Citigroup Global Markets, Inc.February 17, 2004
Mr. Jonathan G. Katz
Dear Mr. Katz: Citigroup Global Markets, Inc. ("CGMI") appreciates the opportunity to comment on the Commission's proposed rule amendments (the "Proposal") on Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities ("CSEs"). We strongly support the Commission's efforts to provide alternative broker-dealer capital requirements based on mathematical models, including value-at-risk ("VaR") methodology, used by broker-dealers for their own internal risk management purposes. Citigroup has been generating such information for its own management purposes and for compliance with regulatory requirements imposed by the Board of Governors of the Federal Reserve System (the "Fed") for many years. We also strongly support the creation of broker-dealer capital standards that recognize the best available risk management methodologies available to both bank and non-bank affiliated broker-dealers. Consistency of capital and consolidated supervision standards among national and international regulators will help to promote stability in international markets and ensure fair competition. We have two principal concerns with the Proposal as it is currently drafted.1 First, we believe that the Proposal should be revised to ensure that Citigroup and similarly situated bank holding companies do not become subject to a new layer of comprehensive consolidated supervision ("CCS") in addition to that already exercised by the Fed. Similarly, we believe that the proposal should be revised to permit CGMI and other broker-dealer affiliates of bank holding companies, in calculating their regulatory capital, to use the same general model and methods they use to provide consolidated information to the Fed. We believe that these revisions would better promote the Commission's regulatory policy objectives in advancing the Proposal, provide better use of the Commission's resources, and allow the Commission to make use of the best available information in evaluating Citigroup's risk management at the holding company level, and within CGMI. I. Consolidated Supervision Under the Proposal, the ultimate holding company2 in any group containing a registered broker-dealer that meets certain minimum size requirements3 would have to contractually undertake to meet the following consolidated supervision requirements (the "CS Requirement") as a condition to the broker-dealer being eligible for the alternative regulatory capital requirement:
The Proposal should be modified to avoid the potential for duplicative and conflicting requirements for banking institutions that are already subject to comprehensive consolidated supervision. We believe that the Proposal's CS Requirement, as it would affect consolidated supervision at the holding company level, is primarily directed at those broker-dealer holding companies that are not now subject to a CCS regime of the type to which Citigroup is subject. Accordingly, we ask that the Proposal be revised to expressly limit the application of the CS Requirement to institutions of this type. In particular, in order to avoid the potential for duplicative or conflicting regulation, in the case of institutions that are subject to the type of consolidated supervision to which Citigroup is subject, the Proposal should be revised to: (i) clearly exempt both the holding company and non broker-dealer affiliates from the Commission's examination authority; (ii) specifically limit the consolidated risk data and reports that would be required to be provided to information that is already prepared for regulatory reporting or other purposes; (iii) require that consolidated information be provided indirectly through broker-dealer subsidiaries pursuant to Section 17(h) of the Exchange Act, rather than directly from holding companies, unless and until there is a clear statutory basis for protecting the confidentiality of such information; and (iv) provide that the methods by which consolidated capital is calculated for purposes of the Proposal are consistent with those approved by the CCS regulator. The Proposal should clearly identify during the application process those firms that will be exempted from duplicative holding company oversight. At the outset, the Proposal should be revised to clarify how the Commission will define those firms that are subject to CCS by another regulator and therefore will be exempted from the terms of the CS Requirement that would impose conflicting, duplicative, or burdensome requirements. In this regard, the term "primarily in the insured depository institutions business" as used in the Proposal, at least in the absence of clear guidelines as to how this concept would be applied, will create unnecessary uncertainty. There is no settled definition of "primarily in the insured depository institutions business" in other securities or banking law or regulation, and the Commission did not offer a definition in the Proposal. Without greater clarity, a diversified bank holding company like Citigroup will never be certain whether it satisfies or will continue to satisfy this test. If the test were applied by reference only to institutions the deposits of which are insured by the Federal Deposit Insurance Corporation ("FDIC") -- which is what the term "insured depository institution" refers to under the U.S. banking laws -- the test would be unduly limiting for international universal banking groups like Citigroup. For example, it might exclude uninsured banking, such as wholesale banking, much of private banking and financial products (e.g., leasing) activities conducted outside an insured depository institution, and non-FDIC-insured foreign banking. It might also exclude life, annuity, pension-related and other actuarially predictable insurance underwriting, which has long been recognized as banking for purposes of determining whether a foreign bank is predominantly engaged in banking under the qualifying foreign banking organization test5 and as an activity