Capital Regulation Induced Reaching for Systematic Yield: Financial Instability Through Fire Sales
46 Pages Posted: 24 Feb 2020 Last revised: 21 Sep 2022
Date Written: September 20, 2022
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
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