incentive

Research

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.

From mortgages and mutual funds to insurance — buyers of financial products should understand the incentives in place and how those incentives may affect them.

2 Responses to Do Incentives Create Lax Loan Standards?

  1. Kathy Davis says:

    Your statement that “buyers of financial products should understand the incentives in place and how those incentives may affect them,” struck a chord. But how can you protect elderly parents suffering from dementia from being victims of such incentives?

    After my father had been diagnosed with Alzheimer’s disease and a few months before his 80th birthday, Wells Fargo Advisors sold him a fixed index annuity. They were aware of my father’s cognitive difficulties at the time (he died of Alzheimer’s only three years later). In addition, in their rush to make the sale and earn their commission before my father turned 80, and would not be able to purchase an annuity, they failed to establish a cost basis for the annuity, telling my parents that it would not matter until later.

    (The cost basis would have been discoverable at that time because once I found out about the situation after my father’s death, I was able to trace it to the source with just a few phone calls. Unfortunately, by that time the records had been destroyed.)

    Wells Fargo has been nothing but dismissive when I have questioned the sale of the annuity to my father under the above conditions. Their only response has been that they were not responsible for establishing the cost basis. Meanwhile, they enjoyed a substantial commission from my father’s hard-earned money.

  2. Kim Blanton says:

    Kathy, I am working on an interesting blog post now about the dangers of mixing dementia and financial management. Please stay tuned!
    Thank you for your comment, which may be useful to other readers.
    Kim (blog writer)