Thursday, 18 September 2008

How SEC Regulatory Exemptions were too little, too late

The Big Picture (which I usually love) has picked up a story from the American Banker (which I cannot link to as it is behind a firewall). It seems:
"The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.

The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.
Up to a point, your honour. The way it really worked was this.

The SEC had a deeply antiquated set of capital rules which in particular provided no capital requirement AT ALL for OTC derivatives. Under pressure from the EU they reluctantly conceded that consolidated supervisiion for capital might be a good idea. They took the market risk rules from Basel - basically VAR - and put their own spin on them. (That's diplomatic. Some would say `bastardised them'.) They ignored some parts of the Basel project, like operational risk.

The big 5 B/Ds were permitted to apply for permission to be supervised as investment bank holding companies (IBHC)s. The rules for them are here.

Whether the IBHC regime increased leverage isn't clear to me simply because the net capital requirements before it did not include all the entities - you literally could not tell how much risk the firms were running from their capital requirements. The new rules certainly permitted asset growth and on balance sheet leverage did increase. Criticising the SEC for bringing broker/dealer capital requirements kicking and screaming into the 1990s is however unfair, even if they did it in 2004. The new regime clearly wasn't good enough, but it was better than the thing it replaced, if only in that it actually required capital for all the market risks the B/Ds were taking.

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