Friday, November 22, 2013
Kathleen Weiss Hanley and Stanislava Nikolova have posted The Removal of Credit Ratings from Capital Regulation: Implications for Systemic Risk on SSRN with the following abstract:
We examine whether the removal of references to credit ratings affects one channel for the transmission of systemic risk identified by the Financial Stability Oversight Council: asset liquidation. In 2009 and 2010 insurance regulators replaced credit ratings with model-generated valuations for determining required capital and accounting treatment of residential and commercial mortgage-backed securities. We document that this regulatory change results in significant capital savings though much of the savings are accompanied by large write-downs. We find that insurers who save more capital under the new regime are less likely to sell distressed RMBS and CMBS, and also less likely to gains trade corporate bonds. We also show that the regulatory change reduces the need for insurers to raise additional capital through equity issuance. Finally, valuation-based capital regulations, in contrast to credit-rating-based ones, allow insurance companies to purchase assets below investment grade and retain an investment grade equivalent capital treatment. This creates the potential for yield chasing and may shift insurance companies’ portfolios toward greater risk-taking than may be advisable from a regulatory perspective.