Division of Trading and Markets
Broker-Dealers Using the Alternative Net Capital Computation under Appendix E to Rule 15c3-1
A broker-dealer may apply to the Commission for authorization to use the alternative method for computing capital (alternative net capital, or ANC, computation) contained in Appendix E to Rule 15c3-1. Under Appendix E, firms with strong internal risk management practices may utilize the mathematical modeling methods they use to manage their own business risk, including value-at-risk (VaR) models and scenario analysis, to compute deductions from net capital for market risks and for credit risks arising from OTC derivatives transactions. As a condition of approval, applicants effectively must maintain an “early warning” level of at least $5 billion in tentative net capital1 and minimum levels of at least $1 billion in tentative net capital and at least $500 million in net capital.
Broker-dealers that wish to use the ANC computation must file an application that, among other things, describes their VaR models, including how the models meet the requirements of Appendix E, and the broker-dealer’s internal risk management control system, including how that system satisfies the requirements of Exchange Act Rule 15c3-4. The application must also include sample risk reports that are produced for the persons at the firm who are responsible for internal risk management. In addition, provided that they have a principal regulator, holding companies of broker-dealers applying to use the ANC computation must execute a written undertaking in which they agree, among other things, to do the following:
- Make available to the Commission information on controls relevant to the broker-dealer but resident in the holding company;
- Make available to the Commission information about the ultimate holding company or any of its material affiliates that is necessary to evaluate financial and operational risks within the ultimate holding company and its material affiliates; and
- Make available to the Commission capital adequacy measurements computed in accordance with the standards published by the Basel Committee on Banking Supervision and provided to the principal regulator.
If the Commission approves the broker-dealer’s use of the ANC computation, the broker-dealer must continue to maintain tentative net capital of at least $1 billion and net capital of at least $500 million. Moreover, if the tentative net capital of a broker-dealer using this alternative method falls below $5 billion, it must notify the Commission. If the deficiency is not cured promptly, the Commission would consider whether to revoke the broker-dealer’s authorization to use the ANC computation. In addition, the Commission would monitor financial, operational, and risk controls residing in the holding company to the extent they impact the broker-dealer.
In essence, the Commission’s supervision of ANC broker-dealers consists of four parts:
- First, the SEC staff reviews the application prior to action by the Commission. As part of the review, the staff assesses the firm’s financial position, the adequacy of the firm’s internal risk management controls, and the mathematical models the firm will use for internal risk management and regulatory capital purposes. SEC staff also conducts on-site reviews to verify the accuracy of the information included in the application, and to assess the adequacy of the implementation of the firm’s internal risk management policies and procedures.
- Second and following approval, the SEC staff reviews monthly, quarterly, and annual filings containing financial, risk management, and operations data. These reports include consolidating financials (which show intercompany transactions that are eliminated during the preparation of consolidated financial statements), risk reports substantially similar to those provided to the firm’s senior managers, and the consolidated capital calculations filed with the principal regulator.
- Third, the SEC staff meets regularly with senior risk managers at the holding company level to review the packages of risk analytics prepared for the firm’s senior management. The focus is on the performance of the risk measurement infrastructure, including statistical models, risk governance issues including modifications to and violations of risk limits, and the management of outsized risk exposures.
In addition, there are regular meetings focused on financial results, the management of the firm’s balance sheet, and, in particular, the liquidity of the balance sheet. Emphasis is placed on funding and liquidity risk management plans and liquidity stress scenarios. Because of the importance of mark-to-market accounting, Commission staff also meets regularly with financial controllers to review and discuss price verification results and other financial controls, particularly concerning illiquid or hard-to-value assets or large asset concentrations. In addition, Commission staff meet regularly with the internal audit department to discuss implementation of the audit program as well as findings and reports that might bear on financial, operational, and risk controls.
- Finally, SEC staff conduct examinations of the books and records and capital calculations of the registered broker-dealer. In addition, SEC staff reviews the adequacy of implementation of the firm’s documented internal risk management controls, some of which may be resident in the holding company.
ANC firms are also members of self-regulatory organizations such as the Financial Industry Regulatory Authority (FINRA), which promulgate, administer, and examine for compliance with their membership rules.
This overview of the Commission’s prudential supervision program for broker-dealers was prepared by and represents the views of the staff of the Division of Trading and Markets, and does not constitute rules, regulations or statements of the Securities and Exchange Commission. For further information, contact Michael A. Macchiaroli, Associate Director, at (202) 551-5525 or Thomas K. McGowan, Deputy Associate Director, at (202) 551-5521.
1 “Tentative net capital” is defined in Exchange Act Rule 15c3-1(c)(15) as net capital before deductions for market and credit risk.