Net Capital Rule - Net Capital Rule in Financial Crisis Inquiry Commission Report

Net Capital Rule in Financial Crisis Inquiry Commission Report

The Financial Inquiry Crisis Report ("FCIC Report") issued by the FCIC on January 27, 2011, presented the FCIC majority's view of the effect of the 2004 net capital rule change on leverage by stating: "Leverage at the investment banks increased from 2004 to 2007, growth that some critics have blamed on the SEC's change in the net capital rules…In fact, leverage had been higher at the five investment banks in the late 1990s, then dropped before increasing over the life of the CSE program—a history that suggests that the program was not solely responsible for the changes."

Thus, while the FCIC Report identified leverage, especially leverage at investment banks, as an important feature of the financial crisis, it did not identify the 2004 net capital rule change as creating or permitting that leverage. The FCIC Report also noted the 18 month delay before all the CSE Holding Companies qualified for the CSE Program. While the FCIC Report did not draw any conclusion from this delay beyond including it in a general critique of the SEC's execution of the CSE Program, as described in Section 5.2 above the delay eliminates the 2004 rule change from playing a role in any increase in CSE Holding Company leverage in 2004. Because they all only entered the CSE Program at the beginning of their 2006 fiscal years, the delay eliminates the 2004 rule change from playing a role in any 2005 leverage increases reported by Bear Stearns, Lehman Brothers, or Morgan Stanley.

The FCIC Report was highly critical of the SEC's implementation of the CSE Program, rejected former SEC Chairman Christopher Cox's assertion that the program was "fatally flawed" by being voluntary, and specifically concluded that the SEC failed to exercise the powers it had under the CSE Program to restrict the "risky activities" of CSE Holding Companies and to "require them to hold adequate capital and liquidity for their activities." The SEC did not have those powers before 2004 and only gained them through the CSE Program.

The persistent confusion about the application of the net capital rule to CSE Holding Companies, however, resurfaced in the FCIC Report. After explaining the net capital rule applied to broker-dealers, not their parent holding companies, the FCIC Report misquoted the 2009 Sirri Speech as stating "investment bank net capital was stable, or in some cases increased, after the rule change." As a more serious indication of continuing misunderstanding of the 2004 rule change, on the day the FCIC issued its report (January 27, 2011) economist Robert Hall addressed an MIT symposium on economics and finance. In describing the background to the financial crisis he stated: "I think that the one most important failure of regulation is easy to identify. In 2004 the SEC removed its capital requirements on investment banks… So the reason that Lehman was able to do what it did, which proved so destructive, was that it had no limits on the amount of leverage it could adopt."