February 27, 2004
Mr. Jonathan G. Katz
Re: File No. S7-21-03; Proposed Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities(Release No. 34-48690)
Dear Mr. Katz:
Morgan Stanley welcomes the opportunity to comment on the above-referenced proposal by the Securities and Exchange Commission (the "Commission") to provide a regulatory capital framework for broker-dealers that meet certain minimum criteria and are part of a consolidated supervised entity ("CSE").1 Specifically, the proposed framework would establish a voluntary alternative method for computing regulatory capital charges for a qualifying broker-dealer that is part of a holding company, if the holding company has in place group-wide internal risk management control processes and consents to group-wide Commission supervision (the "CSE Framework").
Morgan Stanley commends the Commission's efforts to develop a framework for the consolidated supervision of broker-dealers that are part of a CSE. We applaud the Commission's thoughtful and comprehensive approach to the complex issues raised by the Commission's proposed rulemaking, particularly in light of the time constraints under which the Commission has operated. We also appreciate the Commission's recognition of the significance and potential impact of the proposed CSE Framework for the securities industry.
Morgan Stanley believes that the CSE Framework will establish a rigorous and practical supervisory model, which, subject to the comments below, we strongly endorse. We are confident that the CSE Framework, once finalized, will gain recognition as a "functionally equivalent" supervisory framework for purposes of the European Union ("EU") Directive for Financial Conglomerates.2 In addition, we believe that by strengthening and reinforcing group-wide risk management practices, the CSE Framework will promote investor protection and other core policy objectives of the Securities Exchange Act of 1934 (the "Exchange Act").
Our recommendations, including those set forth in detail in the attached Appendix, are generally designed to (i) clarify elements of the CSE Framework, (ii) harmonize regulatory capital requirements at the broker-dealer and holding company levels, (iii) promote greater consistency with The New Basel Capital Accord ("Basel II"), (iv) minimize duplicative or unnecessary regulatory burdens and (v) facilitate implementation of the CSE Framework. We have fashioned our recommendations with a view to ensuring that they are consistent with or enhance the recognition of the CSE Framework as a functionally equivalent framework for global supervision.
We firmly believe that in order for the CSE Framework to be effective and to promote best risk management practices, the regulatory requirements for risk management and capital adequacy must be consistent with the manner in which firms actually manage the risks and capitalization of their businesses. As important, the CSE Framework must be consistent with the related supervisory standards that are applicable to financial institutions across international markets. Once supervisory standards for the CSE Framework that are consistent with these principles are established, the Commission's ongoing role is to ensure that CSEs comply faithfully with their risk management responsibilities, and to do so in an environment that mandates reciprocity and mutual deference among international supervisors. Against the background of these themes, we would like to highlight briefly below the following major points for the Commission's consideration in connection with its finalization of the CSE Framework:
Harmonization of Risk Management and Capital Computation; Risk-Based Capital Charges. The evaluation of a firm's capital adequacy is a core component of an effective risk management system. For the two to be effectively integrated, the models used by a firm to compute capital charges should be consistent, to the maximum extent possible, with the firm's risk management systems. Accordingly, in implementing the CSE Framework, the Commission should seek to maximize a firm's ability to utilize existing risk management models and processes for the computation of capital charges.
We note in this regard that the implementation of a risk-based model for the calculation of capital charges is fundamental to the proposed CSE Framework. We urge the Commission to be rigorous in adopting this model in the case of market, credit and operational risk. A capital framework that properly calibrates capital charges to actual risk will most successfully promote and reward effective risk management and will deter business decisions motivated by anomalies in the computation of risk-based capital charges.
Consistency at the Broker-Dealer and Holding Company Levels. As discussed more fully in Part II.A of the attached Appendix, the Commission's framework for risk-based capital should be consistent, to the maximum extent possible, at the U.S. broker-dealer and holding company levels. If they are not, discontinuities will exist in the firm's group-wide risk management processes for risk measurement and in the computation of capital charges. Disparities between the methodologies used to compute capital charges will also invariably lead to additional costs, burdens and operational inefficiencies. Moreover, a bifurcated approach to capital computation will encourage regulatory arbitrage. Finally, we do not believe any clear analytical basis exists for quantifying identical units of risk differently at the holding company and broker-dealer levels and would be particularly concerned by material disparities in the capital requirements applicable to U.S. broker-dealers, on the one hand, and non-U.S. broker-dealers, on the other hand.Appropriate Deference; Greater Legal Certainty. The Commission should endeavor to strike an appropriate balance in determining the scope of host/home country deference. It is important that the Commission do so in a manner that will eliminate unnecessary duplication, and attendant costs and burdens, and that will foster reciprocity and an effective international framework for supervisory cooperation.
In addition, although the CSE Framework by its nature necessitates greater supervisory flexibility, the Commission should nonetheless endeavor to provide greater structure and legal certainty to the process for responding to perceived deficiencies in connection with applications and the ongoing administration of the CSE Framework, consistent with prevailing concepts of administrative due process and prudential supervision.