that is "usual in connection with the transaction of banking or other financial operations" when conducted by so-called Regulation K subsidiaries of U.S. bank holding companies or insured depository institutions.6 If the intention is to distinguish holding companies that are primarily engaged in the securities business from a group primarily engaged in the banking or savings association business, the Commission should treat all these non-FDIC-insured activities as banking. Further, whatever activities the Commission chooses to consider for purposes of this distinction, bank holding companies that are deemed to meet the test at one point in time could have to monitor their business activities on a continuous basis in order to determine that they continue to meet it. Such a continuous monitoring obligation would be burdensome and could deter the rational development of a universal banking group because of the incentive to avoid redundant supervision. In order to avoid these problems, we suggest that the Proposal be revised to delete use of the term "primarily in the insured depository institutions business." We suggest instead that the Commission reference firms that are subject to "comprehensive consolidated supervision" by another U.S. federal or home country supervisor that is equivalent to the CS Requirement (referred to hereafter as "CCS Entities"). As part of the application process, the Commission should confirm whether the applicant meets this test, based on both the nature of its businesses, considered as a whole, as well as the nature and extent of the consolidated supervision to which it is subject. The final rules also should make clear that, once the Commission has made this determination, the applicant will continue to have this designation for so long as it remains subject to the same consolidated supervision regime. This alternative would both permit the Commission to exempt from duplicative requirements only those institutions that are substantially involved in banking activities and subject to a rigorous supervisory regime at the holding company level, while at the same time avoiding the uncertainty and unintended consequences that are inherent in the approach taken by the Proposal. Citigroup and other similarly regulated firms are subject to intensive and ongoing consolidated supervision. A broad exemption for CCS Entities from Commission examination authority under the CS Requirement with respect to holding company affiliates, as well as limits on documents that would be required to be provided directly by the holding company, is entirely appropriate based on the nature and extent of oversight to which Citigroup and other bank holding companies are now subject. The Fed regularly conducts examinations of bank holding companies and their consolidated affiliates.7 It imposes consolidated capital requirements on them based on Basel Accord standards.8 It imposes extensive risk management requirements, including anti-money laundering and anti-terrorist financing requirements.9 Finally, it requires them to file a wide range of financial and operational reports.10 In particular, the following reports are required to be provided on a periodic basis:
Citigroup also provides to the Fed more current information concerning certain types of transactions. For example, we provide to the Fed on a weekly basis daily information on deposit transactions in domestic and off-shore books. We also provide a weekly estimated domestic balance sheet and report on repurchase agreements. The Fed maintains examiners on the premises of major bank holding companies, including Citigroup, on a full-time basis, providing continuous supervision on a consolidated basis. To ensure close coordination and consistency in the examination and supervision of banking organizations, the federal bank regulatory agencies coordinate the bank holding company inspection and the examination of the lead bank. In the case of Citigroup, the Fed coordinates with the Office of the Comptroller of the Currency (the "OCC"), the principal regulator of Citibank, N.A. The Fed conducts inspections of Citigroup's operations in the U.S. and overseas through a series of targeted or limited-scope reviews as part of continuous supervision. The procedures of a full-scope inspection focus in part on assessing the types and extent of risks to which a bank holding company and its subsidiaries are exposed, including credit, market, liquidity, operational, legal and reputational risks. Inspections also focus on evaluating the organization's policies and procedures for identifying, managing and controlling such risk exposures, and determining whether the management and directors are actively involved in the oversight of the organization's risk-management program. Inspections or reviews also generally include transaction and compliance testing to determine whether the organization's policies and procedures for risk management are fully effective and being followed.12 As contemplated by the GLB Act, the Fed coordinates with other responsible bank, and functional regulators to avoid duplication and minimize regulatory burden.13 The Fed exercises its authority pursuant to express statutory authority to act as the exclusive consolidated supervisor for bank holding companies, including those that have broker-dealer affiliates.14 The Fed is charged and empowered with the responsibility to consider all the relative risks posed by the activities of holding company affiliates, pursuant to a statutory scheme that is designed to create a "system of functional regulation designed to utilize the strengths of the various Federal and State supervisors."15 The Proposal, in contrast, would empower the Commission to exercise essentially the same authority, in conducting examinations and requiring consolidated risk information over CCS Entities like Citigroup, as it could exercise over firms that are not subject to any consolidated supervision at the holding company level. The result would be to