Excessive Leverage and Bankers’ Pay: Governance and Financial Stability Costs of a Symbiotic Relationship

Debt has traditionally been viewed as an effective corporate governance tool. On the other hand, high leverage levels can lead to rapid expansion of the size of bank assets maximizing, in the short-to-medium term, banks return on equity. In the absence of regulatory controls on leverage, all it takes to assume excessive risks, even for benign bankers, is to imitate competitor business strategies. This form of herding can be motivated by compensation considerations or by career concerns. However, while bankers’ compensation has been a major factor behind bank short-termism, excessive leverage creates serious governance/agency costs even in the absence of compensation incentives. Therefore, a reasonably protective leverage ratio can prove an effective measure in containing rent seeking and smoothing up the leverage cycle to improve bank governance, prevent deep recessions, and safeguard financial stability.