Excessive leverage and bankers’ incentives: refocusing the debate

High leverage levels can lead to virtually limitless expansion of bank asset size, which maximizes, 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 and herd. This form of herding is not solely motivated by compensation considerations but also by career (job retention/promotion) concerns. Namely, while bankers’ compensation has been a major factor behind bank short-termism and excessive risk-taking, the availability of high leverage entails serious agency costs even in the absence of compensation incentives. As a result, regulatory reforms that focus on regulation of private compensation contracts ought to be supplemented by well-calibrated leverage ratios. Otherwise, they are bound to produce, in the long-term, sub-optimal results, notwithstanding the conspicuous political gains of such a strategy.