Crisis on Wall Street: A retrospective analysis of the 2004 SEC net capital requirement rule change.

Abstract

The 2007-8 financial crisis is the subject of many retrospectives and policy pieces. This thesis focuses on a then little-known 2004 SEC rule change to net capital requirements that established a controversial alternative net capital calculation and created a regulatory body known as the CSE program. It asks whether the blame for the financial crisis, and in particular the collapse and acquisition of Bear Stearns, ought to be attributed to the SEC and its CSE program administrators. In answering this question, this thesis approaches the financial crisis from three perspectives. First it prods at the origins of the SEC and its CSE program and of net capital requirements in general to understand the framework in which the 2004 rule change operated. Secondly, it analyzes various publicly available data to answer two empirical questions about the crisis. These regard whether leverage at the holding-company level increased in the run-up to the financial crisis because of the 2004 rule change and if the creation of the alternative method of net capital calculation prompted an erosion in broker-dealer regulatory capital requirements. Finally, it examines the end of Bear Stearns, beginning with the implosion of two of its prominent hedge funds, and ending with the freezing of the tri-party repo market and Bear’s acquisition by JP Morgan. This three-pronged approach attempts a relatively comprehensive review of the SEC’s role within the financial crisis at large. It arrives at the conclusion that though the alternative method and CSE program likely did not result in a blow-up of leverage at the banks or the erosion of broker-dealer net capital requirements, the regulatory body was not an innocent bystander. Regulatory competition created a framework that greatly restricted the regulatory freedom of the SEC but given certain discrete policy failures on the part of its ‘monitors’ and the SEC leadership, is it not the case that the program was doomed from the start. This paper’s primary policy recommendation is that regulatory arbitrage stemming from competition among independent, non-cooperative agencies should be avoided at all costs. It is perhaps overly simple to argue that the failure of the tri-party repo market was a case of just plain bad luck for the SEC regulators and the financial system at large. Both problems may be remedied in the future if U.S. policymakers institute a comprehensive and powerful body that can delegate the prudential regulation of novel financial instruments as they are born. One further problem meriting examination is the culture insufficient financial transparency at both commercial and investment banks and how the SEC compounded this issue in the run-up to the financial crisis.