Do Loan Officers' Incentives Lead to Lax Lending Standards?

To better understand the role that loan officers’ incentives played in the origins of the financial crisis, we study a controlled field experiment conducted by a large bank. In the experiment, the incentive structure of a subset of small business loan officers was altered from fixed salary to volume-based pay. We document that incentives increased origination rates (+31%), loan sizes (+15%), and the likelihood of default (+28%). These effects are partly driven by moral hazard: treated loan officers use their discretion more in the approval decision; however, their risk assessment is not informative about the likelihood of default. The default rate in the treated group is materially higher for loans approved based on loan officers’ discretion and for loans with aggressive loan terms (unrelated to observable fundamentals). We show that factors related to the profitability of origination for loan officers increase the likelihood of origination and of default, and the marginal loans that were originated had a negative net present value.