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Sophistication in Risk Management, Bank Equity, and Stability

  • Gersbach, Hans
  • Wenzelburger, Jan

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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  1. 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.
  2. Krahnen, Jan Pieter & Weber, Martin, 2000. "Generally accepted rating principles: A primer," CFS Working Paper Series 2000/02, Center for Financial Studies (CFS).
  3. Harald Uhlig, 1996. "A law of large numbers for large economies (*)," Economic Theory, Springer, vol. 8(1), pages 41-50.
  4. Bhattacharya, S. & Boot, A.W.A. & Thakor, A.V., 1995. "The Economics of Bank Regulation," Papers 9516, Centro de Estudios Monetarios Y Financieros-.
  5. Gersbach, Hans & Uhlig, Harald, 2006. "Debt contracts and collapse as competition phenomena," Journal of Financial Intermediation, Elsevier, vol. 15(4), pages 556-574, October.
  6. 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.
  7. 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.
  8. Gehrig, Thomas & Stenbacka, Rune, 2001. "Screening Cycles," CEPR Discussion Papers 2915, C.E.P.R. Discussion Papers.
  9. Elsinger, Helmut & Lehar, Alfred & Summer, Martin, 2005. "Using Market Information for Banking System Risk Assessment," MPRA Paper 817, University Library of Munich, Germany.
  10. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  11. Bhattacharya Sudipto & Thakor Anjan V., 1993. "Contemporary Banking Theory," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 2-50, October.
  12. Gersbach, Hans & Wenzelburger, Jan, 2005. "Do Risk Premia Protect from Banking Crises?," CEPR Discussion Papers 4935, C.E.P.R. Discussion Papers.
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