DP6353 Sophistication in Risk Management, Bank Equity, and Stability

Author(s):	Hans Gersbach, Jan Wenzelburger
Publication Date:	June 2007
Keyword(s):	banking regulation, Financial intermediation, macroeconomic risks, rating, risk management, risk premia
JEL(s):	D40, E44, G21
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=6353

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.