In 2013, the SEC adopted amendments to the net capital rule that eliminated references to credit ratings that had previously applied to non-exotic debt securities such as high grade corporate debt and commercial paper that have a ready market.

Broker-dealers were supposed to either use a 15% haircut for their portfolios of these items or to have procedures in place to determine whether they have minimal credit risk. We can’t blame the SEC for changing the rules as they had little choice but to comply with the law. The changes were dictated by the politicians in Congress that passed the Dodd-Frank Act. That Act was a reaction or an over-reaction to abuses in the credit ratings industry. Perhaps the fiscal acumen of members of Congress could be questioned.

So, the SEC changed the net capital rule and FINRA examines its members and determines if its members comply with what the SEC did. Major broker-dealers with huge portfolios have whole departments that are able to evaluate credit risk.

Smaller broker-dealers have little inclination or the resources available to increase overhead by hiring people to evaluate credit risk. For decades they relied upon credit agencies such as Standard & Poor’s and Moody’s that were for the most part very reliable. It is no mystery, and most of us intuitively know, that bonds with superior ratings are inherently high grade and have minimal credit risk. On the other hand, the 2013 SEC amendments forced many firms to alter their standard way of thinking and respond to the change by burdening them with more rules to comply with.

Recently, FINRA examiners visited one of our smaller broker-dealers that for the most part, is a broker of high grade corporate debt, but occasionally also underwrites these instruments. The broker-dealer had underwritten a minute portion of a multi-billion dollar offering of a well-known NYSE-listed financial powerhouse whose debt had multiple investment grade credit ratings[1]. It wouldn’t take more than a few seconds for any industry professional to conclude that the debt had only minimal credit risk. The mere issuance size and the fact that it had a market interest rate and was being issued at par made its credit risk or lack thereof quite apparent, even to a Wall Street outsider, let alone an industry professional. Yet, the FINRA examiners insisted that the broker-dealer did not have written procedures that allowed it to conclude that the firm that indeed underwrote the debt securities incurred minimal credit risk. We rely on experts. In this case, it’s not the examiners’ fault or stubbornness.

We are stuck with a law adopted by Congress that unfortunately forced the SEC to modify rules that had worked well for decades, and in turn, which forces regulatory examiners to seek out infractions of the strange rules, etc.

Were it up to us, we would petition Congress to invalidate the silliness of not allowing broker-dealers to rely upon credit ratings and pervasive industry knowledge. Congress is too busy right now dealing with the pandemic and the need for economic stimulus. Thus, our petition would fall on deaf ears. Congress is also stymied by partisan politics. Instead, we are compelled to ensure that written supervisory procedures conform to what the SEC was forced to adopt. Perhaps the SEC left out one major criterion called “Common Sense.”

We must change our ways, if we haven’t already. Remember, they are from the Government and they are here to help us?

_{[1] As of May 25, 2020 on its publicly available website, Moody’s had the following to say about this particular issuer: Rating Action: Moody's reviews [issuer name] for upgrade (A3 senior/Prime-2). S&P also had an investment grade rating for this issuer.}