subject the holding company and affiliates of already supervised CCS Entities to multiple examinations, duplicative reporting, and potentially conflicting guidance with respect to risk management practices. We believe that this is not the result the Commission intended. Citigroup would not object to providing to the Commission information at the holding company level that is already prepared for other purposes. Subject to the concerns about confidentiality expressed below, Citigroup does not object to providing the Commission with specific information that it already prepares for its own risk management purposes or provides to the Fed, for purposes of the Commission's understanding and evaluation of how activities by affiliates or at the holding company level could impact the capital position of CGMI. Specifically, we would not object to providing a specified subset of the reports provided to the Fed under its CCS authority, and in addition monthly unaudited balance sheets and income statements at the holding company level and for Citibank, N.A., if the Commission would find such information useful. Firms must be able to be sure that any information that is provided to the Commission under the alternative capital regime will be held confidential. We do not object to providing the Commission with information directly from the holding company, as long as we are not prohibited from doing so,16 there is a clear statutory basis for protecting the confidentiality of such information, and the Commission is subject to limitations on the scope of the information it can require equivalent to those contained in Section 17(h) of the Exchange Act. Non-public financial and risk management information by its nature is highly sensitive and proprietary, and it is therefore of paramount importance, for Citigroup and other firms who would be subject to the CS Requirement or elect alternative capital treatment, that the Commission be able to ensure the protection of such information. Sections 17(i) and (j) of the Exchange Act provide a statutory basis for protecting the confidentiality of information provided to the Commission directly by investment bank holding companies that are not bank holding companies, thrift holding companies or foreign banks.17 Sections 17(h) and (j) provide a similar statutory basis for protecting the confidentiality of information about bank holding companies and their affiliates that is provided indirectly by their broker-dealer affiliates.18 These provisions were expressly designed in part to deal with confidentiality concerns when the Commission requests sensitive information from firms that are subject to federal banking regulation. We are concerned that there do not appear to be statutory provisions similarly guaranteeing the confidentiality of information provided to the Commission directly by bank holding companies. Accordingly, unless and until the Commission can obtain equivalent statutory protection for supervisory and proprietary information provided to it by bank holding companies, we propose that such information be obtained by the Commission from the broker-dealer affiliate of a bank holding company pursuant to the Commission's existing authority under Section 17(h) of the Exchange Act, instead of from the bank holding company itself. Section 17(h) authorizes the Commission to obtain copies of all reports filed by a bank holding company and its affiliates with the Fed.19 It also provides a mechanism for the Commission to request the Fed to expand its reporting requirements to include any supplemental information the Commission determines it needs about the broker-dealer's exposure to the risks of its affiliated group.20 Finally, the Commission has the authority under Section 17(h)(2) to obtain such supplemental information without the Fed's involvement (other than notice and, if possible, consultation) when it believes the broker-dealer is in financial difficulty. If the Commission requires information directly from a bank holding company pursuant to its Proposal, its power to do so should be subject to limitations that are similar to those contained in Section 17(h) with respect to the scope of the information that can be required. The Commission should expressly permit entities such as Citigroup to make capital calculations at the holding company level in accordance with Basel standards as implemented by Fed rules and guidance. In its release accompanying the Proposed Rule, the Commission indicated that it has designed its proposed consolidated capital calculations in Appendix G "to be consistent with the Basel Standards."21 In fact, the provisions contained in Appendix G are not consistent with the original Basel Capital Accord ("Basel I") and may not be entirely consistent with the proposed new Basel Capital Accord ("Basel II") because Basel II has not been finalized. In particular, with respect to market risk, the 1996 Amendment to the Basel Accord, and its implementation by banking regulators in the United States, does not exclude any particular types or classes of transactions for the VaR calculations used to determine risk-weighted assets, as does the Proposal. Instead, regulators review the validity of the VaR model on a desk-by-desk basis. The validity of including each desk within the VaR calculation is based on back testing with test portfolios, with a range of degrees of risk concentration, in order to determine whether the model accurately measures the risk of that particular business activity. In addition, the Proposal differs from the Basel framework in using a VaR calculation in order to ascertain the credit exposure amount related to over-the-counter derivatives contracts. The Fed has for many years required bank holding companies to calculate their consolidated capital in accordance with their rules based on Basel I standards for credit and market risk and has indicated in an advanced notice of proposed rulemaking that it would require the largest banking institutions, and allow all