Risk Management Sophistication and Bank Profitability

This work investigates the latest developments in commercial banking with regard to the measurement and management of risk and analyzes their effect on mid-market financial institutions. We look at how the implementation of advanced rating techniques influences the competitive position of market participants depending on their portfolio structure and competitive environment. To simulate rating sophistication we assume that in the process of credit assessment banks observe noisy signals about the creditworthiness of credit applicants. In the case of a competitive market then banks offer differing interest rates based on their loss estimates, whereas the customer chooses the credit with the lowest price. A simulation procedure is used in order to quantify the resulting profitability effects. The analysis reveals profitability differentials depending on the rating accuracy in different sections of the portfolio, the structure of the rating scale, and the specific competitive environment.