Is Capping Executive Bonuses Useful?
September 29, 2016
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Summary
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.
Subject: Banking, Bonuses, Commercial banks, Financial institutions, Labor, Labor markets, Labor mobility, Tax incentives
Keywords: Asia and Pacific, asset return volatility, base pay, Bonuses, Commercial banks, composite index, Europe, executive compensation, incentive contract, labor market, Labor markets, Labor mobility, market portfolio, payoff schedule, risk shifting, risk taking, schedule of shareholder, underinvestment, WP
Pages:
37
Volume:
2016
DOI:
Issue:
196
Series:
Working Paper No. 2016/196
Stock No:
WPIEA2016196
ISBN:
9781475543254
ISSN:
1018-5941
