Posted On: October 6, 2008

2004 SEC Vote that Changed Net Capital Rule May Have Played a Role in Current FInancial Crisis

A recent New York Times article about the current US financial crisis refers to an April 28, 2004 meeting involving members of the Securities and Exchange Commission.

During the meeting, the SEC members considered an urgent request made by large investment banks for an exemption from an old regulation limiting the amount of debt that their brokerage units could take on. The exemption would release millions of dollars that were in reserve as a cushion against the brokerage units’ investment losses. The released funds could then be used by a parent company to invest in credit derivatives, mortgage-backed securities, and other instruments.

Although one commissioner, Harvey J. Goldschmid, had questions the consequences of such an exemption, he was reassured that only large firms with assets over $5 billion would be able to avail of the exemption. Market regulation head Annette L. Nazareth, who would later be appointed and serve as an SEC commissioner until January 2008, told the commission that the new rules would allow the commission to forbid companies from engaging in high risk activities. Another SEC commissioner, Roel C. Campos, supported the exemption, albeit with “fingers crossed.”

Following a 55 minute discussion that was not attended by many people, a vote was called. The unanimous decision changed the net capital rule—designed to be a buffer during tough financial times. In loosening these rules, the agency also decided to depend on investment companies’ computer models to determine an investment's risk-level. This essentially left the task of monitoring investment risks to the banks themselves.

One man—Indiana software consultant Leonard D. Bole—loudly disagreed with this approach, noting that the firms’ computer software would not be able to predict certain kinds of market turmoil. His letter to the SEC, sent in January 2004, never received a response.

Once the firms availed of the rule change, the ratio of borrowing compared to their overall assets increasing dramatically. While examiners were aware of potential problems related to risky investments and a heavier dependence on debt, they virtually ignored the warning signs while assuming that the firms had the discipline to regulate themselves and not borrow too much.

The SEC, which was now finally able to monitor the large investment banks’ riskier investments, never fully availed of this advantage. Seven people were given the task of monitoring these companies, yet their department currently does not have a director. And not one inspection has been completed since SEC Chairman Christopher Cox reorganized the department some 18 months ago.

The commission formerly ended its 2004 program last month, acknowledging its failure to anticipate problems that have resulted with Bear Stearns and the four other large investment banks. Cox says it is now obvious that “voluntary regulation does not work.” Critics of the SEC, however, say the commission has fallen short with its enforcement efforts in recent years.

If you have lost money during the financial crisis because of broker-dealer misconduct or mismanagement, there are legal remedies available to you.


Related Web Resources:

Agency’s ’04 Rule Let Banks Pile Up New Debt, New York Times, October 2, 2008

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