The Systemic Risk Implications of Using Credit Ratings Versus Quantitative Measures to Limit Bond Portfolio Risk

Journal of Financial Services Research (2019)

37 Pages Posted: 20 May 2019 Last revised: 22 Jun 2019

Date Written: May 6, 2019

Abstract

Despite intense criticism, agency credit ratings are still widely used in regulation and risk management. One possible alternative is to replace them with quantitative default risk measures. For US data, I find that systemically relevant losses from corporate defaults are mostly smaller if risk-taking in portfolios is limited with the help of default probability estimates from the Credit Research Initiative rather than through Moody’s ratings. The results continue to hold when investors follow a regulatory arbitrage strategy that tilts portfolios toward issuers with high systematic risk. I further show that combining information from both measures can lead to a systemic risk profile that is more favorable than can be achieved by using only one.

Keywords: ratings, structural models of default risk, systemic risk, portfolio risk

JEL Classification: G11, G24, G28

Suggested Citation

Löffler, Gunter, The Systemic Risk Implications of Using Credit Ratings Versus Quantitative Measures to Limit Bond Portfolio Risk (May 6, 2019). Journal of Financial Services Research (2019), Available at SSRN: https://ssrn.com/abstract=3363509 or http://dx.doi.org/10.2139/ssrn.3363509

Gunter Löffler (Contact Author)

Ulm University ( email )

Helmholzstrasse
Ulm, D-89081
Germany
+49 731 50 23598 (Phone)
+49 731 50 23950 (Fax)

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