The effects of reward system on bank credit losses – an agent-based model

The purpose of this paper is to investigate how the design of loan officer reward systems affects bank credit losses caused by commercial clients.

This paper uses an agent-based model to investigate how the design of reward systems affects bank credit losses. Two different systems are compared: competitive and a cooperative. The model is designed according to the theoretically derived assumption that a cooperative reward system will make agents more likely to share knowledge with each other in the processes of granting and monitoring credit.

The results show that a cooperative reward system have potential to reduce bank credit losses. The reduction of errors in evaluating company’s probability of default thus mitigates variations induced by variations in industry, region, and firm-specific returns.

The findings imply that reward system design should be considered in credit risk management. Further, managerial issues (e.g. reward systems) should be considered in risk modeling.

The results presented in this paper provide evidence to the value of considering the downside (e.g. loss) when designing reward systems in banks.