Loan Monitoring and Bank Risk

Abstract

We study two issues: the relationship between loan monitoring and loan risk and the corporate value of banks' investments in loan monitoring systems. We find that dynamic monitoring of loans, where the bank is scanning in real time for events that may be of relevance to loan quality, tend to increase the incentive to hold risky loans, which in turn increases the regulatory burden for the bank. The profitability of improved monitoring must be balanced against the increase in the cost of regulation, and we show that the trade off is negative. This can explain the trend in banking of switching away from dynamic monitoring systems to credit scoring systems which use only currently available information to produce a signal of loan quality, without monitoring future events in real time. This matters in the sense that dynamic monitoring of loans can be efficient in assessing the credit quality of certain classes of borrowers -- the informationally challenging ones -- where credit scoring systems are relatively ineffective. We discuss the implications of this finding.

Keywords: Credit scoring, Dynamic monitoring, Loan risk, Loan sales, Monitoring systems

JEL Classification: G21, G28, G32