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We study the economic forces that drive innovation in credit-risk assessment and the role of regulators in fostering technological progress. Recent regulatory proposals base capital-adequacy standards on banks' own internal systems and call for regulators to establish a set of best practices for the industry. We find that the dissemination of innovations mandated by this approach generates a tension between lowering aggregate banking-system risk ex post and providing banks with incentives to innovate ex ante. Moreover, this tension arises purely from regulatory concern for bank safety and not from any interest in promoting competition. We show that achieving the optimal level of innovation requires that regulators restrict the diffusion of technology. If regulators are unable to commit to specific dissemination policies, it may be beneficial to let banks assert intellectual property rights through, for instance, the patenting of their innovations.

Loan-Portfolio Quality and the Diffusion of Technological Innovation