Discussion Paper Details

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Title: Sophistication in Risk Management, Bank Equity, and Stability

Author(s): Hans Gersbach and Jan Wenzelburger

Publication Date: June 2007

Keyword(s): banking regulation, Financial intermediation, macroeconomic risks, rating, risk management and risk premia

Programme Area(s): Financial Economics

Abstract: We investigate the question of whether sophistication in risk management fosters banking stability. We compare a simple banking system in which an average rating is used with a sophisticated banking system in which banks are able to assess the default risk of entrepreneurs individually. Both banking systems compete for deposits, loans, and bank equity. While a sophisticated system rewards entrepreneurs with low default risks by low loan interest rates, a simple system acquires more bank equity and finances more entrepreneurs. Expected repayments in a simple system are always higher and its default risk is lower if productivity is sufficiently high. Expected aggregate consumption of entrepreneurs, however, is higher in a sophisticated banking system.

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Bibliographic Reference

Gersbach, H and Wenzelburger, J. 2007. 'Sophistication in Risk Management, Bank Equity, and Stability'. London, Centre for Economic Policy Research.