Deutsche Bank AG Deutsche Bank Securities Inc.
February 18, 2004
By E-Mail to email@example.com
Mr. Jonathan G. Katz
Re: File No. S7-21-03; Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities
Dear Mr. Katz:
Deutsche Bank AG and Deutsche Bank Securities Inc. (together "Deutsche Bank") are pleased to submit comments to the Securities and Exchange Commission's ("the Commission") proposal for "Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities" ("the proposal"). Deutsche Bank commends the Commission for proposing a rule that represents such a great stride towards consistency with modern comprehensive risk management practices employed by most highly capitalized financial institutions. We appreciate the efforts that the Commission's staff has made to engage in dialogues with affected trade associations and institutions to explain the intent of the proposal. We also commend the Commission because, while we recognize that the proposal was originally generated in response to the needs of U.S. investment banks unaffiliated with bank holding companies arising out of certain European Union ("EU") directives, the Commission has attempted to make the proposal attractive to broker-dealer affiliates of U.S. bank holding companies and foreign banks.
Having actively participated in the dialogue with the Securities Industry Association, ABASA, the New York Clearing House and the Institute of International Bankers, we are very familiar with and generally support their comments. Given the importance of this proposal, and given the impact it would have on our organization, Deutsche Bank would like to provide its unique perspective on the issue.
For the reasons highlighted below, we respectfully urge that a number of changes to the proposal be made to eliminate unfair competitive disadvantages the proposed regulatory scheme would impose on U.S. and foreign banking organizations and their broker-dealer subsidiaries.
Our primary concerns with the proposal as written are as follows:
As such, the potential benefits of the proposal, as written, may be outweighed, in our view, by the potential costs of compliance and additional regulatory burdens that would be imposed on affiliates of bank holding companies and foreign banks if their subsidiary U.S. broker-dealers were to elect the alternative net capital standard provided for in the proposal.
We believe that the Commission's objectives can be met without the imposition of overlapping consolidated supervision by creating a regulatory scheme that adheres to the following guiding principles.
To align the current proposal with these guiding principles, we would suggest that the Commission modify its current proposal to create a regulatory scheme where the principal Consolidated Supervisor of a parent bank holding company or foreign bank maintains responsibility for, and authority over, consolidated supervision and examination of the holding company and its subsidiaries, but that provides the Commission with the authority to request from the U.S. broker-dealer information necessary to assess financial risks to the broker-dealer for each MAP of the U.S. broker-dealer. This would level the playing field for U.S. broker-dealer subsidiaries of foreign and domestic banks and bank holding companies by affording them the capital benefits offered in proposed 240.15c3-1 Appendix E without unfairly subjecting them to a duplicate scheme of comprehensive supervision.
We further suggest that Appendix E be modified to permit the U.S. broker-dealer subsidiary of a foreign or domestic banking organization with a Consolidated Supervisor to use the same capital adequacy requirements and computation methodology utilized by its parent banking organization. Otherwise, the costs of redundant regulatory reporting systems are likely to outweigh the benefits of the proposal for banking organizations subject to capital adequacy rules imposed on a consolidated basis by Consolidated Supervisors.
We believe that the best way to implement the foregoing guiding principles would be to revise the proposal so that there would be an entirely separate set of rules that apply to organizations that already are subject to effective consolidated supervision. This will require the Commission to define the circumstances under which it will regard an applicant as already being subject to effective consolidated supervision. One possibility would be for the Commission to defer to the Federal Reserve Board's CCS determinations. In the new separate part of the proposal, the Commission could define the scope of information it will routinely seek from the applicant's existing regulators and from the broker-dealer, where appropriate; clarify that it will not duplicate the examination authority of the existing regulator; and adopt specific protocols for deferring to the primary regulator's assessment of adequacy of capital, risk models, and internal controls.
Finally, we recommend that the Commission's staff confer with the staff of the Commodity Futures Trading Commission ("CFTC") and encourage the CFTC to adopt, for broker-dealers also registered as futures commissions merchants, proposed Appendix E as finally approved.
