naked capitalism

The Financial Times reports that the SEC has launched a probe into whether other financial firms used repos to engage in what amounted to financial fraud (as in fraudulent financial reporting), although perilous few are using the “F” word.

From the Financial Times:

US regulators on Monday asked more than 20 financial groups whether they engaged in transactions along the lines of “Repo 105” – an accounting device that helped Lehman Brothers conceal its high leverage ratio during the financial crisis.

The corporate finance division of the Securities and Exchange Commission wrote to chief financial officers of “close to two dozen” large foreign and domestic banks and insurers, demanding details of repurchase agreement deals.

The SEC probe includes whether companies booked repos as asset sales for accounting purposes over the past three years, and whether these deals were concentrated with certain counterparties or certain countries. Regulators also asked companies to quantify the amount of repos that were disclosed as asset sales and to explain the “business reasons” for use of these structures.

Yves here. While this is a welcome move, the open question is whether the SEC has sufficient reach to be effective. Repo 105 provides a template for one sort of violation, but how many other balance-sheet flattering games, involving God-knows-what jurisdictions, might have taken place? The SEC regulates broker-dealers, so for commercial banks with broker-dealer operations, its authority extends only to the US broker dealer operations. Even for the former investment banks, the SEC’s authority over the holding companies was tenuous. Per an earlier post:

The SEC did not have statutory authority over Lehman’s holding company. Its authority was “voluntary”, a sort of regulatory default. The lack of statutory authority creates ambiguity as to its basis for action (for instance, it cannot use statutory violations as a basis for action, nor can it threaten to revoke a license, since it does not have licensing authority. The examiner’s report is definitive upon this point (p. 1484):

The Gramm‐Leach‐Bliley Act of 1999 had created a void in the regulation of systemically important large investment bank holding companies. Neither the SEC nor any other agency was given statutory authority to regulate such entities.

In keeping, to induce the US LIBHCs to participate in an toothless regulatory scheme, the SEC weakened net capital requirements, an action that many experts see as having played a direct role in the crisis (as it is allowed investment banks to attain higher levels of leverage). Moreover, note the implicit limits on the SEC’s authority. From Report 466-A, published September 25, 2008:

The CSE program is a voluntary program that was created in 2004 by the Commission pursuant to rule amendments under the Securities Exchange Act of 1934. This program allows the Commission to supervise these broker-dealer holding companies on a consolidated basis. In this capacity, Commission supervision extends beyond the registered broker-dealer to the unregulated affiliates of the broker-dealer to the holding company itself. The CSE program was designed to allow the·Commission to monitor for financial or operational weakness in a CSE holding company or its unregulated affiliates that might place United States regulated broker-dealers and other regulated entities at risk.

Yves here. Did you catch that? While the SEC can supervise the holding company and unregulated entities, its scope of action is limited to preserving the health of regulated entities only.

The CSE program focused on liquidity, NOT solvency.

Back to the current post. So for the former investment banks, the SEC presumably has some history in supervising their “unregulated entities” but it can’t really force them to comply. Now these firms don’t want to appear to be obstructionist, but I would not be surprised to see any queries answered as narrowly as possible.

And how far can the SEC get, say, with a US or foreign bank with US broker dealer operations? It can presumably demand that the US broker dealer explain any suspect looking end of reporting period transactions, but the SEC’s ability to demand documents from the entity on the other side of the trade (even if it is another affiliate) would seem to be limited.

That is a long-winded way of saying that it is not a good sign that the SEC appears to be conducting this investigation without the support of other regulators, both in the US and overseas. Perhaps some will throw their weight behind it, but the lack of coordinated action does not bode well for reform.