The SEC Rule That Broke Wall Street
Importantly, this wasn’t “deregulation” any more than adding an extra traffic lane to a government highway is privatization. In fact, the SEC went out of its way in explaining the new rule to show that this was part of its regulatory view of how markets should operate under supervision:
The Commission took into account several considerations in deciding whether to provide this exemptive relief and designate additional categories of permissible collateral. For example, the Commission considered whether the risks of customer losses associated with permitting a new category of collateral were sufficiently small relative to the benefits the additional kinds of collateral will provide. Those benefits include adding liquidity to the securities lending markets and lowering borrowing costs for broker-dealers. In issuing this Order, the Commission is drawing on its experience in assessing the liquidity of markets in a variety of contexts including, for example, the net capital requirements for broker-dealers.
It’s easy to see what happened once both amendments were in place. Investment banks now could collateralize securities borrowings with an asset type that received favorable capital treatment. It’s a recipe for insatiable craving for mortgage-backed securities.
The rotation of the entire financial world toward mortgage risk was accompanied by well-meaning if misguided regulatory changes. In retrospect, it seems unwise to have put in place rules that tended to homogenize the balance sheets of our commercial banks and our investment banks. The financial crisis would not have been anywhere near as severe if different supervisory rules had encouraged different types of investment banks to adopt different strategies. But at the time, this homogenization was regarded as a feature and not a bug.
“The CSE rule also requires monthly calculation at the holding company level of a capital adequacy measure that is designed to be consistent with the standards adopted by the Basel Committee on Banking Supervision. This should allow for greater comparability of a CSE firm's financial position to other international securities firms and banking institutions,” Robert L.D. Colby, then acting director of the SEC’s Division of Market Regulation, told a House subcommittee in 2006.
McLean’s article is right when it says that the 2004 changes didn’t cause the crisis by unleashing deadly leverage. But it’s wrong to extend this to an exoneration of the 2004 amendments. Those did have lethal consequences on Wall Street and nearly fatal results for the entire economy.
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