Specific Observations and Recommendations
The remainder of this letter will comment on specific provisions of the proposal, as drafted, and serve to reinforce the overriding concerns discussed above regarding the proposal.
This paragraph would permit the Commission to approve an application or amendment to an application by a U.S. broker-dealer to calculate net capital using the market and credit risk standards of Appendix E (section 240.15c3-1e), "subject to any conditions or limitations the Commission may require as necessary or appropriate in the public interest and consistent with the protection of investors."
We believe that the proposal would be clearer if there were an explicit cross-reference to the standards set forth in paragraph (a)(6) of Appendix E. Moreover, if the Commission contemplates imposing routine conditions to approvals of such applications, those conditions should be explicitly set forth in the proposed rule. Additionally, we believe that in the interest of fairness, the rule, as ultimately adopted, should provide for the right of the applicant to have a hearing before an application is denied or before an application is granted with additional conditions not specifically listed in the rule.
The definition of "entity that has a principal regulator" should be revised to delete from paragraph (ii) the phrase "the person is primarily in the insured depository institutions business". This phrase would serve to exclude as an entity having a principal regulator virtually all bank holding companies and foreign banks that could be expected to have a broker-dealer eligible to use the proposed net capital requirement.
Any parent of a broker-dealer willing to subject itself to comprehensive consolidated supervision by the Federal Reserve Board or a FFSRA should be deemed to be an entity having a principal regulator and should not be subject to Commission examination or supervision. Such a determination would be fully consistent with the scheme of functional regulation established by the Gramm-Leach-Bliley Act.
Appendix E (Section 240.15c3-1e)
The proposed application process is extremely burdensome and complicated. While much detail is explicitly required, the Commission may request even more information and impose additional conditions. Consequently, we believe that the Commission should provide that an applicant has a right to a hearing before an application is denied or before conditions to approval are imposed. Similarly, the Commission should provide the opportunity for a hearing in the event it decides to revoke a broker-dealer's exemption to allow it to use the market risk standards of Appendix E if it finds that "such exemption is no longer necessary or appropriate in the public interest, or is no longer consistent with the protection of investors."
Subparagraph (a)(1)(viii) requires the holding company of a broker-dealer using the alternative capital requirement to commit in writing as part of the application to comply with requirements for internal risk management control systems applicable to the broker-dealer, and to submit to the Commission any proposed changes to those systems. While such requirements make sense in the case of an otherwise unregulated Investment Bank Holding Company seeking to make the Commission its consolidated supervising entity for purposes of EU directives, they are not justified for bank holding companies and foreign banks that are already required by their principal regulators to maintain adequate risk management control systems. Such entities should be permitted to rely on findings by their principal regulators regarding the adequacy of their risk management systems. The Commission should address any concerns it may have by utilizing the procedures in Section 17(h) of the Securities Exchange Act of 1934, requiring modifications to the broker-dealer's tentative net capital requirement contained in the proposal, or modifying the VaR multiplication factors used in the U.S. broker-dealer's market risk charge determination.
These requirements highlight the importance for the Commission to amend the definition of "entity that has a principal regulator" in Section 240.15c3-1(13), because any holding company excluded from this definition would be subject to Commission examination. Moreover, under the proposed provision (a)(1)(viii)(E), the Commission asserts the authority to examine the books and records of all affiliates of the U.S. broker-dealer that do not have a principal regulator, as defined in proposed section 240.15c3-1(c)(13). The Commission should confirm that, for this purpose, the Federal Reserve Board or other Consolidated Supervisor is the principal regulator, not only of the bank holding company itself, but also of all subsidiaries of the holding company other than banks (except state member banks), insurance companies and broker-dealers.
We note that the Federal Reserve Board examines material subsidiaries of bank holding companies on a routine periodic basis. Thus, it is unnecessary and inconsistent with the notion of functional regulation that is fundamental to the Gramm-Leach-Bliley Act for the Commission to duplicate the Federal Reserve Board's authority as the primary consolidated regulator of bank holding companies and their subsidiaries. Section 17(k) of the Securities Exchange Act of 1934, also requires the Commission to eliminate unnecessary and burdensome duplication in the examination process. Consequently, we strongly recommend that subparagraph (E) be deleted in its entirety and all other provisions relating to the application and other aspects of the proposal be modified to take this concept into account.
