Credit Ratings, Regulatory Arbitrage and Capital Requirements: Do Investors Strategically Allocate Bond Portfolios?

45 Pages Posted: 24 Feb 2020 Last revised: 27 Jul 2020

See all articles by Martijn Adriaan Boermans

Martijn Adriaan Boermans

De Nederlandsche Bank; Utrecht University - School of Economics

Bram van der Kroft

Maastricht University: School of Business and Economics; Open University: Accounting and Finance

Date Written: July 24, 2020

Abstract

This study investigates whether banks and insurance corporations perform regulatory arbitrage by buying bonds with inflated credit ratings. We argue that credit rating based capital requirements incentivize banks and insurance corporations to hold more bonds with inflated credit ratings. We estimate the probability of a bond having an inflated credit rating using conditional credit default swap spread distributions and merge this with a unique bond-level portfolio holdings dataset. The results show that banks and insurance corporations invest more in bonds with inflated credit ratings, while this effect is absent for investors who do not face capital requirements based on credit ratings. Predominantly, banks and insurance corporations hoard systemic risk not penalized in capital regulation, as they are especially inclined to hold bonds with inflated credit ratings that carry substantial systemic risk. Consequently, the required capital buffers of banks and insurance corporations are effectively reduced by respectively 9 and 20 percent.

Keywords: Inflated credit ratings, capital requirements, regulatory arbitrage, systemic risk, portfolio choice, securities holdings statistics.

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

Suggested Citation

Boermans, Martijn Adriaan and van der Kroft, Bram, Credit Ratings, Regulatory Arbitrage and Capital Requirements: Do Investors Strategically Allocate Bond Portfolios? (July 24, 2020). 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: School of Business and Economics ( 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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