NEW YORK (TheStreet) - The Securities and Exchange Commission said last Friday it would adopt amendments to remove references to credit ratings in calculating the regulatory capital financial firms need to put behind commercial paper, debt and preferred stock, pushing forward one of the major tenets of the 2010 Dodd Frank Wall Street Reform and Consumer Protection Act. The change appears targeted at mitigating some of the risks uncovered in the collapse of commodity trading firm MF Global in October 2011.
The amendments will remove references to credit ratings in the broker-dealer financial responsibility and confirmations of transactions rules. New regulations will also prohibit broker-dealers from using customer securities and cash to finance their own trading, and will force them to maintain more than a dollar of highly liquid assets for each dollar of liabilities.
Those rules will "ensure that if the broker-dealer fails, it will have sufficient liquid assets to cover its liabilities," the SEC said. The new regulations appear to have the biggest impact on how financial institutions calculate the capital they need to put behind assets such as commercial paper, nonconvertible debt, and preferred stock.
In some instances, the credit ratings of so-called nationally recognized statistical rating organizations (NRSROs) such as Standard & Poor's, Moody's (MCO - Get Report) and Fitch Ratings had allowed firms to minimize the size of haircuts they would have to take against certain assets. If commercial paper, nonconvertible debt or preferred stock met some ratings thresholds, a broker dealer could gain an exemption from taking large haircuts.
Those rules appeared to allow some firms to hold risky but highly-rated assets as a means to generate leveraged investment gains. Minimal haircuts against risky assets also meant that a firm could stake bets beyond their capacity to repay without dipping into client funds. Some consider the failure of MF Global and the firm's misfired $4 billion bet on the highly rated but risky short-term debt of peripheral European nations as the type of arbitrage that new regulators seek to mitigate.
Now, instead of relying on credit ratings, firms will have to evaluate credit spreads, internal and external credit assessments, default statistics, index performance, credit enhancements, price activity and other financial data when calculating they haircuts they set aside for certain assets. Firms will also be required to document their methodologies.
"[The] Commission does not intend for the new standard to result in a more liberal requirement that broadens the scope of the rule by allowing more positions to qualify for the lower haircuts," the SEC said in its final rule.
-- Written by Antoine Gara in New York