The irrelevance of bankers' bonuses

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Over on Cato-at-Liberty, Jeffrey A. Miron writes about EU plans to cap bankers' bonuses. He thinks it is a pointless step:

The key question about compensation limits is why shareholders and creditors have not imposed these on bank executives already. If the possibility of large bonuses indeed generates excessive risk-taking, then bank stakeholders have ample incentive to adopt such limits without government coercion.

The answer is that bank risk-taking was not necessarily excessive from the perspective of the bank stakeholders, since banks were living in a world with private gains but public losses. Stakeholders stood to earn large returns when times were good, and they knew taxpayers would cushion the losses — via deposit insurance or accomodative monetary policy — when times went bad.

Since events of the past two years have done nothing but reinforce the view that major banks are too big to fail, the incentive to pile on risk is stronger than ever.

Miron is exactly right. Effective reform of the banking sector requires three things: (1) an elimination of moral hazard; (2) monetary stability; and (3) a more competitive market. Bankers' bonuses are a politically appealing but largely irrelevant sideshow.