Bonus caps and bankers’ risk-taking

Esa Jokivuolle, Jussi Keppo and Xuchuan Yuan

Journal of Risk

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.

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