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Haircuts, Rating Equivalents, and the Net Capital Rule for Broker-Dealers

May 6, 2011

In accordance with Title IX of the Dodd-Frank Act, the SEC has published proposed amendments that would remove references to credit ratings in several rules under the Securities Exchange Act. The proposal removes references to credit ratings:

  1. in the SEC’s net capital rule for broker-dealers;
  2. in the definition of “major market foreign currency;”
  3. when determining net capital charges for credit risk; and
  4. from Rule 15c3-3, Rules 101 and 102 of Regulation M, and Rule 10b-10.

The Commission also requested comment on potential standards of creditworthiness for purposes of Exchange Act Sections 3(a)(41) and 3(a)(53), which define the terms “mortgage related security” and “small business related security,” respectively, as the Commission considers how to implement Section 939(e) of the Dodd-Frank Act.

The most problematic aspect appears to be the proposed amendments to the net capital rule for broker-dealers, Exchange Act Rule 15c3-1.

Standard Haircut

The net capital rule requires a broker-dealer to ensure that its actual net capital exceeds its minimum net capital requirement at all times. In calculating its assets, the broker-dealer must subtract prescribed percentages of the market value of securities it owns (known as “haircuts”) to discount for potential market movements. The current net capital rule applies a lower haircut to securities that are rated in higher rating categories by at least two credit rating agencies. In place of the current references to credit ratings, the Commission proposes that a broker-dealer take a 15 percent haircut on its proprietary positions in commercial paper, nonconvertible debt, and preferred stock unless the broker-dealer has a process for determining creditworthiness that satisfies certain criteria. Commercial paper, nonconvertible debt, and preferred stock without a ready market would be subject to a 100 percent haircut.

Alternative Process for Determining Creditworthiness

If a broker-dealer has written policies and procedures for determining creditworthiness, the broker-dealer would be permitted to apply the lesser haircut requirement currently specified in the net capital rule for commercial paper, nonconvertible debt, and preferred stock. The processes and procedures must assess the credit and liquidity risks applicable to a security, and based on this process, would have to determine that the investment has only a “minimal amount of credit risk.”

Credit Risk

Various factors would be employed to assess credit risk. They include credit spreads; securities-related research; credit risk assessments; default statistics; inclusion on an index; priorities and enhancements; and price, yield, or volume.

Request for Comments

Among other things, the Commission is interested in receiving comments on the potential impact of the proposed amendments on the capital markets generally, and on capital-raising efforts by issuers of the affected types of securities specifically. It also asks whether conditions should be placed on the ability of a broker-dealer to outsource the determination of creditworthiness to a third party.

The deadline for comments to be submitted is July 5th. View the proposal here.

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