The New York Times has a long story today about the disastrous 2004 change to the SEC’s “net capital rule.” The rule change allowed America’s five largest investment banks to greatly increase their leverage ratios, from 12-1 to as much as 40-1. All five investment banks have since either collapsed or transformed themselves into commercial banks.
The Times story mentions that “The five investment banks led the charge [to change the rule], including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.”
[W]e and other global firms have, for many years, urged the SEC to reform its net capital rule to allow for more efficient use of capital. This is the single most important factor in driving significant parts of our business offshore, so that our firms can remain competitive with our foreign competitors risk-based capital standards must become the norm.
In the same testimony, Paulson also called on the SEC to change to more “voluntary regulation”â€”exactly what the SEC chair Christopher Cox now says “does not work.” (No kidding.)
Here are some relevant sections from today’s Times story, although it’s well worth reading it all:
Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control…
On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.
They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments.
The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr…
The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.
With that, the five big independent investment firms were unleashed.
In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firmsâ€™ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.