U.S. banking institutions, to calculate their consolidated capital in accordance with Basel II if and when Basel II is adopted. Further, banking regulators rigorously review the application of these standards by each institution that is subject to supervisory oversight. For example, the Fed and the OCC conduct an intensive review on a periodic basis of the VaR models and other systems used by bank holding companies to generate consolidated capital data with regard to market risk. The regulators require extensive back-tests of hypothetical test portfolios with different degrees of risk concentration. These back tests consist of comparing the ex-ante VaR to the ex-post change in the market value of a number of test portfolios for each desk, over a long period of time, e.g. one year. Further, the Fed requires back tests for each desk on an annual basis. Requiring bank holding companies to alter their systems to comply with both the Fed's current consolidated capital rules (which are based on Basel I) and Appendix G, without conforming Appendix G to the Basel capital standards currently in effect would impose burdens on bank holding companies that are not justified by any supervisory need. Accordingly, we propose that the Commission amend Appendix G to provide that CCS Entities can calculate allowable capital and allowances for market, credit, and operational risk on a consolidated basis in accordance with Basel standards as applied under the guidance provided by the entity's CCS regulator. The Commission would have the opportunity to review the risk architecture adopted by each such firm, and the assumptions built into the capital calculation models, in order to confirm adherence to Basel standards and understand contextually the capital calculations generated by the firm's models. II. Alternate Proposed Broker-Dealer Capital Requirement In its release accompanying the Proposal, the Commission indicated that it modeled the proposed alternative broker-dealer capital requirement on its "rules pertaining to over-the-counter ("OTC") derivatives dealers." ("Broker-Dealer Lite").22 Under the proposed alternative rule, a broker-dealer that meets the minimum size requirements mentioned above, the CS Requirement and certain other conditions could "elect to calculate certain of its market and credit risk capital charges using the firm's own internal mathematical models for risk measurement, including internally developed VaR models and scenario analysis."23 "[E]liminating the need to maintain a separate system to calculate regulatory capital should reduce regulatory costs for broker-dealers that have developed mathematical risk measurement models as part of a risk management system for business purposes."24 We commend the Commission for recognizing that, given recent developments in international capital regulation, broker-dealer capital calculations should be based on internal mathematical models developed to manage risk for business purposes. As noted, above, however, because bank holding companies like Citigroup are already required to calculate their capital in accordance with Basel standards, imposing capital calculation methodologies based on the Commission's experience with OTC derivative dealers will require bank holding companies to make two different types of capital calculations: one at the holding company level and one at the broker-dealer level. Also, it appears to run counter to the Commission's objectives as expressed by the language quoted above. The Commission should permit consistency of capital methodologies at the holding company and broker-dealer levels. We therefore would propose that broker-dealers that are affiliated with CCS Entities should be allowed to use the same general capital calculation methodology at the broker-dealer level that are used at the consolidated level, while allowing for modifications that do not require electing firms to adopt a separate VaR model and that permit continued evolution of capital standards through the Basel process. This approach is far superior to the Proposal's approach. The optional capital charge provisions adopted by the Commission under the Broker-Dealer Lite rules were part of a series of alternative regulatory requirements designed to encourage the efficiency and competitiveness of U.S. securities firms in global OTC derivatives markets by permitting U.S. firms to conduct both securities and non-securities derivatives activities through a single legal entity. They were not designed to incorporate the most sophisticated and accurate methodologies, nor are they based on internationally accepted capital standards. Indeed, since the adoption of the Broker-Dealer Lite rules in 1998, there has been significant evolution of capital standards under the Basel framework. Requiring that CCS Entities use the Broker-Dealer Lite approach in order to elect alternative capital treatment would run counter to this evolution and the substantial efforts that have been made toward convergence of capital standards at an international level. Further, the requirement to construct alternative models and systems solely for purposes of the Commission's alternative capital regime at the broker-dealer level would be extraordinarily costly, burdensome, and inefficient, particularly for CCS Entities that are already subject to Basel I standards and will most likely be subject to Basel II standards. Devising entirely new systems for this purpose would require a substantial lead time to implement, involve enormous start-up expenses, and require substantial ongoing expenses in order to staff and maintain such systems. Moreover, such systems would have no application or utility apart from compliance with the alternative capital regime. In this regard, it should be noted that the Proposal contemplates that the methodology used under Appendix E be the same methodology used by firms to prepare internal risk management reports. It is critical that the Commission's process for approving the use of VaR