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Bonus caps, deferrals and bankers' risk-taking

Esa Jokivuolle, Jussi Keppo and Xuchuan Yuan

No 5/2015, Bank of Finland Research Discussion Papers from Bank of Finland

Abstract: Regulators restrict bankers' risk-taking by bonus caps or deferrals. We derive a structural model to analyze these compensation regulations and show that for a risk-neutral banker subject to positive switching costs of reducing bank risk, a bonus deferral is impotent while a sufficiently tight bonus cap reduces risk-taking. The model suggests that a bonus cap that equals fixed salary (as in the EU) reduces risk on average by 13% under conservatively calibrated positive switching costs. Further, the bonus cap would have considerably reduced risk-taking incentives in most US banks that did poorly during the global financial crisis. We also show that the bonus deferral is effective if the banker is risk-averse and the switching costs are not too high.

JEL-codes: G01 G21 G28 J33 M52 (search for similar items in EconPapers)
Date: 2015
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