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Incentivizing Calculated Risk-Taking: Evidence from an Experiment with Commercial Bank Loan Officers

Listed author(s):
  • Shawn Cole

    ()

    (Harvard Business School, Finance Unit)

  • Martin Kanz

    ()

    (World Bank)

  • Leora Klapper

    ()

    (World Bank)

This paper uses a series of experiments with commercial bank loan officers to test the effect of performance incentives on risk-assessment and lending decisions. We first show that, while high-powered incentives lead to greater screening effort and more profitable lending, their power is muted by both deferred compensation and the limited liability typically enjoyed by credit officers. Second, we present direct evidence that incentive contracts distort judgment and beliefs, even among trained professionals with many years of experience. Loans evaluated under more permissive incentive schemes are rated significantly less risky than the same loans evaluated under pay-for-performance.

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File URL: http://www.hbs.edu/research/pdf/13-002.pdf
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Paper provided by Harvard Business School in its series Harvard Business School Working Papers with number 13-002.

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Length: 69 pages
Date of creation: Jul 2012
Handle: RePEc:hbs:wpaper:13-002
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