Application Process. As the Commission is aware, timely completion of the CSE application process is particularly important to those broker-dealers for whom the Commission will be the sole comprehensive consolidated supervisor. In this connection, the application process should incorporate appropriate procedural elements and substantive criteria designed to promote predictability and timeliness. In addition, as discussed in Part I.B of the attached Appendix, the Commission should leverage any familiarity it may already have with the existing risk management systems or models used by applicants, as well as examinations previously undertaken by other functional regulators, in order to expedite its completion of the review and approval process for such applicants.
Evolution of Regulatory Standards. Morgan Stanley supports the development of rigorous, internationally consistent standards that are designed to accommodate the evolutionary character of risk management. We believe that the Commission should ensure that the CSE Framework incorporates a dynamic and adaptive approach to risk management and capital standards and accommodates changes in business practices, economic environment, risk management theory and practice, as well as developments in international standards. Operational risk is a prime example of an area of risk management and capital adequacy that requires a dynamic framework. We also urge the Commission to ensure that it is able to dedicate adequate ongoing resources to the continued development and implementation of risk management processes and capital standards and to maintain a leadership role together with other international regulators in furtherance of consistent development of these standards.
* * *
Morgan Stanley appreciates the opportunity to comment on the Commission's CSE Framework. Should you have any questions or require additional information regarding any of the matters discussed in this letter and the attached Appendix, please do not hesitate to contact the undersigned at 212-761-4275 or Ralph Pellecchio at 212-761-6686.
/s/ Stephen S. Crawford
cc: The Honorable William H. Donaldson, Chairman
The Honorable Paul S. Atkins, Commissioner
The Honorable Roel C. Campos, Commissioner
The Honorable Cynthia A. Glassman, Commissioner
The Honorable Harvey J. Goldschmid, Commissioner
Annette L. Nazareth, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Michael A. Macchiaroli, Associate Director, Division of Market Regulation
Catherine McGuire, Associate Director and Chief Counsel, Division of Market Regulation
Matthew J. Eichner, Assistant Director, Division of Market Regulation
Lourdes Gonzales, Assistant Chief Counsel, Division of Market Regulation
Thomas K. McGowan, Assistant Director, Division of Market Regulation
Linda Stamp Sundberg, Attorney Fellow, Division of Market Regulation
Bonnie L. Gauch, Attorney, Division of Market Regulation
Rose Russo Wells, Attorney, Division of Market Regulation
David Lynch, Financial Economist, Division of Market Regulation
Giovanni P. Prezioso, General Counsel
I. CONSOLIDATED SUPERVISION ISSUES.
A. Recognition that the CSE Framework Meets the Functional Equivalence Standards of the EU Financial Conglomerates Directive.
As the Commission has recognized, following implementation of the EU Financial Conglomerates Directive, firms of non-EU parentage doing business in the EU must demonstrate that they are subject to consolidated supervision at the holding company level that is "equivalent" to EU standards for global consolidated supervision.3 Morgan Stanley appreciates the Commission's attention to this development and the steps the Commission has taken to date to ensure recognition of the proposed CSE Framework by EU financial market regulators, including in particular the Technical Group advising the Financial Conglomerates Committee established by the EU Commission.
As noted above, Morgan Stanley is confident that the CSE Framework, once finalized, will achieve recognition as a framework for consolidated supervision of broker-dealer CSEs that is equivalent to EU standards for global consolidated supervision as contemplated in the EU Financial Conglomerates Directive. We encourage the Commission to continue its ongoing dialogue with its counterparts in the EU regarding the CSE Framework and to seek formal confirmation, at the earliest possible date, that the CSE Framework is functionally equivalent to EU global consolidated supervisory standards.4
The 2005 effective date of the EU Financial Conglomerates Directive5 increases the importance of an expeditious approval process for applicants who will not have a comprehensive consolidated supervisor other than the Commission. In this regard, the open-ended character of the proposed application process for the CSE Framework is a source of concern.
In particular, the proposed CSE rules include no specific process for satisfactory completion of the steps necessary to qualify for approval under the CSE Framework. No period is specified within which the Commission must complete its review of a CSE application (or any component) and either approve an application (or submission) or note any material deficiencies that require attention. We believe the proposed CSE Framework would benefit from greater specificity in these areas.6
We note, in addition, that the Commission has significant familiarity with the global risk management policies and procedures of many firms, including Morgan Stanley, through its oversight of their broker-dealers and/or through information shared pursuant to the voluntary supervisory framework adopted by the Derivatives Policy Group and otherwise. We believe that this experience should enable the Commission to expedite the application process with regard to such materials and should enable the Commission to specify a more abbreviated time frame for its review and approval of such materials.7 In addition, the risk management processes and procedures for certain of our businesses have been examined by the principal regulators of such businesses. In these instances, we believe that it is appropriate for the Commission to rely, at least on a provisional basis, on the review and examination of the regulators with responsibility for supervising these businesses.8
Deference to Certain Other U.S. and Non-U.S. Regulators in Administering the CSE Framework.
