White Papers for Basel II Capital Accord (Basel II)

The Basel II Accord Internal Ratings and Bank Differentiation

Center for Financial Studies

The Basel Committee plans to differentiate risk-adjusted capital requirements between banks
regulated under the internal ratings based (IRB) approach and banks under the standard
approach. We investigate the consequences for the lending capacity and the failure risk of
banks in a model with endogenous interest rates. The optimal regulatory response depends on
the banks’ inclination to increase their portfolio risk. If IRB-banks are well-capitalized or gain
little from taking risks, then they will increase their market share and hold safe portfolios. As
risk-taking incentives become more important, the optimal portfolio size of banks adopting
intern rating systems will be increasingly constrained, and ultimately they may lose market
share relative to banks using the standard approach. The regulator has only limited options to
avoid the excessive adoption of internal rating systems.

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