How Efficiency Wage Theory Helps Explain Differences in Bank Financial Performance

Theoretical concepts and empirical tests in one area of economics and finance can provide insights into other areas far removed from the original area of inquiry. We show that efficiency wage theory (EWT) helps explain differences in commercial bank financial performance. EWT is a macroeconomic concept developed to explain sticky wages. EWT suggests that productivity gains and savings on non-wage costs can more than offset higher money wages, so firms competing actively for the best workers and supervisors would be reluctant to cut salaries in times of distress. EWT is also useful in understanding commercial bank lending because of: (a) the difficulty in reducing adverse selection and moral hazard costs; and (b) the complexity in monitoring and properly motivating loan officers. Research finds that banks paying higher salaries (after regression adjustment for other factors) are more profit efficient. Hence, banking research and EW research reinforce one another