Morgan Stanley believes that the purpose of the Commission's consolidated supervision is to assure the financial integrity of CSEs and that, accordingly, its supervisory jurisdiction over CSEs is appropriately focused on the supervision of capital adequacy and risk management control systems. While we appreciate the Commission's need to understand all the risks and related control systems within the CSE, we urge that the Commission confirm that the information to which it is to have access is intended to be limited to information directly related to the CSE's capital adequacy and risk management control systems. At a minimum, we believe that the scope of the Commission's supervisory jurisdiction should be consistent with and no more expansive than that of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") under the Bank Holding Company Act or the Commission's own jurisdiction under the Gramm-Leach-Bliley Act with respect to supervision of investment bank holding companies.
A number of entities within a CSE may already be subject to supervision by U.S. and non-U.S. regulators. We believe that, as part of its supervisory obligations under the CSE Framework, the Commission should further develop cooperative relationships with the principal regulators of affiliates within the CSE to avoid duplicative and potentially inconsistent supervision and regulation.
Specifically, we urge the Commission to adopt a clear standard for addressing home/host issues that incorporates a strong presumption in favor of deference to certain regulators, particularly with respect to examination and reporting requirements. We agree that deference should depend on whether an affiliate is "an entity that has a principal regulator." In our view, any entity that has a home country regulator or supervisor, whether or not in the United States, charged with substantive supervision of the activity in which the entity is engaged, such as banking, insurance, securities, commodities or investment management activities, should be presumed to be "an entity with a principal regulator."9 This presumption is necessary and appropriate because each such principal regulator is best situated to be primarily responsible for supervision of the regulated entity and the assessment and monitoring of its risk.10 We also note that an area where deference is not only appropriate but necessary is the establishment of capital requirements, as well as model approvals related to such capital requirements, which are clearly within the jurisdiction of the principal regulator and not the consolidated supervisor.
In particular, the Commission should rely on the examinations performed by the principal regulator (or a self-regulatory organization exercising delegated authority from a principal regulator) and any reports or information that the holding company or subsidiary is required to file with (or that are prepared by) the principal regulator.11 The presumption in favor of deference should be overcome only where the Commission reasonably believes the affiliate is engaged in an activity that poses a material risk to the CSE and that remains unresolved by such reports or information.12
It is also important that the Commission remain alert to the competitive implications of the CSE Framework and avoid imposing requirements on CSEs for whom the Commission will be the consolidated supervisor that could place them at a competitive disadvantage to CSEs who are subject to comprehensive consolidated supervision by a supervisor other than the Commission.
D. Need to Ensure Protection of Confidential Information.
It is essential that any information provided pursuant to the CSE Framework, including any changes in models, calculations or procedures made in response to Commission comments, be accorded confidential treatment.13 We support the provision in proposed Appendix E, which would provide for confidential treatment of all information or documents submitted in connection with an application under Appendix E.14 Similarly, we support Paragraph (b)(7) of proposed Appendix G, which would provide confidential treatment for statements filed by a holding company under Appendix G. We recommend that the Commission clarify that confidential treatment will be afforded all similar information provided to the Commission, at its request, in connection with the Commission's administration of the CSE Framework.
In addition, the Commission should clarify that it will not share any such information with another U.S. or non-U.S. regulator except pursuant to statutory or other binding provisions ensuring the confidential treatment of such information by the other regulator and then only with the consent of the CSE.
Finally, we request that the Commission explicitly confirm in the adopting release its implicit determinations that: (i) the scope of the information it will obtain from CSEs under the proposed CSE Framework is, by its nature, competitively sensitive; (ii) CSEs have a commercial interest both in their risk models and in the data they obtain through use of the models; and (iii) the Commission's inability to afford confidential protection to information obtained under the CSE Framework would give rise to fundamental concerns about the CSE Framework's viability.II. CAPITAL FRAMEWORK ISSUES.
Morgan Stanley believes that the CSE capital structure, which lies at the heart of the CSE Framework, represents an important step in developing broker-dealer capital requirements that appropriately reflect the risks to which a CSE is subject. Our goal in commenting on the capital aspects of the CSE Framework is to achieve a global risk management paradigm that aligns regulatory requirements for risk management and capital with the manner in which firms manage and measure risk across their businesses. Specifically, we urge the Commission to construct a principles-based approach under which the regulator and the regulated entity evaluate risk in a similar fashion, using a common methodology for evaluating the models, processes, systems and reporting tools that measure and monitor capital and risk. In our view, any such framework should incorporate incentives to encourage the development of best risk management practices and should strive to implement a dynamic approach.
We believe that Basel II generally incorporates all these elements and, additionally, is sufficiently flexible to assure appropriate capital levels at the U.S. broker-dealer while maintaining the requisite consistency with international regulatory standards. Morgan Stanley is fully committed to the adoption of Basel II standards and urges the Commission to implement Basel II standards both at the broker-dealer and holding company levels. At the same time, we note that the proposed Basel II standards may need to be modified prior to their effectiveness to ensure the appropriate treatment of the broker-dealer business model. Once Basel II standards are finalized, individual regulators will maintain a degree of flexibility within the construct of Basel II with respect to the interpretation and application of applicable standards.