models by various firms for regulatory capital purposes provides for both completeness and accuracy of measurement and equal application. We think the key components of the Commission's review of the adequacy of VaR models should focus on (i) the completeness and comprehensiveness of the data captured; (ii) the appropriateness of VaR simulations for the instruments comprising the portfolio; and (iii) most important, comprehensive and exhaustive back testing. In adopting final rules, the Commission should elucidate the criteria it will apply in reviewing VaR models and how the criteria will be applied in order to ensure fair and equal treatment among firms. We appreciate that if the Commission permits regulatory capital calculations to be based on Basel standards, it will want to ensure that capital levels are appropriate to the nature of the securities business and sufficient to achieve the purposes of the Commission's net capital rule. Our principal concerns with the requirements of Appendix E are those just described, rather than the amount of regulatory capital that would be required for CGMI. If the Commission believes that adjustments are necessary, a more appropriate way to ensure that appropriate capital levels are maintained would be to adjust multipliers to VaR numbers and/or increase minimum capital thresholds. We would welcome the opportunity to work with the staff of the Commission to identify useful alternatives for making such adjustments. In Appendix I, we have provided more specific suggestions and responses to certain specific requests for comment contained in the Proposal. Citigroup and CGMI appreciate the opportunity to comment on the Commission's Proposal. Please do not hesitate to contact the undersigned (tel: 212-816-8173) or Randall Guynn or Steven Lofchie at Davis Polk & Wardwell (tel: 212-450-4239 or 4075) if you should have any questions about this letter.
cc: The Honorable William H. Donaldson, Chairman
APPENDIX 1 CERTAIN ADDITIONAL RECOMMENDATIONS 1. "Material" Changes to Mathematical Models The Proposal would require a broker-dealer to amend and resubmit its application to use Appendix E if the broker-dealer or its holding company desired to make a material change to a mathematical model used to calculate market or credit risk or its internal risk management control system as described in the application. In addition, a broker-dealer would be required to notify the Commission of any material change to the corporate structure of the broker-dealer or its holding company as described in its application. The Proposal does not, however, define the term "material." We suggest that the Commission revise its proposal to include a non-exclusive list of material changes in order to provide guidance to CSEs and their broker-dealer subsidiaries regarding when notification is required. 2. Revocation of the Alternative Capital Calculation Exemption The Proposal would allow the Commission, by order, to revoke a broker-dealer's exemption from the Net Capital Rule if the Commission finds that the exemption is no longer necessary or appropriate in the public interest or is no longer consistent with the protection of investors. The Proposal is silent, however, as to the circumstances that would allow the Commission to revoke a particular broker-dealer's exemption, and it does not provide a broker-dealer with an opportunity to seek to cure any deficiencies triggering the loss of the exemption. We suggest that the Commission specify the circumstances in which revocation of the exemption would be appropriate. In addition, in order to ensure a stable capital regime, CSEs should be granted a "cure period."25 3. Specific Issues with the Proposed VaR Limitations The current proposal prohibits the use of the VaR methodology for computing market risk charges on certain of the broker/dealer's positions. We believe that use of VaR should be available for all securities which meet the definition of "trading book" as outlined in the third consultative paper on the New Basel Accord. This approach is consistent with how Citigroup and other institutions internally manage and report market risk. Further, since market risk is managed by strategy, not by security type, we believe that the requirement for a phase in period by security type is not practical and would produce illogical results. 4. Specific Issues Concerning the Treatment of Credit Risk CGMI supports the aspects of the Proposal that would permit firms to calculate current and potential exposure by counter-party, rather than by transaction. We also support the SEC's willingness to recognize the effect of netting arrangements, collateral arrangements, and protection from the use of credit derivatives. At the same time, we question the appropriateness of the fixing the determination of future exposure by reference to "maximum potential exposure" as defined in the Appendix E.26 Questions concerning the appropriate means to measure future exposure are presently being considered by the Basel Committee. 27 The active discussion that exists concerning this issue reinforces the wisdom of permitting firms to calculate credit, market and other risks consistent with Basel standards as they evolve, rather than freezing these methodologies at the time of the adoption of the new rules. We also believe that the counter-party concentration and portfolio credit concentration charges are onerous and unnecessary and will discourage the movement of derivative positions onto the books of registered broker-dealers. No comparable charges are envisioned under Basel I or Basel II. Controlling for counter-party and portfolio concentrations is a fundamental aspect of risk management, and a better way to approach concerns with concentrations is by reviewing the adequacy of risk management controls in this area. We also would propose the following changes with respect to specific aspects of the Proposal as it concerns the treatment of credit risk.
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