To the extent that the information sought is with respect to foreign affiliates, in the case of foreign banks, coordination with the home country FFSRA may be appropriate.
In addition, to the extent that the Commission obtains information other than through the processes set forth in Section 17(h)(3) and 17(k), it is unclear whether the Commission could maintain the confidentiality of information it obtains about a bank holding company that the Federal Reserve Board could maintain as confidential under the exemption from disclosure under the Freedom of Information Act ("FOIA") for examination information. 5 U.S.C. § 552(b)(8). The Federal Reserve Board, or the Commission, has the ability to make public or use in a public manner any information it receives. However, the FOIA exemption for examination information is designed to permit financial institutions' regulatory agencies to preserve the confidentiality of such information in order to promote candor between the agencies and regulated institutions and the integrity of the examination process. The proposal, if adopted in its current form, would jeopardize these principles by seeking to obtain examination information in a manner that would not enable the Commission to preserve confidentiality in response to a public request even if the Commission wanted to do so. Although the Commission asserts the ability to use the (b)(8) exemption (17 C.F.R. § 200.80(b)), it is unclear whether assertion of this exemption would be upheld if information is provided to the Commission by an entity over which the Commission has no statutory examination authority.
Similarly, the Commission must ensure that it has the ability to preserve the confidentiality of its decisions on applications under the proposal. If such "orders" contain Commission decisions regarding add-ons or multipliers customized for the applicant's circumstances, permitting such orders to become publicly available could permit the public to discern the Commission's determination of the adequacy of an applicant's financial condition and internal controls relative to other successful applicants. We are not concerned that the models would become publicly available; they clearly constitute proprietary trade secrets that could be protected under the (b)(4) exemption in the FOIA. However, the Commission's own comments as to the merits of those models may not be protected unless the Commission can assert the exemption for examination material. We note that under the Commission's regulations at 17 C.F.R. § 200.80a, orders are generally publicly available.
Using the Federal Reserve Board's application process as a model, an applicant seeking to keep information confidential under the (b)(4) exemption must specify the reason that such information qualifies for the exemption, and the applicant has the burden of separating the confidential information into a separate confidential volume of the application (redacting the protected information from the public volume). This is consistent with the Commission's procedure set forth in 17 C.F.R. § 200.80(b). When a Federal Reserve Board order refers to confidential information contained in a separate, non-public letter, that information is generally protected by the examination exception to disclosure (the (b)(8) exemption). As noted above, using the U.S. broker-dealer as the source of all information under the proposal - including the application - would permit the Commission to assert the (b)(8) exemption for examination information in withholding information from public availability. Otherwise, it appears the Commission would be relying on its asserted ability to maintain confidentiality of documents pursuant to 17 C.F.R. § 200.83, without clear statutory mandate.
Finally, we note that even if the Commission is able to assert the (b)(8) exemption in the FOIA to preserve the confidentiality of examination information, it is not clear that information provided to the Commission would be afforded the same common law examination privilege from disclosure in third party litigation that is afforded to information provided to U.S. bank regulators. This privilege should be available if the Commission receives its information through the Federal Reserve Board under Section 17(h) of the Securities Exchange Act.
(c) Market Risk
Paragraph (c)(2) restricts the use of VaR models to determine capital charges for positions with no ready market, for debt securities of less than investment grade, or for any derivative instrument based on the value of these positions, unless the Commission approves an application for such use pursuant to Section 240.15c3-1(a)(7). The referenced section should contain standards for approving such an application. Broker-dealers are currently using VaR and credit risk models for such instruments, which typically have the ability to model extreme illiquidity risk associated with securities for which there is no ready market. The Commission should recognize this fact by making it clear that institutions with a proven track record of using such models would be able to continue to use these models to calculate market risk charges under the proposed net capital standards.
