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August 30, 2007

When Getting Bad News Is Good News for Banks

Rotating loan officers makes them more likely to report bad news about their portfolios, leading to more accurate internal reporting for lenders.


When getting bad news is good news for banks

When it comes to a bank’s assessment of its lending portfolio, the only truly bad news is unknown news. A basic tenet of the economics of asymmetrical information holds that when a lender has poor information about prospective borrowers, its disinclination for risk prompts it to ration credit, and when a lender is more fully informed about borrowers, it is more likely to allocate more credit.

But in the quest for accurate information, banks can be hindered by their loan officers, who don’t always provide accurate reports about the portfolios they manage. That’s because loan officers often play dual roles that present them with conflicting incentives.

Loan officers’ initial review of prospective borrowers’ financial portfolios requires that the officers act as active monitors, in which they make decisions about allocation of capital based on information they collect. But loan officers then take on a second role, as passive monitors, reviewing borrowers’ repayment histories and reporting back to the bank about the status of the same loans they approved. In organizational terms, this dual active and passive role is known as delegated monitoring.

That loan officers should have monitoring responsibility for credit they recommended that the bank extend makes sense intuitively. But what if some of the loans an officer approved end up teetering on default? It’s unlikely the officer wants his or her employer to see evidence of bad credit assessment checkering their portfolio. Wanting to appear competent, the loan officer’s reports can fail to reflect the true status of the portfolio.

“How to provide incentives to loan officers is a big question among banks,” says Professor Daniel Paravisini, who recently examined different incentive practices. “Some pay loan officers with stock options in the hopes that having a stake in the upside of the stock prices of the bank will induce them to behave better. Others have given loan officers very little say in lending decisions — they are almost transcribing hard data into a computer, which does all the work, acknowledging the officer might not report the accurate information.”

Between those extremes, one tactic banks have used is to rotate officers and their portfolios on a regular basis. The idea behind rotation is that, knowing their current portfolio will pass into the hands of another officer who would have little incentive to hide bad information about loans he or she hadn’t previously managed, a loan officer would prefer to reveal that information rather than be exposed later by a colleague about to take on the portfolio.

Banks have relied on the theory that rotation will prompt better reporting because of officers’ concern for their reputations, but haven’t been able to show that the tactic works. Rotation is also a common practice in many settings where there is a delegated monitor, such as auditing and governance, so confirming that rotating loan officers has an incentive effect to induce more accurate reporting has implications for organizational design and practice beyond banking.

Paravisini, along with coresearchers Andrew Hertzberg and Jose Maria Liberti, both of the Kellogg School of Management at Northwestern University, were granted access to a bank’s data as part of an internal review to improve its organizational design and practices. With access to loan reports — information that is never made public — the researchers were able to measure the accuracy of its internal reporting, accuracy being the main measure of the ability of the bank’s internal rating to predict future default.

The researchers found that the threat or possibility of rotation induced more accurate reporting on the part of the loan officers. Confirming the principle of asymmetrical information, they also found that the bank was allocating increased credit in periods right before rotation — just when the reports would have been at their highest level of accuracy.

“At the end of the day, rotation does impact the capital allocation decisions of the bank,” says Paravisini. Loan officers do a better job of reporting, banks make more credit available and borrowers find it easier to get credit. “

This research bears only indirectly on the recent credit market crisis, but Paravisini points out that the potential for information to be lost inside financial organizations may be partially to blame.

“Banks are fully aware of internal conflicts of interest, but it’s difficult to predict the full consequences of lending policy changes,” he explains. “A variety of circumstances — development of derivatives markets, rising real estate prices, high liquidity — led banks to expand lending to the sub-prime mortgage markets but the high default rates in this sector seem to have caught the same banks, and investors, by surprise.”

Daniel Paravisini is assistant professor of finance and economics at Columbia Business School.

Read the Research

Daniel Paravisini, Andrew Hertzberg, Jose Maria Liberti

"Information and Incentives Inside the Firm: Evidence from Loan Officer Rotation"

View abstract/citation  Download PDF  

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