Bonus Caps, Deferrals and Bankers' Risk-Taking

We derive a principal-agent model to analyze the effectiveness of bonus caps and deferrals in regulating banks' risk-taking. We calibrate the model to a sample of large US banks on the eve of the Global Financial Crisis and run counterfactual analyses of the potential effects of the regulations. We find that the risk-reduction effect on the median bank is negligible as banks respond to the regulations by increasing the earnings sensitivity of bonuses. However, on a small number of banks with high bonus to salary ratios prior to 2008, the bonus cap has a sizeable risk-reduction effect. In contrast, bonus deferrals have only negligible effects on all sample banks