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

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.