One major lesson from the 2008-09 financial crisis that subsequently shaped in part the regulatory framework that emerged in the last decade was that downgrades of securities occurring in an interconnected financial system create a need for capital relief for regulated entities. This happens because banks’ and insurers’ capital requirements are based on credit ratings. The question is what kind of short-term and long-term incentives arise from such relief programs. In “Rethinking the Use of Credit Ratings in Capital Regulations: Evidence From the Insurance Industry,” Kathleen Weiss Hanley and Stanislava Nikolova examine a change in how insurance regulators assess capital adequacy for certain mortgage-backed securities (RMBS and CMBS) in the wake of the 2008-09 financial crisis. They find that the new regulations result in $17.6 billion of required and statutory capital savings. Insurers change their investment behavior as a result of the relief, perhaps an unintended consequence of the new capital regulations. First, sales of distressed RMBS/CMBS and gains trading in corporate bonds are less likely, and insurers with larger regulatory capital savings are less likely to engage in these asset-sale practices. Second, insurers are also less likely to raise external capital. Third, the average rating of insurers’ secondary market RMBS/CMBS purchases worsens and the proportion of low-rated RMBS/CMBS purchased increases. Even more interesting is the finding that insurers whose portfolio fared worse during the financial crisis were more likely to purchase low-rated assets. Overall, these findings point toward some very important consequences of the regulatory reform: there were short-term benefits, but it may have incentivized risk taking and left some insurers excessively exposed to market risk.
Spotlight by Andrew Ellul
Photos courtesy of Kathleen Weiss Hanley & Stanislava Nikolova