Is Capping Executive Bonuses Useful?
IMF Working Papers, September 29, 2016
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Bibliographic details
- Authors: Kentaro Asai
- Published: September 29, 2016
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781475543254.001
Theoretical framework and model design
- Develops a theoretical framework to study the impact of bonus caps on banks’ risk taking.
- Incorporates labor market price adjustments that can offset the direct effects of bonus caps.
- Focuses on interactions between executive compensation design, labor mobility, and bank investment/risk choices.
- Key terminology preserved from the source: base pay, Bonuses, incentive contract, payoff schedule, schedule of shareholder, market portfolio, composite index.
Calibrated model findings
- Bonus caps are only effective when bank executives’ mobility is restricted.
- Irrespective of the degree of labor market mobility:
- Bonus caps reduce risk shifting by bank executives (defined as too much risk taking because of limited liability).
- Bonus caps aggravate underinvestment (bank executives foregoing risky but productive projects).
- Welfare effects of bonus caps critically depend on initial conditions, including the relative importance of risk shifting versus underinvestment.
- Labor market price adjustments can offset direct effects of bonus caps.
Policy implications and caveats
- Effectiveness of bonus caps hinges on labor market mobility: restricted mobility increases effectiveness.
- Policymakers should weigh reductions in risk shifting against potential increases in underinvestment when considering bonus caps.
- Optimal policy assessment requires information on initial conditions and the relative prevalence of risk shifting versus underinvestment in the banking sector.
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- Is Capping Executive Bonuses Useful?