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Felix Shipkevich October 22, 2012

A new rule on capital requirements proposed by the Securities and Exchange Commission (SEC) is causing controversy. The rule mandates that financial institutions will be required to hold between $20 million and $5 billion in capital for their securities derivatives.

The SEC maintains that the proposed capital rule will ensure that customer property can be returned quickly to customers if the swap dealer bank fails. This rule references 2008’s financial crisis, when AIG’s sale of swaps without sufficient capital reserves led to the firm’s collapse and an almost $200 million taxpayer bailout.

“One of the most important goals of Title Seven of Dodd-Frank Act is to reduce the risks posed by large uncollateralized derivatives positions not just to the risks to the players in the market but also the risk to the financial system, the broader economy, investors, taxpayers and working men and women,” said Luis Aguilar from the SEC.

The amount of capital reserves required for a given institution will depend on whether they use internal models to determine risk of investment. Yet the use of internal models is complex, and many regulatory observers doubt that the SEC has the resources to verify bank reports.

Does the SEC have the Resources?

“You have to ask the question: If the regulators can’t figure out the value-at-risk modelling what is the point of all this?” said Wallace Turbeville, former banker at Goldman Sachs. “What benefit are these derivatives providing people?” he added.

Other regulatory observers are questioning whether current methods of determining capital requirements are even satisfactory.

“How do we really know that Wells Fargo has a less risky profile than another big bank?” said Clifford Rossi, professor at University of Maryland. “Unless you are sitting next to them as they work on their terminal it is extraordinary difficult to keep tabs.”

As seen by regulatory observers, the problem is twofold: 1) Do standing methods of assessing risk actually work? 2) If so, does the SEC have the resources to validate these risk assessment models?

In addition to the new capital requirements, financial institutions will also be subject to stress tests and liquidity requirements, further compounding the need for agency resources.

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