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

See all articles by Ishita Sen

Ishita Sen

Harvard University - Harvard Business School

Varun Sharma

London Business School

Date Written: January 1, 2020

Abstract

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

Sen, Ishita and Sharma, Varun, Internal Models, Make Believe Prices, and Bond Market Cornering (January 1, 2020). Harvard Business School Working Paper, Available at SSRN: https://ssrn.com/abstract=3534313 or http://dx.doi.org/10.2139/ssrn.3534313

Ishita Sen (Contact Author)

Harvard University - Harvard Business School ( email )

Soldiers Field
Baker Library
Boston, MA 02163
United States

Varun Sharma

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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