Loan Rates as Incentive Instruments

Loan rates are usually viewed as prices that shape borrower incentives, but they can also serve another role in a principal-agent problem by determining how informative repayment is about unobservable effort inside the bank. I study how the two roles interact: because loan rates move repayment probabilities differently for different borrowers, the bank designs its wage contract and its loan rate menu jointly. I show that the cost-minimizing wage contract is non-monotone, including pay after default, and that the bank tilts loan rates toward levels that make rewarded outcomes most diagnostic of correct assignment. When failure pay is restricted, the bank instead re-prices some loans toward the rate at which repayment probabilities are most similar across borrowers and may ultimately take more risk to conserve on agency costs. I show that a capital requirement introduced to correct a leverage externality caps failure pay in this way and, under a countercyclical capital requirement, the economy can enter a permanent two-point cycle in which banks alternate between non-monotone contracts with less risk-taking and monotone contracts with more.