Abstract: Our model shows that when capital standards are based on credit ratings that reflect expected default losses, a bank raises its shareholder value by selecting similarly-rated loans and bonds with the highest systematic risk. This moral hazard occurs if loan and bond credit spreads incorporate systematic risk premia but credit ratings do not. Our empirical evidence confirms that similarly-rated bonds have significantly higher credit spreads when their issuers have higher systematic risk or “debt beta.” Moreover if a bank chooses the higher-yielding bonds within a given Basel Accord credit rating class, its systematic risk rises by an economically significant amount. Our theory provides an explanation for prior research documenting that banks and capital-regulated insurance companies took excessive systematic risks.
Bio sketch: George G. Pennacchi is a professor of finance and a co-director of the Office for Banking Research at the University of Illinois at Urbana-Champaign. His research focuses on financial intermediaries and the valuation of fixed-income securities and government guarantees. Currently, he is an editor of the Journal of Financial Intermediation and an associate editor of the Journal of Banking and Finance, the Journal of Financial Services Research, and the Journal of Money, Credit and Banking. Previously, he was an associate editor for the Journal of Finance, the Review of Financial Studies, and Management Science, and a co-editor of Advances in Futures and Options Research. His consulting experience includes work for the Federal Reserve Bank of Cleveland, the World Bank, the U.S. Office of Management and Budget, and the Federal Deposit Insurance Corporation. He has been a visiting professor at the Università Bocconi in Milan, Italy, and was a member of the finance faculty at the Wharton School of the University of Pennsylvania. Professor Pennacchi received a ScB degree in applied mathematics from Brown University in 1977 and a PhD in economics from the Massachusetts Institute of Technology in 1984.
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