Information and Incentives Inside The Firm: Evidence From Loan Officer Rotation

This paper provides evidence that a bank policy that routinely reassigns loan officers to different borrowers acts as an incentive device. We argue that the new loan officer who is assigned to the task has no reputation incentive to hide bad information. Therefore, the threat of rotation induces the incumbent to reveal bad news so as to avoid being uncovered by her successor. Using a proprietary monthly panel of internal risk rating data, we show that a three-year rotation rule induces incumbent loan officers to reveal negative information about the creditworthiness of the firms they manage. Consistent with our theory, loan officers systematically downgrade firms leading up to the three-year rule, and these downgrades are informative about the future probability of default. In line with our reputation concerns argument, we document that loan officers who fail to report bad news and are subsequently exposed by a successor, later go on to manage smaller sized lending portfolios. Finally we show that loan officer rotation impacts upon the capital allocation decisions of the bank.