Pay-For-Loan-Performance V. Piece-Rate Loans What Is Better?

Origination incentives create a typical example of rewarding the loan officer along a single plane, quantity, rather than on quality. This gives the loaner no incentive to search for "good" loans; as a result, distortions and "rogue" behavior manifest. On the other hand, incentives based on profitability would give the advantage of direct incentives to find "good" credit risks; however, such a plan would subject the agent to greater risk, due to unpredictable events post loan approval and thus increasing the firm's costs. The trade-off is thus between risk and distortion, as well as incentives and insurance.

The typical plan is dependent on hard or soft information provided by the loan officer to the committee, and whether the information can be distorted. Hidden soft information allows for moral hazard, as officers' incentives are high to maximize loan quantity not quality. The degree of distortion (D) will vary with the size of the monetary reward (R), (R=>D), as R increases coordination is more difficult to achieve: agents will try harder to hid information. "Paying for A, while getting B." The committee's purpose is to try to eliminate the moral hazard induced by the officers' hidden actions. If information is soft then it is kept at the lower levels, i.e., the loan officer, but hard-information and verifiable information works well to align the loan officer's incentives with incentives to search for good loans. The firm's goal is loan repayment, a goal not immediately realized. The limited observability due to the degree of soft and hard information available decreases the firm's ability for proper evaluation. Observability is pushed into the future to when the loan is either repaid or not.

Scenario 2 creates career concern. This option motivates by imposing risk thus creating risk adverse employees who take extra time to search out "good" loans. Structure