Capital Regulation Induced Reaching for Systematic Yield: Financial Instability Through Fire Sales

54 Pages Posted: 24 Feb 2020 Last revised: 30 Nov 2023

See all articles by Martijn Adriaan Boermans

Martijn Adriaan Boermans

De Nederlandsche Bank

Bram van der Kroft

Massachusetts Institute of Technology (MIT)

Date Written: November 13, 2023

Abstract

Credit rating-based capital regulation induces financial institutions to take on additional systematic risk. In this paper, we uncover interconnected channels through which this systematic risk hoarding affects financial stability using a proprietary ECB bond holdings dataset. First, banks and insurance corporations effectively reduce their capital buffers by hoarding bonds with high systematic credit risk. Second, this hoarding increases the portfolio concentration of credit rating-constrained and unconstrained financial institutions. Third, in addition to the general tendency of regulated financial institutions to fire sale bonds after rating downgrades, we reveal even larger fire sales precisely when their regulatory advantages of reaching for systematic yield disappear. Using a shock in capital regulation, we establish this causal relationship between the severity of fire sales and the tendencies of regulatory-constrained financial institutions to seek bonds with high systematic credit risk. Such systematic risk hoarding reduces capital buffer by an additional 16% in economic downturns.

Keywords: Credit ratings, systematic risk, regulatory arbitrage, portfolio concentration, capital buffers

JEL Classification: G11, G21, G22, G24, G28

Suggested Citation

Boermans, Martijn Adriaan and van der Kroft, Bram, Capital Regulation Induced Reaching for Systematic Yield: Financial Instability Through Fire Sales (November 13, 2023). Journal of Banking and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3542264 or http://dx.doi.org/10.2139/ssrn.3542264

Martijn Adriaan Boermans (Contact Author)

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

Bram Van der Kroft

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

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