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
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: Suggested Citation