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

Martin Kanz's picture

In the aftermath of the global financial crisis, there has been much criticism of compensation practices at banks. Although much of this debate has focused on executive compensation (see the recent debate on this blog), there is a growing recognition that non-equity incentives for loan officers and other employees at the lower tiers of a bank’s corporate hierarchy may share some of the blame — volume incentives for mortgage brokers in the United States that rewarded high-risk lending at wildly unsustainable terms are a particularly striking case in point.

The view that excessive risk-taking in the run-up to the crisis had its roots in flawed incentives at all levels of financial institutions — not just at the top — has made inroads in policy circles, and has been reflected in efforts to regulate how banks can pay their loan officers. Well-intentioned as these efforts may be, they mask the fact that providing performance incentives in lending is, in fact, a very difficult problem. Assessing a borrower’s creditworthiness requires a complex tradeoff between risk and return; it contains an inherent element of deferred compensation and requires the interpretation of a noisy signal about an applicant’s actual creditworthiness. Whether and how performance incentives work in this setting is unclear: the limited evidence that exists about the impact of performance pay on employee behavior comes from the labor economics literature and suggests that — even in simple production tasks — the behavioral response to incentives tends to be much more complex than a simple mapping from stronger incentives to greater effort and performance.

So how does “pay-for-performance” affect the risk-appetite and lending decisions of loan officers? In a recent paper, coauthored with Shawn Cole of Harvard Business School we designed a field experiment with real-life loan officers to examine the impact of performance incentives on loan officer behavior. Working with a number of leading commercial banks in India, we recruited more than 200 loan officers with an average of more than ten years of experience in banking and brought them to a behavioral economics lab. In the lab, participants were asked to evaluate a set of loan applications under different, exogenously assigned incentives. This cross-over between an actual field experiment and a controlled lab setting allowed us to study risk-taking behavior using a real life population of highly experienced loan officers, while being able to get detailed measurements of risk-assessment and risk-taking behavior — the kind of data that would usually only be available from a lab experiment.

We deliberately set up our experiment in an informationally challenging emerging credit market — the Indian market for unsecured small enterprise loans. Borrowers in this market typically lack reliable credit scores and an established track record of formal sector borrowing. This generally rules out the use of predictive credit scoring and other advance loan approval technologies, making banks particularly reliant on the risk-assessment of their frontline employees. The credit files that our loan officers evaluated in the experiment consisted of actual loan applications from small enterprises applying for their first formal-sector loan. Each loan was matched with ten months of repayment history from the lender’s proprietary database (not surprisingly, more than 90% of defaults occur in the first three months of a loan’s tenure). This allowed us to compare the actual outcome of the loan with the loan officer’s decision and risk assessment in the experiment and to offer incentive payments based on the profitability of lending decisions loan officers took in the lab.

The reassuring news is that basic incentives seem to work quite well in lending. We find that pay for performance (incentives that reward profitable lending and penalize default) indeed induces loan officers to exert much greater effort in reviewing the information that is presented to them. This is all well, but the real question is whether this translates into improved lending decisions. One common concern with performance pay in lending is that stronger incentives may indeed make loan officers much more conscientious, so conscientious in fact that they may shy away from risks that would be profitable from the viewpoint of the bank and simply stop lending. In our experiment, we find this not to be the case: when loan officers faced high-powered incentives, the probability that they would approve a non-performing loan was reduced by 11% while overall lending went down by only 3.6%. In other words, more stringent incentive schemes actually made loan officers better at identifying and eliminating bad credits from the pool of loan applicants. Profits per loan increased by up to 4% over the median loan size and by more than 40% compared with the case when loan officers faced volume incentives.

These strong results highlighting the negative impact of volume incentives are in line with much recent evidence using observational data (Agarwal and Ben-David 2012; Berg, Puri, and Rocholl 2012). So is pay-for performance the solution to all of a bank’s internal agency problems? Unfortunately not. In an additional set of experiments, we varied the time horizon of the loan officer’s compensation contract — an important second dimension of the incentive scheme over which a bank typically has control. Interestingly, our results show that performance incentives quickly lose their bite as they are deferred even by a couple months. Given that in real life performance pay typically occurs in the form of a quarterly or annual bonus, this casts some doubt on the wisdom of trying to fix agency problems within financial institutions with monetary incentives alone. Interestingly, however, deferred compensation also makes permissive incentive schemes less tempting and can attenuate many of the negative effects of volume incentives. Some direct advice that comes out of this finding is that if a bank finds it necessary to provide volume incentives, it can limit the potential damage through deferred compensation.

Perhaps most interestingly, the results from our experiment also show that incentives affect not only actual lending decisions, they also distort loan officers’ subjective assessment of credit risk. Put simply, we find that when participants faced incentives that emphasize lending volume over loan quality, they started viewing their clients’ creditworthiness through rose-colored glasses. They inflated internal risk ratings — which were neither seen by any supervisor nor tied to incentives — by up to .3 standard deviations for the same loan. This finding resonates with the psychological concept of “cognitive dissonance” (Akerlof and Dickens 1982) and is in line with behavioral economics explanations that have tried to make sense of seemingly irrational behavior in sub-prime lending prior to the crisis, which are nicely summarized in a recent article by Nicholas Barberis (2012) from the Yale School of Management.

What are we to take away from these results? The question of how to better align private incentives with public interest is a major unresolved policy question that has arisen from the global financial crisis. Our experiments provide some of the first rigorous evidence on the link between performance pay and behavior among loan originators, which we hope will be a first step that can help tackle this important issue from the angle of corporate governance —– with the ultimate aim of making compensation policy a more effective component of a bank’s risk management mechanisms. Much work has recently gotten underway in this exciting research agenda, but it is clear that much more evidence is needed to translate these findings into meaningful policy prescriptions. To contribute to this agenda, we are currently working on a number of follow-up experiments to more fully understand the behavioral and psychological implications of the problem of incentives and individual risk-taking. Stay tuned.

 

References

Agarwal, Sumit, and Itzhak Ben-David. 2012. “Do Loan Officer Incentives Lead to Lax Lending Standards?” Ohio State University, Fisher College of Business. Working Paper WP-2012-7.

Agarwal, Sumit, and Faye H. Wang. 2009. “Perverse Incentives at the Banks? Evidence from a Natural Experiment.” Federal Reserve Bank of Chicago. Working Paper WP-09-08.

Akerlof, George A., and William T. Dickens. 1982. “The Economic Consequences of Cognitive Dissonance.” American Economic Review 72 (3):307–19.

Baker, George, Michael Jensen, and Kevin Murphy. 1988. “Compensation and Incentives: Practice vs. Theory.” Journal of Finance 43 (3):593–616.

Bandiera, Oriana, Iwan Barankay, and Imran Rasul. 2007. “Incentives for Managers and

Inequality among Workers: Evidence from a Firm-Level Experiment.” Quarterly Journal of Economics 122 (2):729–73.

_____. 2009. “Social Connections and Incentives in the Workplace: Evidence from Personnel Data.” Econometrica 77 (4):1047–94.

_____ Team Incentives: Evidence from a Firm Level Experiment. Journal of the European Economic Association, forthcoming.

Barberis, Nicholas. 2012. “Psychology and the Financial Crisis of 2007-2008.” In Financial Innovation and the Crisis, edited by M. Haliassos. Cambridge, MA: MIT Press.

Berg, Tobias, Manju Puri, and Jorg Rocholl. 2012. “Loan Officer Incentives and the Limits of Hard Information.” Duke University Fuqua School of Business Working Paper.

Comments

Submitted by Inci on
Martin, Leora: Very nice article. And interesting and policy-relevant research.

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