The compensation theory of the financial crisis had all the makings of a "just so" story.
It made sense in the abstract. The incentives in the bonus for short-term performance compensation packages of bankers were potentially dangerous. Bankers stood to make a lot more than they would lose if their bets on the market went bad. This could encourage bankers to engage in overly risky activity.
But the facts just didn't add up. Banks in the U.S. did not load up on risky assets. They loaded up on mortgage-related securities that had the highest ratings, that they thought offered extra yield without much additional risk. When things started to go wrong, many couldn't believe the signals of the market. It was "dislocation" and "market misbehavior." Weren't these triple-A tranches?
The Obama administration quietly gave up on the compensation theory long ago, deciding to focus on the much more important fact of undercapitalization.
But in Europe the politicians just kept on targeting compensation.
While the United States was injecting capital in banks, guaranteeing debt and trying to increase capital requirements, European regulators were fighting behind the scenes to keep capital requirements low.
Instead, European regulators, including Ms. [Christine] Lagarde, jumped on the banker compensation bandwagon, which might have won her political points, but appears now to have also kept the public eye off the bigger issue: Europe’s banks were woefully undercapitalized and every regulator knew it.
The theory that the compensation structure almost destroyed the financial system will be very hard to maintain going forward. Will politicians really be able to claim that Europe's banks are loaded with Greek debt because their bankers were paid to take wild risks?
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