Bank Regulation, Credit Ratings, and Systematic Risk

Abstract

A model is presented that shows when (Basel Accord) capital standards and (FDIC) insurance premiums primarily reflect a bank’s physical expected default losses, a bank can increase its shareholder value by making loans and investing in bonds that have relatively high systematic risk. Such an incentive occurs because, holding expected default losses constant, credit spreads are higher for systematically risky debt as they reflect risk-neutral, rather than physical, expected default losses. If credit ratings are based on physical expected default losses, then credit rating-based regulation, such as the Basel “Standardized Approach,” will subsidize banks’ systematically risky investments.Using an international sample of almost 4,000 bonds, we test whether credit rating based- regulation can create the bank moral hazard predicted by our model. First, we estimate each bond issuer’s debt beta, a measure of the debt’s systematic risk, and find that it positively affects the bond’s credit spread, even after controlling for the bond’s credit rating. In contrast, the idiosyncratic risk of the issuer’s debt has no impact on its bond’s credit spread after accounting for the bond’s credit rating. Second, credit ratings only partially reflect systematic risk. If a bank chooses bonds within a given credit rating that have above median credit spreads, the systematic risk of its investments rises by an economically significant amount. Third, while Moody’s and S&P do not differ significantly in their assessments of systematic risk, the likelihood of a split rating (disagreement between raters over the same issue) decreases with the issuer’s beta.