Bonus Caps and Bankers' Risk-Taking

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.