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When Good Incentives Lead on Bad Situation

An Experimental Field Study

In an experimental field study, the researchers set out to test the efficacy of three distinct incentive schemes for employees in charge of assessing risk and issuing loans: the origination bonus (in which officers are rewarded a commission for every loan issued); the low-powered incentive (in which officers receive small rewards for loans that perform well and small penalties for loans that perform badly); and the high-powered incentive (in which officers receive big rewards for issuing loans that perform well, but big penalties for loans that default).

To begin, the researchers collected a random sample of actual applications from entrepreneurs seeking commercial loans for the first time. They acquired the loan files from a large commercial lender in India, a country challenged by a dearth of verifiable financial data. As is common in emerging markets, many residents have no personal identification documentation, let alone a credit score. Loan officers often end up relying on qualitative information and intuition, all the while knowing that these loans may be vital to the nation’s economy.

“Small businesses in emerging markets are thought to be among the large engines of employment and economic growth,” Cole explains. “But they often find it hard to get access to financing because they lack the large amounts of collateral that banks typically require. So we were interested in studying this small business segment, which is difficult to lend to but could potentially have a large impact.”

The researchers then recruited 209 experienced loan officers from several leading private—and public-sector Indian commercial banks to participate in up to 15 loan assessment sessions. Participants were asked to evaluate six applications per session, rating applications on personal, business, management, and financial risk before granting or denying the loan.