SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-39456; File No. S7-32-97]
RIN 3235-AH29
Net Capital Rule
AGENCY: Securities and Exchange Commission
ACTION: Concept Release; Request for Comments.
SUMMARY: The Securities and Exchange Commission is continuing its study of
its approach to determining net capital requirements for broker-dealers.
As part of its study, the Commission is considering the extent to which
statistical models should be used in setting the capital requirements for a
broker-dealer's proprietary positions. Accordingly, the Commission is
posing a number of questions on this subject as well as soliciting views on
other possible alternatives for establishing net capital requirements.
DATES: Comments must be received on or before [insert date 90 days after
date of publication in the Federal Register].
ADDRESSES: Interested persons should submit three copies of their written
data, views, and opinions to Jonathan G. Katz, Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
Comments also may be submitted electronically at the following E-mail
address: rule-comments@sec.gov. Comment letters should refer to File No.
S7-32-97; this file number should be included on the subject line if E-mail
is used. All submissions will be available for public inspection and
copying at the Commission's Public Reference Room, 450 Fifth Street, N.W.,
Washington, D.C. 20549. Electronically submitted comment letters will be
posted on the Commission's Internet web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
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Director, at 202/942-0132; Peter R. Geraghty, Assistant Director, at
202/942-0177; Thomas K. McGowan, Special Counsel, at 202/942-4886; Marc J.
Hertzberg, Attorney, at 202/942-0146; or Gary Gregson, Statistician, at
202/942-4156, Division of Market Regulation, Securities and Exchange
Commission, 450 Fifth Street, N.W., Mail Stop 2-2, Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION:
I. Introduction
As part of a comprehensive review of the net capital rule, Rule 15c3-1
(17 CFR 240.15c3-1) (the "net capital rule" or the "Rule"), the Securities
and Exchange Commission ("Commission") is publishing this release to
solicit comment on how the net capital rule could be modified to
incorporate modern risk management techniques as to a broker-dealer's
proprietary positions and to reflect the continuing evolution of the
securities markets. More specifically, the Commission seeks comment on how
the existing haircut structure could be modified and whether the net
capital rule should be amended to allow firms to use statistical models to
calculate net capital requirements.
A. The Current Net Capital Rule
The Commission adopted the net capital rule in substantially its
current form in 1975. The Rule requires every broker-dealer to maintain
specified minimum levels of liquid assets, or net capital. The Rule
requires broker-dealers to maintain sufficient liquid assets in order to
enable those firms that fall below the minimum net capital requirements to
liquidate in an orderly fashion. The Rule is designed to protect the
customers of a broker-dealer from losses upon the broker-dealer's failure.
The Rule requires different minimum levels of capital based upon the nature
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of the firm's business and whether a broker-dealer handles customer funds
or securities.
In calculating the capital requirement, the Rule requires a broker-
dealer to deduct from its net worth certain percentages, known as haircuts,
of the value of the securities and commodities positions in the firm's
portfolio. The applicable percentage haircut is designed to provide
protection from the market risk, credit risk, and other risks inherent in
particular positions. Discounting the value of a broker-dealer's
proprietary positions provides a capital cushion in case the portfolio
value of the broker-dealer's positions decline.
The Rule requires a broker-dealer to compute its haircuts by
multiplying the market value of its securities positions by prescribed
percentages. For example, a broker-dealer's haircut for equity securities
is equal to 15 percent of the market value of the greater of the long or
short equity position plus 15 percent of the market value of the lesser
position, but only to the extent this position exceeds 25 percent of the
greater position.<(1)> In contrast to the uniform haircut for equity
securities, the haircuts for several types of interest rate sensitive
securities, such as government securities, are directly related to the time
remaining until the particular security matures. The Rule uses a sliding
<(1)> For example, in the case where a firm has a long
position of $100,000 in equity securities and a short
position of $50,000 in equity securities, that firm's
haircut for equity securities would be:
1. Long Position: $100,000 x 15% = $15,000
2. Short Position: $50,000 - $25,000 (25% of
long position) x 15% = $3,750
3. Total haircut for equity securities: $15,000
+ $3,750 = $18,750.
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scale of haircut percentages with these securities because changes in
interest rates will usually have a greater impact on the price of
securities with longer remaining maturities compared to those securities
with shorter remaining maturities. For example, there is no haircut on
government securities with less than three months remaining maturity, but
there is a six percent haircut on government securities with 25 years or
more remaining maturity.
The Commission believes the Rule has worked well over the years. The
Commission and the self-regulatory organizations ("SROs") have generally
been able to identify at early stages broker-dealers that are experiencing
financial problems and to supervise self-liquidations of failing securities
firms. This early regulatory intervention has helped to avoid customer
losses and the need for formal proceedings under the Securities Investor
Protection Act of 1970.
B. Prior Relevant Actions
Since 1993, the Commission has undertaken a number of initiatives to
better understand how securities firms manage market and credit risk and to
evaluate whether the firms' risk management techniques could be
incorporated into the net capital rule. This section reviews four of the
Commission's initiatives as well as recent rules addressing capital
requirements for banks adopted by the Board of Governors of the Federal
Reserve System, the Office of the Comptroller of the Currency, and the
Federal Deposit Insurance Corporation (collectively, the "U.S. Banking
Agencies").
