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Do Loan Officers' Incentives Lead to Lax Lending Standards?

  • Ben-David, Itzhak

    (OH State University)

  • Agarwal, Sumit

    (National University Singapore and Federal Reserve Bank of Chicago)

To understand better the role of loan officers' incentives in the origins of the financial crisis, we study a controlled field experiment conducted by a large bank. In the experiment, the incentive structure of a subset of small business loan officers was altered from fixed salary to volume-based pay. We use a diff-in-diff design to show that while the characteristics of loan applications did not change, incentive-paid loan officers book 19% loans with dollar amounts larger by 19%. We show that treated loan officers use their discretion more in the booking decision. Although loans booked by incentive-paid loan officers have better observable credit quality, they are 28% more likely to default. The increase in default is concentrated in loans that wouldn't have been booked in the absence of commission-based compensation, and in loans with excessive dollar amount. Our results support the idea that the explosion in mortgage volume during the housing bubble and the deterioration of underwriting standards can be partly attributed to the incentives of loan officers.

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Paper provided by Ohio State University, Charles A. Dice Center for Research in Financial Economics in its series Working Paper Series with number 2012-07.

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Date of creation: Apr 2012
Date of revision:
Handle: RePEc:ecl:ohidic:2012-07
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