Raghuram Rajan in this speech given at Institute for Economic Growth, Delhi says:
A second lesson from the crisis is that the incentives and abilities of players matter enormously. Our regulations assume that management has financial knowledge, control over the financial institution’s operations, and cares about the long run. Yet, the growing revelations, for example from UBS, suggest that none of these assumptions need be true. Traders ran amuck building large positions, with management seemingly unable to restrain them.
Raghu Rajan first indicated the damage incentives can bring to the financial system in a superb paper presented at Kansas City Fed Symposium -2005. He even analysed the subprime crisis from the perverse incentives angle. So so far so good. Then he says:
In this context, a major source of concern in in India are the state-owned public sector banks. While some of the finest bankers in India are to be found in public sector banks, their inability to pay market salaries to top managers has eroded their strength. The chairman of the State Bank of India, India’s largest bank, makes less than $1000 a month in basic salary. The worry mounts as generations that were recruited in good times, when the public sector had a monopoly, retire.
So, what exactly is his concern? Above he says high incentives lead to the crisis and next he says low incentives erode strength of the Indian Public sector banks? How do you draw the line between high and low?
This huge incentive structure in finance is clearly overdone. The salaries of public sector banks may be little low but what makes it look really low is the huge salaries in private sector banks. Huge salaries lead to higher risks, which has been proven time and time again. I am sure with this crisis regualtors would take note and push to limit incentives. When this happens, the salaries of public sector banks would be more in line with markets.
I have noted all the governments which have passed various bailout packages have introduced limits on compensation in case the firm participates in the bailout plan. On these grounds, I think all financial sector regulators should make Indian government/regulators its consultant on designing appropriate incentive structure.
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