1. 1993 Concept Release
In May 1993, the Commission began a comprehensive review of the Rule
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by issuing a concept release soliciting comment on alternative methods for
computing haircuts on derivative financial instruments ("Concept
Release").<(2)> Although the Concept Release's focus was on
derivative instruments, the Commission intended to commence a dialogue with
the securities industry regarding how the Rule could better reflect the
market and credit risks inherent in a broker-dealer's proprietary
securities portfolio. At that time, the Commission envisioned a multi-step
revision of the net capital rule that would substantially change how
broker-dealers calculate the market and credit risk haircuts arising from
their proprietary positions.
2. Derivatives Policy Group
The Derivatives Policy Group ("DPG"), consisting of the six U.S.
firms<(3)> most active in the over-the-counter ("OTC") derivatives
market, was formed at the Commission's request to address the public policy
issues arising from the activities of unregistered affiliates of registered
broker-dealers and registered futures commission merchants. In March 1995,
after discussions with the Commission, the DPG published its Framework for
Voluntary Oversight ("Framework") under which the members of the DPG agreed
to report voluntarily to the Commission on their activities in the OTC
derivatives market.<(4)> The Framework provides for the use of
<(2)> Securities Exchange Act Rel. No. 32256 (May 4, 1993),
58 FR 27486 (May 10, 1993).
<(3)> The six firms in the DPG are CS First Boston, Goldman
Sachs, Morgan Stanley, Merrill Lynch, Salomon Brothers,
and Lehman Brothers.
<(4)> Framework For Voluntary Oversight, A Framework For
Voluntary Oversight Of The OTC Derivatives Activities
Of Securities Firm Affiliates To Promote Confidence And
(continued...)
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proprietary statistical models to measure capital at risk due to the firms'
OTC derivatives activities; however, the Framework was not intended to be
used as a method for calculating minimum capital standards for the DPG
firms.
For purposes of using models to measure capital at risk, the DPG
defines risk of loss, or "capital at risk," to be "the maximum loss
expected to be exceeded with a probability of one percent over a two-week
holding period."<(5)> The Framework covers several products,
including: interest rate, currency, equity, and commodity swaps; OTC
options (including caps, floors, and collars); and currency forwards (i.e.,
currency transactions of more than a two-day duration, except that firms
may elect to include only currency transactions of 14 days or more of
duration). The Framework provides that each firm's model must capture all
material sources of market risk that might impact the value of the firm's
positions, including nine specific material sources of risk, or core risk
factors, based on interest rate shocks, changes in equity values, and
changes in exchange rates.<(6)>
<(4)>(...continued)
Stability In Financial Markets, Derivatives Policy
Group (March 1995).
<(5)> Id. at 28.
<(6)> Specifically, the core risk factors include: (1)
parallel yield curve shifts, (2) changes in steepness
of yield curves, (3) parallel yield curve shifts
combined with changes in steepness of yield curves, (4)
changes in yield volatilities, (5) changes in the value
of equity indices, (6) changes in equity index
volatilities, (7) changes in the value of key
currencies (relative to the U.S. dollar), (8) changes
in foreign exchange rate volatilities, and (9) changes
in swap spreads in at least the G-7 countries plus
Switzerland.
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Each DPG firm agreed to calculate capital at risk under two scenarios.
Under the first scenario, each firm would independently determine the size
of the shocks used to calculate its capital at risk. Under the second
scenario, each firm would calculate its capital at risk due to certain
Commission specified, hypothetical large shocks to the core risk factors.
The purposes of preparing a second set of capital at risk data are to
assist the Commission in comparing volatility among the firms' portfolios
and to evaluate the usefulness of the firms' models in measuring market
risk during times of unusual market stress.
The Framework does not specify minimum correlations between securities
that are to be used in the models. The Framework states that there are
many generally accepted methods for estimating historical or market-implied
volatilities and correlations and, instead of utilizing predetermined
correlation factors, the Framework provides that hedging would be permitted
where contracts and instruments within the category exhibit an
"ppropriately high degree of positive price correlation." Thus, the degree
to which firms would recognize positions as hedges was left to the
individual discretion of each firm. The Framework notes, however, that
estimates of volatility and correlation may not be accurate during times of
market stress.
The Framework also sets forth common audit and verification procedures
of the technical and performance characteristics of the models. Under the
Framework, the firms are responsible for making all computations necessary
for purposes of assessing risk in relation to capital on a regular basis
and to provide such computations on a current basis upon request. Under
the Framework, the inventory pricing and modelling procedures of firms are
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to be reviewed at least annually by independent auditors or consultants.
The independent auditors or consultants provide reports summarizing the
results of their reviews, and the firms provide the audit reports to the
Commission.
Under the Framework, the DPG firms have enhanced reporting
requirements regarding their exposure to credit risk. The information
reported to the Commission falls primarily into two principal categories:
credit concentration and portfolio credit quality. Credit concentration in
the portfolio is reported by separately identifying the top 20 net
exposures on a counterparty-by-counterparty basis. The credit quality of
the portfolio is reported by aggregating for each counterparty the gross
and net replacement value and net exposure of the firm. Credit information
also is categorized by credit rating, industry, and geographic location.
