Loan Officer Incentives, Internal Rating Models and Default Rates
63 Pages Posted: 16 Mar 2012 Last revised: 19 Aug 2019
Date Written: August 19, 2019
Manipulation of hard information has been at the center of a wave of investigations into fraudulent bank behavior, such as mis-selling of mortgages and rigging of LIBOR and FX rates. Despite these prominent cases, little is known as to why employees manipulate hard information. Using almost a quarter million retail loan applications, we show that loan officers who face volume-based incentives significantly manipulate ratings even in settings where ratings are computed using hard information only. Manipulation is widespread across loan officers, with low-performing loan officers manipulating more toward the end of the year. These incentives have a first-order effect on bank profitability, reducing return on equity by 1.5 percentage points. We conclude that reliance on hard information does not overcome loan officer agency problems, and it is important for banks and regulators to take manipulation of hard information into account when using hard information for risk assessment and regulation.
Keywords: loan officer incentives, internal ratings, hard information, Lucas critique
JEL Classification: G21
Suggested Citation: Suggested Citation