Loan Officer Incentives, Internal Rating Models and Default Rates
53 Pages Posted: 16 Mar 2012 Last revised: 3 Nov 2016
Date Written: October 25, 2016
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: Suggested Citation