Essays on the impact of capital regulation on financial institutions

Sen, Ishita (2019) Essays on the impact of capital regulation on financial institutions. Doctoral thesis, University of London: London Business School.

Abstract

This dissertation contains three papers that study the impact of capital regulation on the behavior of financial institutions. The first chapter is my job market paper titled “Regulatory Limits to Risk Management”, in which I study the impact of inconsistencies in regulation on the risk management choices of US life insurance companies. Using comprehensive position level data on derivative instruments, I show that regulation limits the hedging choices of life insurers, results in lower hedging, and leads to greater transfers of risk exposures to off-balance sheet entities. My findings have implications for the fragility of life insurers going forward as regulation interacts with monetary policy in a way that shuts down the incentives for risk management when interest rates rise. My job market paper received the AQR Asset Management Institute Fellowship Award in 2018 and the Macro Financial Modeling Dissertation Fellowship from the Becker Friedman Institute in 2017 and 2018. The second chapter titled “Capital Regulation and Product Market Outcomes” (joint work with David Humphry) was presented at the American Finance Association (AFA) in 2016. We study the impact of the largest ever shift in capital requirements in a developed insurance market, using proprietary data from the Bank of England, and show economically large effects on the market for investment and protection products in the UK that potentially has welfare implications for consumers. The third chapter titled “Demand for Illiquid Assets” is joint work with Varun Sharma. Using corporate bond holdings of life insurers, we micro-found a new channel for the demand of illiquid assets that is due to the discretion institutions have to value such assets to relax balance sheet constraints in bad times. Our findings have implications for the ex-ante portfolio choice of insurance companies, which impacts the holding structure and price discovery of a segment of the corporate bond market. More broadly, my dissertation helps to better understand the objective function and preferences of financial institutions and their impact on economic outcomes.