Loan Officer Incentives, Internal Rating Models and Default Rates

53 Pages Posted: 16 Mar 2012 Last revised: 3 Nov 2016

See all articles by Tobias Berg

Tobias Berg

Frankfurt School of Finance & Management

Manju Puri

Duke University - Fuqua School of Business; NBER; FDIC

Jörg Rocholl

ESMT European School of Management and Technology

Multiple version iconThere are 2 versions of this paper

Date Written: October 25, 2016

Abstract

Banks have been subject to a wave of investigations regarding fraudulent behavior. Much of the discussion centers on manipulation of hard information by employees down the line, who missell mortgages due to flawed debt-to-income ratios or manipulate LIBOR and FX rates. Despite these prominent cases, little is known in the academic literature as to whether and how manipulation of hard information is affected by incentives of these employees, and if anything there is increasing reliance on quantitative, hard information based models for regulating banks. In this paper, we fill this gap by analyzing almost a quarter million of retail loan applications. We show that loan officer incentives significantly skew ratings even in settings where ratings are computed using hard information only. These incentives have a first-order effect on bank profitability. Our results suggest that ratings are subject to the Lucas critique: Incentives influence the hard information reported by loan officers and thus change the link between hard information and default probabilities.

Keywords: loan officer incentives, internal ratings, hard information, Lucas critique

JEL Classification: G21

Suggested Citation

Berg, Tobias and Puri, Manju and Rocholl, Joerg, Loan Officer Incentives, Internal Rating Models and Default Rates (October 25, 2016). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=2022972 or http://dx.doi.org/10.2139/ssrn.2022972

Tobias Berg

Frankfurt School of Finance & Management ( email )

Sonnemannstraße 9-11
Frankfurt am Main, 60314
Germany

Manju Puri (Contact Author)

Duke University - Fuqua School of Business ( email )

100 Fuqua Drive
Box 90120
Durham, NC 27708-0120
United States
919-660-7657 (Phone)

NBER

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

FDIC ( email )

550 17th Street NW
Washington, DC 20429
United States

Joerg Rocholl

ESMT European School of Management and Technology ( email )

Schlossplatz 1
Berlin
Germany

HOME PAGE: http://www.esmt.org/en/159244

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