Risk Management and ABS investment of Financial Institutions

In this study we investigate the function of risk management in financial institutions‟ investment decisions in asset-backed securities (ABS) prior to the 2008 financial crisis, and the interaction of this function with financial regulations. We employ U.S. insurance companies as a laboratory, which provides detailed security-level information on ABS investment. We find that strong risk management not only constrains the overall level of insurers‟ ABS investments, but also helps insurers uncover the underlying ABS quality and avoid ABS with considerable lurking risk – ABS that are deemed as low-risk investments ex ante under risk-based capital requirements but become toxic during the crisis. Importantly, the function of risk management hinges on different financial reporting rules governing property & casualty (P&C) and life insurers. Risk management only appears to play a significant role for P&C insurers (governed by the mark-to-market reporting rule), but not for life insurers (governed by the historical cost reporting rule). Amid ongoing efforts in promoting risk controls, this finding suggests that installing risk management systems into financial institutions alone may not be adequate; allowing for the interaction of risk management with external regulations seems crucial.