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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Danger Ahead – Reducing Protections in our Net Capital Rule


Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission

SEC Open Meeting
Washington, D.C.
April 27, 2011

I join my colleagues in thanking the staff of the Commission for their work on this proposal.

Last month, the Commission proposed removing references to credit ratings from our rules under the Investment Company Act. And today we consider a proposal that would remove credit rating references from our rules under the Exchange Act. Once again, our staff has been given an impossible challenge: finding an appropriate substitute for an objective evaluation of credit risk when it may not exist.

Over the past 17 years, the Commission has repeatedly taken the opportunity to reconsider the appropriate role of credit ratings in its regulations, twice issuing concept releases concerning NRSROs and twice seeking public comment on a specific proposal to remove NRSRO references from Exchange Act rules.1 But, in light of serious concerns expressed by commenters,2 the Commission has, up to this point, preserved the credit rating references that would be removed by today’s proposal.

Now, however, the Dodd-Frank Act requires that we replace each of these references with an appropriate substitute.3 The dilemma that confronts the Commission is what to do when no appropriate substitute exists.

In order to generate comments on today’s proposal, I will support the proposal, but I have serious concerns. As one example, I am troubled about the proposed amendments to Rule 15c3-1, the net capital rule, because it does not appear that we have been able to identify an appropriate substitute for credit ratings.

Although the net capital rule is lengthy and complex, it has a simple purpose: to ensure that broker-dealers have sufficient liquid assets to meet their obligations to customers and counterparties and to wind down their businesses in an orderly way if they encounter financial difficulties. Because of the crucial importance of adequate net capital to customer protection, when the Commission adopted Rule 15c3-1 in 1975, it required broker-dealers to use objective criteria – NRSRO ratings – in determining whether they could deduct less than the standard 15% safety margin, or “haircut,” from the market value of certain debt securities.

Removing objective standards from the net capital rule would poorly serve both investors and market participants. The industry has understood the danger in removing such an objective standard, and it has opposed removing credit ratings from the net capital rule, arguing that “deleting such references might cause uneven application of the rule because some firms do not have the in-house capability to analyze credit risk to the degree necessary.”4

Our current proposal would replace the objective standard of a credit rating with a process that would permit broker-dealers to use their own subjective internal assessments of the credit and liquidity risks applicable to a debt security.

Under the current net capital rule, a small number of very large broker-dealers, the so-called “alternative net capital” firms, may calculate their net capital using proprietary risk models that reflect their subjective assessments of credit risk.5 However, in those instances there are backstops that limit the firms’ discretion and that aid Commission oversight. First, these firms can only use risk models that have been reviewed and approved by the Commission. And, second, our rules impose heightened net capital and “early warning” requirements on these firms, requiring them, among other things, to notify the Commission whenever their “tentative net capital” drops below a high threshold.6

Today’s proposal would allow all other broker-dealers to replace the objective standard of a credit rating with their own subjective analysis of “minimal” credit risk without any backstops like those used in the alternative net capital calculation.7 For example, our proposal does not include pre-approval of a broker-dealer’s policies and procedures relating to credit analysis, and it does not enhance the net capital and “early warning” requirements that apply to all broker-dealers. This concerns me, because, as a commenter noted in response to our 2008 proposal,

[T]here is an inherent conflict of interest involved in allowing broker-dealers to evaluate the credit risk of the securities they hold, and thereby determine how much capital they must hold against those securities. Such a system creates an incentive for broker-dealers to overestimate the creditworthiness of those securities so as to minimize the amount of required capital and thereby to minimize the broker-dealer’s costs.8

Moreover, while increasing the risks of such conflicts, today’s proposal will also result in additional costs both on the industry and on the Commission. Broker-dealers that previously relied on NRSRO ratings will either have to expend resources to develop policies and procedures for risk analysis, or they will have to tie up additional capital by increasing the haircut on their debt securities to the default of 15%. Furthermore, by replacing the bright-line test currently used, the Commission will have to expend additional resources developing, staffing, and executing more complicated and time consuming examinations to ensure that broker-dealers that rely on their own subjective risk analysis are complying with the rules.9 Clearly, the proposed subjective standard will be much more difficult to police than the current objective standard that references credit ratings.

As I said when we considered the proposal to remove NRSRO references from certain of our Investment Company Act rules, I believe that an absolute and inflexible requirement to remove a reference – even when the primary regulator is not able to find an appropriate substitute – will ultimately harm investors. And I ask Congress to clarify that without an appropriate substitute there is no obligation to remove a reference to a credit rating. Some of these ratings requirements, in fact, ably serve investor protection and have no effective substitute.

