March 25, 2014
Do Incentives Create Lax Loan Standards?
The answer to the above question is definitely “yes,” according to new research by professors Sumit Agarwal at the National University of Singapore and Itzhak Ben-David at Ohio State.
They examined 30,000 small business loans made in 2004 and 2005 to compare the loans made by salaried bank officers with those made by officers working under a commission system. The commissioned lenders were paid 80 percent of their former salary, plus commissions based on the number of loans they originated, their dollar amount, and how quickly they were approved.
Not surprisingly, the researchers found that commissioned officers, responding to these incentives, originated 31 percent more loans and the dollar amounts per loan were nearly 15 percent greater – they were also often larger than what their clients had requested.
Loans made on commissions also had a higher default rate – 5.5 percent of the loans, compared with 4.3 percent for the salaried officers’ loans.
Although these researchers focused on business loans, the subprime fiasco showed that commission incentives can also harm consumers in the market for personal financial products. Loan brokers were often paid a fee for each subprime mortgage they originated.