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Title: Marginal cost of risk-based capital and risk-taking
Authors: Chen, Tao
Goh, Jing Rong
Kamiya, Shinichi
Lou, Pingyi
Keywords: Business::Finance
Issue Date: 2019
Source: Chen, T., Goh, J. R., Kamiya, S., & Lou, P. (2019). Marginal cost of risk-based capital and risk-taking. Journal of Banking and Finance, 103, 130-145. doi:10.1016/j.jbankfin.2019.03.011
Journal: Journal of Banking and Finance
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.
ISSN: 0378-4266
DOI: 10.1016/j.jbankfin.2019.03.011
Schools: Nanyang Business School 
Rights: © 2019 Elsevier. All rights reserved. This paper was published in Journal of Banking and Finance and is made available with permission of Elsevier.
Fulltext Permission: open
Fulltext Availability: With Fulltext
Appears in Collections:NBS Journal Articles

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