Choice of Rating Technology and Loan Pricing in Imperfect Credit Markets

34 Pages Posted: 9 Jun 2016

See all articles by Hannelore De Silva

Hannelore De Silva

Vienna University of Economics and Business

Engelbert J. Dockner

WU Vienna University of Economics and Business (deceased)

Rainer Jankowitsch

WU (Vienna University of Economics and Business); Vienna Graduate School of Finance (VGSF)

Stefan Pichler

WU - Vienna University of Economics and Business - Department of Finance, Accounting and Statistics; VGSF (Vienna Graduate School of Finance)

Klaus Ritzberger

Institute for Advanced Studies (IHS)

Date Written: October 31, 2014

Abstract

Accurate rating systems are of central importance for banks to price and manage their loan portfolios. A bank’s choice to invest in a more accurate rating technology is based on a trade-off: the better rating system usually comes at higher cost, but endows the bank with a competitive advantage, which includes potentially better access to funds. This paper models the rating technology choice of a bank as a two-stage game in an oligopolistic banking sector. In the first stage banks choose between two alternative rating technologies that provide estimates about a borrower’s default probability with varying precision. In the second stage banks set their loan prices based on estimated default probabilities in an imperfectly competitive loan market. While rating technology investment is lumpy and characterized by fixed costs, loan prices vary continuously with their markup over the risk-free rate of interest. The interaction of loan pricing and rating technology investment gives rise to the following predictions: equilibrium adoption of the new rating technology need not increase individual banks’ profits; identical banks in a symmetric banking sector might adopt the more accurate rating technologies sequentially rather than simultaneously; and increased competition in the banking sector slows investment in the new rating technology.

Keywords: loan pricing, rating systems, loan portfolios

Suggested Citation

De Silva, Hannelore and Dockner, Engelbert J. and Jankowitsch, Rainer and Pichler, Stefan and Ritzberger, Klaus, Choice of Rating Technology and Loan Pricing in Imperfect Credit Markets (October 31, 2014). Journal of Risk, Vol. 17, No. 1, 2014, Available at SSRN: https://ssrn.com/abstract=2791413

Hannelore De Silva (Contact Author)

Vienna University of Economics and Business ( email )

Welthandelsplatz 1
Vienna, Wien 1020
Austria

Engelbert J. Dockner

WU Vienna University of Economics and Business (deceased)

Heiligenstaedter Strasse 46-48
Vienna, 1190
Austria
+431313366302 (Phone)
+43131336906302 (Fax)

HOME PAGE: http://www.wu.ac.at/finance/people/faculty/list/dockner

Rainer Jankowitsch

WU (Vienna University of Economics and Business) ( email )

Welthandelsplatz 1
Vienna, Vienna AT1020
Austria
+43 1 31 336 4340 (Phone)
+43 1 310 0580 (Fax)

Vienna Graduate School of Finance (VGSF) ( email )

Welthandelsplatz 1
Vienna, 1020
Austria

Stefan Pichler

WU - Vienna University of Economics and Business - Department of Finance, Accounting and Statistics ( email )

Heiligenstaedter Strasse 46-48
Wien 1190
Austria

VGSF (Vienna Graduate School of Finance) ( email )

Heiligenstaedter Strasse 46-48
Vienna, 1190
Austria

Klaus Ritzberger

Institute for Advanced Studies (IHS) ( email )

Josefstädter Straße 39
1080 Vienna
Austria
(+43-1) 599 91-153 (Phone)
(+43-1) 599 91-163 (Fax)

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