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Information or Insurance? On the Role of Loan Officer Discretion in Credit Assessment

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  • Brown, Martin

    ()

  • Schaller, Matthias

    ()

  • Westerfeld, Simone

    ()

  • Heusler, Markus

    ()

Abstract

We employ a unique dataset of 6,669 credit assessments for 3,542 small businesses by nine banks using an identical rating model over the period 2006-2011 to examine (i) to what extent loan officers use their discretion to smooth credit ratings of their clients, and (ii) to assess whether this use of discretion is driven by information about the creditworthiness of the borrower or by the insurance of clients against fluctuations in lending conditions. Our results show that loan officers make extensive use of their discretion to smooth clients’ credit ratings: One in five rating shocks induced by changes in the quantitative assessment of a client is reversed by the loan officer. This smoothing of credit ratings is prevalent across all rating classes, is independent of whether the borrower experiences a positive or a negative rating shock, and is independent of whether the shock is firm-specific or market-related. We find that discretionary rating changes have limited power in predicting future loan performance, indicating that the smoothing of credit ratings is only partially driven by information about creditworthiness. Instead, in line with the implicit contract view of credit relationships loan officers are more likely to smooth ratings when rating shocks have stronger implications for interest rates.

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File URL: http://www1.vwa.unisg.ch/RePEc/usg/sfwpfi/WPF-1203.pdf
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Bibliographic Info

Paper provided by University of St. Gallen, School of Finance in its series Working Papers on Finance with number 1203.

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Length: 50 pages
Date of creation: May 2012
Date of revision:
Handle: RePEc:usg:sfwpfi:2012:03

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Keywords: Relationship banking; Asymmetric information; Implicit contracts; Credit rating.;

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  1. Stiglitz, Joseph E & Weiss, Andrew, 1983. "Incentive Effects of Terminations: Applications to the Credit and Labor Markets," American Economic Review, American Economic Association, vol. 73(5), pages 912-27, December.
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Cited by:
  1. Gropp, Reint & Gruendl, Christian & Guettler, Andre, 2013. "Hidden gems and borrowers with dirty little secrets: investment in soft information, borrower self-selection and competition," Working Paper Series 1555, European Central Bank.
  2. Ben-David, Itzhak & Agarwal, Sumit, 2012. "Do Loan Officers' Incentives Lead to Lax Lending Standards?," Working Paper Series 2012-07, Ohio State University, Charles A. Dice Center for Research in Financial Economics.

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