Incentivizing Calculated Risk-Taking: Evidence from an Experiment with Commercial Bank Loan Officers

by Shawn Cole, Martin Kanz & Leora Klapper

Overview — Recent research presents convincing evidence that incentives rewarding loan origination may cause severe agency problems and increase credit risk, either by inducing lax screening standards or by tempting loan officers to game approval cutoffs even when such cutoffs are based on hard information. Yet to date there has been no evidence on whether performance-based compensation can remedy these problems. In this paper, the authors analyze the underwriting process of small-business loans in an emerging market, using a series of experiments with experienced loan officers from commercial banks. Comparing three commonly implemented classes of incentive schemes, they find a strong and economically significant impact of monetary incentives on screening effort, risk-assessment, and the profitability of originated loans. The experiments in this paper represent the first step of an ambitious agenda to fully understand the loan underwriting process. Key concepts include:

High-powered incentives that penalize the origination of non-performing loans while rewarding profitable lending decisions cause loan officers to exert greater screening effort, approve fewer loans, and increase the profits per originated loan.
In line with predictions, these effects are weakened when deferred compensation is introduced.
More surprisingly, they find that incentives actually have the power to distort loan officers' perceptions of how a loan will perform. More permissive incentive schemes lead loan officers to rate loans as significantly less risky than the same loans evaluated under pay-for-performance.

Author Abstract

This paper uses a series of experiments with commercial bank loan officers to test the effect of performance incentives on risk-assessment and lending decisions. We first show that, while high-powered incentives lead to greater screening effort and more profitable lending, their power is muted by both deferred compensation and the limited liability typically enjoyed by credit officers. Second, we present direct evidence that incentive contracts distort judgment and beliefs, even among trained professionals with many years of experience. Loans evaluated under more permissive incentive schemes are rated significantly less risky than the same loans evaluated under pay-for-performance.