Survey_FH_2004

Abstract

We consider the simplest possible model for our purposes, an economy with two banks and two types of projects. Safe projects feature a higher expected return and lower risk than risky projects. Initially, neither banks nor rating agencies or the regulator can discriminate between safe and risky projects. One of the banks, however, has the option to invest in an improvement of its credit scoring system and will then be able to screen between safe and risky projects. With this investment, the bank qualifies to use the IRB approach. Our model consists of two banks, Bank A and Bank B. Initially, both banks have rating systems of low quality. However, Bank A can invest C ? 0 into improving its rating system. If C is invested, Bank A acquires an internal rating system (IRS) that is sufficient to qualify for the use of internal ratings (IRB) under the Basel II Accord.3 If Bank A invests C, it has the option to submit its IRS to the regulator, who can verify the quality of the IRS and will grant approval to Bank A to operate as an IRB-bank. Note that, for simplicity, only Bank A has an option to invest and to become an IRB-bank. The investment in an IRS is really a technical decision to upgrade the bank’s information system, and the bank could undertake this investment independently of the regulatory environment. to invest in an IRS, at a cost of C, without requesting to be regulated as an IRB-bank. A bank (Bank A or Bank B) that uses the standard approach is called a SA-bank.