National League pitchers must take their turn at bat. American League hurlers are replaced by a designated hitter.

The American League rule creates a "moral hazard" - an invitation to self-interested bad behavior. National League pitchers throw far fewer beanballs. Presumably they realize they might soon be on the receiving end.

In banking, moral hazard is not just the province of giant banks thought to be protected by "too big to fail." Community banks are also vulnerable.

Consider policies that reward lending officers for the volume of loans they place on the books rather than on successful repayment. Such policies create a great temptation to make marginal loans. And if such a loan eventually goes bad, the lenders may be long gone from the organization.

Indeed, the whole concept of performance-based compensation needs thorough examination, to make sure that individuals do not make decisions that reward themselves but place the bank at risk.

Here is a favorite example of what not to do.

Death brought control of a Maine bank to the majority stockholder's secretary. She hired a vice president to run the portfolio. The vice president's bonus was to depend on earnings, including capital gains and losses.

The vice president promptly sold bonds that had appreciated considerably thanks to a recent decline in interest rates. Substantial capital-gains tax was paid on the appreciation; the after-tax proceeds were reinvested in new bonds.

The new bonds, of course, had much lower coupons. The moral hazard in the vice president's incentive package undercut the bank's earnings for years to come.

Now, most community banks have little to worry about from moral hazard. But it still pays to dig through your bank's policies to make sure that employees are not tempted to take "heads I win, tails I will have left the bank already" steps.

The whole concept of performance-based compensation needs to be addressed, so that banking's beanballers know they could face punishment for decisions that do them good but put the bank at risk.

Mr. Nadler, an American Banker contributing editor, is professor of finance at Rutgers University Graduate School of Management.

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