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SEC to FRB- are you sure about that?

Speaking to the Institute of International Bankers early this week, SEC Commissioner Daniel Gallagher gave an interesting speech criticising the imposition of one-size-fits-all capital requirements on differing market participants. His views are particularly relevant following the Fed’s final rule forcing large non-US banks to effectively submit all their US subsidiaries to costly FRB regulation. He noted that bank capital requirements function is “to reduce risk and protect against failure”; in contrast broker-dealer capital requirements serve to provide adequate capital to ensure an orderly liquidation in the event of insolvency.

Given that the broker-dealer capital rules are not intended to disincentivise risk-taking, but to minimise its consequential fall-out; the Commissioner argues that it is counterproductive to inflict overly-conservative banking requirements on the qualitatively different broker-dealer business. It may be argued that the risk-capital burden on broker-dealers is actually more onerous than that on banks; they take no cognisance of credit secured by illiquid assets and subject even highly-liquid collateral to significant haircuts. This imbalance is only exacerbated by the broker-dealer’s lack of access to cheap funding via the FRB discount window. The SEC’s view is encapsulated in the Commissioner’s pointed conclusion to his speech,

“When it comes to the broker-dealer subsidiaries of banks, however, we stand ready to work with the Fed and other banking regulators to ensure that any new rules applicable to those entities are enhancements to our existing regime, not duplicative, contradictory or counterproductive regulations inspired by a regulatory paradigm designed for wholly different entities.”

The Commissioner makes an important point and his speech is worth reading in full. The FRB’s recent “power-grab”, following but not necessarily consequent upon intense lobbying by domestic U.S. banks, will inevitably result in lower returns and hence lower investment by broker-dealers. The repo markets have an important role to play in both liquidity provision and price discovery; subjecting them to politically-motivated, punitive capital requirements may actually increase systemic risk in the overt cause of reducing it.

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