Loan Officer Incentives, Internal Rating Models, and Default Rates. (28th August 2019)

• Record Type: Journal Article
• Authors: Berg, Tobias; Puri, Manju; Rocholl, Jörg
• Is Part Of: Review of finance. Volume 24:Number 3(2020)
• Page Start: 529
• Page End: 578
• Publication Date: 2019-08-28
• Subjects: G20 -- G21; Loan officer incentives -- Internal ratings -- Hard information; Finance -- Europe -- Periodicals; Financiën; Finance; Periodicals; 332.09405
• DOI: 10.1093/rof/rfz018
• Languages: English
• ISSNs: 1572-3097

Abstract

Abstract: 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 London Interbank Offered Rate and Foreign Exchange 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.