We further believe that it is important that the Commission's approach to capital minimize unnecessary costs and burdens and not create competitive disparities between U.S. broker-dealers who are subject to the CSE Framework and their U.S. and non-U.S. competitors who are not. We offer a number of suggestions immediately below to enhance the viability of the capital-related components of the Commission's CSE Framework.
We are pleased that the CSE Framework contemplates a value-at-risk ("VaR") model approach to capital computation and urge the Commission to implement a more comprehensive approach to risk-based capital computation that is based on the use of internal models and that eliminates the use of haircuts and similar charges that are based on "categorization" rather than on statistically demonstrable risk attributes.
We similarly recommend that the Commission adopt consistent capital frameworks at the broker-dealer and holding company levels to the maximum extent possible so that firms are able to use a single, integrated approach to managing capital throughout a CSE. A bifurcated model approach encourages regulatory capital arbitrage and requires firms to maintain multiple, inconsistent capital computation systems. Effective group-wide risk management depends on a consistently implemented approach to risk measurement and management on a group-wide basis. Capital computations should be a fully integrated component of such systems. Accordingly, we recommend that the Commission adopt policies aimed at promoting such integration and related efficiencies and avoid policies that impede successful integration.
For these reasons, we urge the Commission to eliminate the proposed phase-in of risk-based capital computations at the broker-dealer level and eliminate the use of haircuts, or differential, haircut-based treatment for defined categories of securities, such as securities without a "ready market" or below investment grade securities.
B. Use and Approval of Risk Models.
The Commission should develop a flexible approach to model approval. For example, firms should be permitted to use proprietary VaR models that are acceptable to the Commission. The Commission should approve risk management processes and controls (including component models) that have previously been approved by a functional regulator or that the Commission has already reviewed. To minimize duplication and inconsistency, we suggest that the Commission work together with the principal regulators for each applicant to develop a uniform set of model approval criteria. If the Commission identifies specific concerns with respect to a particular model, it should address these concerns through the use of a multiplier that should be subject to phase-out after appropriate backtesting establishes the validity of the model or other adjustment to the model by the firm.
We urge the Commission to permit the use of VaR or other risk-based capital models for all instruments in the "trading book" as defined in Consultative Paper 3 ("CP3") of Basel II.15
Any position in the trading book (including initial public offering securities and below investment grade securities) should be eligible for VaR- or other model-based capital treatment. Any concerns as to uncaptured risk, or data or control deficiencies, should be addressed through the use of specific risk add-ons.
We encourage the Commission's active participation in the International Organization of Securities Commissions ("IOSCO") working group on trading book issues. Basel II has been developed with a principal focus on "banking book" activities and has not comprehensively addressed "trading book" issues. Examples of trading book issues that we think are urgently in need of reassessment include "potential future exposure" ("PFE") associated with OTC derivatives and the use of VaR models for calculating PFE for securities financing transactions and credit derivatives treatment. We urge the Commission to assume a leadership role in the effort to harmonize global "trading book" standards and request that the Commission incorporate any changes recommended by the IOSCO working group into the CSE Framework at the earliest opportunity.As a condition to approval of a capital model, a firm should be required to demonstrate that its model effectively captures the risks associated with the category of securities for which it is to be used. This will obviate the need to exclude any particular category of securities, other than those securities that entail risks that the firm is unable to demonstrate it can effectively model. The Commission should not require approval for the use of a model to compute capital for a specific new security, unless the security introduces a category of risk not previously addressed by the model. Similarly, we do not believe that the lack of a historical price time series for specific securities should preclude the use of a proprietary model for the computation of capital in circumstances where other appropriate historical data exists for the purpose of generating reliable modeling results.
We also ask that the Commission revise the proposed CSE Framework with respect to "material" changes in a model. A "material" change should not include regular benchmark updates or minor time series modifications, additions, or deletions. We recommend that firms be permitted to present any proposed material change to the VaR model at the firms' monthly meetings with the Commission staff or through other dialogue with the Commission. The presentation should include a description of the model change, the reason for the change including any business or statistical rationale, the impact of the model change, with before and after results, and backtesting results, if applicable, of the model with the change. If, after a reasonable period, the Commission does not identify any problems with the proposed material change, the firm should be permitted to adopt the change.
C. Applicable Basel Standards.
The proposed implementation of the CSE Framework and the projected time frame for adoption of Basel II create significant difficulties for prospective CSE applicants who are not currently operating under a supervisory framework based on the use of Basel capital standards and who therefore have not implemented a Basel I capital model. Firms have unique internal systems that differ in the extent to which they incorporate features consistent with the standards established under Basel I or II. It is important that the Commission clarify that, prior to the projected implementation of Basel II in 2007, it will be flexible as to the Basel standard broker-dealers and their holding companies are permitted to implement.
