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Perverse incentives at the banks? Evidence from a natural experiment

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  • Sumit Agarwal
  • Faye H. Wang

Abstract

Incentive provision is a central question in modern economic theory. During the run up to the financial crisis, many banks attempted to encourage loan underwriting by giving out incentive packages to loan officers. Using a unique data set on small business loan officer compensation from a major commercial bank, we test the model’s predictions that incentive compensation increases loan origination, but may induce the loan officers to book more risky loans. We find that the incentive package amounts to a 47% increase in loan approval rate, and a 24% increase in default rate. Overall, we find that the bank loses money by switching to incentive pay. We further test the effects of incentive pay on other loan characteristics using a multivariate difference-in-difference analysis.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-09-08.

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Date of creation: 2009
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Handle: RePEc:fip:fedhwp:wp-09-08

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Related research

Keywords: Incentive awards;

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Cited by:
  1. Pierre-Guillaume Méon & Roy Mersland & Ariane Szafarz & Marc Labie, 2011. "Discrimination by Microcredit Officers:Theory and Evidence on Disability in Uganda," DULBEA Working Papers 11-06, ULB -- Universite Libre de Bruxelles.
  2. Andrea Bellucci & Alexander V. Borisov & Alberto Zazzaro, 2009. "Does Gender Matter in Bank-Firm Relationships? Evidence from Small Business Lending," Mo.Fi.R. Working Papers 31, Money and Finance Research group (Mo.Fi.R.) - Univ. Politecnica Marche - Dept. Economic and Social Sciences.
  3. Beck, T.H.L. & Behr, P. & Madestam, A., 2011. "Sex and Credit: Is There a Gender Bias in Microfinance?," Discussion Paper 2011-101, Tilburg University, Center for Economic Research.
  4. Berger, Allen N. & Kick, Thomas & Schaeck, Klaus, 2012. "Executive board composition and bank risk taking," Discussion Papers 03/2012, Deutsche Bundesbank, Research Centre.
  5. Deniz Igan & Prachi Mishra & Thierry Tressel, 2011. "A Fistful of Dollars: Lobbying and the Financial Crisis," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 195-230 National Bureau of Economic Research, Inc.
  6. Inderst, Roman & Pfeil, Sebastian, 2010. "Securitization and Compensation in Financial Institutions," CEPR Discussion Papers 8089, C.E.P.R. Discussion Papers.
  7. Masazumi Hattori & Kohei Shintani & Hirofumi Uchida, 2012. "Authority and Soft Information Production within a Bank Organization," IMES Discussion Paper Series 12-E-07, Institute for Monetary and Economic Studies, Bank of Japan.
  8. Florian Heider & Roman Inderst, 2012. "Loan Prospecting," Review of Financial Studies, Society for Financial Studies, vol. 25(8), pages 2381-2415.
  9. Gropp, R. & Grundl, C. & Guttler, A., 2012. "Does Discretion in Lending Increase Bank Risk? Borrower Self-Selection and Loan Officer Capture Effects," Discussion Paper 2012-030, Tilburg University, Center for Economic Research.
  10. Deniz Igan & Thierry Tressel & Prachi Mishra, 2009. "A Fistful of Dollars," IMF Working Papers 09/287, International Monetary Fund.
  11. Tzioumis, Konstantinos & Gee, Matthew, 2013. "Nonlinear incentives and mortgage officers’ decisions," Journal of Financial Economics, Elsevier, vol. 107(2), pages 436-453.
  12. Beck, T.H.L. & Behr, P. & Madestam, A., 2012. "Sex and Credit: Is there a Gender Bias in Lending?," Discussion Paper 2012-062, Tilburg University, Center for Economic Research.
  13. Gregory Connor & Thomas Flavin & Brian O’Kelly, 2010. "The U.S. and Irish Credit Crises: Their Distinctive Differences and Common Features," Economics, Finance and Accounting Department Working Paper Series n206-10.pdf, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.

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