The Basel Accord and The Value of Bank Differentiation

U. HEGE, E. Feess

Review of Finance

October 2012, vol. 16, n°4, pp.1043-1092

Departments: Finance

The authors investigate optimal capital requirements in a model in which banks decide on their investment in credit scoring systems. The main result is that regulators should encourage sophisticated banks to keep their asset portfolios safe, while assets with high systematic risk should be concentrated in smaller banks. The proposed regulatory differentiation follows the Basel Accord's distinction between internal ratings-based approach and standard approach. Sophisticated banks should increase their equity capital relative to other banks, leading to further size differentiation. The moral hazard problem of banks misrepresenting their loan portfolio risk is analyzed, with the result that it induces stricter capital requirements.