can we have a new financial system?

Our investigation reveals a very tight link between deregulation and human capital in the financial sector. Highly skilled labor left the financial sector in the wake of Depression era regulations, and started flowing back precisely when these regulations were removed. This link holds both for finance as a whole, as well as for subsectors within finance. Along with our relative complexity indices, this suggests that regulation inhibits the ability to exploit the creativity and innovation of educated and skilled workers. Deregulation unleashes creativity and innovation and increases demand for skilled workers.

The second set of forces that appear to have a large influence on the demand for skills in finance are non-financial corporate activities: in particular, IPOs and credit risk. (deregulation spurs the ipo and the pricing of the risk)

In the long run, it appears that the most important factors driving the relative skill demand and relative wages in the financial sector are regulation and corporate finance activity, followed by financial innovation.

Our results have another important implication for regulation. Following the crisis of 1930-1933 and 2007-2008, regulators have been blamed for lax oversight. The Pecora Hearings of 1933 and 1934 documented such lax oversight and made the case for financial regulation; this led to the Glass-Steagall Act, the Securities Act of 1933 and the Securities Exchange Act of 1934. In retrospect, it is clear that regulators did not have the human capital to keep up with the financial industry, and to understand it well enough to be able to exert effective regulation. Given the wage premia that we document, it was impossible for regulators to attract and retain highly-skilled financial workers, because they could not compete with private sector wages. Our approach therefore provides an explanation for regulatory failures. Of course, regulators will be able to hire cheap skilled labor in 2009, just as they were able to in the 1930s.