Full implementation of Basel II capital standards will take some time and can in any event only be accomplished following finalization of the standard. Conversely, the imposition of the significant expense of implementing portions of the Basel I framework that will be superseded in a very short time would make little policy or economic sense. Therefore, during a transitional period the Commission should permit broker-dealers and their holding companies:
· to implement a Basel I approach;
to implement a Basel II approach (even if it has not been formally adopted in all member states); or
to implement a combination of the two approaches, consistent with the state of the firm's internal systems development, in circumstances where one or more, but not all, of the firm's business units have been operating under a Basel I capital standard, and provided that the Commission finds, in the context of the application, that the specific combination of standards proposed to be implemented by the applicant would not undermine the financial integrity of the applicant's capital model (and therefore would not compromise the functional equivalence of the resulting capital framework).16
Both Basel I and Basel II raise numerous interpretative issues that may significantly impact a firm's financial capital. Many interpretations have been made in the context of the banking business and do not effectively reflect the different business model and portfolio characteristics of major, internationally active broker-dealers. Recognizing this, we urge the Commission to exercise its discretion in interpreting and implementing Basel standards in a manner that accounts appropriately for the characteristics of broker-dealers and differences between the broker-dealer and commercial banking businesses.
D. Credit Risk Capital Issues.
1. Credit Concentration Charges.
The CSE Framework would incorporate credit concentration charges at the broker-dealer level. In our view, the proposed credit concentration charges for OTC derivatives at the broker-dealer level attach at such low thresholds and are so significant that they effectively limit the scope of OTC derivatives business that can be booked in a broker-dealer in a capital efficient manner. Moreover, Morgan Stanley believes that the proposed charges are inappropriate as well as inconsistent with Basel II standards and the approach taken by other U.S. supervisors in implementing this aspect of Basel II and, therefore, should be eliminated in their entirety. Instead, undue portfolio concentration should be controlled through internal risk management models and regulated by the Commission through the model approval process, the Commission's oversight of the adequacy of the CSE's risk management controls with respect to portfolio and counterparty credit concentration and its monthly reviews of firm compliance.
We further believe that the CSE Framework should treat the credit exposures arising from OTC derivatives in a manner that is consistent at the holding company and broker-dealer levels.
2. Potential Credit Exposure Issues.
Morgan Stanley regards the Commission's proposed use of "maximum potential exposure" in calculating the "credit equivalent amount" as an improvement to the "add-on" methodology in CP3 of Basel II. While preferable to the approach in CP3, this "sum of the peaks" approach nonetheless results in a significant overstatement of credit risk because, among other deficiencies, it assumes that all counterparties default when their positions have the greatest positive value to the firm. Morgan Stanley believes that a more appropriate approach would be to model default scenarios that are statistically more realistic and that account for portfolio diversification effects. It should be noted that we believe these issues are significant in the case of both derivatives and securities financing transactions.
Morgan Stanley also believes that "maximum potential exposure" should appropriately account for the future value of collateral that would be collected through calls for collateral. In this context, for collateralized derivatives transactions, the industry consensus is that the appropriate time horizon for computing "maximum potential exposure" should be ten business days, rather than one year, in circumstances where the position is marked-to-market daily and the firm has the ability to call for additional collateral.
In the Basel II capital computations, there is an adjustment factor for the effective maturity of exposures. The maturity adjustment factor is not specifically mentioned in the Commission's proposal. The Commission should clarify whether this maturity adjustment factor should be applied.
We endorse the credit risk work that is currently being conducted under the auspices of the International Swaps and Derivatives Association, Inc., and, in particular, the work that is currently underway in developing the concept of "expected positive exposure" and similar approaches that promote recognition of portfolio diversification effects and do not assume unrealistic, maximum loss default scenarios. We encourage the Commission to promote the recognition of this type of methodology through IOSCO and other international forums and urge that, if this type of approach is incorporated in Basel II, the Commission also incorporate it into the CSE Framework as soon as practicable.
3. Treatment of Margin Loans.
The Commission has proposed a 5% credit conversion factor for margin loans at the holding company level.17 Morgan Stanley believes that the proposed conversion factor should be eliminated. Margin loans that are marked-to-market and subject to collateral calls daily should be considered economically equivalent to secured financing transactions and should be eligible for VaR-based exposure treatment.
4. Collateral Limitations.
Paragraph (d)(6) of proposed Appendix E specifies that the fair market value of pledged and held collateral may be taken into account when calculating current exposure and maximum potential exposure only if such collateral meets certain requirements. Morgan Stanley believes that the proposed collateral restrictions are too onerous and that the Commission should recognize all classes of securities, and, in any event, securities eligible for "trading book" treatment, as eligible collateral. For example, the Commission should eliminate the exclusion of collateral value for securities without a ready market.18 Instead, appropriate risk-based adjustments for liquidity should be made in determining the collateral value to be accorded such securities.
