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Ratings-Based Regulation and Systematic Risk Incentives

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  • Giuliano Iannotta
  • George Pennacchi
  • João A C Santos

Abstract

Our model shows that when regulation is based on credit ratings, banks with low charter value maximize shareholder value by minimizing capital and selecting identically rated loans and bonds with the highest systematic risk. This regulatory arbitrage is possible if the credit spreads on same-rated loans and bonds are greater when their systematic risk (debt beta) is higher. We empirically confirm this relationship between credit spreads, ratings, and debt betas. We also show that banks with lower capital select syndicated loans with higher debt betas and credit spreads. Banks with lower charter value choose overall assets with higher systematic risk.Received July 27, 2016; editorial decision May 29, 2018 by Editor Itay Goldstein.

Suggested Citation

  • Giuliano Iannotta & George Pennacchi & João A C Santos, 2019. "Ratings-Based Regulation and Systematic Risk Incentives," Review of Financial Studies, Society for Financial Studies, vol. 32(4), pages 1374-1415.
  • Handle: RePEc:oup:rfinst:v:32:y:2019:i:4:p:1374-1415.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhy091
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    Cited by:

    1. Dr. Kyriazopoulos Georgios & Thanou Efthymia, 2020. "Mergers and Acquisitions and how they affect the Labor productivity. Evidence from the Greek Banking system," Journal of Applied Finance & Banking, SCIENPRESS Ltd, vol. 10(2), pages 1-3.
    2. Ambrocio, Gene & Hasan, Iftekhar & Jokivuolle, Esa & Ristolainen, Kim, 2020. "Are bank capital requirements optimally set? Evidence from researchers’ views," Journal of Financial Stability, Elsevier, vol. 50(C).
    3. Abu Amin & Blake Bowler & Mostafa Monzur Hasan & Gerald L. Lobo & Jiri Tresl, 2020. "Firm Life Cycle and Cost of Debt," CERGE-EI Working Papers wp665, The Center for Economic Research and Graduate Education - Economics Institute, Prague.

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