Risk management, soft information and bankers' incentives

What is it about?

We investigate the influence of soft information on integrated risk management in banks. Risk management, capital budgeting and capital structure policies are performed by bank management using information on loan quality provided by a loan officer. The information can be a combination of hard and soft information, the latter being more precise but not verifiable. We set-up a principal-agent framework with moral hazard with hidden information to perform our theoretical analysis. The results show the existence of an incentive of the loan officer to manipulate the soft information, which can be prevented provided an incentive compatible compensation contract. We then show that access to more accurate soft information allows bank management to economize on capital allocation for Value at Risk coverage and to expand capital budgeting for loans origination.

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