Incentives Drive Behavior and Bad Incentives Drive Bad Behavior

link here to article

One of the reasons why banks take on excessive risk and leverage is because of the way that executive performance, and compensation, is determined. The prevailing incentive is return on equity (ROE). Return is maximized by taking risk and using leverage. ROE is maximized by keeping equity low as well. Efforts to raise the amount of equity that banks are required to hold, as a cushion against asset loss, are being resisted by bankers. Tax law and deposit insurance also encourage banks to prefer debt as a source of capital rather than equity. This article does a good job of describing how a faulty incentive system encourages bad behavior and increases the risk taken by shareholders.