Incentivizing Calculated Risk-Taking: Evidence from Experiments with Commercial Bank Loan Officer

Principal Investigators: Shawn Cole (Harvard Business School), Leora Klapper (World Bank), Martin Kanz (World Bank), Andreas Fuster (Federal Reserve Bank of New York)
Research Team: Anushree
LEAD Centre: Centre for Microfinance
Focus Area: Credit
Project Geography: Gujarat, India
Status: Completed


Given the massive sanctioning of bad loans leading up to the recent financial crisis, the incentive structure of lending organizations, specifically banks, has been called into question. While the management of lending organizations was held responsible for bad lending decisions (perhaps for good reason), lower-level employees often have more influence over decisions regarding smaller loans. The current study examines how bank loan officers, who are largely responsible for making decisions on small and medium loans, respond to various incentive schemes. In developing countries, loan officers are generally more informed about small and medium borrowers and are sometimes better equipped to make a lending decision compared to their supervisors. But since loan officers enjoy limited liability they may not put much effort into screening applications or evaluating the risk that prospective clients pose to the institution. For this reason, understanding how loan officers can be incentivized to make smarter lending decisions is critical to improving individual staff as well as bank performance.

Methodology & Research Design
The present study is being conducted in partnership with the Bank of Baroda, the third largest public sector bank in India. In the first stage of the intervention, researchers collect files for loans of between 1 and 5 lakhs that have already been sanctioned by the bank. These files include information about the client, his business, and the client businesses’ performance. The files also indicate how well the loan has performed over the last year. Researchers then registered 256 loan officers to participate a lab experiment where they are given loan files to evaluate. Loan officers have the option of sanctioning a loan or a rejecting a loan based on information they are shown about the client and his business.

The experiment is comprised of 11 different incentive schemes. These incentive schemes differed in terms of magnitude of penalties and returns for sanctioning a bad loan file or a good loan file. To evaluate whether the loan officer made a “good” or “bad” decisions, researchers match the loan officer’s lending decision to the loan’s historical delinquency status.

Initial Findings:
The study finds that a higher-powered incentive scheme which combines compensation for sanctioning a good file and a penalty for sanctioning a bad one, positively impacts lending profitability. Loan officers become more conservative in their lending decisions under the scheme but they also make better lending decisions. Researchers found that the high-powered incentive scheme was successful in improving loan officer performance in terms of the effort they invest in screening the files, the quality of their risk evaluation and the quality of their final lending decisions. Under the high-powered incentive scheme, loan officers sanctioned loans which were $180 more profitable on average than the loans that they sanction under nominal incentive schemes.

When compared to loans that officers sanctioned under a scheme that paid them based on lending volume, loan officers sanctioned loans that were $290 more profitable. Unsurprisingly, loan officers who were told that they would be rewarded for approving more loans (on volume),rather than on the quality of their lending portfolio, sanction a significantly higher share of the loans.

Notably, when researchers delayed incentive payments by three months, loan officers put less effort into screening loan files than when the payments were made on the spot, suggesting that incentives should be paid immediately in order to be effective.

Policy Implications:

–     Based on the findings from this study, banks could try to improve loan staff performance by providing loan officers with high-powered monetary incentives that reward them for making good decisions and penalize them for bad decisions.
–     However, because deferred incentive payments adversely impact loan officer performance, banks may face difficulty tying incentives to the performance of a loan (since loan officers would not receive a payout until sometime in the future).
–     Academics should conduct more research to understanding the incentives that drive good and bad lending decisions. This research could help practitioners identify incentive schemes that would improve bank operations and increase profitability.

Study Status:

A second series of experiments started in October 2011. Under the new framework there are 4 incentive schemes. The loan officers can choose one incentive from two randomly chosen incentives. They also have an option to evaluate the loans in teams or individually. Researchers will study the dynamics of group decision-making as well as the behaviour of differently incentivized individuals within a group setting.