Optimal Communication In Bank Lending Decisions

Abstract

I study the optimal design of compensation contracts and information systems that motivateloan officers to provide high effort and truthful communication of borrowers’ soft information. I explore how a bank can balance these competing objectives in equilibrium. My findings suggest that if the bank seeks to incentivize both effort and truthful communication, it may design a positively biased information system and compensate loan officers even if a loan application is ultimately rejected. When the cost of motivating effort increases, the bank may opt for a less informative information system and shift to a hard information regime that prioritizes perfect revelation of states while disregarding soft information communication. Interestingly, the loan officer may prefer a perfect information system if she is in charge of the information design process.