Given the concerns I have expressed, I am particularly interested in public comments addressing the following questions:

  1. What substitute for the use of NRSRO ratings in the net capital rule would provide an objective standard?; and
  2. How does the Commission make a finding that removing the existing credit rating references is in the public interest if there is no appropriate substitute?

Thank you.

1 See Concept Release: Nationally Recognized Statistical Rating Organizations, Release No. 34-34616, 1994 WL 469346 (Aug. 31, 1994); Concept Release: Rating Agencies and the Use of Credit Ratings Under the Federal Securities Laws, Release No. 33-8236 (June 4, 2003), available at http://sec.gov/rules/concept/33-8236.htm; References to Ratings of Nationally Recognized Statistical Rating Organizations, Release No. 34-58070 (July 1, 2008), available at http://sec.gov/rules/proposed/2008/34-58070.pdf; References to Ratings of Nationally Recognized Statistical Rating Organizations, Release No. 33-9069 (Oct. 5, 2009) (reopening comment period on 2008 proposals), available at http://sec.gov/rules/proposed/2009/33-9069.pdf.

2 See, e.g., Letter from Jeffrey T. Brown, Senior Vice President, Charles Schwab & Co., Inc. (Sept. 5, 2008), available at http://sec.gov/comments/s7-17-08/s71708-9.pdf; Letter from Keith F. Higgins, Chair, ABA Committee on Federal Regulation of Securities, and Vicki O. Tucker, Chair, ABA Committee on Securitization and Structured Finance (Sept. 12, 2008), available at http://sec.gov/comments/s7-18-08/s71808-31.pdf; Letter from Keith F. Higgins, Chair, ABA Committee on Federal Regulation of Securities (Oct. 10, 2008), available at http://sec.gov/comments/s7-18-08/s71808-36.pdf ; Letter from Sean C. Davy, Managing Director, Securities Industry and Financial Markets Association (Dec. 8, 2009), available at http://sec.gov/comments/s7-17-08/s71708-26.pdf.

3 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203 939A (2010).

4 Letter from Securities Industry and Financial Markets Association, supra n.2, at 3.

5 The Commission estimates in today’s rulemaking release that there are 480 broker-dealers that hold proprietary positions in debt securities. Of these firms, only six have been approved by the Commission to use proprietary risk models, rather than NRSRO ratings, to calculate appropriate net capital charges for debt securities. The six firms are Barclays Capital, Inc. (formerly Lehman Brothers, Inc.); Citigroup Global Markets, Inc.; Goldman Sachs & Co.; J.P. Morgan Securities LLC; Merrill Lynch, Pierce, Fenner & Smith Incorporated; and Morgan Stanley & Co. Incorporated.

6 As noted in today’s rulemaking release, in order to be approved as an alternative net capital firm, a broker-dealer must maintain an “early warning” level of at least $5 billion in tentative net capital, minimum levels of at least $1 billion in tentative net capital, and $500 million in net capital. See also Exchange Act Rule 15c3-1(a)(7), 17 C.F.R.  240.15c3-1(a)(7). By comparison, other broker-dealers must notify the Commission when, among other measures, their net capital falls below 120% of their required net capital, their aggregate indebtedness exceeds 1,200% of net capital, or their net capital is less than 5% of their aggregate debit items. See Exchange Act Rule 17a-11(c), 17 C.F.R.  240.17a-11(c).

7 While today’s proposal represents an improvement from our 2008 proposal to amend the Net Capital Rule – our current proposal would require documented policies and procedures, and it would tighten the credit standard from “moderate” to “minimal” with respect to certain securities – it still replaces an objective standard with an internal, subjective standard. See References to Ratings of Nationally Recognized Statistical Rating Organizations, Release No. 34-58070 (July 1, 2008), available at http://sec.gov/rules/proposed/2008/34-58070.pdf.

8 See Letter from the ABA Committee on Federal Regulation of Securities and the ABA Committee on Securitization and Structured Finance, supra n.2, at 9.

9 See U.S Gov’t Accountability Office, GAO-10-782, Securities and Exchange Commission: Action Needed to Improve Rating Agency Registration Program and Performance-Related Disclosures at 53-56 (2010), available at http://www.gao.gov/new.items/d10782.pdf.



Modified: 04/27/2011