The Basel II Accord: Internal Ratings and Bank Differentiation

Abstract

We investigate optimal capital requirements in a model in which banks decide on their investment in credit scoring systems. Our 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 and standard approach. Sophisticated banks should increase their equity capital relative to other banks, leading to further size differentiation. We analyze the moral hazard problem of banks misrepresenting their loan portfolio risk, and find that it induces stricter capital requirements.