Incentive compensation in the banking industry: insights from economic theory

How can banks and similar institutions design optimal compensation systems? Would such systems conflict with the goals of society? This paper considers a theoretical framework of how banks structure job contracts with their employees to explore three points: the structure of a socially optimal compensation system; the structure of a compensation system that is privately optimal, given the reality of government-guaranteed bank debt; and policy interventions that can lead from the second structure to the first. Analysis reveals a potential policy option: providing proper incentives to banks by charging debt default insurance premiums that depend on the compensation structure banks choose. If policymakers consider this unwise or impractical, then it may be useful for government to regulate bank compensation more directly.