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MF
41,9
The effects of reward system
on bank credit losses – an
agent-based model
908 Sara Jonsson
Received 30 July 2014
Centre for Banking and Finance,
Revised 8 June 2015 School of Architecture and the Build Environment,
Accepted 20 June 2015 The Royal Institute of Technology, Stockholm, Sweden
Abstract
Purpose – The purpose of this paper is to investigate how the design of loan officer reward systems
affects bank credit losses caused by commercial clients.
Design/methodology/approach – 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.
Findings – 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.
Practical implications – 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.
Originality/value – The results presented in this paper provide evidence to the value of considering
the downside (e.g. loss) when designing reward systems in banks.
Keywords Banks, Simulation
Paper type Research paper
1. Introduction
The credit market has experienced significant growth in recent decades: banks have
increased their lending to both corporations and households. This development
has been accompanied by sophisticated ways to manage credit risks (e.g. credit
derivatives). In addition to the development of financial instruments, both academics
and institutions have increased their focus on managerial issues as means to manage
risk: bank managements that define clearly stated credit policies are claimed to be in a
better position to manage credit risk. Bank employee reward systems are an efficient
way to implement such policies and should thus have an effect on banks’ credit risk
exposure (Caouette et al., 2008).
Reward systems refer to the basis upon which rewards are distributed to two or more
individuals, specifically on an operative level (e.g. Wageman and Baker, 1997). Research
on reward systems has studied their effects on, for example, increased sales, increased
units produced, and corporate-level performance (Bartol and Srivastava, 2002). These
studies have mainly been conducted in non-bank organizations. Furthermore, the focus
Managerial Finance has mainly been on the “upside,” such as increased units produced, as appose to the
Vol. 41 No. 9, 2015
pp. 908-924
“downside,” such as losses or failures. In the aftermath of the recent financial crisis, both
© Emerald Group Publishing Limited
0307-4358
regulators and academics have stressed the relevance of sound compensation plans and
DOI 10.1108/MF-07-2014-0209 reward systems in the banking sector, since these systems were considered one of the
causes of the crisis (Diamond and Rajan, 2009). Much research in this area has focussed The effects
on the executive level and CEO compensation plans (e.g. Victoravich et al., 2012), while of reward
less attention has been given to the operational level. Hence, the purpose of this paper is
to investigate how the designs of loan officer reward systems affect banks’ expected
system
credit losses produced by commercial clients.
Task completion (e.g. units produced or sold) is often the dependent variable in
studies of reward systems; however, detailed specification of the task has commonly 909
been silent in the literature, despite the initial emphasis on specification of the task by
organizational theorists (e.g. Fayol, 1949). There are a limited number of studies
investigating how the specific tasks that organization members perform are affected by
different reward system designs. In “taskless” settings, task completion is improved by
working harder or faster. However, most of the issues that arise because of task-based
constraints on agents (such as which agent has the necessary skills for this particular
task) cannot be addressed when the task is underspecified. Furthermore, with taskless
settings, it becomes difficult to generate management implications with sufficient
detail. By providing credit, banks perform a fundamental task in society; hence,
studying factors (e.g. reward systems) that explicitly affect the performance and
outcome of this task is relevant.
This study’s methodology combines a survey distributed to loan officers (bankers) and
a computer-based simulation model, a so-called agent-based model (ABM). The simulation
results show that credit losses are reduced in systems where rewards are based on joint
performance. By investigating the implications of reward systems on the downside
of task execution, this study provides novel insight for organizations whose business
concept is the management of risk (i.e. banks). Furthermore, the model shows
how management and organizational theory can contribute to credit risk modeling.
Banks have devoted many resources to developing internal risk models in order to better
quantify the financial risks they face when assigning the necessary economic and
regulatory capital. The ABM presented in this paper shows how managerial factors could
be incorporated in developing this type of models.
3. Literature review
3.1 Reward systems
Bank compensation system have been widely discussed among researchers and
practitioners, especially in the aftermath of the credit crisis of 2007-2008; indeed, these
systems have been considered one of the most fundamental causes of the crisis
(Diamond and Rajan, 2009). There have been claims that executives received excessive
compensation as a reward for taking on risk during the period following deregulation
of the banking industry. Studies of banks and compensation plans have mainly
focussed on compensation plans for executives. One primary issue in these discussions
has been on how compensation could be structured in order to reduce of agency
problems (e.g. Macey and O’Hara, 2003). Other studies have investigated the relationship The effects
between executive compensation plans and bank performance (Akhigbe et al., 1997), of reward
the association between institutional investor ownership and executive compensation
(Victoravich et al., 2012), and implications of pay differences between CEO pay
system
and the compensation to other top executives within the organization (Kini and
Williams, 2012).
