B. The ALCO devides to increase Bank’s ccredit standards for loans although overall tolerance is unchanged.
Answer: Bank should have more leeway to invest in below-investment quality debt in bond portfolio.
I do not get the logic. Increased standards means the standards are more strict now,
to balance the lowered risk, isn’t it the securities portfolio that can have more leeway investing in below-investment grade, and not the bond portfolio?
For a bank , the portfolio risks are split into allocation to fixed income ( majority of their assets ) and equities . If their overall risk tolerance were to remain same and their risk tolerance for fixed income is reduced ( by implementing a tighter credit risk standard , effectively reducing the risk on bonds ) , then the only choice to keep risk tolerance the same is to invest larger allocation to equities.
I take it this way
Banks takes deposit & grants loan. Any left over funds are invested in securities. So they have loan portfolio & securities portfolio (bond +equity).
Increasing credit standards on loans means credit is granted to only few who meet the more stricter criteria than before. Keeping overall risk tolerance same, this decline in risk structure of loan portfolio now allows to take more risk in bond portfolio (now can assume more risk by investing in high yield bonds )