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Sophistication in Risk Management, Bank Equity, and Stability

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  • HANS GERSBACH
  • JAN WENZELBURGER
Abstract
We investigate the question of whether sophistication in risk management fosters banking stability. We compare a simple banking system that uses an average rating 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 with 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 may be lower. As an economy with a sophisticated banking system invests its funds more efficiently, there is a trade‐off between efficiency and stability of a banking system.

Suggested Citation

  • Hans Gersbach & Jan Wenzelburger, 2010. "Sophistication in Risk Management, Bank Equity, and Stability," International Review of Finance, International Review of Finance Ltd., vol. 10(1), pages 63-91, March.
    • Handle: RePEc:bla:irvfin:v:10:y:2010:i:1:p:63-91
    DOI: 10.1111/j.1468-2443.2010.01105.x
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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