Incentives matter: banking file

From Jeffrey Miron at Forbes.com,

The European parliament has just approved a measure that would limit bonus payments and other aspects of compensation for bankers. National finance ministers are expected to approve the measure next week, and it will take effect Jan. 1. The goal of the legislation is to limit banker incentives to take risk, since this was allegedly a major cause of the recent financial crisis.

The key question about compensation limits is why shareholders and creditors have not imposed these on bank executives already. If the possibility of large bonuses indeed generates excessive risk-taking, then bank stakeholders have ample incentive to adopt such limits without government coercion.

The answer is that bank risk-taking was not necessarily excessive from the perspective of the bank stakeholders, since banks were living in a world with private gains but public losses.  Stakeholders stood to earn large returns when times were good, and they knew taxpayers would cushion the losses - via deposit insurance or accomodative monetary policy - when times went bad.

Since events of the past two years have done nothing but reinforce the view that major banks are too big to fail, the incentive to pile on risk is stronger than ever.

Moral hazard really does matter. Trying to limit bankers bonus payments (and other aspects of compensation) will do little to control risk taking. Making banks pay the true cost of risk taking would. So lets get rid of the deposit insurance, accommodating money policy and the "too big to fail" mentality.