The Framework established risk management guidelines that provide a
comprehensive framework for the DPG firms to implement their business
judgments as to the appropriate scope and level of their OTC derivatives
activities. The Framework provides that each firm's board of directors
should adopt written guidelines addressing the scope of permitted
activities, the acceptable levels of credit and market risk, and the
structure and independence of the risk monitoring and risk management
processes and related organizational checks and balances from the firm's
trading operations. Senior management should also implement independent
risk measuring and risk monitoring processes to manage risk within the
guidelines established by the board of directors.
3. Theoretical Options Pricing Models
In February 1997, the Commission completed an important step in its
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review of the net capital rule by amending the Rule to allow broker-dealers
to use theoretical option pricing models to determine capital charges for
listed equity, index, and currency options, and related positions that
hedge these options.<(7)> The amendment permits broker-dealers to use
a model (other than a proprietary model) maintained and operated by a
third-party source ("Third-Party Source") and approved by a designated
examining authority ("DEA").<(8)> The Third-Party Source is required
to collect certain information on a daily basis concerning different
options series.<(9)> Using this information, the Third-Party Source
measures the implied volatility for each option series and inputs to the
model the resulting implied volatility for each option series. For each
option series, the model calculates theoretical prices at 10 equidistant
valuation points using specified increases and decreases in the underlying
instrument.
After the model calculates the theoretical gain or loss valuations,
the Third-Party Source provides the valuations to broker-dealers. Broker-
dealers download this information into a spreadsheet from which the broker-
<(7)> Securities Exchange Act Rel. No. 38248 (February 6,
1997), 62 FR 6474 (February 12, 1997).
<(8)> Currently, the model maintained and operated by The
Options Clearing Corporation ("OCC") is the only
approved model. OCC's model has been temporarily
approved until September 1, 1999.
<(9)> Under the rule amendment, the Third-Party Source will
collect the following information: (1) the dividend
streams for the underlying securities, (2) interest
rates (either the current call rate or the Eurodollar
rate for the maturity date which approximates the
expiration date of the option), (3) days to expiration,
and (4) closing underlying security and option prices
from various vendors.
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dealer calculates the profit or loss for each of its proprietary and
market-maker options positions. The greatest loss at any one valuation
point is the haircut. This amendment to the Rule was a milestone because
it was the first time the Commission allowed modelling techniques for
regulatory capital purposes.
4. OTC Derivatives Dealers
Simultaneously with this release, the Commission is proposing a new
limited regulatory regime for OTC derivatives dealers.<(10)> Under
this regime, OTC derivatives dealers could register with the Commission and
be subject to specialized net capital requirements. The Commission is
considering requiring OTC derivatives dealers registered under this
framework to maintain tentative net capital of not less than $100 million
and net capital of not less than $20 million. As part of this proposal,
the Commission is contemplating giving OTC derivatives dealers the option
of taking either the existing securities haircuts or haircuts based on
statistical models. OTC derivatives dealers electing to use models would
have to calculate potential losses and specific capital charges for both
market and credit risk. These OTC derivatives dealers also would have to
maintain models that meet certain minimum qualitative and quantitative
requirements that are substantially similar to the requirements set forth
in the U.S. Banking Agencies' rules.
5. U.S. Banking Agencies
In August 1996, the U.S. Banking Agencies adopted rules incorporating
into their bank capital requirements risk-based capital standards for
<(10)> Securities Exchange Act Rel. No. 39454 (December 17,
1997).
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market risk that cover debt and equity positions in the trading accounts of
certain banks and bank holding companies and foreign exchange and commodity
positions wherever held by the institutions. The U.S. Banking Agencies'
rules were designed to implement the Basle Committee on Banking
Supervision's ("Basle Committee")<(11)> agreement on a model based
approach to cover market risk. These rules apply to any bank or bank
holding company whose trading activity equals ten percent or more of its
total assets, or whose trading activity equals $1 billion or more. The
U.S. Banking Agencies' final rules became effective January 1, 1997 and
compliance will be mandatory by January 1, 1998. Institutions that do not
meet these minimum securities trading thresholds will not be subject to
market risk capital requirements.
The U.S. Banking Agencies' rule amendments require affected banks or
bank holding companies to adjust their risk-based capital ratio to reflect
market risk by taking into account the general market risk and specific
risk of debt and equity positions in their trading accounts.<(12)>
These institutions also must take into account the general market risk
associated with their foreign exchange and commodity positions, wherever
<(11)> The Governors of the G-10 countries established the
Basle Committee on Banking Supervision in 1974 to
provide a forum for ongoing cooperation among member
countries on banking supervisory matters.
<(12)> The Banking Agencies defined general market risk as
changes in the market value of on-balance sheet assets
and liabilities and off-balance sheet items resulting
from broad market movements, such as changes in the
general level of interest rates, equity prices, foreign
exchange rates, and commodity prices. Specific risk is
defined by the Banking Agencies as changes in the
market value of individual positions due to factors
other than broad market movements and includes such
risks as the credit risk of an issuer.
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located. The capital charge for market risk must be calculated by using
the institution's own internal model.
