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Marginal cost of risk-based capital and risk-taking

Author

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  • Chen, Tao
  • Goh, Jing Rong
  • Kamiya, Shinichi
  • Lou, Pingyi

Abstract

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.

Suggested Citation

  • Chen, Tao & Goh, Jing Rong & Kamiya, Shinichi & Lou, Pingyi, 2019. "Marginal cost of risk-based capital and risk-taking," Journal of Banking & Finance, Elsevier, vol. 103(C), pages 130-145.
    • Handle: RePEc:eee:jbfina:v:103:y:2019:i:c:p:130-145
    DOI: 10.1016/j.jbankfin.2019.03.011
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    Citations

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    Cited by:

    1. Paulusch, Joachim & Schlütter, Sebastian, 2022. "Sensitivity-implied tail-correlation matrices," Journal of Banking & Finance, Elsevier, vol. 134(C).
    2. Cheng, Maoyong & Qu, Yang, 2020. "Does bank FinTech reduce credit risk? Evidence from China," Pacific-Basin Finance Journal, Elsevier, vol. 63(C).
    3. Paulusch, Joachim & Schlütter, Sebastian, 2021. "Sensitivity-implied tail-correlation matrices," ICIR Working Paper Series 33/19, Goethe University Frankfurt, International Center for Insurance Regulation (ICIR), revised 2021.
    4. Aigner, Philipp, 2023. "Identifying scenarios for the own risk and solvency assessment of insurance companies," ICIR Working Paper Series 48/23, Goethe University Frankfurt, International Center for Insurance Regulation (ICIR).

    More about this item

    Keywords

    Risk-based capital; Risk taking; Capital regulation; Insurance companies;
    All these keywords.

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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