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Perverse incentives at the banks? Evidence from a natural experiment

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  • Sumit Agarwal
  • Faye H. Wang

Abstract

Incentive provision is a central question in modern economic theory. During the run up to the financial crisis, many banks attempted to encourage loan underwriting by giving out incentive packages to loan officers. Using a unique data set on small business loan officer compensation from a major commercial bank, we test the model?s predictions that incentive compensation increases loan origination, but may induce the loan officers to book more risky loans. We find that the incentive package amounts to a 47% increase in loan approval rate, and a 24% increase in default rate. Overall, we find that the bank loses money by switching to incentive pay. We further test the effects of incentive pay on other loan characteristics using a multivariate difference-in-difference analysis.

Suggested Citation

  • Sumit Agarwal & Faye H. Wang, 2009. "Perverse incentives at the banks? Evidence from a natural experiment," Working Paper Series WP-09-08, Federal Reserve Bank of Chicago.
    • Handle: RePEc:fip:fedhwp:wp-09-08
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    Cited by:

    1. Connor, Gregory & Flavin, Thomas & O’Kelly, Brian, 2012. "The U.S. and Irish credit crises: Their distinctive differences and common features," Journal of International Money and Finance, Elsevier, vol. 31(1), pages 60-79.
    2. Gropp, R. & Grundl, C. & Guttler, A., 2012. "Does Discretion in Lending Increase Bank Risk? Borrower Self-Selection and Loan Officer Capture Effects," Other publications TiSEM bfec5360-2a2b-47e4-ba3f-d, Tilburg University, School of Economics and Management.
    3. Florian Heider & Roman Inderst, 2012. "Loan Prospecting," The Review of Financial Studies, Society for Financial Studies, vol. 25(8), pages 2381-2415.
    4. Labie, Marc & Méon, Pierre-Guillaume & Mersland, Roy & Szafarz, Ariane, 2015. "Discrimination by microcredit officers: Theory and evidence on disability in Uganda," The Quarterly Review of Economics and Finance, Elsevier, vol. 58(C), pages 44-55.
    5. Bogaard, Hein & Svejnar, Jan, 2018. "Incentive pay and performance: Insider econometrics in a multi-unit firm," Labour Economics, Elsevier, vol. 54(C), pages 100-115.
    6. Deniz Igan & Prachi Mishra & Thierry Tressel, 2012. "A Fistful of Dollars: Lobbying and the Financial Crisis," NBER Macroeconomics Annual, University of Chicago Press, vol. 26(1), pages 195-230.
    7. Acharya, Viral & Litov, Lubomir P. & Sepe, Simone M., 2014. "Seeking Alpha, Taking Risk: Evidence from Non-executive Pay in U.S. Bank Holding Companies," Working Papers 13-18, University of Pennsylvania, Wharton School, Weiss Center.
    8. Roman Inderst & Sebastian Pfeil, 2013. "Securitization and Compensation in Financial Institutions," Review of Finance, European Finance Association, vol. 17(4), pages 1323-1364.
    9. Tam, On Kit & Liang, Hsin-Yu & Chen, Sheng-Hung & Liu, Bin, 2021. "Do valued independent directors matter to commercial bank performance?," International Review of Economics & Finance, Elsevier, vol. 71(C), pages 1-20.
    10. Tzioumis, Konstantinos & Gee, Matthew, 2013. "Nonlinear incentives and mortgage officers’ decisions," Journal of Financial Economics, Elsevier, vol. 107(2), pages 436-453.
    11. Skała, Dorota & Weill, Laurent, 2018. "Does CEO gender matter for bank risk?," Economic Systems, Elsevier, vol. 42(1), pages 64-74.
    12. Efing, Matthias & Hau, Harald & Kampkötter, Patrick & Steinbrecher, Johannes, 2015. "Incentive pay and bank risk-taking: Evidence from Austrian, German, and Swiss banks," Journal of International Economics, Elsevier, vol. 96(S1), pages 123-140.
    13. Berger, Allen N. & Kick, Thomas & Schaeck, Klaus, 2014. "Executive board composition and bank risk taking," Journal of Corporate Finance, Elsevier, vol. 28(C), pages 48-65.
    14. Bellucci, Andrea & Borisov, Alexander & Zazzaro, Alberto, 2010. "Does gender matter in bank-firm relationships? Evidence from small business lending," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 2968-2984, December.
    15. Thorsten Beck & Patrick Behr & Andreas Madestam, 2011. "Sex and Credit: Is There a Gender Bias in Lending?," Working Papers 411, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    16. Masazumi Hattori & Kohei Shintani & Hirofumi Uchida, 2012. "Authority and Soft Information Production within a Bank Organization," IMES Discussion Paper Series 12-E-07, Institute for Monetary and Economic Studies, Bank of Japan.

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    Keywords

    Incentive awards;

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