The Removal of Credit Ratings from Capital Regulation: Implications for Systemic Risk
Kathleen Weiss Hanley
University of Maryland
University of Nebraska - Lincoln
February 7, 2014
We examine whether removing references to credit ratings from capital regulations of financial firms, as mandated by the Dodd-Frank Act, affects the transmission of systemic risk through the asset liquidation channel. We analyze the insurance regulators initiative to replace credit ratings in the determination of capital requirements and accounting treatment for RMBS and CMBS with a new methodology that considers an asset’s expected loss relative to its current value on an individual insurer’s books. In the wake of significant downgrades in these securities, this regulatory change reduced the need for insurance companies to repair regulatory capital. We find that insurers with more capital saved are less likely to sell distressed mortgage-backed securities, gains trade corporate bonds, raise external capital and cut dividends. However, reduced reliance on credit ratings also increases their purchases of low-rated securities. By decreasing insurers’ need to sell, the new regime may alleviate price pressure and limit systemic risk transmission, but potentially at the expense of greater risk taking than may be advisable from a prudential regulatory perspective.
Number of Pages in PDF File: 50
Keywords: Credit Ratings, Systemic Risk, Capital Regulation, Dodd-Frank Act, Insurance Industry, RMBS, CMBS, Corporate Bonds, FSOC
JEL Classification: G22, G28, G31working papers series
Date posted: November 20, 2013 ; Last revised: February 8, 2014
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