II. Alternatives to the Current Financial Responsibility Regime
The Commission is soliciting comment on possible alternative methods
for calculating credit and market risk capital requirements for broker-
dealers. This release will help the Commission evaluate different ways the
net capital rule could be modified to accommodate changes in the securities
business since the current uniform net capital rule was adopted in 1975,
with a particular emphasis on incorporating modern risk management
techniques. In this regard, the Commission believes it can modernize the
Rule by either amending the current haircut percentages or by allowing
certain broker-dealers to use a model-based system to calculate appropriate
capital charges for market risk. This section discusses each of the
alternative structures and lists relevant questions.
A. Modify Current Haircut Approach
As discussed above, the Rule requires a broker-dealer to deduct from
its net worth certain fixed percentages, or haircuts, of the value of its
securities positions. The present prescriptive haircut methodology has
several advantages. It requires an amount of capital which will be
sufficient as a provision against losses, even for unusual events. It is
an objective, although conservative, measurement of risk in positions that
can act as a tool to compare firms against one another. Moreover, the
current methodology enables examiners to determine readily whether a firm
is properly calculating haircuts. The examiner can review either the
entire net capital calculation or just material portions of the firm's
proprietary positions.
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However, there are some weaknesses associated with determining capital
charges based on fixed percentage haircuts. For example, the current
method of calculating net capital by deducting fixed percentages from the
market value of securities can allow only limited types of hedges without
becoming unreasonably complicated. Accordingly, the net capital rule
recognizes only certain specified hedging activities, and the Rule does not
account for historical correlations between foreign securities and U.S.
securities or between equity securities and debt securities. By failing to
recognize offsets from these correlations between and within asset classes,
the fixed percentage haircut method may cause firms with large, diverse
portfolios to reserve capital that actually overcompensates for market
risk.
To eliminate weaknesses in the current haircut structure, the
Commission could modernize the Rule by maintaining the current methodology
but changing the haircut percentages and recognizing additional offsetting
positions. For example, the proposing release issued simultaneously with
this concept release proposes amendments to the Rule that would treat
haircuts on certain interest rate products as being part of a single
portfolio, similar to the standard approach in the Basle Committee's
Capital Accord.<(13)> As proposed, the net capital rule would
recognize hedges among government securities, investment grade
nonconvertible debt securities (or corporate debt securities), pass-through
mortgage backed securities, repurchase and reverse repurchase agreements,
money market instruments, and futures and forward contracts on these debt
instruments. As a next step, the Commission could revise the current
Securities Exchange Act Rel. No. 39455 (December 17, 1997).
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haircut percentages and develop methodology to account for more
correlations and hedges among other types of securities.
The Commission solicits comment on the following topics. It is not
necessary, however, that comments be limited to the specific issues raised
in this release. Commenters are encouraged to submit statements with
respect to any aspect of the current net capital rule that may be useful to
the Commission.
Question 1: Should the Commission retain the current haircut approach
but revise the current percentages? If so, which haircut percentages
should be modified? How should these percentages be modified? What
should be the objective basis for modified haircut percentages?
Please provide relevant data to support your response.
Question 2: Do the current haircut percentages adequately account for
the market risk, credit risk, and other risks inherent in a particular
position?
Question 3: Do the current haircut percentages enable firms to reserve
sufficient capital for times of market stress, including one day
movements and movements over a period of time? Please provide
relevant data to support your response.
Question 4: How can haircut percentages be further adjusted to account
for correlations between and within asset classes? Please provide
relevant data to support your response.
Question 5: How can the current haircut approach be modified to
improve the treatment for specific types of securities, including
foreign securities, collateralized mortgage obligations ("CMOs"), and
over-the-counter options on interest-rate securities? Please provide
relevant data to support your response.
Question 6: Should the Commission include security-specific models,
other than the option pricing models, in the Rule? If so, what forms
should these models take and what types of minimum requirements should
apply to the use of such models?
Question 7: If the Commission includes other security-specific models
in the Rule, what types of securities should be covered by such models
(i.e., CMOs, over-the-counter options, or treasury securities)?
B. Model Based Approach
1. Generally
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A number of broker-dealers, primarily those with large proprietary
securities portfolios, have indicated to the Commission that they may be
willing to incur the expenses associated with developing and using
statistical models to calculate haircuts on their securities portfolios.
Under a model based net capital rule, in lieu of taking fixed percentage
haircuts, a broker-dealer would use either an external or internal model as
the basis for a market risk charge and take a separate charge, or charges,
for other types of risk, such as credit risk and liquidity risk.
The Commission could allow firms to calculate market risk capital
charges according to external models for specific types of securities that
are similar to the options pricing models allowed under Appendix A to the
Rule. The benefit of an external model is that all firms would be
utilizing the same model. However, the Commission could have difficulty
finding a third party (comparable to the Options Clearing Corporation for
listed options) that would have access to all the data necessary to
facilitate external security-specific models for securities other than
options.
With respect to internal models, the Commission would need to
prescribe certain minimum quantitative and qualitative standards that a
firm's model would have to meet prior to that firm using its internal model
for regulatory capital purposes. Currently, several large firms use value
at risk ("VAR") models as part of their risk management system. These
firms typically utilize VAR modelling to analyze, control, and report the
level of market risk from their trading activities. Generally, VAR is an
estimate of the maximum potential loss expected over a fixed time period at
a certain probability level. For example, a firm may use a VAR model with
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a ten-day holding period and a 99 percentile criteria to calculate that its
$100 million portfolio has a potential loss of $150,000. In other words,
the firm's VAR model has forecasted that with this portfolio the firm may
lose more than $150,000 during a ten-day period only once every 100 ten-day
periods.
