Internal Models, Make Believe Prices, and Bond Market Cornering
Harvard Business School Working Paper
66 Pages Posted: 10 Mar 2020 Last revised: 2 Jul 2020
Date Written: January 1, 2020
Exploiting position-level heterogeneity in regulatory incentives to misreport and novel data on regulators, we document that U.S. life insurers inflate the values of corporate bonds using internal models. We estimate an additional $9-$18 billion decline in regulatory capital during the 2008 crisis, i.e., a 30% greater decline than what was reported. Supervision helps dissuade misreporting, but only when close pricing benchmarks exist. Insurers, in response, strategically shift asset selection toward bonds where price verification is harder, and corner small bonds. Our findings have consequences for assessing the fragility of financial institutions and for understanding the price discovery of corporate bonds.
Keywords: Life Insurers, Capital Regulation, Internal Models, Corporate Bonds, Regulatory Supervision, Concentrated Ownership.
JEL Classification: G11, G12, G14, G22, G28, G32
Suggested Citation: Suggested Citation