Loan Monitoring and Bank Risk

We study two issues: the relationship between loan monitoring and loan risk and the effects of regulations on banks' incentives for investments in loan monitoring systems. We describe dynamic monitoring of loans as an optimal stopping problem where the bank stops monitoring loans when it has become sufficiently certain that the loan is of good or bad quality. This process increases the incentive to hold risky loans, which in turn increases the cost of regulatory compliance when the regulator seeks to limit the risk taken by banks. The profitability of improved monitoring must be balanced against the increase in the cost of regulation, and we show that the trade off is always negative. This can explain the trend in banking of switching away from the monitoring of existing loans and instead investing in credit scoring systems, which can improve the initial lending decision, but eliminates certain classes of borrowers.