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

Abstract

Severe economic distress that provokes regulators to curb speculation by financial institutions may have unintended costs for non-financial firms. In 1936 the Comptroller of the Currency unexpectedly announced just such a regulation, stating that supervised banks were no longer eligible to purchase securities rated below “investment grade”. Using a differences-in-differences design I provide the first evidence on the costs of the establishment of federal rating-based investment restrictions. I find a sudden persistent rise in speculative bond yields after the announcement, even comparing bonds within the same firm, and a substantial decline in equity value for firms reliant on external speculative debt financing. Anecdotal and empirical evidence suggests that effects of the regulation were exacerbated by the reliance on ratings. Firms reduced the size of their debt issuances in order to “game” the ratings, leading to reduced investment and slower asset growth in subsequent years. Since these restrictions were broad, affecting almost half of even publicly traded corporate bonds, they likely had important macroeconomic implications and may have even played a role in the size of the 1937-1938 recession.