Bonus caps and bankers’ risk-taking

Esa Jokivuolle; Jussi Keppo; Xuchuan Yuan

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A principal-agent model is built to analyze the effect of bonus caps on bankers’ risk-taking and calibrated to a sample of large US banks prior to the global financial crisis.
The risk-reduction effect of bonus caps on the median bank is negligible.
Bonus caps have a sizeable risk-reduction effect in a few banks with extremely high bonus-to-salary ratios.
A more careful design of bonus cap regulation is needed to improve its effectiveness.

Abstract

We analyze the effect of bonus caps on bankers’ risk-taking. Using a principal–agent model calibrated to a sample of large US banks, we find that the risk-reduction effect on the median bank is negligible, as banks respond to the bonus cap by increasing the earnings sensitivity of bonuses. The bonus cap has a sizable risk-reduction effect only in a small number of banks with extremely high bonus-to-salary ratios. Results shed further light on why a more careful design of bonus cap regulation may be needed to improve its general effectiveness.

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