SEC Commissioner Daniel M. Gallagher gave a speech before the Institute of International Bankers about regulatory capital requirements and, in particular, the differences between broker-dealer and bank capital requirements.
Commissioner Gallagher explained that one of the primary differences between bank and broker-dealer capital requirements is how risk is viewed and handled; bank capital requirements serve to “reduce risk and protect against failure,” while broker-dealer capital requirements seek to manage risk and the corresponding potential for failure by providing enough cushioning to ensure that a failed broker-dealer can liquidate in an orderly manner and transfer its assets to another broker-dealer. Given that capital requirements for these two types of institutions serve different purposes, he noted, they must be tailored accordingly.
Instead, Commissioner Gallagher argued, “bank regulators seem increasingly determined to seek a one-size-fits all regulatory construct for financial institutions.” As an example of this, he cited the Federal Reserve Board’s final rule requiring foreign banking organizations with U.S. non-branch assets of $50 billion or more to establish a U.S. intermediate holding company over their U.S. subsidiaries. He asserted that these new rules “force a foreign bank organization to impose a bank holding company into existence over its non-bank holdings, thus subjecting those entities’ broker-dealer subsidiaries to regulation by the FRB.” He argued that the ultimate result of this would be a destructive reduction in the amount of credit available to finance the securities markets.
Lofchie Comment: The gist of the Commissioner’s remarks is that imposing conservative bank capital requirements on top of presumably less conservative broker-dealer capital requirements will result in a material reduction of investment in broker-dealers, and thus a material reduction in the ability of broker-dealers to make capital available to keep markets liquid and finance the types of credit transactions that are essential for the smooth operation of the securities markets, particularly margin loans, repurchase transactions and securities lending. While the Commissioner is quite pessimistic as to effects of the imposition of bank capital rules on top of broker-dealer capital rules, he understates the causes for pessimism.
The Commissioner observes, I think correctly, that broker-dealer capital requirements are not meant to prevent risk taking and so are intended to allow for a material possibility of failure. That said, broker-dealer capital requirements are much more conservative than the Commissioner suggests. In fact, in most respects, broker-dealer capital requirements are more restrictive than bank capital requirements because (i) they give no value to either unsecured credit exposure or loans that are secured by illiquid assets and (ii) the amount of haircuts that they require even on highly liquid assets are large (15% on U.S.-listed equities). Because banks are in the business of making unsecured loans or loans secured by illiquid collateral (e.g., mortgages), banks would not be deemed solvent if they were subject to the broker-dealer capital rules. (Banks are able to stay solvent, notwithstanding their “illiquid” capital by broker-dealer standards, because they have access to the Fed. Window, which serves to alleviate fears of a bank run.)
In short, when regulators impose bank capital regulations on top of broker-dealer capital regulations, they are taking what is already a very conservative system of capital regulation and making it even more restrictive, but at the same time are denying broker-dealers access to the Fed. Window that is available to banks. Think about the failures of Bear Stearns and Lehman Brothers during the financial crisis. In neither case did the SEC-registered broker-dealers become insolvent, in the sense of their assets exceeding their liabilities, as a result of risky investments. Rather, their problems were illiquidity and, in the case of Lehman, insufficient controls around custody of client assets. Further, I am not aware that any bank acting as an agent in securities lending lost money as a result of its guaranteeing the performance of the securities borrower, since credit transactions in the securities markets are highly collateralized, unlike credit transactions in the banking markets.
Ultimately, the effect of imposing bank capital requirements on top of broker-dealer capital requirements will have a significant impact on the financial markets. These new regulations will (i) raise capital requirements on the holding companies for broker-dealers and (ii) establish punitive capital requirements on securities lending and borrowing. As a result, it will become more difficult for investors to finance liquid securities positions through broker-dealers and to borrow securities to make short sales. Neither of these outcomes is a good result for the economy or for the price discovery process (a process in which short sellers are acknowledged to play an important role). The Commissioner’s concerns, understated as they may be, should receive more attention.
See: Daniel Gallagher’s Speech.