Reward systems can broadly be categorized according to whether they are based solely 911
on joint performance (cooperative system) or based solely on the performance of one
individual relative to another (competitive system). Researchers have concluded that the
degree of task interdependence is the mediating variable when advocating either a
competitive or a cooperative reward structure in order to achieve task completion (Stanne
et al., 1999; Wageman, 1995, 2001; Wageman and Baker, 1997). Task interdependence is
derived from the demands and constraints inherent in a team’s tasks (Humphrey et al.,
2007) and describes situations in which cooperation is a necessary antecedent to good team
performance. The idea is that a competitive system is preferred when people work
independently, whereas a cooperative system should be implemented when people are
interdependent (Stanne et al., 1999; Wageman, 1995).
In addition to the degree of interdependence, tasks can also be differentiated in
terms of whether their execution demands speed, accuracy, or both ( Jenkins et al.,
1998). Most complex tasks are multidimensional and therefore place multiple demands
on role incumbents. Because employees in a group are likely to have complementary
knowledge that is beneficial when it comes to solving complex tasks, the demand for
accuracy would imply a cooperative system. The demand for speed would, however,
advocate an individual system (Beersma et al., 2003). While most complex tasks require
some degree of both speed and accuracy, there are trade-offs that make it difficult to
meet both of these task requirements at the same (Woodworth, 1899; Elliott et al., 2001).
4. Methodology
A combination of empirical and computational analyses was used in this study.
The empirical data, collected through a survey distributed to bankers with the
authority to grant credit to commercial clients, served as a foundation on which a
computational model was designed.
Linking real-world cases with a computational model makes it possible to find a clearer
causal relationship between specific variables and bank credit losses while holding other
variables constant. Using such experimental “what if” analyses makes it possible to
assess the relative value of restructuring a bank’s reward system. This study used an
agent-based computational model (ABM), hereafter referred to as the BankModel, that
was built in Java using the Java agent-based simulation library (Sonnessa, 2004).
The survey results were used to construct a representation of the diversity banker
assessment errors. Individual bankers are assigned a normal distribution representing
their individual risk assessment error. For each new client firm with a credit
application, the bankers make a client-specific error drawn from their error distribution.
The error distribution is determined by a mean (errorMean) and a standard deviation
(errorSD), which are assigned to each banker agent accordingly. The survey results
showed that a majority (77 percent) stated that their colleagues correctly evaluated the
risk of clients, and therefore the errorMean was set to 0 for all bankers. The standard
deviation for banker agent error distributions (errorSD) were assigned according
MF to data on use and perceived usefulness of non-social sources of information. Non-social
41,9 sources refer to sources that do not require social interaction (e.g. financial reports and
data sources within or outside the bank). The survey respondents were asked about
information sources they had used in their last credit-granting process and the
usefulness of different sources of information (see Table I). For example, 86 percent
stated that they had used “financial accounts,” and 41 percent considered financial
914 accounts to be a useful source of information. In addition, 86 percent stated that they
had used other data from the client, which 30 percent considered to be a useful source of
information. Five random numbers were drawn from a uniform distribution between 0
and 1 for each agent. If the first number was below 0.86, this agent would use “financial
accounts” in the estimation. If the second number was also below 86 percent, the banker
agent would also use other data from the client as a source of information, and so forth
until all options were considered. The set of activities was then translated by summing
the usefulness indexes of the information sources (i.e. 0.41+0.30). A high usefulness
index was then translated to a low-standard deviation of the error term.
5.1.1 Bankers’ learning process. Bankers are assumed to have an individual,
experience-based learning process. Duration of a bank-firm relationship positively
affects the banker’s ability to make an accurate risk assessment of a commercial client
(Uzzi, 1999). Accordingly, in the BankModel, the error in credit risk assessments
decreases in each time period t according to the following negatively autocorrelated
process ( j denotes the j-th firm):
where ρj is the autocorrelation coefficient, and nj, t is the random component of the
evolution of the error term. ρj is drawn from a uniform distribution [0.7-0.9] and nj, t
from a random distribution [−0.02-0.02]. The learning process occurs as the last step in
the simulation schedule (see Table V).
