An experimental study of the effects of negative, capped and deferred bonuses on risk taking in a multi-period setting
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An experimental study of the effects of negative, capped and deferred bonuses on risk taking in a multi-period setting Frank Hartmann • Sergeja Slapnicˇar
Ó Springer Science+Business Media New York 2014
Abstract As a response to the financial crisis in 2008, the European bank authorities have adopted new rules for managerial remuneration. These rules are intended to mitigate managerial propensity to excessive risk taking. The purpose of this paper is to examine three prominent recommendations in these remuneration rules: the use of negative bonuses, the use of bonus caps and the use of deferred bonus payment. The paper advances the theory that cognitive frames created by compensation design affect risk-taking behaviour. We conduct a two-by-two withinsubject experiment in which 153 students are set an investment task involving two periods. We find higher risk taking with the high variance bonus scheme that contains a negative bonus option. While bonus deferral appears to have no such initial effect on risk taking, it affects risk behaviour in the second period as a response to positive and negative outcomes from the first period. The findings contribute to the theory and practice of bonus system design and the application of contemporary remuneration recommendations in the financial sector. Keywords Compensation scheme Risky decision making Inter-temporal choices Negative bonus Bonus deferral Bonus cap Banking JEL Classification
J33 G32
Electronic supplementary material The online version of this article (doi:10.1007/s10997-014-9297-6) contains supplementary material, which is available to authorized users. F. Hartmann RSM Erasmus University, Burgemeester Oudlaan 50, 3062 PA Rotterdam, The Netherlands e-mail: [email protected] S. Slapnicˇar (&) Faculty of Economics, University of Ljubljana, Kardeljeva pl. 17, 1000 Ljubljana, Slovenia e-mail: [email protected]
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F. Hartmann, S. Slapnicˇar
1 Introduction The financial crisis has drawn the attention of practitioners and academics to the effects of pay-for-performance systems on risk inclinations of decision-makers in financial institutions and beyond. One of the specific concerns is that bonus systems may stimulate dysfunctional risk taking by decision-makers. Excessive risk taking is considered to be a logical consequence of traditional bonus schemes, which reward positive performance deviations more than they punish negative ones (Chen et al. 2006; Sanders and Hambrick 2007). In response to this alleged dysfunction of traditional bonus systems, new pay policies have been suggested at the global level (Steward 2009) and the European level (CRD 3/2010/76/EU). These recommendations aim to regulate executive remuneration as a part of the oversight regulation of banks. Three specific types of policy measures seek to reduce dysfunctional risk taking. The first type entails a deferral of bonus payments over a period of years in order to align the incentive effect of the bonus with the periods in which outcomes of decisions become evident.
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