Rethinking the Use of Credit Ratings in Capital Regulation

53 Pages Posted: 20 Nov 2013 Last revised: 25 Dec 2015

Kathleen Weiss Hanley

Lehigh University - College of Business & Economics

Stanislava Nikolova

University of Nebraska - Lincoln

Date Written: December 23, 2015

Abstract

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.

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

Suggested Citation

Hanley , Kathleen Weiss and Nikolova, Stanislava, Rethinking the Use of Credit Ratings in Capital Regulation (December 23, 2015). Available at SSRN: https://ssrn.com/abstract=2357145 or http://dx.doi.org/10.2139/ssrn.2357145

Kathleen Weiss Hanley (Contact Author)

Lehigh University - College of Business & Economics ( email )

Bethlehem, PA 18015
United States

Stanislava Nikolova

University of Nebraska - Lincoln ( email )

Lincoln, NE 68588-0490
United States
402-472-6049 (Phone)

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