This study investigates whether banks and insurance corporations perform regulatory arbitrage by buying bonds with inflated credit ratings. We argue that flaws in minimum capital requirements incentivize risk-taking behavior by financial institutions, diminishing financial stability. We estimate the probability of a bond having an inflated credit rating using conditional credit default swap spread distributions. We merge this data 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. Consequently, the regulatory capital buffers of banks and insurance corporations are effectively reduced by respectively 13 and 28 percent.
Keywords: Inflated credit ratings, capital requirements, regulatory arbitrage, Basel III, Solvency II, portfolio choice, securities holdings statistics.
JEL codes: G11, G21, G22, G24, G28.
Working paper no. 673