Leverage, Bank Employee Compensation and Institutions

Abstract

This paper investigates the empirical relationship between financial structure and employee compensation in the banking industry. Using an international panel of banks, we show that well-capitalized banks pay higher wages to their employees. Our results are robust to changes in measurement, model specification and estimation methods. In order to account for the positive association between bank capital and employee compensation, we illustrate a stylized 3-period model and show that well-capitalized banks have incentives to pay higher wages to induce monitoring. Such monitoring rents of employees at capitalized banks are expected to be higher in societies with weak institutions. Further empirical analysis shows that the weaker is institutional quality of a country the stronger is the positive relationship between bank capital and wages -- supporting our theoretical conjectures. High compensations in the financial industry received increasing criticism over the course of years following the great recession, whereas capitalization of banks has been encouraged. Our paper is the first to highlight that there is an empirically visible trade-off between the two and that institutions strongly interact with this relationship.

Keywords: Bank Financial Structure, Wage Determination, Human Capital

JEL Classification: G3, G21, J24, J31