Sophistication in Risk Management, Bank Equity, and Stability

We investigate the question of whether sophistication in risk management fosters banking stability. We compare a simple banking system which uses an average rating 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 with 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 may be lower. As an economy with a sophisticated banking system invests its funds more efficiently, there is a trade-off between efficiency and stability of a banking system.