Capital Regulation Induced Reaching for Systematic Yield: Financial Instability Through Fire Sales

46 Pages Posted: 24 Feb 2020 Last revised: 21 Sep 2022

See all articles by Martijn Adriaan Boermans

Martijn Adriaan Boermans

De Nederlandsche Bank; Utrecht University - School of Economics

Bram van der Kroft

Maastricht University: Finance; Open University: Accounting and Finance

Date Written: September 20, 2022

Abstract

We investigate whether the omission of systematic risk in rating-based capital regulation induces strategic bond portfolio allocations that decrease financial stability. Capital regulation does not constrain systematic risk-taking by using credit ratings. We show that this incentivizes banks and insurance corporations to hoard bonds with excessive systematic risk using a confidential bond-level holdings dataset of the ECB. Our findings highlight three interconnected channels through which this systematic risk-taking reduces financial stability by increasing the likelihood and severity of fire sales. Specifically, we show that it effectively reduces required capital buffers, increases portfolio concentration among regulated financial institutions, and heightens the vulnerability to more frequent rating downgrades in the portfolios of regulated investors. We estimate that banks and insurance corporations will lose more than 15\% of their capital buffers during economic downturns solely due to their systematic risk hoarding. Therefore, omitting systematic risk in capital regulation increases the fragility of the financial sector.

Keywords: Credit ratings, systematic risk, regulatory arbitrage, portfolio concentration, capital buffers

JEL Classification: G11, G21, G22, G24, G28

Suggested Citation

Boermans, Martijn Adriaan and van der Kroft, Bram, Capital Regulation Induced Reaching for Systematic Yield: Financial Instability Through Fire Sales (September 20, 2022). De Nederlandsche Bank Working Paper No. 673, Available at SSRN: https://ssrn.com/abstract=3542264 or http://dx.doi.org/10.2139/ssrn.3542264

Martijn Adriaan Boermans (Contact Author)

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

Utrecht University - School of Economics ( email )

Kriekenpitplein 21-22
Adam Smith Building
Utrecht, +31 30 253 7373 3584 EC
Netherlands

HOME PAGE: http://www.uu.nl/leg/staff/MABoermans/0

Bram Van der Kroft

Maastricht University: Finance ( email )

Tongersestraat 53
Maastricht, Limburg 6211LM
Netherlands
0614812713 (Phone)

HOME PAGE: http://https://www.maastrichtuniversity.nl/about-um/faculties/school-business-and-economics

Open University: Accounting and Finance ( email )

Valkenburgerweg 177
Heerlen, 6419 AT
Netherlands
0614812713 (Phone)

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