Bonus Caps, Deferrals and Bankers&Apos; Risk-Taking
75 Pages Posted: 2 Mar 2016 Last revised: 10 Jul 2018
Date Written: March 3, 2015
Regulators restrict bankers’ risk-taking by bonus caps or deferrals. We derive a structural model to analyze these compensation regulations and show that for a risk-neutral banker subject to positive switching costs of reducing bank risk, a bonus deferral is impotent while a suﬃciently tight bonus cap reduces risk-taking. The model suggests that a bonus cap that equals ﬁxed salary (as in the EU) reduces risk on average by 13% under conservatively calibrated positive switching costs. Further, the bonus cap would have considerably reduced risk-taking incentives in most US banks that did poorly during the global ﬁnancial crisis. We also show that the bonus deferral is eﬀective if the banker is risk-averse and the switching costs are not too high.
JEL Classification: G01, G21, G28, J33, M52
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