Playing the devil's advocate: The causal effect of risk management on loan quality

Tobias Berg (Universität Bonn)
Monday, June 30, 2014 - 2:00pm
Spandauer Straße 1, Room 23

Casual observation suggests that most banks do not try to align loan officer incentives with those of the bank (i.e. to grant positive NPV loans). Instead, they deliberately assign opposing incentives to loan officers (loan volume) and risk management (risk). Decisions are then driven by competition of loan officers and risk management trying to defend their particular causes. Using 75,000 retail mortgage applications at a major European bank from 2008-2011, I analyze the effect of risk management involvement on loan default rates. In the period under study, the bank requires risk management approval for loans that are considered risky based on hard information, using a sharp threshold that changes during the sample period. Using a difference-in-difference estimator and a regression discontinuity design, I am able to show that risk management involvement reduces loan default rates by more than 50%. These results add to the understanding of agency conflicts within banks and point to the crucial importance of risk management in resolving internal agency conflicts.