Net Capital Requirement (aka Net Capital Rule, Net Capital Ratio)
A rule issued by the Securities and Exchange Commission (SEC) that required member firms and broker-dealers of securities not to exceed a specific debt/liquid capital ratio (aka leverage ratio). Debt includes margin loans and commitments to buy securities in an underwriting.
Since 1997, this ratio was 15/1, but on April 28, 2004, the SEC decided, because of pleas from the investment banks themselves, to allow investment banks with assets greater than $5 billion to use their own risk models for risk management, one of the factors leading to their collapse or their absorption by stronger financial institutions during the Great Recession of2008. Bear Stearns, for instance, increased their leverage ratio to 33 to 1 — they had 33 dollars of debt to every dollar of assets. Because of the risk that such a large debt ratio posed, and because it was losing large amounts of money from its mortgage-backed securities, the government feared that a domino effect would cause other financial institutions to fail, so the Federal Reserve arranged for JPMorgan to acquire Bear Stearns, with Federal Reserve backing, on March 17, 2008 for $2 per share (in the previous year, Bear Stearns stock sold for more than $170 per share). On March 24, JPMorgan increased the payment per share to $10.
17 CFR 240.15c3-1, Net Capital Requirements for Brokers or Dealers, provides broker-dealers with a voluntary, alternative method of computing net capital that permits very highly capitalized broker-dealers to use their internal mathematical models for net capital purposes, subject to specified conditions. The proposed alternative method of computing certain market and credit risk net capital charges involves the use of internal mathematical models that the broker-dealer uses to measure risk.
On August 29, 2008, the net capital requirement was restored to its previous value.