Credit ratings, regulatory arbitrage and systemic risk

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.