an arms - race element. consider an unsecured creditor about to refinance. the larger the existing fraction of secured financing, and the greater the uncertainty about this fraction, the greater will be their incentive to seek security. not to do so runs the risk of other creditors leapfrogging ahead of them in the seniority queue. creditors ’ incentives are very similar to those during a bank run, except with investors now seeking security rather than immediacy. 27 as with a bank run, this dynamic risks becoming self - fulfilling. the greater the level of, and risk around, encumbrance levels, the higher the return unsecured creditors will demand given the risks of subordination. and the higher this cost, the greater banks ’ incentives to finance instead on secured terms. both banks and their individual investors have incentives to encumber the balance sheet by progressively – and self - fulfillingly – larger amounts. there is an arms race spiral. yet the equilibrium of this seniority game is unlikely to be an optimal one, either for individual investors or for the financial system as a whole. to queue - jump is ultimately futile for creditors ; it is another red queen race. not everyone can be at the front of the seniority queue. indeed, at high levels of encumbrance, the financial system as a whole may even be riskier, as it is more susceptible to pro - cyclical swings in the underlying value of banks ’ assets. the quest for individual security generates system - wide instability. so under an arms race to safety, the like of which may be currently underway, the outcome for the financial system could be both socially and individually inefficient. if there were a benign, enlightened regulatory planner, able collectively to co - ordinate investors and banks on a lower - encumbrance equilibrium, this race for safety could be forestalled. unfortunately, there is not. * * * * * * * * * * * * what public policy lessons might be drawn from these financial arms races? first, because they generate sub - optimal outcomes, policy intervention can be justified. this policy intervention ought to act like a self - denying ordinance for financial firms, a protection against themselves. it ought not to be a tug - of - war between regulator and regulated. rather, it aims to defuse a competitive tug - of - war among regulated firms. second, to be effective this intervention needs to constra

3 million. us bank ceo compensation rose from $ 2. 8 million to $ 26 million, also by 13 % per year ( chart 3 ). over the same period, compensation in the non - financial sector rose by around 4 % per year in the united states. as thomas phillipon and ariell reschef have shown, that himalayan rise in bank executive salaries made the financial sector salary boom of even the 1920s look like a foothill. 11 in 1980, a similarly - skilled individual earned about the same in investment banking as in the non - financial sector. by 2005, that same person would be benefitting from a salary four times that of their non - financial sector counterpart. what explains this extra - ordinary period of high returns in finance? arithmetically, the answer is simple – leverage. the pre - crisis rise in returns on bank equity can be explained almost diamond and dybvig ( 1983 ), brunnermeier and oehmke ( 2010 ). phillipon and reschef bis central bankers ’ speeches fully by higher bank leverage. 12 equity returns inflated in line with bank balance sheets. so too did bank ceo salaries. 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