5. Credit Risk Weights; Recognizing Diversification of the Default Event.
The CSE Framework would allow a holding company to adjust credit risk weights of receivables covered by certain types of guarantees.19 Specifically, for the portion of a current exposure covered by a guarantee, a CSE affiliate may substitute the credit risk weight of the guarantor for the credit risk weight of the counterparty if certain conditions are met.20
Morgan Stanley believes that the Commission's proposal to substitute the risk weight of the guarantor for the reference credit does not give enough recognition to the benefit of credit default diversification. Instead, we support the efforts of the Federal Reserve Board to find alternatives that recognize the double-default effects.21
E. Operational Risk Capital Issues.
Morgan Stanley understands that operational risk is a key component of a risk-sensitive capital structure. We commend the Commission's proposal to afford CSEs flexibility in adopting a preferred approach to the computation of operational risk allowances from among the existing methodologies recognized in Basel II.However, we are concerned about the relative immaturity of current practices for the quantification and modeling of operational risk. While the discipline of operational risk management is highly developed, the use of quantitative techniques to predict future losses and relate these to a prudential level of capital is in its infancy. A consensus regarding approaches and techniques has not been achieved in academic or industry circles. Key challenges in developing appropriate measures of operational risk include the following:
As a result, we believe that the Commission's approach to operational risk should include the following key elements.
Finally, Morgan Stanley urges the Commission to incorporate, on a consistent basis, an operational risk component in the capital frameworks at the holding company and broker-dealer levels. Given the lack of extensive historical data on which to model operational risk at the broker-dealer level, Morgan Stanley suggests the use of a single operational risk calculation at the holding company level with an allocation of operational risk allowances to the various CSE entities (including the U.S. broker-dealer) based on the scope and character of the activities of each such entity.
F. Treatment of Funding Liquidity Risk.
Morgan Stanley recognizes that broker-dealers may be subject to funding liquidity risks. We believe that, consistent with Basel II, Pillar 2 provides the appropriate framework within which to address funding risks. In our opinion, Pillar 2 would provide the Commission with a flexible framework within which to address concerns that may arise in relation to a firm's management of this risk.
G. Allowable Capital.
The definition of "allowable capital" in the proposed CSE Framework would exclude deferred tax assets and other intangible assets as well as certain types of preferred stock and subordinated debt.22 Morgan Stanley believes that the proposed definition is too narrow.
We urge the Commission to revise the definition of allowable capital to achieve greater consistency with Basel II. Specifically, the Commission should not exclude from allowable capital deferred tax assets whose realization is not dependent on future taxable income and that the holding company expects to realize within one year due to future, projected taxable income.23 We also believe that the Commission should permit trust preferred securities to be included in allowable capital.24
In addition, we believe that the definition of allowable capital should include long-term debt during a 5-year phase-out period. Although we understand that long-term debt is not currently recognized as capital under either Basel I or II, such a phase-out would be consistent with earlier Federal Reserve Board precedent. Specifically, we note that when the Federal Reserve Board adopted risk-based capital guidelines in 1989, it provided that unsecured term debt issued by bank holding companies prior to March 12, 1988 that qualified as secondary capital at the time of issuance would continue to qualify as an element of supplementary capital under the risk-based framework.25 We have proposed a 5-year phase-out period based on our belief that a shorter period would unduly increase the cost of any required balance sheet restructuring if multiple firms were required to restructure their long-term debt in a shorter time frame.III. GENERAL CSE FRAMEWORK ISSUES.
A. Broad Commission Discretion.
The Commission should revise the CSE Framework to provide greater clarity regarding the administration of the CSE application process. The proposed authority of the Commission to impose limitations on business activities, increase multiplication factors and to revoke CSE status without any clear conditions or standards is, in our view, too broad.26 The Commission's remedial authority should be carefully defined to address particular deficiencies in a manner that is appropriately calibrated to the seriousness of the deficiency. The prospect that a CSE might lose its exemption under Appendix E for a minor or remediable deficiency would raise serious concerns for a broker-dealer. The Commission should incorporate in any final rulemaking as much detail as possible regarding the standards and procedures for addressing deficiencies and revoking CSE status, consistent with prevailing administrative due process and prudential supervision practices. At a minimum, these should include an opportunity for a CSE to address any deficiency before Commission action.
B. Application Requirements.
CSE applicants may already be required to report or provide to the Commission certain of the information that is required as part of the application to become a CSE. Morgan Stanley suggests that applicants be permitted to incorporate such information into their CSE applications by reference. For example, applicants should be permitted to use public company Regulation S-K Item 305 disclosure in lieu of the required comprehensive description of risk management control systems. Similarly, firms should be permitted to refer to descriptions in their 10-K filings for purposes of describing their businesses.
