Rethinking the Use of Credit Ratings in Capital Regulation
Kathleen Weiss Hanley
Lehigh University - College of Business & Economics
University of Nebraska - Lincoln
December 23, 2015
We analyze an initiative by insurance regulators to rethink the use of credit ratings in assessing capital adequacy. The new regulations replace ratings with potentially more precise third-party estimates of expected credit losses and take into consideration an insurer's current exposure to such losses when determining the appropriate capital charge. This change alleviates the need for insurers to rebalance their portfolios or raise equity to repair regulatory capital. After the change, insurers are less likely to sell distressed MBS, gains trade corporate bonds, or raise external financing. However, the new regime allows insurers to purchase more low-rated MBS at significant capital savings. Our analysis highlights some of the tradeoffs financial agencies should consider when implementing the Dodd-Frank mandate to remove credit ratings in financial regulations.
Number of Pages in PDF File: 53
Keywords: Credit Ratings, Systemic Risk, Capital Regulation, Dodd-Frank Act, Insurance Industry, RMBS, CMBS, Corporate Bonds, FSOC
JEL Classification: G11, G12, G14, G18, G22, G28, G31
Date posted: November 20, 2013 ; Last revised: December 25, 2015
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