Reaching for Yield in the ABS Market: Evidence from German Bank Investments
Matthias Efing
Review of Finance, Volume 24, Issue 4, July 2020, Pages 929–959, https://doi.org/10.1093/rof/rfz013
It is well documented how the creditworthiness of asset-backed securities (ABSs) deteriorated rapidly during the financial crisis, causing significant financial distress among investors and the economic system as a whole. Yet, it is less well understood why investors exposed themselves to high systematic risk in the securitization market.
Some theories point to the role of inflated credit ratings, which could have seduced unsophisticated investors to buy highly rated ABSs with high promised yields. Other theories show that regulatory reliance on credit ratings can incentivize even sophisticated investors to buy risky assets with inflated credit ratings. This paper shows evidence in favor of the second hypothesis and analyzes the regulatory incentives of German banks to take risk in the securitization market.
Using confidential data provided by the Deutsche Bundesbank, I track securitization exposures on the balance sheets of German banks between 2007 and 2012. The security-level data allow me to analyze how German banks choose between different ABSs. Whereas most papers study the role of banks on the supply side of the securitization market, this paper has the unique opportunity to study banks’ own demand for securitized assets.
The analysis yields three main results. First, I show that regulatory reliance on credit ratings is indeed an important driver of bank demand in the securitization market. German banks systematically tilt their portfolios towards the ABSs with the highest yield spreads conditionally on rating-implied capital requirements. The scope for such “reaching for yield” is large due to high systematic risk in the securitization market, which is not fully captured by ratings (and, hence, regulation) but priced by market participants.
Second, precisely the banks with tight regulatory constraints herd into the least capital-intensive but systematically risky ABSs. In other words, the banks with the weakest capitalization levels tend to expose themselves to simultaneous failures of ABSs during economic downturns.
Third, I find no evidence that differences in bank sophistication, market power across banks, or incentives to retain securitized assets explain why a given bank would reach for yield more aggressively when its regulatory constraints become more binding. Instead, the analysis suggests that rating-based regulation incentivizes banks to build ABS positions with higher ex-post delinquency rates, more rating downgrades, and higher value losses. This result is worrying as even small losses can put banks into jeopardy due to their high leverage and funding risk.