Giving Life to Private (Rated) Credit

Abstract

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.