Ratings-Based Regulation and Systematic Risk Incentives. (16th August 2018)

• Record Type: Journal Article
• Authors: Iannotta, Giuliano; Pennacchi, George; Santos, João A C
• Is Part Of: Review of financial studies. Volume 32:Number 4(2019)
• Page Start: 1374
• Page End: 1415
• Publication Date: 2018-08-16
• Subjects: Finance -- United States -- Periodicals; Finance -- Periodicals; 332
• DOI: 10.1093/rfs/hhy091
• Languages: English
• ISSNs: 0893-9454

Abstract

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.