The Costs of Curbing Speculation: Evidence from the Establishment of 'Investment Grade'

Recent regulatory restrictions on proprietary trading by banks, such as the “Volcker Rule”, have elevated discussion about the potential costs to non-financial firms of restricting investments of major institutional investors, such as banks. History provides some hints to the possible costs of excluding banks from “speculative” investments. On February 15th, 1936 the Office of the Comptroller of the Currency unexpectedly announced that member banks of the Federal Reserve System, one of the largest investors in corporate bonds, were no longer allowed to purchase securities rated as speculative grade by rating agencies. This controversial ruling affected more than half of all publicly traded corporate bonds and represented the inception of federal rating-contingent bank investment restrictions. Using a fuzzy regression discontinuity at the investment grade cut-off, I find that following the announcement financing constraints induced by the exclusion of banks from the speculative grade corporate debt market cause a persistent 3-5% decline in the equity market value of firms requiring speculative financing. I find that this decline is concentrated among firms in industries reliant on external financing. This decline does not, however, appear to be driven by a change in perceived default risk or direct debt financing costs, since bond yields do not change. Instead, I find that firms who initially require speculative financing reduce the size of their debt issuances to improve their credit rating. These firms subsequently have less long-term debt, fewer investments, and slower asset growth in the years following the ruling. Overall these results provide evidence that regulators may need to consider the costs to non-financial firms of policies that attempt to curb speculative trading by banks.