April 20, 2015

Nikolova Examines Systemic Risk Implications of Reduced Reliance on Credit Ratings

Dr. Stanislava Nikolova, assistant professor of finance at the University of Nebraska–Lincoln College of Business Administration, is researching whether less regulatory reliance on credit ratings might reduce systemic risk transmission through the asset liquidation channel. In a co-authored paper, titled “The Removal of Credit Ratings from Capital Regulation: Implications for Systemic Risk,” she analyzes an initiative to reduce reliance on ratings for capital requirements in the insurance industry.
 
The financial crisis in the late 2000’s underscored the role that credit ratings play in the transmission of systemic risk. In the 2008 and 2009 credit rating, agencies downgraded a large number of mortgage-backed securities. Many of these securities were held by institutions, whose capital requirements are determined by the credit ratings of the securities they hold. As a result of the downgrades, these institutions found themselves with insufficient regulatory capital. In the process of trying to repair their capital position, mainly by selling securities, they put downward pressure on prices and quickly spread the negative effects of the downgrades through the financial system. This is commonly referred to as the asset-liquidation channel of systemic risk transmission.
 
Stas Nikolova
Nikolova found that after the regulatory change insurers are less likely to repair their regulatory capital by selling securities. She concludes that this change in insurers’ behavior has the potential to reduce systemic risk transmission in the short run by alleviating downward pressure on prices. However, the research also shows that under the new regime insurers purchase more low-rated mortgage-backed securities, which may have negative implications for systemic risk in the long run.
 
Nikolova says the key message of this research is that less regulatory reliance on credit ratings could be a double-edged sword when it comes to systemic risk transmission. “In the short term, systemic risk appears to be reduced, but this reduction might come at the expense of higher systemic risk down the line if insurers use the change in regulation to shift into riskier investments,” she said. “All government agencies that are still working on implementing the mandate of the Dodd-Frank Act need to reconsider their use of credit ratings in rules and regulations.”
 
The research has generated strong interest from academics and regulators alike. It has been presented at several prestigious conferences, including those organized by the Western Finance Association, National Bureau of Economic Research, and Federal Deposit Insurance Corporation. Nikolova was also invited to present her findings at universities in Singapore, Australia and Italy.