Incentive Compensation In Banking Was Not The Cause of Excessive Risk Taking

My comment to "Change incentives instead of regulating outcomes" by Russ Robert on Cafe Hayek blog:

Pay both as to amount and type, e.g. straight commission (performance bonuses) versus fixed salary, is a signaling mechanism to the prospective employee marketplace. Commission based pay attracts a more risk taking, performance oriented worker compared to a fixed salary worker.

Banking is a low margin, capital constrained business, especially in comparison to businesses outside of the financial services arena. The net interest margin in banking is around 3-4 percent while many consumer and industrial product businesses have gross margins of 40 percent or more. Non-banking businesses usually do not face capital or equity issues.

Low margins and capital constraints push banks into high volume, high leverage and efficient capital and funds uses, such as securitization. High volumes increase risk because in banking often the volume at a given risk level is fixed and the easiest way to increase volume is by increasing risk.

Banks use incentive compensation to signal to the prospective employee marketplace that they need high performance, volume generating, risk taking employees. If the regulators and government eliminate or curtail the use of incentive compensation, banks will just find other ways to signal to the future employee marketplace their need for risk taking, high volume performers and the banks will find other ways to compensate successful employees other than through incentive compensation.

Left unchecked by too big to fail or possible bankruptcy, the underlying economic forces of banking created the push for higher volumes and risk taking in banking. The incentive compensation was just a signal to filter the prospective employee marketplace. Removing incentive compensation will not change the underlying economic forces of banking and will not stop the search for high volumes and the consequential risk caused by higher volumes. Banks will find other ways to signal and adequately compensate the desired employees.