Further, the rule should specify that any market risk models approved by the Federal Reserve or by another G-10 FFSRA for a broker-dealer's domestic bank or foreign bank parent holding company should be presumptively valid for initial approval purposes and for continued reporting purposes.
(d) Credit Risk
Paragraph (d) describes a very detailed methodology for determining credit risk capital charges only for derivatives on issues for which Appendix E is used to calculate the market risk capital charge. While setting forth specific requirements for credit risk models makes sense for broker-dealers that are not already supervised on a consolidated basis, it is unnecessary and causes conflicts for broker-dealers that are supervised on a consolidated basis by the Federal Reserve or by another G-10 FFSRA.
The rule should specify that any credit risk models approved by the Federal Reserve or by another G-10 FFSRA for a broker or dealer's domestic bank or foreign bank parent holding company should presumptively be valid for initial approval purposes and for continued reporting purposes.
(e) VaR Models
Subparagraph (e)(1) requires that the VaR model used to calculate market and credit risk for a position must be the same model used to report the market or credit risk of that position to senior management and must be integrated into the daily internal risk management system of the firm. Bank holding companies using more robust forms of VaR than that permitted in the proposed rule are not going to abandon those models. To the extent that the Commission does not permit a bank holding company to use its existing form of VaR for all purposes, pursuant to the application process set forth in section 240.15c3-1e(c), the U.S. broker-dealer and its holding company would be effectively required to have two versions of VaR integrated into their management systems. This would be extremely costly and impractical.
Pursuant to subparagraph (e)(1)(ii), VaR models must be reviewed "both periodically and annually." Here again, to the extent that the Federal Reserve or another G-10 FFSRA has standards relating to the review of VaR models, the Commission should defer to those standards, or, at a minimum, coordinate its requirements for review with those of the other relevant regulators, to avoid unnecessary burdens. In addition, the Commission's review and approval should be limited to the use of the model by the regulated broker-dealer. The Commission should not second-guess a Consolidated Supervisor about the adequacy of the review process for the bank holding company or foreign bank.
(f) Additional Regulatory Conditions
Paragraph (f) permits the Commission to impose any additional regulatory conditions - not just those listed as illustrations - to a U.S. broker-dealer's ability to use the alternative net capital rules, if the Commission finds that the imposition of such conditions is "necessary or appropriate in the public interest, and for the protection of investors." However, the section clearly was intended to permit the imposition of additional conditions only if a broker-dealer committed a failure of the nature specified in subparagraphs (1) through (5). Therefore, paragraph (f) should be revised to read: "As a condition for the broker or dealer to use this Appendix E to calculate certain of its capital charges, the Commission may impose additional regulatory conditions that the Commission deems necessary or appropriate in the public interest, and for the protection of investors, on the broker or dealer, which may include: . . . ." Then, add "or" at the end of subparagraph (4), delete the word "or" in subparagraph (5), and delete subparagraph (6).
Appendix G (Section 240.15c3-1g)
(a) Conditions Regarding Computation of Allowable Capital and Risk Allowances
The Commission should defer to Basel standards for the calculation of allowable capital and allowances for market, credit and operational risk. The Commission provides in subparagraph (5) that a holding company may use Basel II upon approval of a request to the Commission. The provision should specify that the burden should be on the Commission to demonstrate that it would be contrary to the public interest to permit the holding company to use the Basel II standards. Moreover, bank holding companies and foreign banks currently using Basel I standards should presumptively be able to continue to use these standards until the Basel II standards are adopted.
(b) Conditions Regarding Reporting Requirements
Subparagraph (1) requires a holding company to file a monthly report within 17 days after the end of each month consisting of: a consolidated balance sheet and income statement (including notes and computations of allowable capital and allowances for market, credit, and operational risk); daily intra-month VaR; detailed consolidated credit risk information for exposures, listed by counterparty, for the largest credit exposures; aggregate maximum potential exposures; a summation of the geographic distribution of the holding company's exposures on a consolidated basis; and certain risk reports to management. Consistent with our comment that the Commission should obtain information from a Consolidated Supervisor whenever possible, the Commission should not require that information be required more frequently than banking organizations provide identical information to their Consolidated Supervisors.
