The Impact of Incentives and Communication Costs on Information Production and Use: Evidence from Bank Lending

Abstract

In 2002 and 2003, many Chinese banks implemented reforms that delegated authority to individual loan officers. The change followed China's entrance into the WTO and offers a plausibly exogenous shock to loan officer incentives to produce information. We find that the bank's internal risk rating becomes a stronger predictor of loan interest rates and ex post outcomes after reform. When the loan officer and the branch president who approves the loan work together longer, the rating also becomes more strongly related to loan prices and outcomes. Our results highlight how incentives and communication costs affect information production and use.HIGH-QUALITY INFORMATION is essential for successful business transactions. A growing literature emphasizes how both individual incentives and the cost of communication to decision-making authorities affect the production and use of information. In this paper, we study how banks use information to set loan interest rates, how that information forecasts future outcomes (default), and how the quality (predictive power) of information production varies with incentives and communication costs. many banks implemented a series of reforms during the second half of 2002 and throughout 2003 focusing on decentralizationshifting the responsibilities of making lending decisions from committees to individuals. 1 These reforms strengthened incentives for loan officers to produce and banks to use high-quality information, yet they are plausibly exogenous from the perspective of loan officers because the reforms came from the highest level due to external pressure. We exploit proprietary loan-level data from a large, nationwide state-owned bank that provides information on both interest rates and outcomes (full repayment on time, partial or late repayment, total loss). We test how incentives to produce and use information affect, first, how banks set ex ante loan pricing based on that information, and, second, how well that information forecasts future loan performance. We then test how communication costs affect information production and use, where costs are proxied by the time the information producer (loan officer) and final decision maker (branch president) have worked in the same branch.Our sample covers borrowers located in more than 30 cities across China over the 2000 to 2006 period. We treat the first half of 2002 and earlier as the pre-reform period, and 2004 and later as the post-reform period. The key information measure is the bank's internally generated credit rating, which measures the bank's assessment of borrower risk. Before reform these ratings were produced and approved by a group of loan officers from the bank's loan investigation unit; after reform, however, individual loan officers within the unit become responsible for the ratings and can be held liable for bad loans extended based on inaccurate or biased ratings.In the first part of our analysis, we test the theoretical prediction that increasing the authority and accountability of individual loan officers strengthens...

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“…The central government, under the tight control of the 4 Different from Hakenes and Schnabel (2014) who focus on the bailout policy of government and Qian et al (2015) who focus on the incentives of bank loan officers, our paper emphasizes the role of local politicians. As argued by Hakenes and Schnabel (2014), bailout expectation leads to steeper bonus schemes and even more risk taking if there is a risk-shifting problem.…”

“…As argued by Hakenes and Schnabel (2014), bailout expectation leads to steeper bonus schemes and even more risk taking if there is a risk-shifting problem. Qian et al (2015) point out that higher incentives of loan officers to produce high-quality information after the reforms of Chinese banks between 2002 and 2003 can help forecast future loan performance. 4…”

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“…Interestingly, measures of decentralization do not have predictive power towards borrowers' default and delinquency. Qian et al (2014) explore an exogenous shock to the Chinese banking system following China's entrance into WTO to study implications for bank lending of delegation of authority. Specifically, at the time many Chinese banks implement decentralization reforms that delegate decision-making authority to loan officers, and thus exogenously affect incentives for information production and use.…”

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“…This measure has been used in Qian and Yeung 2014. 8 The NERI index had been used in many papers (e.g., in Firth et al 2009 andin Qian, Strahan, andYang 2015). 9 The measure we used in this paper can reflect the credit allocation in the PRC well (Fan, Wang, and Zhu 2011).…”