Portfolio decisions, financial regulation, and financial intermediation
One of the key objectives of financial regulation is to govern the stability of the financial system. This objective is achieved primarily through regulatory-capital requirements. Capital requirements ensure that a larger fraction of losses induced by risky investments is borne by equity holders of financial firms rather than debt holders, or, ultimately, the taxpayers.
This project identifies the role of capital regulation of institutional investors for long-term asset allocation. Our study exploits a recent regulatory reform affecting U.S. insurers that significantly reduced capital requirements for certain mortgage-backed securities (MBS) in the aftermath of the recent financial crisis. These types of “toxic” securities were primarily responsible for causing the crisis in the first place. Paradoxically, this regulatory reform increased the ability of insurance companies to hold on to these types of risky assets, and even allowed U.S. insurers to increase the proportion of these assets in their investment portfolios.
The scale of this reform is so significant that it has the potential not only to explain dramatic shifts in insurance companies’ investment behavior in the aftermath of the financial crisis, but also to affect the market prices of these risky securities. Ultimately, the reform should distort issuance and real investment in the overall economy while increasing the vulnerability of insurers to shocks in the housing market.
Final report
This project aimed to understand the role of capital regulation of institutional investors for asset allocation. Our study exploits a recent regulatory reform affecting U.S. insurers that significantly reduced capital requirements for certain mortgage-backed securities (MBS) in the aftermath of the Great Financial Crisis. These types of “toxic” securities were primarily responsible for causing the crisis in the first place.
Paradoxically, we show that the reform eliminates capital buffers against unexpected losses associated with portfolio holdings of MBS, but not for other fixed-income assets. By 2010, aggregate capital relief relative to the previous regime amounted to over $18bn, with large life insurers being the primary beneficiaries both in absolute and relative terms. Since other fixed-income assets (corporate bonds, municipal bonds, asset-backed securities other than MBS, agency debt, etc.) were not affected by the reform, we are able to separate the impact of reduced capital requirements on insurance companies' portfolios from overall time trends in their risk appetite. After the reform, we document that U.S. insurance companies are much more likely to retain downgraded (and riskier) MBS compared to other downgraded assets, such as corporate bonds. This pattern is more pronounced for financially constrained insurers who have a higher incentive to gamble for resurrection.
Figure 1 presents suggestive evidence for our main results. In the 2005-2008 period, the high-yield share in the U.S. insurance industry's MBS portfolio increased from 2.6% to 22% in 2009 (see Panel A in Figure 1), largely driven by unprecedented downgrades of MBS held by insurance companies. By 2015 this share increases to 34%. In contrast, the high-yield share for non-MBS assets (see Panel B in Figure 1) remains remarkably stable at almost exactly 5% throughout the entire 2005-2015 period, including the Great Financial Crisis. The stability of the high-yield share outside MBS is maintained through selling of downgraded assets (consistent with Ellul et al. 2015) and new purchases of highly rated assets. As a result of these divergent trends, by 2015 40% of all high-yield assets in the overall fixed-income portfolio are MBS investments.
Figure 1. Ratings Distribution of MBS and Non-MBS holdings of the U.S. insurers.
For each year-end from 2005 to 2015, this graph plots the ratings distribution of MBS holdings (Panel A) and non-MBS holdings (Panel B) of all U.S. life and P&C insurers. The respective weights are computed using the book value of aggregate security holdings (BACV) obtained from NAIC Schedule D Part 1. The graph conditions on securities for which at least one rating is available. If multiple ratings are available for a given security, we create a comprehensive rating equal to the lowest rating (for two ratings) or the median (for three ratings).
Whether holding on to such risky legacy assets is desirable from a financial stability perspective depends on the trade-off between increased continued exposure to risks and the costs of selling such assets during the midst of a crisis (at fire-sale discounts). Interestingly, we show that the documented risk-taking behavior not only applies for legacy assets, but also newly issued MBS (for which the fire-sale discount motive is moot). As a result, our study suggests that this reform affects the financial stability of insurers going forward. Finally, our paper improves identification of the effects of capital requirements relative to existing studies. Exploiting discontinuities in the reform’s implementation, we can apply a regression discontinuity technique to identify the relevance of the capital requirements channel.
Future research on this reform may examine other outcomes, such as spill-over effects on prices and the real economy. In a world in which financial intermediaries, such as insurance companies, are marginal investors (see, e.g., He and Krishnamurthy (2013) or Koijen and Yogo, 2015) and the shadow cost of regulatory capital is positive, we should observe feedback effects of the regulatory regime on equilibrium prices. These equilibrium prices, in turn, should affect issuers' incentives to place securities in the primary market, and, ultimately have an impact on real investment in the economy. While this type of analysis is beyond the scope of this project, it would be interesting to analyze these important effects in future work.