In practice, VAR models aggregate several components of price risk
into a single quantitative measure of the potential for loss. In addition,
VAR is based on a number of underlying mathematical assumptions and firm
specific inputs. For example, VAR models typically assume normality and
that future return distributions and correlations can be predicted by past
returns.<(14)>
<(14)> The Commission recognizes that there is a wide variety
of secondary source information discussing both the
positive and negative aspects of VAR. See Philippe
Jorion, Value at Risk: The New Benchmark for
Controlling Market Risk (1996) (explaining how to use
VAR to manage market risk); JP Morgan, RiskMetrics-
Technical Document (1994) (providing a detailed
description of RiskMetrics, which is JP Morgan's
proprietary statistical model for quantifying market
risk in fixed income and equity portfolios); Tanya
Styblo Beder, VAR: Seductive but Dangerous, Financial
Analysts Journal, September-October 1995, at 12 (giving
an extensive analysis of the different results from
applying three common VAR methods to three model
portfolios); Darrell Duffie and Jun Pan, An Overview of
Value at Risk, The Journal of Derivatives, Spring 1997,
at 7 (giving a broad overview of VAR models); Darryll
Hendricks, Evaluation of Value-at-Risk Models Using
Historical Data, Federal Reserve Bank of New York
Economic Policy Review, April 1996, at 39 (examining
twelve approaches to value-at-risk modelling on
portfolios that do not include options or other
securities with non-linear pricing); and Robert
Litterman, Hot Spots and Hedges, Goldman Sachs Risk
Management Series (1996) (giving a detailed analysis on
portfolio risk management, including how to identify
the primary sources of risk and how to reduce these
risks).
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Given the increased use and acceptance of VAR as a risk management
tool, the Commission believes that it warrants consideration as a method of
computing net capital requirements for broker-dealers. However, while VAR
can be used to manage market risk, broker-dealers that rely solely on VAR
for risk management may not have a comprehensive risk management program.
VAR models, unlike haircuts, do not typically account for those risks other
than market risk, such as credit risk, liquidity risk, and operational
risk. Broker-dealers that utilize VAR models should therefore use
additional techniques to manage those risks.
Further, while VAR may be useful in helping broker-dealers project
possible daily trading losses under "normal" market conditions, VAR may not
help firms measure the losses that fall outside of normal conditions during
times of market stress. For example, VAR models may not capture possible
steep market declines because these models typically measure exposure at
the first percentile (or the fifth percentile) and steep market declines
are, by definition, below the first percentile. In addition, the most
common VAR approaches may pose a problem for those portfolios that utilize
options or other products with non-linear payoffs.<(15)>
The purpose of the Commission's net capital rule is to protect markets
from broker-dealer failures and to enable those firms that fall below the
minimum net capital requirements to liquidate in an orderly fashion without
the need for a formal proceeding or financial assistance from the
<(15)> See Autoro Estrella et al., Options Positions: Risk
Measurement and Capital Requirements, Federal Reserve
Bank of New York Research Paper number 9415, September
1994 (evaluating different methods of measuring the
market risk of options and analyzing the capital
treatment of the market and credit risk of options).
======END OF PAGE 18======
Securities Investor Protection Corporation. The Commission believes that
market risk charges must adequately protect a broker-dealer during severe
market stress, whether that stress occurs on only one day or over a period
of several days, such as the drop in equity prices during the October 1987
market break or the Mexican debt crisis in 1994. Because VAR models do not
typically reserve capital for severe market declines, it may be necessary
to impose additional safeguards to account for possible losses or decreases
in liquidity during times of stress. This may include the use of a
multiplier or the use of stress tests that firms could apply to their
portfolios. A multiplier could be used to account for the other risks in a
firm's portfolio that are not captured by VAR models, such as operational,
settlement, or legal risk. On the other hand, stress testing could provide
a more complete picture of the portfolio's sensitivity to changing market
conditions and a more accurate representation of capital needs than a
simple multiplier.
The primary advantage of incorporating models into the net capital
rule is that a firm would be able to recognize, to a greater extent, the
correlations and hedges in its securities portfolio and have a
comparatively smaller capital charge for market risk. Accordingly, if the
Rule is amended to permit models to be used to calculate market risk in
lieu of taking the haircuts currently imposed by the rule, the Commission
solicits comment on how the Rule may be modified to include separate
capital requirements to cover sources of risk other than market risk.
Other issues associated with incorporating models into the Rule are the
need for management controls necessary to ensure that the firm is
collecting accurate and comprehensive information on its proprietary
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positions and the effectiveness of those controls to monitor the risk
assumed by the firm.
