Is Capping Executive Bonuses Useful?

Abstract

This paper develops a theoretical framework to study the impact of bonus caps on banks' risk taking. In the model, labor market price adjustments can offset the direct effects of bonus caps. The calibrated model suggests that bonus caps are only effective when bank executives' mobility is restricted. It also suggests, irrespective of the degree of labor market mobility, bonus caps simultaneously reduce risk shifting by bank executives (too much risk taking because of limited liability), but aggravate underinvestment (bank executives foregoing risky but productive projects). Hence, the welfare effects of bonus caps critically depend on initial conditions, including the relative importance of risk shifting versus underinvestment.

Keywords: Labor markets, Labor mobility, Risk management, Bonus, Econometric models, Employee compensation, Banks, Investment, executive compensation; risk taking; risk shifting; underinvestment, executive compensation, risk taking, risk shifting, underinvestment, Government Policy and Regulation, Personnel Economics: Compensation and Compensation Methods and Their Effects, General, International, or Comparative

JEL Classification: G32, G38, J33, M52, N20