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

Abstract

We use an experiment with commercial bank loan officers to test how performance based compensation affects risk-assessment and lending. High-powered incentives lead to greater screening effort and more profitable lending decisions. This effect, however, is muted by deferred compensation and limited liability, two standard features of loan officer incentive contracts. We find that career concerns and personality traits affect screening behavior, but show that the response to monetary incentives does not vary with traits such as risk-aversion, optimism or overconfidence. Finally, we present evidence that incentive contracts distort the assessment of credit risk, even among trained professionals with many years of experience. Loans evaluated under permissive incentives are rated significantly less risky than the same loans evaluated under pay-for-performance.