SEC Holding Company Supervision
Program Description

Consolidated Supervised Entities (“CSEs”)

The Commission supervises certain 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 and the holding company itself. In supervising these Consolidated Supervised Entities ("CSEs"), the Commission focuses on the financial and operational condition of the group. The aim is to reduce the likelihood that weakness in the holding company or an unregulated affiliate endangers a regulated entity or the broader financial system. Like other consolidated supervisors overseeing internationally active institutions, the Commission requires CSEs to compute capital adequacy measures consistent with the Basel Standard.

A broker-dealer becomes a CSE by applying for an exemption from the standard net capital rule, and the broker-dealer’s ultimate holding company consenting to group-wide Commission supervision (if it does not already have a principal regulator).¹

Under the alternative method for computing capital, contained in new Appendix E to Rule 15c3-1, 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 exposure modeling to compute deductions for credit risks related to over-the-counter derivatives. A broker-dealer calculating net capital adequacy using the alternative method must maintain tentative net capital² 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. The Commission then would consider whether to require the broker-dealer to take appropriate remedial action.

As noted above, the associated holding company must consent to a consolidated supervision regime if it does not already have a principal regulator. The ultimate holding company must execute a written undertaking in which it agrees, among other things, to do the following:

• Maintain and document an internal risk management control system for the affiliate group;
   
• Calculate a group-wide capital adequacy measure consistent with the international standards adopted by the Basel Committee on Banking Supervision (“Basel Standards”);
   
• Consent to Commission examination of the books and records of the ultimate holding company and its affiliates, where those affiliates do not have principal regulators;
   
• Regularly report on the financial and operational condition of the holding company, and make available to the Commission information about the ultimate holding company or any of its material affiliates that is necessary to evaluate financial and operations risks within the ultimate holding company and its material affiliates; and
   
• Make available examination reports of principal regulators for those affiliates that are not subject to Commission examination.

The ultimate holding company must provide the Commission with monthly, quarterly, and annual reports. The reports must include specified consolidated financial and credit risk information, including a consolidated balance sheet and income statement audited by a registered public accounting firm; the capital adequacy measurement (statements of allowable capital and allowances for market, credit, and operational risk); the results of a review by the internal auditor of the risk management and control system of the ultimate holding company; and certain reports that the ultimate holding company regularly provides to its senior management to assist in monitoring and managing risk. The ultimate holding company must make and keep current records of funding and liquidity stress tests, the basis for the determination of credit risk weights for each counterparty, the basis for the determination of internal credit ratings for each counterparty, and a record of the calculations of allowable capital and allowances for market, credit, and operational risk.

These reports will assist the Commission in monitoring the financial condition, the risk management control system, and the activities of the affiliate group to detect any events or trends that may adversely affect regulated entities or the broader financial system.

Holding Companies With Principal Regulators

To avoid duplicative or inconsistent regulation, a reduced set of requirements applies to holding companies with principal regulators associated with broker-dealers that seek to apply the alternative method of computing net capital. These holding companies 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.

CSE Supervisory Program

The Commission’s supervisory program with respect to CSEs has four components:

• 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. The 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 by the Commission, 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) and risk reports substantially similar to those provided to the firm’s senior managers. At least monthly, the holding company files a capital calculation made on a consolidated, group-wide basis consistent with the Basel Standards.
   
• Third, the SEC staff meets at least monthly with senior risk managers and financial controllers at the holding company level to review the packages of risk analytics prepared at the ultimate holding company level 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 quarterly meetings focused on financial results, the management of the firm’s balance sheet, and, in particular, the liquidity of the balance sheet. Also on a quarterly basis, Commission staff meet with the internal auditor department to discuss implementation of the audit program as well as findings and reports that might bear on financial, operational, and risk controls. These regular discussions are augmented with focused work on risk management, regulatory capital, and financial reporting issues of topical concern, which in some cases are pursued at several firms simultaneously.
   
• Fourth, the SEC staff conducts examinations of the books and records of the ultimate holding company, the registered broker-dealers (along with staff of the responsible self-regulatory organizations), and material affiliates that are not subject to supervision by a principal regulator. The examinations focus on the capital calculation and on the adequacy of implementation of the firm’s documented internal risk management controls.

At present, four firms are subject to this regime:

• Goldman Sachs,
   
• Lehman Brothers,
   
• Merrill Lynch and
   
• Morgan Stanley.

Holding Companies With Principal Regulators

The Commission’s supervisory program with respect to a CSE with a principal regulator is distinct from that with respect to a CSE where the Commission has primary consolidated supervision responsibility for the holding company. The former relies significantly on the principal regulator to supervise the holding company, and thus focuses more narrowly on the broker-dealer. In general, the program in such cases consists of four parts.

• First, the SEC staff reviews the application prior to action by the Commission, as described above.
   
• 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) as well as the consolidated capital calculations filed with the principal regulator.
   
• Third, the SEC staff meets at least semi-annually with senior risk managers to review the packages of risk analytics prepared for the firm’s senior management. The focus is on the overall performance of the risk measurement infrastructure, and especially the mathematical models used to compute deductions from net capital in the broker-dealer.
   
• Fourth, SEC and self-regulatory organization staff conduct examinations of the books and records of the registered broker-dealer. The examinations focus on the capital calculation and on the adequacy of implementation of the firm’s documented internal risk management controls, some of which may be resident in the holding company.

This overview of the Commission’s consolidated supervision program for broker-dealers and affiliates 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, Matthew J. Eichner, Assistant Director, or Thomas K. McGowan, Assistant Director at (202) 551-5530.

¹ The definition of principal regulator contained in the rules encompasses, inter alia, the Federal Reserve and foreign supervisory regimes recognized by the Board of Governors of the Federal Reserve System (“Federal Reserve”).

² “Tentative net capital” is defined in the CSE rules as net capital before deductions for market and credit risk.

http://www.sec.gov/divisions/marketreg/hcsupervision.htm