5.1.2 Cooperative reward system. When a cooperative reward structure is employed,
banker agents are divided into medium-sized teams (3-11 members). Research on group
structure implies a curvilinear relationship between group size and performance. Very
small teams (two or three members) lack a diversity of viewpoints and perspectives,
whereas large teams (more than about 12 members) become too unwieldy to enable
effective interaction, exchange, and participation (Poulton and West, 1999).
In the cooperative system it is assumed that bankers do not adopt long-term
strategies from the knowledge they acquire from their partners. This assumption is
based on the complexity of the credit decision situation. Because of the inherent
Financial accounts 86 41
Other data from client 86 30
Data sources outside the bank 80 18
Table I. Data sources within the bank 38 2
Survey responses Sources within the applicant’s industry 18 3
uncertainty in the situation, they cannot predict the amount of learning that will take The effects
place in the long run. In a cooperative structure, bankers need to learn and acquire of reward
information not only about their own client firms but also about their colleagues’
clients. Hence, it is assumed that the individual pace of learning about each firm is
system
reduced in proportion to the number of team members: ρj is recalculated accordingly:
1−((1−ρj)/number of team members).
However, in the cooperative design each team member has access to the knowledge 915
and skills of other team members. The group decision-making literature makes it clear
that group decisions tend to be much more accurate than those of their average members
but are rarely better than those of their best members (Levine and Moreland, 1998).
Accordingly, the bankers’ error term is recalculated in the cooperative work design: when
making an estimation of a client firm’s PD, the banker’s current error associated with that
firm is compared to the team members’ error for that firm. If eit Wejt in absolute terms
(where j is any other banker in this group), banker i will learn from banker j meaning that
banker i’s error term will be set to the error term of banker j (Table II).
errorDistribution Normal distribution with mean (errorMean) and standard deviation (errorSD)
loanPortfolioList The bankers’ client firms are recorded in a list (loanPortfolioList). Each firm is
associated with a specific error term
teamMemberList The bankers are assigned a number, drawn from the uniform distribution Table II.
[3-11], of other bankers which are addressed in the corporate reward system Banker attributes
MF Firm attribute Comment
41,9
assetValue Information (www.largestcompanies.com) on total asset values was obtained from
26,532 public and private businesses. The total sample size was limited to 20,841
firms with asset values below 100 million Swedish kronor (MSEK). The data were
fitted by an exponential distribution with a mean of 30 million. The market asset
value of a firm in the BankModel was randomly assigned from this exponential
916 distribution
volatility Volatility is a measure of the standard deviation of the annual percentage change in
asset value, which is a measure of a firm’s business and industry risk. The annual
volatility was derived from a uniform distribution with a range from 0.3 to 0.5.
Firms with larger asset values are assigned lower volatility
leverageRatio Firms’ leverage ratios (L) in the BankModel are randomly generated from a uniform
distribution with a range from 0.2 to 0.9, corresponding to a leverage of 20-90%.
The leverage ratio was used to calculate the contractual liabilities, F ¼ V × L
expROA The expected return on assets is generated from a normal distribution with a mean
of 0.04 and SD of 0.02
region The region is indicated by a number 1-8
industry The industry is indicated by a number 1-10
Table III. regionBeta Assigned from a uniform distribution from 0.5 to 1.5
Firm agent attributes industryBeta Assigned from a uniform distribution from 0.5 to 1.5
The BankModel approximates the probability distribution of the firm’s asset values as
a normal distribution, with a mean equal to Vx and a standard deviation equal to σx.
Hence, PDx is estimated accordingly:
If the PPD is above the PDLimit, if the credit is granted the credit application is rejected.
If the PPD is below the PDLimit, the loan is granted and accepted by the firm.
5.3.3 Update of firm PD. Each firm belongs to a specific industry and a specific
region. There are ten industries and eight regions in the model. The firms are connected
through their industrial and regional membership, and the evolution of their assets
depends on changes in the regions and industries to which they belong, as well as changes
that are specific to the firm. Each firm has a specific sensitivity to economic changes in the
industry and region, as measured by the firm’s β values: bix (firm’s sensitivity x to changes
in its industry) and brx (firm’s sensitivity x to changes in its region).
