Sorting Out Capitalization Requirements And Bond Ratings

Restricting the quality of bonds in which banks can invest is legacy regulation from the Great Depression.

Is it still good policy?  The question is particularly germane given the recent downgrading of multi-obligor bonds and the resulting capitalization issues facing a number of banks.

On the surface the regulation exists to protect banks from themselves.  Or more specifically, to protect depositors (and the FDIC) from being exposed to risky investments banks could make with their customers’ deposits.

It is nice to believe that having minimal standards for bonds will keep banks out of trouble. History has proven otherwise. Banks have a world of unregulated risk into which they can delve, and they do. To limit their investments in riskier bonds and not to limit their investment in all the other ways banks get into trouble makes little sense. It is time for the restrictions to be expunged.

It is impossible to protect bad businesspeople from themselves. All that you succeed in doing is artificially depressing the value of riskier bonds by limiting the size of their market and unfairly encumbering those bankers who have the ability to aggressively and ably manage risk