Inflated credit ratings, regulatory arbitrage and capital requirements: do investors strategically allocate bond portfolios?

Martijn Adriaan Boermans, Bram van der Kroft

Research output: Working paperProfessional

Abstract

This study investigates whether banks and insurance corporations perform regulatory arbitrage by buying bonds with inflated credit ratings. We argue that flaws in minimum capital requirements incentivize risk-taking behavior by financial institutions, diminishing financial stability. We estimate the probability of a bond having an inflated credit rating using conditional credit default swap spread distributions. We merge this data 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. Consequently, the regulatory capital buffers of banks and insurance corporations are effectively reduced by respectively 13 and 28 percent.
Original languageEnglish
PublisherSocial Science Research Network (SSRN)
Publication statusPublished - 13 Feb 2020

Publication series

SeriesDe Nederlandsche Bank Working Papers
Number673
Volume2020

JEL classifications

  • g11 - "Portfolio Choice; Investment Decisions"
  • g21 - "Banks; Depository Institutions; Micro Finance Institutions; Mortgages"
  • g22 - "Insurance; Insurance Companies"
  • g24 - "Investment Banking; Venture Capital; Brokerage; Ratings and Ratings Agencies"
  • g28 - Financial Institutions and Services: Government Policy and Regulation

Keywords

  • Inflated credit ratings
  • capital requirements
  • regulatory arbitrage
  • Basel III
  • Solvency II
  • portfolio choice
  • securities holdings statistics

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