Incentive Mechanisms, Loan Decisions and Credit Rationing: A Framed Field Experiment on China's Responsibility System for Rural Credit

Abstract

Incentive mechanisms are important attributes to financial decision-making. A framed field experiment was conducted to test loan decision behaviors. It showed that lenders’ risk-aversion and behavioral responses resulted in credit rationing under certain incentive schemes. In the experiment, loan officers from Rural Credit Cooperatives (RCCs) in Shandong, China were recruited to evaluate randomly selected loan applications and make lending decisions. All the loan files were previously approved with known performance and repayment status. Each loan officer was randomly assigned to one of two incentive groups. One was analogous to pure Personal Responsibility System (PRS), which provided bonuses to loan officers for approved loans that were in performance and imposed penalties on non-performing loans (NPLs). And the other was PRS with additional penalties for Type II error (i.e. rejecting loans that would have been good). The two groups were further randomized over prior knowledge about probability distribution of the application pool. Results showed that PRS made a risk-averse loan officer inclined to reject loans to avoid risk of penalty. This side effect generated credit rationing, increased Type II error in loan classification and lowered the interest returns of RCCs. Providing prior information about the application pool helped to increase decision accuracy. In theory, this study extended the incentive mechanism design under uncertainty to a behavioral scope. In practice, it can lead to increased profitability in financial institutes, alleviated credit rationing and stabilized credit supply in the market.