C. Notification Requirements.
Morgan Stanley recommends that Paragraph (e)(2) of proposed Appendix G, which would require notification to the Commission of material changes to holding company corporate structure and material changes in material affiliate status, be revised. We suggest instead that the criteria for determining material changes be clarified in the finalized CSE Framework, that the requirement be limited to material affiliates, and that any reports be filed on a quarterly cycle.27
D. Reporting Requirements.
1. Monthly and Quarterly Reporting.
In our view, the deadlines for the submission of monthly and quarterly reports, 17 and 35 days after the end of each period, respectively, are too aggressive. Although these deadlines coincide with the deadlines for FOCUS reports (and with the ultimate 10-Q reporting deadline in the case of quarterly reports), the proposed reports will require detailed risk and capital information that typically is not readily available and takes greater time to produce. We urge the Commission to conform, to the extent possible, the content and timing of reporting requirements to other Commission public reporting requirements. For example, the proposed requirements relating to management controls should be aligned with the requirements for management's report on internal control over financial reporting under the Sarbanes-Oxley Act. In addition, footnotes to financial statements should only be required with quarterly reports, including footnotes to the consolidating balance sheet for material affiliates.
The Commission should also clarify that the required quarterly description of pending legal proceedings or arbitration proceedings disclosable under GAAP is intended to be identical in scope to the 10-K/10-Q standard of disclosure applicable to public companies.
Proposed Appendix G would require a holding company to compute allowances for market and credit risk on a daily basis.28 Given that firm risk managers run and review daily risk management reports and conduct daily backtesting, we believe daily calculation of holding company market and credit risk allowances would constitute a material cost and burden and represent a significant change in current practice, without materially enhancing CSE supervision. Holding companies should be permitted to calculate market and credit risk allowances as part of their monthly group-wide capital computations.
2. Quarterly Reporting on Aggregate Borrowings of Subsidiaries.
Paragraph (b)(2)(v) of proposed Appendix G requires quarterly reporting on aggregate borrowings by each subsidiary broker-dealer and each material affiliate. The Commission should confirm that the requirement to include in quarterly reports the aggregate amount of borrowings for material affiliates and for subsidiary broker-dealers refers to external borrowings only and does not include intercompany loans. In addition, the Commission should permit quarterly reports to include disclosure on borrowings prepared in connection with 10-K and 10-Q reports.
3. Affiliate Reporting.
The requirement in proposed Paragraph (j)(4) of Rule 17a-11 that a broker-dealer provide same-day notice to the Commission if it becomes aware of a situation that may have a material adverse effect on the financial or operational condition of an affiliate of the holding company of the broker-dealer is unduly burdensome, particularly given the international structure of many firms and the geographic dispersion of many of their subsidiaries. We believe that this requirement should be limited to the provision of information regarding situations having a material adverse effect on the financial or operational condition of the holding company with notice to the Commission within five business days.
E. Recordkeeping Requirements.
Paragraph (c)(1)(iv) of proposed Appendix G would require a holding company to retain (a) a record of the results of stress tests the holding company has conducted of its funding and liquidity in response to certain events (including its inability "to access credit or assets held at a particular institution" in certain circumstances) at least once each quarter and (b) a record of the contingency plan to respond to these events. The Commission should clarify what would constitute an inability of a holding company "to access credit or assets held at a particular institution."
F. VaR Model Audit Requirements.
We believe that the requirement in Paragraph (e)(1) of proposed Appendix E that VaR models be reviewed annually by a registered public accounting firm is too onerous. We suggest that the Commission consider an alternative whereby models are subject to an initial review by a registered public accounting firm and subsequent annual reviews by the internal audit staff of the holding company.
G. Certain Additional Relief.
Morgan Stanley believes that, in order to enable broker-dealers to utilize the CSE to full advantage, and remove certain regulatory obstacles to expansion of the business activities conducted in U.S. broker-dealers, the Commission should consider adopting or ensuring the additional relief summarized immediately below.
In addition, Morgan Stanley recommends that the Commission permissively extend the CSE capital relief to registered OTC derivatives dealers who elect to adopt the CSE capital framework.
H. Pillar 3 Disclosure Standards.
The Proposing Release solicits comment on whether the Commission should require any additional disclosures by broker-dealers to meet the requirements of the third pillar of Basel II.29 Pillar 3 is intended to enhance public disclosure. Morgan Stanley believes that effective public disclosure plays an important role in promoting effective risk management practices and enhances public awareness. However, in our view, the Commission should not establish disclosure standards as part of the proposed CSE Framework, as such standards would have potentially broad ramifications and competitive implications, particularly if they are not uniform across industry participants. Appropriate disclosures, therefore, should be considered further by groups such as the Working Group on Public Disclosure established by the Federal Reserve Board.
1 See SEC Release No. 34-48690 (Oct. 24, 2003), 68 Fed. Reg. 62871 (Nov. 6, 2003) (the "Proposing Release").
2 Directive 2002/87/EC of the European Parliament and of the Council of 16 December 2002 ("EU Financial Conglomerates Directive").
3 In the absence of a finding that CSE supervision meets the EU "equivalency" standard, regulators in the EU may subject such firms to significantly higher capital requirements or other burdensome restrictions such as requiring that they establish an intermediate level holding company in the EU.
4 In particular, we encourage the Commission to emphasize to the EU that publication of the findings of the Technical Group advising the Financial Conglomerates Committee on its assessment of U.S. supervisory equivalency on August 11, 2004, will provide an unreasonably short time frame for implementation of the new standards in 2005.
