Sophistication in risk management and banking stability. The short term

We explore the impact of sophistication in risk management as required by Basel II on banking stability and market conditions. We compare a competitive banking system in which only average ratings are available with a competitive system in which banks are able to assess the default risk of individual firms. We show that sophistication in banking decreases default probabilities for individual firms and lowers deposit and loan-interest rates. Sophistication decreases the default probability for banks and thus increases banking stability, provided that initial equity is not too low. Otherwise banking stability declines.