The uniform net capital rule is a rule created by the U.S. Securities and Exchange Commission ("SEC") in 1975 to regulate directly the ability of broker-dealers to meet their financial obligations to customers and other creditors.See Section 2 below. Broker-dealers are companies that trade securities for customers (i.e., brokers) and for their own accounts (i.e., dealers).See Section 2.1 below.
The rule requires those firms to value their securities at market prices and to apply to those values a haircut (i.e., a discount) based on each security's risk characteristics.General Accounting Office (“GAO”) Report, “Risk-Based Capital, Regulatory and Industry Approaches to Capital and Risk,” GAO/GGD-98-153, July 1998 ("GAO Risk-Based Capital Report") at 132, fn. 11. The haircut values of securities are used to compute the liquidation value of a broker-dealer's assets to determine whether the broker-dealer holds enough liquid assets to pay all its non-subordinated liabilities and to still retain a "cushion" of required liquid assets (i.e., the "net capital" requirement) to ensure payment of all obligations owed to customers if there is a delay in liquidating the assets.See Section 3.1 below
On April 28, 2004, the SEC voted unanimously to permit the largest broker-dealers (i.e., those with "tentative net capital" of more than $5 billion) to apply for exemptions from this established "haircut" method.See Section 5 below and, for details of the SEC action, GAO, Major Rule Report: Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities (B-294184), June 25, 2004. ("GAO Major Rule Report") Upon receiving SEC approval, those firms were permitted to use mathematical models to compute the haircuts on their securities based on international standards used by commercial banks.See Section 5 below.
Since 2008, many commentators on the 2008 financial crisis have identified the 2004 rule change as an important contributor to the crisis on the basis it permitted certain large investment banks (i.e., Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley) to increase dramatically their leverage (i.e., the ratio of their debt or assets to their equity).See Section 1.1 below. Financial reports filed by those companies show an increase in their leverage ratios from 2004 through 2007 (and into 2008), but financial reports filed by the same companies before 2004 show higher reported leverage ratios for four of the five firms in years before 2004.See Section 1.1 and 7.2 below. The leverage ratios for the five companies (A) from 1993 to 2002 are found in note 95 below and (B) from 2003 to 2007 in note 93 below. Notes 95-97 below contain information on the fiscal quarter end leverage reported by these firms in various Form 10-Q Reports for fiscal quarters in the 1990s and after 2004.
The 2004 rule change remains in effect. The companies that received SEC approval to use its haircut computation method continue to use that method, subject to modifications that became effective January 1, 2010.See Section 1.3 below. As explained there, (1) the assets of Lehman Brothers Inc were acquired by Barclays Capital, and the SEC granted Barclays approval, with restrictions, to continue using the new method for the operation of that business and (2) the Bear Stearns broker-dealer authorized to use the new method continued to use that method as part of JP Morgan Chase.
The net capital rule and the 2008 financial crisis 2008 explanation Beginning in 2008, many observers remarked that the 2004 change to the SEC's net capital rule permitted investment banks to increase their leverage and this played a central role in the 2008 financial crisis.
This position appears to have been first described by Lee A. Pickard, Director of the SEC's Division of Market Regulation (the former name of the current Division of Trading and Markets) at the time the SEC's uniform net capital rule was adopted in 1975. In an August 8, 2008, commentary, Mr. Pickard wrote that before the 2004 rule change, broker-dealers were limited in the amount of debt they could incur, to a ratio of about 12 times their net capital, but that they operated at significantly lower ratios. He concluded that, if they had been subject to the net capital rule as it existed before the 2004 rule change, broker-dealers would not have been able to incur their high debt levels without first having increased their capital bases.Lee A. Pickard, “Viewpoint: SEC's Old Capital Approach Was Tried--And True”, American Banker, August 8, 2008, at page 10 (Before the rule change "the broker-dealer was limited in the amount of debt it could incur, to about 12 times its net capital, though for various reason broker-dealers operated at significantly lower ratios...If, however, Bear Stearns and other large broker-dealers had been subject to the typical haircuts on their securities positions, an aggregate indebtedness restriction, and other provisions for determining required net capital under the traditional standards, they would not have been able to incur their high debt leverage without substantially increasing their capital base."). In what became a widely cited September 18, 2008, New York Sun article (the "2008 NY Sun Article"), Mr. Pickard was quoted as stating the SEC's 2004 rule change was the primary reason large losses were incurred at investment banks. (quoting Mr. Pickard as stating "The SEC modification in 2004 is the primary reason for all of the losses that have occurred." Separately, the article states "the SEC, under its new Consolidated Supervised Entities program, allowed the broker dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1."). A later report stated Mr. Pickard "estimated that prior to the 2004 program most firms never exceeded an 8-to-1 debt-to-net capital ratio" Ben Protess, “’Flawed’ SEC Program Failed to Rein in Investment Banks”, ProPublica, October 1, 2008. As late as February 18, 2009, Mr. Pickard was still being quoted as recalling "banks rarely exceeded gross leverage over about 6% on his own watch at the SEC in the late 1970s. In the following decades, leverage generally ranged around 12%, comfortably beneath the rule's 15% ceiling." Vanessa Drucker, “The SEC Killed Wall Street On April 28, 2004”, Real Clear Markets, February 18, 2009. Compare these statements with the pre-2004 leverage information described below in Section 4.1 (for broker-dealers) and 7.2 (for holding companies).
