocation of risk between financial claimholders and employees. One of the project’s findings is that family firms provide more implicit employment insurance to their employees in countries and periods in which workers have less generous unemployment insurance. No such substitutability emerges instead for nonfamily firms.

The degree of labor market competition is another crucial element in the provision of implicit insurance by firms: when firms compete aggressively for talent, they cannot insure low-talent employees at the expense of high-talent ones, as the latter would otherwise resign. This is highlighted by two theoretical contributions of the project, which respectively focus on two possible ways in which workers may protect themselves from the risk generated by firms’ learning about their talent. One is to slow down such learning by “churning” across employers so as to provide each of them with fewer observations about their performance; the second is to choose only jobs where performance has low sensitivity to their talent. Both of these responses are socially inefficient: the first results in low-talent workers being assigned to jobs where they make frequent mistakes, leading to inefficiently high risk for firms; the second prevents the development of firms featuring high talent-sensitivity, which are typically more productive, when only high-talent workers are retained. Such inefficiency can be removed by public unemployment insurance, which substitutes for the lack of private insurance against layoff risk inherent in talent-sensitive technologies.