SEC May Cap Leverage for Brokers

Funding rules under consideration would be designed to prevent runs on broker-dealers.

U.S. regulators worried that banks and brokerage firms remain too dependent on risky types of short-term funding are weighing new rules designed to reduce reliance on parts of what is often called the shadow banking system.

Now the SEC is weighing new funding rules for brokers as well as a limit on leverage similar to those used by the Federal Reserve and other regulators for banks, according to a regulatory document and SEC officials familiar with the matter.

The initiatives are aimed at financing tools such as repurchase agreements, or repos, that were relied on by Bear Stearns Cos. and Lehman Brothers Holdings Inc. until their failures accelerated the 2008 financial crisis. Lehman’s bankruptcy provoked criticism of the Securities and Exchange Commission (SEC) for lax oversight of investment banks.

“We all learned during the crisis that the shadow banking system, of which broker-dealers are a part, is subject to runs just like banks,” said Phillip L. Swagel, a professor at the University of Maryland who served as a Treasury Department assistant secretary during the crisis. “What seems like highly liquid collateral can turn illiquid during the next crisis.”

Federal Reserve officials have warned for years that the $4.5 trillion web of repo deals remains prone to unravel during a panic, potentially leading to fire sales of assets that could spread losses across the financial system.

Federal Reserve Bank of Boston President Eric Rosengren said last year that the SEC’s current rules for broker-dealers haven’t changed enough since the financial crisis.

The SEC oversees broker-dealers, the largest of which are owned by big banks supervised by the Fed. Wall Street’s largest bond dealers became heavy users of the Fed’s emergency-lending facilities during the crisis. Their borrowing via two programs peaked at $401 billion on two separate days in September 2008.

The broker-dealer units of banks including JPMorgan Chase & Co. and Goldman Sachs Group Inc. would be affected by the proposal, as would firms such as Leucadia National Corp.’s Jefferies Group LLC that aren’t within Fed-regulated holding companies.

In an effort to head off regulators, Wall Street banks and industry groups are developing a proposal to have a third party, such as the Fixed Income Clearing Corp., process and clear transactions. That would reduce the risk brokers face from a trading partner’s default.


Raising Cash

Broker-dealers use repos, or repurchase agreements, to raise cash to finance their inventory of assets and to provide short-term funding to clients such as hedge funds. For instance, a broker-dealer receives cash in return for collateral, typically Treasury bills or notes, that it has the obligation to repurchase at the original price plus interest. If a broker isn’t able to renew the agreement, it can be forced to sell other assets to get needed cash. Roughly 45 percent of large banks’ trading portfolios are funded by repos, according to an October 2013 report by Citigroup Global Markets Inc.

Federal Reserve Governor Daniel Tarullo said last month that regulators may want large, complex banks that house broker-dealers to hold more capital or rely more on longer-term funding. The $71 trillion shadow-banking system, which includes the $4.5 trillion market for U.S. repos, still isn’t adequately protected by regulation, Tarullo said.

“We have yet to address head-on the financial stability risks from securities financing transactions and other forms of short-term wholesale funding that lie at the heart of shadow banking,” Tarullo told the Senate Banking Committee on Feb. 6.

One measure of a broker’s indebtedness is the ratio of its assets to capital. U.S. broker-dealer leverage reached 40-to-1 in 2007 before falling to 22-to-1 in 2012, according to the most recent annual report of the Financial Stability Oversight Council (FSOC), an umbrella group of U.S. regulators led by the Treasury Secretary. Broker-dealers’ leverage is still “significantly higher” than that of commercial banks, according to FSOC.

Brokers contend that their borrowing is generally less risky than bank lending. Repo borrowing, for instance, is backed by collateral that can be readily sold to raise cash in case the other party defaults, said Steven Lofchie, co-chairman of the financial services group at Cadwalader, Wickersham & Taft LLP.

“If you think about a bank that is lending 90 percent against a house, versus a broker-dealer taking in 102 percent against a loan of a security, the broker dealer’s credit risk is exponentially less,” Lofchie said.

SEC Commissioner Daniel M. Gallagher said the agency should show its “learned lessons from the crisis” and should consider the Fed’s views. At the same time, the agency’s capital rules should remain focused on protecting customers, not trying to shield brokers from the possibility of failure.

“The thing we will not be able to do is allow the bank paradigm to come into the capital markets and stifle out all that liquidity,” Gallagher, a Republican, said in an interview. “If that happens it will be a travesty.”

Some brokers may already be subject to stricter leverage limits through rules imposed on their parent companies. In July, the Fed proposed a stricter leverage limit for the eight largest U.S. banks, most of which also own large broker-dealers. Last month it voted to apply similar standards to the U.S. operations of foreign banks with more than $50 billion in assets, which also relied on the Fed’s emergency lending programs during the crisis.


Reach Expanded

The SEC rules would expand the reach of such rules, since they would apply to all of the largest broker-dealers, not only those owned by banks. The rules also would try to ensure a bank-owned broker doesn’t remain dangerously leveraged even as its parent bank complies with the Fed’s limit by paring back assets or activities in other businesses.

The Fed’s “bank capital rules apply on a consolidated basis across all the subsidiaries, which will include the broker-dealers,” said Michael P. Jamroz, a former SEC lawyer and expert on broker capital rules who is now a partner at Deloitte & Touche LLP. “It has an impact right now, today.”

The SEC is now considering changes to its own capital rules, including placing a cap on brokers’ borrowing and imposing a cushion of liquid assets to rely on in a crisis. While the SEC’s current rules require the largest brokers to maintain a capital cushion of at least $5 billion, they don’t set a strict cap on leverage.

In a regulatory document issued last year, the SEC said it’s considering setting a maximum leverage ratio for broker-dealers. While it’s unclear whether the SEC will define the ratio differently from the Fed, SEC Chairman Mary Jo White has warned against imposing bank-like standards on broker-dealers.

A leverage ratio like the one currently used by banking regulators would make brokers’ leverage appear much higher by counting their repo borrowing, said Jefferson Duarte, a finance professor at Rice University.

White told a conference last month that the agency is planning to update its capital rules for brokers while seeking “to avoid a rigidly uniform regulatory approach solely defined by the safety and soundness standard that may be more appropriate for banking institutions.”


Capital Cushion

In addition to a leverage cap, the SEC is weighing another rule that would require brokers to set aside enough cash and easily sold assets to survive a period during which borrowing costs spike or creditors restrict funding, according to a person familiar with the matter who asked to not be named because the effort isn’t public yet.

The SEC’s proposal may apply to the roughly 200 broker-dealers that hold customers’ assets, and the firms may be asked to conduct monthly stress tests to determine whether they’re prepared for such conditions, the person said.

“Those are the ones that are arguably systemic,” said James Fanto, a law professor at Brooklyn Law School and co-director of its Center for the Study of Business Law & Regulation. “They are the ones you worry about if they go down because they are in charge of the money and the securities.”

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