Playing the Devil's Advocate: The Causal Effect of Risk Management on Loan Quality

Abstract

This paper studies the dual role of risk managers and loan officers in a bank's organizational structure. Using 75,000 retail mortgage applications, I analyze the effect of risk management involvement on loan default rates. The bank requires risk management approval for loans that are considered risky based on hard information, using a sharp threshold that changes during the sample period. Using a regression discontinuity design and a difference-in-differences estimator, I am able to show that risk management involvement reduces loan default rates by more than 50%. My findings suggest that a two-agent model can help to facilitate efficient screening decisions.

Keywords: risk management, loan officer incentives, organizational design

JEL Classification: G21, G32, D74