5 The EU Financial Conglomerates Directive requires that firms not currently subject to comprehensive consolidated supervision identify their prospective comprehensive consolidated supervisor effective from their fiscal year beginning in 2005 or be subject to more stringent EU supervision.Morgan Stanley will become subject to the EU Financial Conglomerates Directive for its fiscal year beginning December 1, 2005.
6 See, e.g., the approaches to approval taken in Section 17(i)(1)(B) of the Exchange Act and National Association of Securities Dealers, Inc. ("NASD") Rule 1014(c).
7 If the Commission deemed it necessary, any such approval could be granted on a provisional basis, subject to timely remediation of any deficiencies subsequently discovered by the Commission.
8 We also strongly encourage the Commission to liaise with its EU and other foreign counterparts with a view to establishing a common framework and criteria for the review and approval of models used for the computation of risk-based capital charges.
9 We recommend that the Commission adopt a definition of an "entity that has a principal regulator" that includes any "depository institution," as defined in Section 3(c) of the Federal Deposit Insurance Act, and any subsidiary of such institution.
10 This presumption could be rebutted if the Commission reasonably determines during the CSE application process that the presumption is not justified.
11 We recognize that certain reports may be unavailable or may require specific consent that will necessitate a dialogue with the principal regulator.
12 See, e.g., Section 5(c)(2)(B) of the Bank Holding Company Act, which provides that the Federal Reserve Board may examine a functionally regulated subsidiary of a bank holding company only if the Federal Reserve Board has reasonable cause to believe that the subsidiary is engaged in activities that pose a material risk to an affiliated depository institution.
13 In this connection, we believe it is important that the Commission exercise care in determining the scope of information it includes in any order approving or denying a CSE application.
14 See Paragraph (a)(4) of proposed Appendix E.
15 See Part 2 VI.A of CP3. Specifically, under CP3 the term "trading book" includes positions in financial instruments and commodities that are (i) held either with trading intent or for purposes of hedging, (ii) free of any restrictive covenants or able to be hedged completely, (iii) frequently and accurately valued, and (iv) a part of a portfolio that is actively managed. Paragraph 643 of CP3.
16 We do not regard as compelling the argument that a combination of the use of Basel I and Basel II capital standards by different business entities during a transitional period would inherently undermine the functional equivalence of the CSE Framework. Equivalence does not mean that the standards must be the same. Whether different standards are equivalent is a facts and circumstances determination that should be made on the basis of a specific proposal. It is likely that firms operating under the EU Financial Conglomerates Directive will likely migrate on different time frames from Basel I to Basel II. As a result, certain firms will be operating under Basel I while others are operating under Basel II. This inevitability cannot cause firms in either category to fail the functional equivalence standard. It is accordingly not at all clear why different business units of a CSE - during a transitional phase - should not similarly be permitted to operate under different Basel standards. The failure to adopt a flexible approach in this context may also impede business combinations between financial institutions.
17 See Paragraph (a)(3)(i)(A)(2) of proposed Appendix G (imposing a 5% conversion factor for margin loans extended at the holding company level for purposes of calculating the appropriate allowance for credit risk).
18 See Paragraph (d)(6)(ii) of proposed Appendix E.
19 See Paragraph (a)(3)(i)(J) of proposed Appendix G.
20 See also Paragraph (d)(7)(v) of proposed Appendix E (permitting the same treatment of guarantees on the broker-dealer level).
21 See "Treatment of Double-Default and Double-Recovery Effects for Hedged Exposures under Pillar I of the Proposed New Basel Capital Accord," Federal Reserve Board White Paper (June 2003), available at www.federalreserve.gov/generalinfo/basel2/docs2003/doubledefault.pdf.
22 See Paragraph (a)(1) of proposed Appendix G.
23 See 12 C.F.R. 225, Appendix A, Part II.B.4, in which the Federal Reserve Board limits the exclusion of deferred tax assets from a bank holding company's capital.
24 See 12 C.F.R. 225, Appendix A, Part II.A.l.(iv).
25 See 12 C.F.R. 225, Appendix A, footnote 12.
26 The unrestricted scope of the Commission's authority is also inconsistent with the current practices of other U.S. financial market regulators and goes beyond the scheme for functional regulation established by the Gramm-Leach-Bliley Act.
27 We also request that the Commission clarify that the requirement in proposed Rule 17a-11(j)(2) that a broker-dealer provide the Commission with same-day notice of any supervisory agreement, order or other report regarding an instance of non-compliance issued by an appropriate regulatory agency or self-regulatory agency applies only to the broker-dealer and not to any of its affiliates. The text of the proposed rule applies only to a broker-dealer, but the description of the rule in the text of the Proposing Release suggests that the requirement also applies to affiliates. It is our understanding that the requirement was intended to apply to only the broker-dealer.
28 Paragraph (a)(2) of proposed Appendix G would require daily calculation of an allowance for market risk; paragraph (a)(3) would require daily calculation of an allowance for credit risk. Under paragraph (a)(1) of proposed Appendix G, a holding company would be required to calculate allowable capital monthly.
29 See Proposing Release at 62885.