2. Two Tiered Approach
One way that the Commission could incorporate models into the net
capital rule would be to have different net capital requirements based on
certain standards ("Two Tiered Approach"). Under the Two Tiered Approach,
broker-dealers meeting certain minimum threshold levels would be required
to use models to determine capital compliance. For example, broker-dealers
with net capital exceeding a certain amount and currently using models for
in-house risk management purposes could use models to determine their
market risk capital charge under prescribed circumstances. Firms with less
than the prescribed level of net capital and those firms with net capital
greater than the prescribed level but not using models for risk management
could be required to continue to follow the current Rule's haircut
methodology. These haircut percentages could either be the same as the
current percentages or modified versions.
A Two Tiered Approach potentially has two primary benefits. First,
the Commission could structure a Two Tiered Approach to limit the use of
models to those firms that currently use sophisticated models such as VAR,
thereby not requiring other firms to incur the cost of implementing such
models. Second, the Commission could design a Two Tiered Approach that
establishes appropriate limits on which firms can utilize models to
determine capital compliance.
A potential weakness of a Two Tiered Approach is that it could inhibit
competition between large and small firms because models may give large
firms more flexibility in determining their net capital requirements.
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However, this advantage could be small if smaller firms did not have to
incur the start-up and maintenance costs associated with models and the
risk management infrastructure to support their use. Additionally, a Two
Tiered Approach could still allow firms with simple portfolios to easily
calculate the applicable haircuts on their portfolios.
3. Base Approach with Pre-Commitment Feature
Another option for incorporating models into the Rule could be to
combine the current haircut methodology using fixed percentage haircuts
with a model-based approach (the "Base Approach"). The Base Approach could
combine the strengths of both haircuts and models and at the same time
possibly address the weaknesses of each. The Base Approach would include
three primary components. First, broker-dealers could be required to
maintain a certain minimum base level of net capital for each of their
business activities, similar to the minimum requirements under the current
rule. For example, higher capital levels could apply to broker-dealers
that hold customer funds and securities as opposed to those firms that only
introduce customer accounts to clearing firms. Second, broker-dealers
could take a fixed percentage haircut for each security in their portfolio.
This haircut would be similar to the haircut requirements under the current
net capital rule; however, the size of the haircut would be lower due to
the additional charge for market risk obtained from the third component.
The third component of the Base Approach could consist of a capital
charge based on the firm's model and include a pre-commitment feature that
could require a broker-dealer to take capital charges based on the realized
performance of its models ("pre-commitment feature"). The pre-commitment
feature could have two steps. First, at the start of a pre-determined time
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period (i.e., one month or one quarter), a broker-dealer could be required
to represent that its losses, as computed by its model, would be within
certain parameters over the fixed time period. Second, at the conclusion
of each fixed time period, the firm's minimum net capital level could
increase by an amount equal to the difference between the actual portfolio
gains and losses and those projected based on its model. These additional
capital contributions would be required because differences between the
actual results and those projected by the model could indicate that the
firm's models may not be accurately assessing the risk of the firm's
portfolio. By incorporating haircuts and models into the Base Approach,
the inherent strengths and weaknesses of each could potentially offset each
other. Additionally, the Base Approach may be a viable capital standard
for firms with diverse portfolios and those that use more sophisticated
methods of risk management. The pre-commitment feature would create
additional incentives for broker-dealers to manage risk effectively. On
the other hand, a Base Approach may be too complicated for firms to apply.
In balance, however, the Base Approach could potentially provide firms with
flexibility in developing models and control systems, encourage the
development of accurate forecasts, and still ensure that firms reserve
sufficient amounts of net capital.
4. Comments on the Potential Use of Models
The Commission solicits comment on the following specific topics,
including the appropriateness of using proprietary models generally and the
recent initiatives of both the DPG and the U.S. Banking Agencies.
a. Models as a means to determine broker-dealer regulatory
capital
Question 8: Should the Commission permit the use of models to
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calculate regulatory capital for registered broker-dealers? If yes,
please explain whether the Commission should allow firms to utilize
internal models or whether the Commission should establish an external
model approach similar to the treatment of options under Appendix A to
the Rule.
Question 9: If the Commission permits the use of internal models,
should the model conform to certain objective criteria, or should they
be subjective? When could the assumptions upon which models rest be
challenged? Should internal or external auditors periodically review
and approve the model and its application? If so, how much should
regulators rely on auditors' application of models? Could the self-
regulatory organizations adequately surveil and examine for net
capital compliance utilizing models?
Question 10: Should the Commission impose limits on the types of firms
that can use models? Should there be certain additional minimum
criteria a firm must satisfy in order to use a proprietary model?
Should firms that meet the minimum criteria for using models have the
option of using an alternate standard approach (i.e., not using
models) to calculate regulatory capital? If so, what should that
approach be?
Question 11: Is VAR an appropriate method of using models as the basis
for calculating capital requirements for broker-dealers? The
Commission understands there are several approaches to calculating VAR
that are currently used by firms (e.g., Monte Carlo,
variance/covariance, and historical simulation approaches). Given the
various methods, the Commission seeks comment on whether minimum
criteria should be established for models used for regulatory capital
purposes? If not, how can the Commission provide for the ability to
compare levels of risks among firms or understand the significance of
levels of risk reported by firms when determining their net capital
requirements?
Question 12: The Commission believes that any approach that uses
models for setting regulatory capital requirements should result in
broadly consistent results for firms with similar portfolios. Can
consistent results for similar portfolios be obtained without the
Commission requiring firms to use a standard model? How else can
consistency of capital standards among firms with similar portfolios
be achieved?