At each time period t, the PD of all firms is recalculated according to their actual
return (rx) and expected return ( µx). The actual return is modeled according to Equation
(4) where [region] and [industry] represent region- and industry-specific shocks that
may be introduced in the model. At each time period t, random disturbances in region
and industry are generated. A shock is generated from a normal distribution, with a
mean value of 0 and standard deviation value of for each industry and region. At each
time period t, a “firm-specific disturbance” known as ex is introduced and drawn from a
normal distribution, with a mean of 0 and a standard deviation equal to the volatility of
the firm’s asset value. Each firm is allocated a goodness-of-fit measure (R2) from 0 to 1:
qffiffiffiffiffi qffiffiffiffiffiffiffiffiffiffiffi
r x;t ¼ R2x brx ½regiont þ bix ½industryt þ 1R2x ex;t (5)
A new net asset value is calculated using the values of rx and µx, and the current
contractual liabilities (Fx):
" !#
m sx;v sx;v X
t
V x;t F x;t ¼ V 0 exp x t 2 t 2H þ r x;t F x;t1 (6)
f 2f f k¼1
MF Step Event
41,9
Step 1 Initialization {
Generate the initial population of bankers and teams of bankers}
Step 2 Firms apply for credit
{Randomly select n (between 0 and numberOfFirms) firms that apply for credit
For each firm that applies: If the firm is not a previous customer, assign the firm a banker or
918 else assign the firm to its current banker}
Step 3 Bankers make the credit decisions {
If (cooperativeStructure ¼ true) bankers consult their team members in the credit decision and
use their knowledge and the error term is set to the error term of the team member with the
smallest error term
PPD ¼ PD+error
If PPD oPDLimit, grant credit} }
Step 5 Update firms’ PD {
For each firm calculate a new PD
}
Step 6 For each banker: monitor client firms. If (cooperativeStructure ¼ true) bankers consult their
team members. If PPDW PDLimit, there is a probability, probOffloading, that the loan will be
offloaded
Step 6 Calculate credit losses {
For defaulted client firms, calculate loss (LGD * debt level (F))
}
Step 7 Replace defaulted firms {
Create n new firms equal to the number of defaulted firms
}
Step 8 Bankers’ individual learning process
Table V. If t otime, go to step 2
The BankModel End
event schedule Notes: DD, distance to default; PD, probability of default; PPD, perceived probability of default
Equation (5) can be described as a Brownian motion which is a common way to model
development of asset values and liabilities (see, e.g. Merton, 1973), where t is the current
time period and f is the frequency of change in asset value (annual, f ¼ 1; monthly,
f ¼ 12, etc.). The Hurst parameter H allows for the return process to be autocorrelated.
If H is equal to 0.5, there is no autocorrelation; if H is more than 0.5, there is a positive
autocorrelation; and if H is less than 0.5, there is a negative autocorrelation. The new
net asset value is used to calculate a new PD. In this step defaulted firms are identified
and are replaced with new firms. Hence, the number of firms that can apply for credit
is constant.
5.3.4 Monitoring. In each time period, all bankers monitor the firm clients in their
“loanPortfolioList” by estimating the firms’ current PD values. The error term for the
specific firm is retrieved and a PPDx is calculated accordingly: PPDix(t) ¼ PDx(t)+εix.
The error term is determined using the same process as in the credit-granting process.
If “cooperative” ¼ true, bankers will use the smallest error of their group.
If the firm has developed in such a way that the PPDix(t) W PDLimit, there is a
probability (probOffloading) that the bank will offload the firm’s loan to another lender,
and thus the client will be removed in the model.
5.3.5 Calculation of credit exposure and expected credit losses. The bank’s
total amount of outstanding credits (exposure) is calculated at each time period.
Exposure changes according to credits granted and defaulted. At each time period, a The effects
number of firms are expected to reach their default point, and the bank will incur a of reward
credit loss if the firm is a bank client.
system
6. Simulation results
Figure 1 shows expected credit losses during a time period of t ¼ 1 to t ¼ 300 when an
individual reward system is used, while Figure 2 shows expected credit losses in a 919
cooperative reward system. The figures show losses for the same level of PDLimit
(0.10) and illustrate expected credit losses as a percentage of exposure.
The results show that bankers’ ability to correctly assess commercial clients’
probability of default affects banks’ credit risk exposure. In a competitive system,
expected credit losses are initially higher than in a cooperative system, and expected credit
losses drop more rapidly in cooperative system compared to the individual system. Hence,
the cooperative system reaches equilibrium sooner than the individual system. Table VI
reports mean, standard deviations for both systems, and t-tests comparing the means
between the systems for intervals of 50 time periods. The results show that the expected
credit losses are lower in the cooperative system compared to the competitive system.
