Ratings-based regulation and systematic risk incentives

Funding agency and sponsor: CAREFIN, University of Tennessee, University of Virginia and Institut Européen d'Administration des Affaires. Funding text: An earlier version of this paper was titled “Bank regulation, credit ratings, and systematic risk.” Valuable comments were provided by the Editor Itay Goldstein, three anonymous referees, Tobias Berg, Thomas Cooley, Timotej Homar, Christine Parlour, Andrea Resti, Francesco Saita, Andrea Sironi, René Stulz, and Andrew Winton; participants of the 2011 International Risk Management Conference, the 2011 Bank of Finland Future of Risk Management Conference, the 2012 Financial Risks International Forum, the 2012 Red Rock Conference, the 2012 FDIC Bank Research Conference, the 2012 Banque centrale du Luxembourg Conference, the 2013 Financial Intermediation Research Society Meetings, the 2013 Banco de Portugal Financial Intermediation Conference, and the 2014 Wharton Liquidity and Financial Crises Conference; and seminar participants at Copenhagen Business School, the Federal Reserve Banks of Cleveland and San Francisco, the Federal Reserve Board, HEC Paris, Imperial College, Indiana University, INSEAD, the Korea Deposit Insurance Corporation, Universitá Bocconi, Universitat Pompeu Fabra, the University of Tennessee, the University of Virginia, and Warwick Business School. We are very grateful to CAREFIN for providing financial assistance. The views stated herein are those of the authors and are not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve SystemOur model shows that when regulation is based on credit ratings, banks with low charter value maximize shareholder value by minimizing capital and selecting identically rated loans and bonds with the highest systematic risk. This regulatory arbitrage is possible if the credit spreads on same-rated loans and bonds are greater when their systematic risk (debt beta) is higher. We empirically confirm this relationship between credit spreads, ratings, and debt betas. We also show that banks with lower capital select syndicated loans with higher debt betas and credit spreads. Banks with lower charter value choose overall assets with higher systematic risk.authorsversionpublishe

Three Essays on Relationships among Financial Institutions

dissertation investigates relationships among financial institutions. I examine relationships from three different perspectives: relationships among affiliated banks and life insurers, correlated trading among life insurers, and relationships between insurers and bond dealers in the over-the-counter markets. The primary purpose of my research is to examine the benefits and drawbacks of relationships among financial institutions. The main findings are as follows. First, life insurers with bank affiliates had higher growth rates relative to other life insurers during the 2008 financial crisis. However, these Bank-Life Financial Holding Companies performed worse than Non-Bank-Life Financial Holding Companies during the same period. It indicates that the cross-selling effect is not large enough to increase firm’s performance. Second, U.S. life insurers’ investment decisions in corporate bonds are correlated across companies. However, the evidence in this dissertation is mixed as to whether insurers’ investment behavior has the potential to disrupt financial markets. Little evidence shows that this herding pushes prices away from fundamental values. Third, we find that there is variation in the impact of trading relationships on execution costs. The variation is related to the variation in a customer’s market power in the dealer relationship. In addition, the outsourcing of investment services to an affiliate of a dealer help customers with the weak market power to decrease bond execution costs. These findings of three essays add to the financial institution and relationship literature