In addition, banking organizations that provide the Commission with the information on credit counterparties could be exposed to liability where release of such information violated applicable laws, particularly absent assurance of the Commission's ability to maintain the confidentiality of the information. As discussed above, there is serious doubt about the Commission's ability to preserve the confidential nature of such information in the face of a FOIA request from the public or a discovery request in third-party litigation, unless the information is obtained only from another Consolidated Supervisor or from the U.S. broker-dealer, so that the Commission can assert the exemption for examination information.
Subparagraph (2) requires quarterly descriptions of all material pending legal or arbitration proceedings. To the extent this requires reporting only of information that would be publicly disclosed anyway, we have no objection. However, if the Commission wants follow-up information (e.g., pursuant to subparagraph (3)), it should obtain such information from banks or bank holding companies through the procedures in section 17(h) of the Securities Exchange Act of 1934 to preserve the confidentiality of such information, which could include litigation strategy and privileged attorney-client communications and attorney work product, the public disclosure of which could seriously prejudice the reporting holding company and its affiliates. Therefore, subparagraph (3) should be deleted, or made inapplicable to bank holding companies and foreign banks, for which the Commission should follow the procedures in section 17(h).
To reiterate, in the instance where the broker-dealer is the subsidiary of a holding company with a Consolidated Supervisor, we believe the Commission should draft the rule in such a way as to require only the registered U.S. broker-dealer to submit the information being requested by the Commission, including information about entities other than the broker-dealer.
(d) Conditions Regarding Preservation of Records
This paragraph requires a holding company to preserve certain information, documents and reports "in an easily accessible place." Since the Commission is requiring a foreign bank to file information about its operations on a consolidated basis, this rule should not require such a bank to create duplicate file systems in the U.S. Subparagraph (2) should be revised so that a foreign bank would not be deemed to violate this rule merely because it stores information and documents in the ordinary course of business at the foreign bank's home office or other non-U.S. location.
(e) Conditions Regarding Notification
Subparagraph (1) requires a holding company to give notification to the Commission of specified events "promptly (but within 24 hours)" of certain specified events. We believe that the 24-hour requirement would be unreasonable in certain circumstances. For example, such a short period would not give a holding company the opportunity to verify that a backtesting exception had occurred before having to report it pursuant to subparagraph (1)(i).
Subparagraph (1)(iii) requires the immediate reporting of the "default" of any affiliate. While the words "otherwise goes into default" seems to be used as a synonym for "bankruptcy", the word "default" could be read to mean a default on any contractual obligation, such as delivery of securities, or failure to timely credit a deposit. Those "defaults" should be of no immediate, if any, consequences to this process. We recommend that the phrase "or otherwise goes into default" be substituted with the phrase "or otherwise enters into insolvency proceedings."
Subparagraph 1(iv) requires the holding company to notify the Commission immediately of a rating downgrade of any affiliates. We recommend that this provision be limited to rating downgrades of wholly or majority-owned material affiliates. Imposing this requirement on downgrades of other entities would be burdensome without necessarily providing the Commission relevant information.
Finally, we reiterate our belief that the rule should provide that, for a U.S. broker-dealer subsidiary of a holding company with a Consolidated Supervisor, the Commission should obtain information from the Consolidated Supervisor; and, that the Commission should request only the registered U.S. broker-dealer to submit any necessary information, including information about entities other than the U.S. broker-dealer, that the Commission cannot obtain from the Consolidated Supervisor,.
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We hope that the Commission will seriously consider our comments, and revise this innovative proposal so that U.S. broker-dealer subsidiaries of foreign banks and bank holding companies will be able to take advantage of the proposal to the same extent as subsidiaries of Investment Bank Holding Companies. If you would like to discuss any of the matters addressed in this letter, please do not hesitate to contact either Michael Kadish (212-250-5081) or Marianna Maffucci (212-250-8481) of Deutsche Bank's Legal Department.