The project results have been widely disseminated both internationally and in Sweden. For example, the paper has been presented at NYU Stern, the Stockholm School of Economics, UC Berkeley, Banque de France, the 2020 EFA Annual Meeting, the 2020 National Bureau of Economic Research Financial Economics of Insurance Meeting, the 2019 Swiss Finance Institute ``Finance meets Insurance'' Conference, and the 2018 UPF-EuroFIT Workshop on ``Financial intermediation and risk.'' We also presented the results at the US insurance regulator, the NAIC, who sought our opinion on how to potentially adapt the regulation in light of our research.
The paper has been published as Open access in the Review of Financial Studies, one of the top 3 Finance journals with an acceptance rate of less than 5%.
Paradoxically, we show that the reform eliminates capital buffers against unexpected losses associated with portfolio holdings of MBS, but not for other fixed-income assets. By 2010, aggregate capital relief relative to the previous regime amounted to over $18bn, with large life insurers being the primary beneficiaries both in absolute and relative terms. Since other fixed-income assets (corporate bonds, municipal bonds, asset-backed securities other than MBS, agency debt, etc.) were not affected by the reform, we are able to separate the impact of reduced capital requirements on insurance companies' portfolios from overall time trends in their risk appetite. After the reform, we document that U.S. insurance companies are much more likely to retain downgraded (and riskier) MBS compared to other downgraded assets, such as corporate bonds. This pattern is more pronounced for financially constrained insurers who have a higher incentive to gamble for resurrection.
Figure 1 presents suggestive evidence for our main results. In the 2005-2008 period, the high-yield share in the U.S. insurance industry's MBS portfolio increased from 2.6% to 22% in 2009 (see Panel A in Figure 1), largely driven by unprecedented downgrades of MBS held by insurance companies. By 2015 this share increases to 34%. In contrast, the high-yield share for non-MBS assets (see Panel B in Figure 1) remains remarkably stable at almost exactly 5% throughout the entire 2005-2015 period, including the Great Financial Crisis. The stability of the high-yield share outside MBS is maintained through selling of downgraded assets (consistent with Ellul et al. 2015) and new purchases of highly rated assets. As a result of these divergent trends, by 2015 40% of all high-yield assets in the overall fixed-income portfolio are MBS investments.
Figure 1. Ratings Distribution of MBS and Non-MBS holdings of the U.S. insurers.
For each year-end from 2005 to 2015, this graph plots the ratings distribution of MBS holdings (Panel A) and non-MBS holdings (Panel B) of all U.S. life and P&C insurers. The respective weights are computed using the book value of aggregate security holdings (BACV) obtained from NAIC Schedule D Part 1. The graph conditions on securities for which at least one rating is available. If multiple ratings are available for a given security, we create a comprehensive rating equal to the lowest rating (for two ratings) or the median (for three ratings).
Whether holding on to such risky legacy assets is desirable from a financial stability perspective depends on the trade-off between increased continued exposure to risks and the costs of selling such assets during the midst of a crisis (at fire-sale discounts). Interestingly, we show that the documented risk-taking behavior not only applies for legacy assets, but also newly issued MBS (for which the fire-sale discount motive is moot). As a result, our study suggests that this reform affects the financial stability of insurers going forward. Finally, our paper improves identification of the effects of capital requirements relative to existing studies. Exploiting discontinuities in the reform’s implementation, we can apply a regression discontinuity technique to identify the relevance of the capital requirements channel.
Future research on this reform may examine other outcomes, such as spill-over effects on prices and the real economy. In a world in which financial intermediaries, such as insurance companies, are marginal investors (see, e.g., He and Krishnamurthy (2013) or Koijen and Yogo, 2015) and the shadow cost of regulatory capital is positive, we should observe feedback effects of the regulatory regime on equilibrium prices. These equilibrium prices, in turn, should affect issuers' incentives to place securities in the primary market, and, ultimately have an impact on real investment in the economy. While this type of analysis is beyond the scope of this project, it would be interesting to analyze these important effects in future work.
The project results have been widely disseminated both internationally and in Sweden. For example, the paper has been presented at NYU Stern, the Stockholm School of Economics, UC Berkeley, Banque de France, the 2020 EFA Annual Meeting, the 2020 National Bureau of Economic Research Financial Economics of Insurance Meeting, the 2019 Swiss Finance Institute ``Finance meets Insurance'' Conference, and the 2018 UPF-EuroFIT Workshop on ``Financial intermediation and risk.'' We also presented the results at the US insurance regulator, the NAIC, who sought our opinion on how to potentially adapt the regulation in light of our research.
The paper has been published as Open access in the Review of Financial Studies, one of the top 3 Finance journals with an acceptance rate of less than 5%.