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

Martijn A. Boermans, Bram van der Kroft

Research output: Working paperAcademic

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.
Original languageEnglish
Place of PublicationAmsterdam
PublisherDe Nederlandsche Bank
Number of pages45
DOIs
Publication statusPublished - 24 Feb 2020

Publication series

SeriesDNB Working Papers
Number673

Keywords

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

Fingerprint Dive into the research topics of 'Credit Ratings, Regulatory Arbitrage and Capital Requirements: Do Investors Strategically Allocate Bond Portfolios?'. Together they form a unique fingerprint.

Cite this