Basel II and the Value of Bank Differentiation

This paper analyzes optimal bank capital requirements when regulation can be differentiated according to banks' heterogeneous risk-assessment capabilities. The new Basel II Accord provides the opportunity to do by introducing distinct regulatory systems for banks authorized to apply internal ratings and externally rated banks. We show that optimal policies provide incentives to specialize: sophisticated banks should be directed towards low-risk loan portfolios and be allowed to grow, whereas banks with less developed rating systems should be regulated as niche players that absorb a maximum of the unavoidable systematic risk in the banking sector. The coexistence of two capital adequacy standards dominates a market structure in which all banks migrate to one regulatory regime. We analyze the moral hazard problem that sophisticated banks may misreport the true risk of their assets, and show that it will reduce the optimal level of differentiation between the two types of banks, but not eliminate the advantage of two coexisting standards. We address the problem of banks deploying internal rating systems without information sharing, and show that this may accelerate the adoption of differentiated regulation.