Marginal Cost of Risk-Based Capital and Risk-Taking
2019 · Published in Journal of Banking & Finance 103: 130–145 · DOI 10.1016/j.jbankfin.2019.03.011
PDF of Marginal Cost of Risk-Based Capital and Risk-Taking
In one sentence
A diversification feature of risk-based capital rules leads insurers with lower marginal capital costs to buy riskier bonds.
Summary
The paper shows that a built-in diversification benefit in the risk-based capital (RBC) system, which comes from how risk categories are aggregated, creates moral hazard for insurers. Insurers facing lower marginal RBC costs on fixed-income investments buy riskier fixed-income securities, even when the lower cost results from higher risk in other categories, an unintended consequence of the RBC square-root rule. Using Hurricanes Katrina and Sandy as shocks to RBC costs, insurers that suffered more took more fixed-income risk and saw their overall risk rise. Insurers with high RBC costs also sold similar risky bonds during the financial crisis, a possible source of systemic risk.
Abstract as published
We explore the impact of capital adequacy requirements on financial institutions’ risk-taking behavior from a novel perspective. Specifically, we show that an important feature of the risk-based capital (RBC) system—a built-in diversification benefit in aggregating risk categories—induces moral hazard. We find that insurers that face lower marginal RBC costs of fixed-income (FI) investment tend to purchase riskier FI securities. This relationship holds even when lower marginal RBC costs result from increased risk in other risk categories, which is an unintended consequence of the RBC's square root rule. Using Hurricanes Katrina and Sandy as exogenous shocks to the RBC cost, we find that insurers that suffered more in the two disasters undertook more risk in their FI investments and witnessed an increase in their overall risk. We further show that insurers with a high RBC cost sell similar risky bonds during the financial crisis, presenting a source of systemic risk. These results provide an important regulatory implication for minimum capital calculation in capital regulation regimes.
Citation
Tao Chen, Jing Rong Goh, Shinichi Kamiya, Pingyi Lou (2019). Marginal cost of risk-based capital and risk-taking. Journal of Banking & Finance, 103, 130–145. https://doi.org/10.1016/j.jbankfin.2019.03.011
BibTeX
@article{chen2019marginal,
title = {{Marginal cost of risk-based capital and risk-taking}},
author = {Tao Chen and Jing Rong Goh and Shinichi Kamiya and Pingyi Lou},
journal = {Journal of Banking \& Finance},
year = {2019},
volume = {103},
pages = {130--145},
doi = {10.1016/j.jbankfin.2019.03.011}
}