Question 13: Some firms use different types of statistical models to
measure risk from different types of businesses, such as fixed income
securities and foreign equities. Should the Commission permit firms
to use more than one model to calculate regulatory capital? If yes,
would the inefficiencies in each model get accentuated or mitigated
when the results of the different models are aggregated?
Question 14: Should the Commission allow the use of models gradually
(i.e., first allow models for debt securities, then allow models for
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equity securities and other securities)?
Question 15: What will be the costs of implementing models? How do
the costs of implementing models compare to the current costs of
computing net capital? At what level would it be economical for firms
to try to use models? How do the start-up costs of implementing
models compare to the ongoing costs of managing models incurred by
firms that currently use models? How does the availability (or
anticipated future development) of software packages and databases
impact cost estimates? Will the costs of implementing models be a
barrier to firms not currently using models? Please provide relevant
data to support your response.
Question 16: Will firms not currently using models be at a competitive
disadvantage to those firms that currently use models? Please provide
relevant data to support your response.
Question 17: If the Commission permits the use of models, what
additional reporting or recordkeeping requirements would the
Commission need to impose on broker-dealers using models? Should
firms using models have to file additional reports with the Commission
or their DEA? Should the Commission amend its books and records rules
to require firms using models to maintain certain books and records
that they are currently not required to maintain? How can the
Commission ensure that it has access to information regarding a firm's
models that is not maintained by the broker-dealer (i.e., information
maintained at an unregistered entity)? What measure could the
Commission require to ensure broker-dealers would not be able to
modify the model (or data inputs) to avoid falling out of net capital
compliance? Should the Commission require models to be stored with
third-parties subject to escrow arrangements?
Question 18: If the Commission permits the use of models, should firms
using models be subject to modified forms of Commission and DEA
inspections? Should the models themselves be subject to review and
approval by the Commission or DEA?
b. Abnormal Market Conditions
Question 19: Because the purpose of VAR is to provide an estimate of
losses over a short period under normal conditions, is it possible for
VAR models to ensure an adequate capital cushion during unusual market
stress or structural shifts in the economy given the nature, size, and
liquidity of a broker-dealer's portfolio? Given the complexity of
models, could an accurate and rapid assessment be made of a firm's
true financial condition? Please provide relevant data to support
your response.
Question 20: Would models be more effective during times of severe
market fluctuations if stress testing were required? Should the
Commission specify what stress tests should be used by the firms?
Please provide relevant data to support your response.
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Question 21: If stress testing were required, should a firm be
required to use the same parameters when conducting stress testing on
each of its business units (i.e., apply the same levels and stress the
same movements in the relevant securities, markets, and indexes)?
Question 22: If stress testing were required, should a firm be
required to test its models based on a predetermined number of
volatile days of market movements (i.e., models would have to be
stress tested based on the 100 most volatile days of market movements
during the last ten years)?
Question 23: Should the results of stress testing impact the
calculation of a firm's capital requirements (i.e., through the use of
some type of multiplication factor)? Please provide relevant data to
support your response.
Question 24: Does the use of a minimum multiplier, as endorsed in the
Basle Standard and by the U.S. Banking Agencies, adequately address
risks arising from severe market movements? Please provide relevant
data to support your response.
Question 25: Should back-testing (i.e., ex post comparisons between
model results and actual performance) be required and, if so, to what
extent? Should back-testing results be used to determine a multiplier
for minimum capital amounts? Could back-testing results be used to
raise minimum capital levels for the firms?
c. Qualitative and Quantitative Criteria for Models
Question 26: Will setting minimum qualitative and quantitative
criteria prevent a firm from adjusting its model to encompass changing
market conditions, the firm's structure, or the firm's business lines?
Question 27: Two important components of models are the length of time
over which market risk is to be measured and the confidence level at
which market risk is measured. The definition of "capital at risk" as
used in the DPG Framework is the maximum loss expected to be exceeded
with a probability of one percent over a two-week period. Is this
definition appropriate for regulatory capital purposes?
Question 28: What should be the minimum criteria for models, including
pricing accuracy, correlations, netting factors, and observation
periods? Please provide relevant data to support your response.
Question 29: Are the minimum standards for the use of models, the
separate calculation of capital at risk due to shocks to the core risk
factors, and the audit requirements used in the DPG Framework
appropriate? Please provide relevant data to support your response.
Question 30: VAR models typically assume normality and that future
return distributions and correlations will behave similar to the way
they behaved in the past. For these reasons, the Commission needs to
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ensure that VAR models can withstand steep market declines. Other
than by specifying minimum qualitative and quantitative criteria, how
can regulators assure themselves that the proprietary models used by
the firms are adequate for capital purposes?
Question 31: Should the Commission require that broker-dealers
utilizing models manage these models from a risk management division
that is separate from the firm's business divisions?
Question 32: Should the Commission require that broker-dealers
utilizing models use the same model for both computing net capital and
internal risk management purposes?
Question 33: Currently, firms utilize a wide variety of risk
management techniques. Should the Commission mandate specific minimum
risk management standards for firms that wish to use models?
