The increase in pre-crisis bank CEO salaries can be fully explained, arithmetically, by high and rising returns on bank equity.13 Javier Gabaix and Augustin Landier have shown that levels of CEO pay generally are well-explained by their market capitalisation – the bigger the market cap, the bigger the bonus.14 But what drove those behaviours in the first place? It was a classic financial arms race, a case not so much of “keeping up with the Jones’s” as “keeping up with the Goldmans”.15 From the early 1990s onwards, league-leading firms began posting high returns on equity. Those firms with lower relative returns, who languished in the league, found themselves with sand kicked in their face. They felt obliged not just to keep pace but to leapfrog, to shake their tail feathers. The lower their rank, the greater these market pressures.16 Facing these competitive pressures, the best-response strategy for languishing banks was simple – gear-up. They added to their waistlines to compete with the dominant male in the pack. Like Hardin’s cattle herdsmen, they multiplied their numbers. Leverage delivered an instant leapfrog in returns on equity, a conspicous display of rich plumage. High equity returns also added fuel to the parallel race in financial sector pay. With equity-based remuneration contracts increasingly dominant, high equity returns added directly to pay packets. And with remuneration committees and pay consultants using relative pay as a reference, an arms race in remuneration took hold. As wages and equity returns ascended, the races in pay and returns joined forces.

Indeed, in the face of acute uncertainty, ranking can be the optimal inference strategy.9 This explains the ubiquity of league tables across the financial sector when judging everything from investment performance to financial deal-making. But ranking has an unfortunate side-effect. By hard-wiring relative standing, it builds in arms-race behaviour among financial participants. A second structural feature of finance, which generates similar incentive effects, is maturity transformation. Banking involves borrowing short in a capital-certain instrument to lend long through a capital-uncertain instrument. When doubts creep in about this balance sheet structure, investors run on the bank knowing it is first-come, first-served. They are engaging  5  Hardin (1968). 6  Veblen (1899). 7  For example, Layard (2005). 8  For example, Dusenberry (1949). 9  Lazear and Rosen (1981). 2  BIS central bankers’ speeches  in a liquidity arms race, penalising those behind them in the queue. These actions are individually rational but collectively self-defeating if the bank goes bust.10 A third structural feature is that some markets for financial services are winner-takes-all tournaments, like elephant seals seeking mates on the beach. Whether it is making markets in financial instruments, lead underwriting a debt or equity issue or advising on a merger or takeover, there is typically only one winner. They take all. Tournaments like these lead to arms-race behaviour as firms seek to leapfrog one another in their competitive quest for top-dog status. In finance, this can lead to the winner being “cursed” and to everyone else over-competing by under-pricing risk.