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Capital regulation induced reaching for systematic yield: Financial instability through fire sales

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  • Martijn Boermans
  • Bram van der Kroft

Abstract

We investigate whether the omission of systematic risk in rating-based capital regulation induces strategic bond portfolio allocations that decrease financial stability. Capital regulation does not constrain systematic risk-taking by using credit ratings. We verify that this incentivizes banks and insurance corporations to hoard bonds with excessive systematic risk using a confidential bond-level holdings dataset of the ECB. Our findings highlight three interconnected channels through which this systematic risk-taking reduces financial stability by increasing the likelihood and severity of fire sales. Therefore, omitting systematic risk in capital regulation increases the fragility of the financial sector, especially in economic downturns.

Suggested Citation

  • Martijn Boermans & Bram van der Kroft, 2020. "Capital regulation induced reaching for systematic yield: Financial instability through fire sales," Working Papers 673, DNB.
  • Handle: RePEc:dnb:dnbwpp:673
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    Cited by:

    1. Martijn Boermans, 2022. "A literature review of securities holdings statistics research and a practitioner’s guide," Working Papers 757, DNB.

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    More about this item

    Keywords

    Credit ratings; systematic risk; regulatory arbitrage; portfolio concentration; capital buffers;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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