Question 34: Should the Commission require that firms using models
manage risk on either a firm-wide, legal entity, or business basis?
d. Additional Risks
Question 35: Usually, VAR models do not handle options products well
because the returns on an options portfolio are not typically normally
distributed. How should the non-linear nature of options be
adequately addressed? For firms with substantial options positions,
is a standard approach (similar to the Commission's amendments to
Appendix A of the net capital rule) more appropriate? Is the approach
set forth in the Commission's recent amendments to Appendix A a viable
alternative?
Question 36: Models typically measure losses by assuming that assets
can be sold at current market prices. However, if a firm has a
portfolio which includes illiquid assets, highly customized structured
products (including, for example, some CMOs), or aged items, the
Commission is particularly concerned that models may underestimate the
true losses since these assets may have to be sold at a discount.
Given the importance of liquidity risk, the Commission solicits
specific comment with respect to how this risk should be addressed if
models are permitted for regulatory purposes.
Question 37: Is it possible to include a credit risk analysis in a
model based methodology? Please provide relevant data to support your
response.
Question 38: As mentioned above, models may not properly account for
additional risks, including credit risk, liquidity risk, operational
risk, settlement risk, and legal risk. How should these additional
risks be treated? Can the Rule be modified to include separate
capital requirements to cover these sources of risk? Please provide
relevant data to support your response.
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Question 39: Is there an alternative to using a multiplier to account
for operational risk, legal risk, and other risks that are difficult
to quantify? Is the use of insurance to cover these risks a viable
option? Please provide relevant data to support your response.
Question 40: In order for a firm to calculate VAR effectively, data
must be aggregated from all its departments worldwide. Also, there is
often incompatibility of trading and back-office accounting computer
systems that operate from different regions of the world. How can
this problem of integration be adequately addressed?
e. OTC Derivatives Dealer
Question 41: Should the Commission amend the Rule so that all broker-
dealers are eligible to use the methodology for calculating market and
credit risk as in proposed Appendix F to the Rule?
Question 42: What minimum capital requirements should the Commission
require a broker-dealer to meet to be eligible to use proposed
Appendix F? Should the criteria be based on tentative net capital,
net capital, or both? Are the $100 million tentative net capital and
$20 million net capital requirements appropriate?
Question 43: Assuming that the Commission were to allow all broker-
dealers to utilize Proposed Appendix F, what sections in Proposed
Appendix F need to be modified for all broker-dealers? Are the market
risk and credit risk sections in Proposed Appendix F appropriate for
all broker-dealers? Are the qualitative and quantitative requirements
for VAR models in Proposed Appendix F appropriate to VAR models used
by non-OTC derivatives dealers?
f. Two Tiered Approach
Question 44: Is a Two Tiered Approach a viable alternative to the
current net capital rule? If so, what standards should the Commission
utilize to determine which broker-dealers are required to utilize
statistical models? Should the tier limits be based on capital,
amount of customer business, level of proprietary trading, or some
other factor(s)? Should these minimum net capital amounts be fixed
dollar amounts or be based on financial ratios such as aggregate
indebtedness or aggregate debit items as in the current rule? Please
provide relevant data to support your response.
Question 45: Should the current haircut percentages be maintained? If
not, what modifications should be made to the current haircut
percentages? Please provide relevant data to support your response.
Question 46: What will be the impact on competition among firms in
different tiers? In this regard, the Commission seeks comment on the
effects of creating a two-tiered system from broker-dealers that do
not currently use models in their risk management system and from
broker-dealers that currently use models for risk management purposes
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but either lack sufficient capital or sufficiently diverse securities
portfolios to use models for net capital purposes.
g. Base Approach with Pre-Commitment Feature
Question 47: Is the Base Approach a viable alternative to the current
net capital rule?
Question 48: Should the Base Approach only apply to firms that meet
certain standards? If so, what are the appropriate standards?
Question 49: What minimum capital requirements should the Commission
establish for certain broker-dealer activities? Should these minimum
net capital amounts be fixed dollar amounts or based on financial
ratios such as aggregate indebtedness or aggregate debit items as in
the current rule? Should the current minimum levels be retained?
Question 50: What modifications should the Commission make to the
current haircut percentages? Please provide relevant data to support
your response.
Question 51: What should be the parameters for the pre-commitment
feature? Should firms be penalized for differences between actual
results and the results as projected by VAR models? If so, what
criteria should be used to determine the additional capital
requirements for these differences?
III. Summary of Requests for Comment
Following receipt and review of comments, the Commission will
determine whether rulemaking or other action is appropriate. Commenters
are invited to discuss the broad range of concepts and approaches described
in this release concerning the Commission's regulation of broker-dealers'
net capital requirements. In addition to responding to the specific
questions presented in this release, the Commission encourages commenters
to provide any information to supplement the information and assumptions
contained herein regarding the current net capital rule, VAR models, and
the other suggested alternatives. The Commission also invites commenters
to provide views and data as to the costs and benefits associated with the
possible changes discussed above in comparison to the costs and benefits of
the current net capital rule. In order for the Commission to assess the
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impact of changes to the Rule, comment is solicited, without limitation,
from investors, broker-dealers, SROs, and other persons involved in the
securities markets.
By the Commission.
Jonathan G. Katz
Secretary
Dated: December 17, 1997