Perhaps the most influential review of the 2004 rule change was an October 3, 2008, front page New York Times article titled "Agency's '04 Rule Let Banks Pile Up New Debt" (the "2008 NY Times Article"). That article explained the net capital rule applied to the "brokerage units" of investment banks and stated the 2004 rule change created "an exemption" from an old rule that limited the amount of debt they could take on. According to the article, the rule change unshackled "billions of dollars held in reserve against losses" and led to investment banks dramatically increasing their leverage.Stephen Labaton, “Agency's ’04 Rule Let Banks Pile Up New Debt”, New York Times, October 3, 2008, page A1.
In late 2008 and early 2009, prominent scholars such as Alan Blinder, John Coffee, Niall Ferguson, and Joseph Stiglitz explained (1) the old net capital rule limited investment bank leverage (defined as the ratio of debt to equity) to 12 (or 15) to 1 and (2) following the 2004 rule change, which relaxed or eliminated this restriction, investment bank leverage increased dramatically to 30 and even 40 to 1 or more. The investment bank leverage cited by these scholars was the leverage reported by the Consolidated Supervised Entity Holding Companies in their financial reports filed with the SEC.Niall Ferguson,“Wall Street Lays Another Egg”, Vanity Fair, December 2008, at page 4. ("It was not unusual for investment banks' balance sheets to be as much as 20 or 30 time larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1.") John C. Coffee, “Analyzing the Credit Crisis: Was the SEC Missing in Action?” ("Was the SEC Missing in Action?"), New York Law Journal, (December 5, 2008) ("For most broker-dealers this 15 to 1 debt to net capital ratio was the operative limit within which they needed to remain by a comfortable margin"... [after the rule change] "The result was predictable: all five of these major investment banks increased their debt-to-equity leverage ratios significantly in the period following their entry into the CSE program.") Joseph E. Stiglitz, “Capitalist Fools” , Vanity Fair, January 2009, at page 3. ("There were other important steps down the deregulatory path. One was the decision in April 2004 by the Securities and Exchange Commission, at a meeting attended by virtually no one and largely overlooked at the time, to allow big investment banks to increase their debt-to-capital ratio (from 12:1 to 30:1, or higher) so that they could buy more mortgage-backed securities, inflating the housing bubble in the process.") Alan S. Blinder, “Six Errors on the Path to the Financial Crisis”, New York Times, January 25, 2009, page BU7. ("The second error came in 2004, when the S.E.C. let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the S.E.C. and the heads of firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn't have grown as big or been as fragile.")
Daniel Gross wrote in Slate magazine: "Going public allowed investment banks to get bigger, which then gave them the heft to mold the regulatory system to their liking. Perhaps the most disastrous decision of the past decade was the Securities and Exchange Commission's 2004 rule change allowing investment banks to increase the amount of debt they could take on their books—a move made at the request of the Gang of Five's CEOs." He was referring to the net capital rule change.The Gang of Five and How They Nearly Ruined Us - Slate-January 29,2010
SEC response In connection with an investigation into the SEC's role in the collapse of Bear Stearns, in late September, 2008, the SEC's Division of Trading and Markets responded to an early formulation of this position by maintaining (1) it confuses leverage at the Bear Stearns holding company, which was never regulated by the net capital rule, with leverage at the broker-dealer subsidiaries covered by the net capital rule, and (2) before and after the 2004 rule change the broker-dealers covered by the 2004 rule change were subject to a net capital requirement equal to 2% of customer receivables not a 12 to 1 leverage test.U.S. Securities and Exchange Commission Office of Inspector General, Office of Audits (“SEC OIG”), “SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program,” Report No. 446-A, September 25, 2008 ("OIG Bear Stearns CSE Report"), at page 87 of the full Report.