Adverse impact of capital regulatory reform and policy remedy: theory and evidence

This paper studies the impact of capital regulatory reform on firm behavior. We develop a portfolio-choice model to investigate how capital regulatory reforms influence the risk-taking behavior of financial institutions with different capital adequacy levels. The model predicts that as regulation becomes more stringent, either all firms reduce their risk-taking, or there exists a capital-adequacy threshold below which risk-taking increases. The Chinese insurance solvency regulatory reform provides a unique natural experiment to examine firms' risk-taking responses to the capital shock driven by the reform. We find that increasing regulatory pressure – i.e. a more stringent regulation – induces greater risk-taking for less capital-adequate insurers, the insurers whose risk-taking the regulator most wants to reduce. We rule out the potential reverse causality that insurers' risk structures prior to the reform determine their degrees of capital shock and that insurers target low capital-adequate positions by taking more risks prior to the reform. Our results suggest that reinforcing the qualitative risk assessment, increasing the penalties of insolvent insurers, and increasing the risk sensitivity of capital requirements could be effective policy remedies for this backfiring problem.