Net capital rule

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. Broker-dealers are companies that trade securities for customers (i.e., brokers) and for their own accounts (i.e., dealers). 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. Broker-dealers are companies that trade securities for customers (i.e., brokers) and for their own accounts (i.e., dealers). 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. 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. 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. 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. Since 2008, many commentators on the financial crisis of 2007-2009 have identified the 2004 rule change as an important cause of 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). 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. 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. 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 financial crisis of 2007-2009. 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. 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. 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. 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.