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.
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