Working papers

We study how ratings inflation can undermine financial regulation and inadvertently fuel the growth of privately rated credit. We exploit the 2021 Risk-Based Capital reform for U.S. life insurers, which aimed to curb reaching-for-yield through its treatment of credit ratings. Following the reform, more exposed insurers—especially those with tighter capital constraints—shifted toward privately rated bonds. These bonds exhibit within-issuer ratings inflation and offer higher yields within rating categories, consistent with greater underlying risk behind similar regulatory labels. Accounting for this inflation substantially attenuates the reform’s apparent improvement in portfolio risk. Despite targeting ratings rather than market structure, the reform indirectly increased demand for private bonds. Consistent with this demand shift, firms more connected to exposed life insurers increased their private debt issuance.

Changes in credit spreads are not the only way in which financial markets adjust to shocks in investor and bank lending capacity. Firms can also respond by changing the composition of debt claims they issue across instruments and markets. We measure the price-elasticity of substitution of corporate debt supply in primary markets. Using granular data on syndicated loans and corporate bonds issued by firms worldwide, we exploit variation in borrowing costs driven by shifts in bank lending capacity and institutional demand for bonds to estimate three margins of debt supply: substitution across instruments within a market, substitution between bank and bond financing, and the scale of total debt issuance. We find that firms respond elastically along all three margins. Therefore, the composition of corporate debt supply is a key channel through which financial markets adjust to shocks in investor and bank lending capacity.