2004 Change To Net Capital Rule
In 2004 the SEC amended the net capital rule to permit broker-dealers with at least $5 billion in "tentative net capital" to apply for an "exemption" from the established method for computing "haircuts" and to compute their net capital by using historic data based mathematical models and scenario testing authorized for commercial banks by the "Basel Standards." According to Barry Ritholtz, this rule was known as the Bear Stearns exemption. This "exemption" from the traditional method for computing "haircuts" ultimately covered Bear Stearns, the four larger investment bank firms (i.e., Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs), and two commercial bank firms (i.e., Citigroup and JP Morgan Chase). It has been suggested Henry Paulson, the then chief executive officer of Goldman Sachs, "led" in "the lobbying charge" for the rule change permitting these "exemptions."
The SEC expected this change to significantly increase the amount of net capital computed by those broker-dealers. This would permit the parent holding companies of the broker-dealers to redeploy the resulting "excess" net capital in other lines of business. To lessen this effect, the SEC adopted a new $500 million minimum net capital (and $1 billion "tentative net capital") requirement for such brokers and, more important, required each to provide the SEC an "early warning" if its "tentative net capital" fell below $5 billion. Previously, their minimum net capital requirement was only $250,000 with an early warning requirement of $300,000, although the relevant minimums for such large broker-dealers were the much larger amounts resulting from the requirement to maintain net capital of 2% of aggregate debit items with an early warning requirement at 5% of aggregate debit balances. The SEC also permitted CSE Brokers to calculate "tentative net capital" by including "assets for which there is no ready market" to the extent the SEC approved the CSE Broker's use of mathematical models to determine haircuts for those positions.
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