Credit ratings, regulatory arbitrage and systemic risk

41 Pages Posted: 24 Feb 2020 Last revised: 30 Jun 2021

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: July 24, 2020

Abstract

This study investigates how credit rating based capital regulation instigates systemic risk. To safeguard the financial system European banks and insurance corporations face stringent capital requirements based on credit ratings to prevent excessive risk taking. Building on prior literature, we estimate the extent to which credit ratings accurately reflect credit risk. We use a confidential granular dataset with bond-level portfolio holdings from 2013Q4 to 2019Q4. First, we find that credit rating based capital regulation incentivizes banks and insurance corporations to hold more bonds with inflated credit ratings, while this effect is absent for investors who do not face capital requirements based on credit ratings. Second, banks and insurance corporations are especially inclined to hoard bonds with inflated credit ratings that carry substantial systematic risk. Third, bonds with inflated credit ratings instigate larger fire-sales after credit rating downgrades which affect required regulatory capital. Finally, the least capitalized banks and insurance corporations are most inclined to effectively reduce their required regulatory capital by holding bonds with inflated credit ratings. Consequently, our findings suggest that credit rating based capital regulation amplifies unanticipated systemic risk and financial fragility through hoarding bonds with inflated credit ratings.

Keywords: Credit rating based capital regulation, “through the cycle”, fire-sales, 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 systemic risk (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: 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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