Does the bonus cap work?

Qun Harris, Ieva Sakalauskaite and Misa Tanaka

After the 2007–08 Global Financial Crisis (GFC), several jurisdictions introduced remuneration regulations for banks with the aim of discouraging excessive risk-taking and short-termism. One such regulation is the bonus cap rule which was first introduced in the European Union (EU) and the United Kingdom (UK) in 2014. This post examines whether the bonus cap mitigates excessive risk-taking and short-termism, both in theory and in practice. It also discusses unintended consequences highlighted by the literature.

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How does remuneration regulation affect bankers’ pay?

Ieva Sakalauskaite and Qun Harris

Following the Global Financial Crisis of 2007–08, some regulators introduced rules on bankers’ bonuses with an aim to mitigate incentives to take excessive risks, and in turn promote financial stability. In a recent paper we use detailed data on remuneration of staff in six large UK banks to look at how two of those rules – the bonus cap and deferral – affected bankers’ pay. We find that the bonus cap did not reduce bankers’ total remuneration but rather shifted it from the variable to the fixed part of the package. And while requirements to defer bonus pay can be expected to affect bankers’ risk-taking incentives, we find some evidence that they increased their total compensation.

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How do bonus structures affect risk and effort choices? Insight from a lab experiment

Qun Harris, Analise Mercieca, Emma Soane and Misa Tanaka.

The bonus regulations were introduced based on the consensus amongst financial regulators that compensation practices were a contributing factor to the 2008-9 financial crisis. But little is known about how they affect behaviour in practice. So we conducted a lab experiment to examine how different bonus structures affect individuals’ risk and effort choices. We find that restrictions on bonuses, such as a bonus cap, can incentivise people to take less risk. But their risk-mitigating effects weaken or disappear once bonus payment is made conditional on hitting a high performance target. We also find some evidence that bonus cap discourages effort to search for better projects.

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