The impact of both reward systems was further investigated changing the client
base according to two extremes: Figure 3 shows the result in a system where the
banker agents only make credit decisions with new clients, and Figure 4 shows
the results in a system where all clients are returning clients. Figure 3 shows that if
clients are new to the bank (and hence there is no individual learning about clients
as a consequence of the duration of the bank-firm relationship), the only way to
improve agent knowledge is access to group members with lower error terms.
0.90
Percentage expected credit loss
0.80
0.70
0.60
0.50
0.40
0.30
0.20
Figure 1.
0.10 Credit losses in a
0.00 competitive system
1 51 101 151 201 251 (PDLimit ¼ 0.10)
Time
1.00
Percentage expected credit
0.90
0.80
0.70
0.60
loss
0.50
0.40
0.30
0.20 Figure 2.
0.10 Credit losses in a
0.00 cooperative system
1 51 101 151 201 251 (PDLimit ¼ 0.10)
Time
MF Correspondingly, the cooperative system naturally outperforms the individual
41,9 system in this scenario.
Figure 4 shows that if the client base is constant (there are only returning clients)
the individual system will outperform the cooperative system in the long run. Hence, if the
client base remains the same, individual knowledge acquisition as a consequence of
the duration of the bank-firm relationship (reduction in the error term) will outperform
920 knowledge sharing with colleagues in the long run.
0.90
0.80
Percentage expected credit loss
0.70
0.60
0.50
0.40
Figure 3. 0.30
Credit losses in
cooperative and 0.20
competitive system Cooperative system
0.10
with solely new Competetive system
clients 0.00
1 51 101 151 201 251
0.90
Competetive system
0.80
Percentage expected credit loss
Cooperative system
0.70
0.60
0.50
0.40
Figure 4.
Credit losses in 0.30
cooperative and 0.20
competitive system
with solely returning 0.10
clients 0.00
1 51 101 151 201 251
7. Conclusion The effects
This paper investigates the impact of bank reward systems on bank credit losses caused of reward
by commercial clients defaulting. The BankModel simulates expected credit losses under
two different reward systems: a competitive system and a cooperative system. The main
system
result is that the bankers’ cognitive ability affects banks’ expected credit losses.
The reduction of error in evaluating firms’ PD mitigates stochastic variations induced by
variations in industry and region returns, as well as firms’ specific variations in return. 921
The results of the baseline models (Figures 1 and 2, Table VI) show that a cooperative
structure reduces expected credit losses to a greater extent than a competitive structure.
Further investigation of these results shows that turnover of the client base also needs to
be considered when advocating for either a cooperative or a competitive system.
When advocating for either a competitive or a cooperative reward system,
researchers have commonly used the “upside” of task completion (e.g. sales, units
produced) as the dependent variable. If cooperation is needed for task completion, a
cooperative reward system should be implemented; if not, a competitive system is better
suited to promote task completion (Stanne et al., 1999; Wageman and Baker, 1997).
The argument put forward in this paper is that the task must be carefully specified in
order to design the best reward system. The task, which is the focus of this study,
involves the granting of credit to firms that will not default. Credit decisions may be
made by individual bankers; typically, in this type of situation, a competitive reward
system should be implemented so as to enhance task completion. Because risk and
uncertainty are inherent in the credit decision-making process, a prominent “downside”
exists in terms of potential credit loss. For bankers to make informed credit decisions and
minimize credit losses, they need accurate risk estimates; hence, uncertainty must be
reduced (Knight, 1921). Because uncertainty is reduced by knowledge acquisition
(Mizruchi, 1992; Stearns and Allan, 1996), the implementation of a reward system
that promotes knowledge sharing should reduce the uncertainty and thus expected
credit losses.
The results presented in this paper imply the need for bank management and
regulators to consider reward system as an important tool for credit risk management.
The recent financial crisis has led to an increased focus on banks’ management of risks
and uncertainties, as demonstrated by the recent Basel III framework. Within the
internal ratings-based approach (IRB), banks are allowed develop their own method for
estimating credit risk. The ABM approach of estimating losses presented in this paper,
therefore, provides a potential tool for such model development.
Note
1. The survey data used in the BankModel was collected 2007.
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Corresponding author
Dr Sara Jonsson can be contacted at: sara.jonsson@abe.kth.se
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