Refined Risk Assessment and Banking Stability
ETH Risk Center – Working Paper Series ETH-RC-13-005
41 Pages Posted: 10 Jan 2014
Date Written: August 2013
Current banking regulatory frameworks are based on the belief that refined assessment of credit risks improves banking stability. This paper investigates this claim in a general setting by comparing a simple banking system with a sophisticated banking system which is capable of assessing default risks of entrepreneurs more accurately. By charging actuarially fair loan-interest rates, the sophisticated system finances fewer entrepreneurs. Relative to the simple system, both their repayments and liabilities are lower. Expected aggregate profits of entrepreneurs are higher but consumers receive lower deposit rates. Refined risk assessment may increase the systemic default risk of a banking system if bank equity is too low. Requiring higher bank equity ratios and forcing banks to refine their risk assessment techniques tend to increase stability if taken together, but may not be successful if only the latter is implemented. We draw implications for the policy debate, sparked by the financial crisis.
Keywords: financial intermediation, macroeconomic risks, risk assessment, risk premiums, banking regulation, rating
JEL Classification: D40, E44, G21
Suggested Citation: Suggested Citation