Adverse Impacts of Regulatory Reforms and Policy Remedies: Theory and Evidence

Abstract

We develop a portfolio-choice model to investigate how regulatory reforms influence the risk-taking behavior of financial institutions with different capital adequacy levels. The model predicts that either all firms reduce their risk-taking, or there exists a capital-adequacy threshold below which risk-taking increases as regulation becomes more stringent. The Chinese insurance solvency regulatory reform provides a unique natural experiment to test our theory. In 2015, each insurer reported two solvency ratios under the original and the new regulatory systems. The difference between them produces an exogenous and insurer-specific measure of the regulatory pressure shock. Consistent with our theoretical predictions, we find that increasing regulatory pressure induces greater risk-taking for less capital-adequate insurers, of which the regulator should want to reduce risk-taking mostly. We show that increasing the penalties of insolvency, increasing the risk sensitivity of capital requirements, and reinforcing the qualitative risk assessment are effective policy remedies for this backfiring problem.

Keywords: Risk-Taking; Capital Requirements; Solvency Regulation; Portfolio Choice; Insurance

JEL Classification: G22, G28, L51