Discussion paper

DP6353 Sophistication in Risk Management, Bank Equity, and Stability

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.


Gersbach, H and J Wenzelburger (2007), ‘DP6353 Sophistication in Risk Management, Bank Equity, and Stability‘, CEPR Discussion Paper No. 6353. CEPR Press, Paris & London. https://cepr.org/publications/dp6353