SEC Exemption That Fanned Crisis Remains on the Books

As federal regulators seek to prevent a repeat of the 2008 financial crisis, they must turn their attention to the alternative capital requirement the Securities and Exchange Commission offered in 2004 to the largest investment banking firms.

Under this alternative to the SEC's traditional net capital rule, significant failures occurred. Two firms, Lehman Brothers and Bear Stearns, failed and several others needed government assistance. Such failures were a precipitating factor in the 2008 crisis. 

Unfortunately, this alternative net capital rule, predicated on financial models to calculate market and credit risk, remains today a financial measure for the six largest investment banking/broker-dealer firms in the United States.

Known as the Consolidated Supervised Entity program and found in Appendix E to SEC Rule 15c3-1, this alternative rule allowed for voluntary supervision by the SEC of a broker-dealer's holding company and at the same time permitted the broker-dealer, if it qualified by virtue of $5 billion or more of net capital, to use a different approach to determine regulatory capital. 

These large investment banking firms were permitted to avoid the highly quantifiable and objective measures found in the traditional net capital rule. Adopted by the SEC at these firms' request, the CSE program allowed them to use risk management practices, including internal mathematical risk measurement models, for regulatory capital purposes in assessing market and credit risks for portfolio positions such as collateralized mortgage obligations, derivatives and other complex securities.  These models, developed by the broker-dealers to be consistent with Basel capital adequacy standards and differing from firm to firm, were thought to more accurately reflect the risks posed by the broker-dealers' diverse activities than the numerical calculations of capital charges in the traditional net capital rule. 

At the same time, the CSE program usually resulted in lower capital charges of the broker-dealer than under the traditional net capital computation.  It was contemplated that the SEC staff would oversee the effectiveness of these mathematical models and related risk taken on by these broker-dealers, supported by the broker-dealer's large capital base.

Significantly, these large broker-dealers operating under this alternative capital computation, such as Lehman Brothers and Bear Stearns, were relieved from three very important capital charges found in the traditional net capital rule. 

First, in calculating regulatory capital the broker-dealers were relieved of having to take specific percentage haircuts (capital charges) on securities positions (e.g., on debt securities a broker-dealer takes a change against its capital of 7% for a five- to 10-year debt instrument; on U.S. government bonds of 10 years, 4.5%). Under the traditional net capital rule these haircuts, together with additional capital changes for concentrated positions, act as a cushion against market and credit risk and, importantly, a restraint on the broker-dealer's ability to build large positions in a particular security – such as the fixed-income instruments that played a big part in the 2008 crisis. Under the CSE's alternative rule, however, such numerical percentage haircut charges on debt instruments were not specified. Rather, firms rely on models to calculate market and credit risk for capital and liquidity measurements.

Second, these broker-dealers were no longer required to deduct 100% of the carrying value in the case of securities or debt instruments in their proprietary accounts for which there is no ready market or which cannot be publicly offered or sold because of statutory, regulatory or contractual arrangements. The SEC defines a "ready" market as one where prices related to the last sale price or current bids and offers can be obtained almost instantaneously.  The purpose of this capital charge in the traditional net capital rule is to assure liquidity of a firm's portfolio – the lack of which, as it turned out, was an important element in Lehman Brothers' and Bear Stearns' demise.

Third, broker-dealers, fitting under the alternative net capital program, are permitted to avoid the capital charges on credit exposure arising from transactions in derivative instruments under the traditional net capital rule and instead measure the exposure by looking to mathematical models to price positions and the allowance for credit risk. 

The alternative net capital computation found in Appendix E, embraced by seven of the largest broker-dealer financial institutions, was seriously flawed, either in its design or, because of its complexity, its administration. These major firms, such as Lehman and Bear Stearns, were able to build up huge positions in subprime and other mortgage-backed securities, much of them under borrowings through repo arrangements. Presumably, their value-at-risk modeling techniques permitted such activity while still being able to meet regulatory capital requirements under the alternative net capital rule. 

Had these firms been required to operate under the quantitative capital charges in the traditional rule, their ability to establish and maintain securities positions (many of which turned out to be illiquid when the crisis deepened) coupled with excessive leverage (including Lehman's infamous Repo 105 transactions), likely would have been diminished. Such instruments would not have been considered good assets for regulatory capital or would have been subject to significant capital charges under the haircut and liquidity provisions.

In addition to the latitude given to investments and liquidity and management's ability to incur risk as a result of the alternative net capital computation, seemingly unforeseen to its authors, the SEC lacked sufficient knowledge, resources and staffing to oversee the scope and mandate of this alternative capital requirement. The Chairman of the SEC acknowledged this in testimony before the House Financial Services Committee in August 2010.  The SEC did not do enough as supervisor to identify risks and require additional capital and liquidity commensurate with the risks. This was due in part to the lack of clarity, softened guidelines, and the expanded discretion given to individual firms on compliance and flexibility in determining capital charges under the alternative capital requirement. 

The alternative net capital requirement under Appendix E was and remains a substantial departure from the SEC's traditional approach of establishing clear rules on capital charges and liquidity, subject to accurate calculations and enforcement.  Capital adequacy rules under the alternative net capital computation did not sufficiently consider the possibility or impact of modeling failures or the limits of such models.  Assets viewed as liquid under value-at-risk models proved not to be under stress. 

In September 2008, after the demise of Bear Stearns and Lehman Brothers, the Chairman of the SEC announced the termination of the CSE program.  This announcement is only partly accurate.  The SEC determined to no longer supervise broker-dealer holding companies. However, the alternative net capital computation in the SEC's Appendix E continues today to be the operative method for determining the required net capital of six of the largest broker-dealer investment banking firms in the securities business.  Thus, these firms, which engage in the majority of investment banking/broker-dealer activities in the industry, are permitted to function under the same alternative net capital standard established by the SEC in 2004.  About 5,000 other broker-dealers operate under the traditional net capital rule.

Given the history of ineffectiveness of the alternative net capital computation under Appendix E, poor management judgment, together with this regulatory deficiency, could bring upon the financial community another Lehman Brothers or Bear Stearns. Although the Dodd-Frank Act of 2010 imposes capital and risk requirements on various regulated entities, the law does not address the capital needs of broker-dealers in any substantial manner. It is unclear whether informal adjustments instructed by the SEC staff help.

Against the backdrop of Lehman and Bear, the SEC must formally reassess the alternative net capital provisions of Appendix E. Among other things, considerations should be given to prescribed capital charges against all securities and other investments, including derivatives carried in the proprietary accounts of the broker-dealer. With more precise quantitative standards, the capital adequacy of the broker-dealer could be more readily determined by management and more readily verified by those conducting regulatory oversight.

Lee Pickard is a former director of the SEC's Division of Trading and Markets and was one of the architects of the SEC's net capital rule.