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.In addi-tion, the Five Investment Banks were concerned about a threat by theEuropean Union to regulate their holding companies and affiliatesunless they were subject to consolidated regulation by one U.S.agency.4The Europeans were accustomed to this model of consolidated supervi-sion from their historic oversight of their own universal banks, whichengaged in a broad range of securities activities as well as traditionalbanking functions.With one set of new SEC rules adopted in 2004, theFive Investment Banks achieved both goals: They were granted an alter-native method of calculating their leverage ratios, and they agreed tosubject their parent holding companies to consolidated SEC supervision.At an open meeting in 2004 to approve the new rules, the head ofthe SEC s Division of Trading and Markets characterized the alternativecalculation method as conservative.Although she admitted that thenew method might result in a 20 30 percent reduction in net capital,she emphasized that it would apply only to the Five Investment Banks.5 We ve said these are the big guys, commented SEC CommissionerHarvey Goldschmid, but that means if anything goes wrong, it s goingto be an awfully big mess. 6According to a 2008 report by the Office of the Inspector General(OIG), the ratio of average assets to net capital for Bear Stearns was 33to 1 at the time of its demise.7 At that time, Bear Stearns was apparentlyin compliance with the new alternative method.Figure 6.2 shows theincrease in the leverage ratio for the Five Investment Banks betweenAugust 31, 2006 and February 29, 2008. Capital Requirements at Brokers and Banks 1333432302826242220Date of Quarter ClosingBear Stearns Company Goldman Sachs Lehman BrothersMerrill Lynch Morgan StanleyFigure 6.2 Major Investment Banks Gross Leverage RatiosSource: OIG Report September 25, 2008.A high leverage ratio is a recipe for disaster for any financial institu-tion, despite a diversified portfolio of loans and long-term investments.A high leverage ratio means that the financial institution will have athin capital cushion against losses from a large volume of assets.If someof those assets experience significant losses, the capital cushion will beeroded.With a 33 to 1 leverage ratio, Investment Bank B could make $33million of loans for every $1 million in capital.An $800,000 loss (after-tax) in its portfolio would reduce its capital from $1 million to $200,000.Then, as shown in Table 6.1, Investment Bank B would have to sell $25.6million in loans (and pay off $25.6 million in borrowings) in order tomaintain a leverage ratio of 33 to 1 ($32.2 million $25.6 million$6.6 million in loans relative to $200,000 in capital or 33 to 1).When capital is depleted, the institution has two main choices to getback to the required leverage ratio: It can raise more capital or sell assets.Because financial institutions often experience significant losses duringtimes of financial crisis, they will find it almost impossible to raise newcapital at that time.Instead, they typically are forced to sell assets in difficultGross Leverage Ratio2006200620072007200720072008y 28,y 31,y 29,uarMauarember 30,ember 30,August 31,August 31,vvebrebrFFNoNo 134 t oo bi g t o s a ve ?Table 6.1 Leverage Ratio EffectsAssets Liabilities Leverage Ratio(Loans, Bonds, etc.) (Plus Capital) (Assets to Capital)T#1 Start $33 m in loans $32 m borrowing 33 to 1$1 m capitalT#2 Losses of $32.2 m in loans $32 m borrowing$800,000 $200,000 capitalT#3 Sells ( $25.6 m sold ( $25.6 m paid to$25.6 m in loans loans) borrowers)and pays backborrowersT#4 Finish $6.6 m in loans $6.4 m 33 to 1borrowing$200,000 capitalmarkets.Such forced sales not only result in unfavorable prices for the sell-ing institution, but also can trigger a downward spiral for the whole marketas multiple institutions are faced with the same dilemma.This downwardspiral occurred with a vengeance during the latter half of 2008.The Need for a Consolidated RegulatorAt that same SEC meeting in 2004, Mr.Goldschmid asked: Do we feelsecure if there are these drops in capital [that] we really will have inves-tor protection? A senior staff member replied that the SEC would hirethe best minds with quantitative skills to implement this ConsolidatedSupervised Entities (CSE) program.In fact, the SEC assigned onlyseven people to examine the parents of the Five Investment Banks,which had combined assets of more than $4 trillion in 2007.8In exchange for greater fl exibility on leverage ratios, the FiveInvestment Banks agreed to have sophisticated systems for risk man-agement, and to allow the SEC more frequent access to these sys-tems, as applied to the parents of the Five Investment Banks as well astheir other affiliates.This group-wide SEC supervision would imposereporting (including reporting of a capital adequacy measurement con-sistent with the standards adopted by the Basel committee on BankingSupervision). 9 Like Basel II, the new consolidated supervision pro-gram at the SEC relied heavily on the internal risk models of the Five Capital Requirements at Brokers and Banks 135Investment Banks in determining the riskiness of their investments inorder to determine their own risk-based capital requirements.The OIG report concluded that the CSE program was neverproperly staffed, did not pay close enough attention to the impor-tant issues, and did not have a formal automated process to ensurethat issues were resolved.According to the report s executive summaryon Bear Stearns:Thus, it is undisputable that the CSE program failed to carryout its mission in its oversight of Bear Stearns because underthe Commission and the CSE program s watch, Bear Stearnssuffered significant fi nancial weaknesses and the FRBNYneeded to intervene during the week of March 10, 2008, toprevent significant harm to the broader financial system.10Although the SEC poorly implemented the 2004 CSE pro-gram, it is no longer the consolidated regulator of the FiveInvestment Banks, which have all become parts of bank hold-ing companies under the Federal Reserve.Nevertheless, if prop-erly staffed, the SEC can be an effective consolidated regulatorof smaller investment banks and broker-dealers
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