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Sophistication in Risk Management, Bank Equity, and Stability

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  • Gersbach, Hans
  • Wenzelburger, Jan

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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6353.

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Date of creation: Jun 2007
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Handle: RePEc:cpr:ceprdp:6353

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Keywords: banking regulation; Financial intermediation; macroeconomic risks; rating; risk management; risk premia;

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References

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  1. Gersbach, Hans & Uhlig, Harald, 2006. "Debt contracts and collapse as competition phenomena," Journal of Financial Intermediation, Elsevier, vol. 15(4), pages 556-574, October.
  2. Elsinger, Helmut & Lehar, Alfred & Summer, Martin, 2005. "Using Market Information for Banking System Risk Assessment," MPRA Paper 817, University Library of Munich, Germany.
  3. Bhattacharya Sudipto & Thakor Anjan V., 1993. "Contemporary Banking Theory," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 2-50, October.
  4. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  5. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
  6. Gersbach, Hans & Wenzelburger, Jan, 2005. "Do Risk Premia Protect from Banking Crises?," CEPR Discussion Papers 4935, C.E.P.R. Discussion Papers.
  7. Krahnen, Jan Pieter & Weber, Martin, 2000. "Generally accepted rating principles: A primer," CFS Working Paper Series 2000/02, Center for Financial Studies (CFS).
  8. Gunter Franke & Jan Pieter Krahnen, 2007. "Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Chapters, in: The Risks of Financial Institutions, pages 603-634 National Bureau of Economic Research, Inc.
  9. Harald Uhlig, 1996. "A law of large numbers for large economies (*)," Economic Theory, Springer, vol. 8(1), pages 41-50.
  10. Bhattacharya, S. & Boot, A.W.A. & Thakor, A.V., 1995. "The Economics of Bank Regulation," Papers 9516, Centro de Estudios Monetarios Y Financieros-.
  11. Al-Najjar, Nabil Ibraheem, 1995. "Decomposition and Characterization of Risk with a Continuum of Random Variables," Econometrica, Econometric Society, vol. 63(5), pages 1195-1224, September.
  12. Gehrig, Thomas & Stenbacka, Rune, 2001. "Screening Cycles," CEPR Discussion Papers 2915, C.E.P.R. Discussion Papers.
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