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

Abstract

Using a comprehensive bond-level holdings dataset of the ECB, we investigate whether the omission of systematic risk in rating-based capital regulation induces financial instability through fire-sales. Capital regulation incentivizes banks and insurance corporations to hoard bonds with excessive systematic risk. We show that reaching for systematic yield increases the likelihood and severity of fire sales by exploiting a quasi-experimental regulatory shock and unique variation in capital requirements across rating downgrades. We estimate capital buffer reductions of more than 15% for banks and insurance corporations during economic downturns solely due to systematic risk hoarding.

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

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