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.

• Revenues are not a good measure of the actual drivers of operational risk. The incentives inherent in a revenue-based approach may result in unintended outcomes, even where such an approach is calibrated reasonably. For example, a firm with a large volume of trades, but very little revenues would receive a relatively low capital charge and would not be incented to adopt sound operational risk practices in handling its large volumes.

• Challenges associated with the use of historical loss data in developing statistical models. Morgan Stanley is mindful of the difficulty in quantifying the risk of losses due to extremely low probability events and incorporating cause and effect relationships into these models. In addition, we recognize challenges in assuring that models respond appropriately to changing circumstances in a firm's operational risk profile. Pure statistical models that do not account for the effects of the control environment and policies may significantly distort true risk and fail to incent further investment in risk management.

• Challenges in identifying and isolating operational risk factors to ensure that capital charges are not inadvertently duplicative. For example, credit risk capital charges associated with margin lending are calibrated at a level far in excess of the level justified by true margin loan defaults, in recognition of the operational risks associated with this activity.

• Challenges in factoring in risk mitigants, such as insurance, in computing operational risk charges.

As a result, we believe that the Commission's approach to operational risk should include the following key elements.

• The operational risk framework must reflect the unique characteristics of the investment bank business model versus that of other financial institutions. We recommend that the Basel Committee on Banking Supervision and the Commission adopt a less prescriptive approach regarding the methodologies and factors to be employed under the advanced measurement approach. We look forward to an active dialogue with the Commission, other regulators and industry counterparts in order to formulate appropriate framework options for investment banks.

• While an operational risk framework must be fact-based and structured, the framework must also be based on the expert judgment of the CSE regarding its unique business characteristics and operational risks. CSEs should be allowed the flexibility to adopt approaches and methodologies that best fit their business models and calibrate operational risk allowances more closely to their level of actual risk. This flexibility will also encourage proactive efforts to manage operational risk effectively.

• The implementation of such a framework should be subject to a three-year phase-in period to afford firms the time necessary to develop internal systems and procedures. During the phase-in period, the Commission should accommodate an evolutionary modeling process that would allow a relatively simple and intuitive starting point and provide for more sophisticated refinements over time.

• The Commission should recalibrate the factors used in the standardized approach to appropriately reflect the operational risk characteristics of investment banking activities. As part of this recalibration, the Commission should consider imposing a cap on the overall operational risk charge at 15% of consolidated revenues. We note that by capping the charge at the level indicated in the basic approach, CSEs will be incented to adopt a more sophisticated approach.

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.

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.

• The Commission should exempt broker-dealers that are part of a CSE from the custody and control requirements of Exchange Act Rule 15c3-3 for collateral pledged to a broker-dealer by an OTC derivative counterparty, equivalent in scope and subject to conditions similar to those applicable to OTC derivatives dealers.

• The Commission should ensure that an appropriate portfolio margining regime is adopted on an expeditious basis under NYSE Rule 431 and NASD Rule 2520 that qualifies for exemption from Regulation T of the Federal Reserve Board.

• The Commission should ensure that the NASD adopts amendments to its position and exercise limits and reporting rules, recognizing an exemption from OTC option position and exercise limits and related relief for hedged option positions.

• The Commission should provide for greater legal certainty with respect to issues related to the liquidation of broker-dealers under the Securities Investor Protection Act of 1970 ("SIPA"). In this regard, Morgan Stanley, together with other industry members, is actively working to formulate suggested solutions to SIPA-related issues.

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.

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.