Out of all the potential deals to be done, some are more risky than others. Ideally, a lender’s underwriting model screens out the risky deals, so the lender only makes loans that do not default. By definition, this means some deals don’t get done.
This creates two problems for lenders. The first relates to certainty. If a deal is screened out, the lender certainly knows it did not collect the income attributable to that deal, but it doesn’t know for sure that the loan would have defaulted. This creates a bias towards screening out fewer deals.
The second issue relates to feedback. If a lender does a deal, there is immediate positive feedback; fee income and interest or servicing income is realized immediately. However, it could be years before a default occurs. The positive feedback occurs immediately, while negative feedback is delayed. Also, except in rare occasions a lender is not aware if a deal it screened out is done by another lender and subsequently defaults, so there is no positive feedback to a successful screening. Again, this creates a bias towards screening out fewer deals.
These issues are outlined in James Reason’s classic Human Error:
All organizations have to allocate resources to two distinct goals: production and safety. In the long term, these are clearly compatible goals. But, given that resources are finite, there are likely to be many occasions on which there are short-term conflicts of interest. Resources allocated to the pursuit of production could diminish those available for safety; the converse is also true. These dilemmas are exacerbated by two factors:
(a) Certainty of outcome. Resources directed at improving productivity have relatively certain outcomes; those aimed at enhancing safety do not, at least in the short term. This is due in large part to the large stochastic elements in accident causation.
(b) Nature of feedback. The feedback generated by the pursuit of production goals is generally unambiguous, rapid, compelling and (when the news is good) highly reinforcing. That associated with safety goals is largely negative, intermittent, often deceptive and perhaps only compelling after a major accident or string of incidents. Production feedback will, except on these rare occasions, always speak louder than safety feedback. This makes the managerial control of safety extremely difficult.
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