Finance and Financial Management Commons^™

Marginal Cost Of Risk-Based Capital And Risk-Taking, Tao Chen, Jing Rong Goh, Shinichi Kamiya, Pingyi Lou

Research Collection School Of Economics

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 Fl 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 …