Information or Insurance? On the Role of Loan Officer Discretion in Credit Assessment

Abstract

We employ a unique dataset of credit assessments for 3,756 small businesses by nine banks using an identical rating model to examine (i) to what extent loan officers use their discretion to smooth credit ratings of their clients, and (ii) to assess whether this use of discretion is driven by information about the creditworthiness of the borrower or by the insurance of clients against fluctuations in lending conditions. Our results show that loan officers make extensive use of their discretion to smooth clients’ credit ratings: One in five rating shocks induced by changes in the quantitative assessment of a client is reversed by the loan officer, independent of whether the borrower experiences a positive or a negative rating shock. We find that this smoothing of credit ratings is hardly driven by soft information: Loan officers are just as likely to smooth persistent and market-related shocks as they are to smooth temporary and firm-specific shocks. We do find that loan officers are more likely to smooth ratings at banks where interest rates are more risk-sensitive. However, this behavior is not purely driven by an implicit insurance contract between loan officers and their clients. Instead, the use of discretion by loan officers seems at least partly driven by their reluctance to communicate price changes: Within banks loan officers are not more likely to smooth rating changes which lead to the strongest interest rate changes.

Keywords: Relationship banking, Asymmetric information, Implicit contracts, Credit rating

JEL Classification: G21, L14, D82