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Release No. 34-49830 69 Fed. Reg. 34427 - June 21, 2004
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 Table of Contents
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I. Introduction
The Commission is amending Rule 15c3-1 2 (the ''net capital rule'') under the Securities Exchange Act of 1934 (the ''Exchange Act'') to establish a voluntary, alternative method of computing net capital for certain broker-dealers. Under the amendments, a broker- dealer that maintains certain minimum levels of tentative net capital and net capital may apply to the Commission for a conditional exemption from the application of the standard net capital calculation. As a condition to granting the exemption, the broker-dealer's ultimate holding company 3 must consent to group-wide Commission supervision.4 The amendments should help the Commission to protect investors and maintain the integrity of the securities markets by improving oversight of broker-dealers and providing an incentive for broker-dealers to implement strong risk management practices. Furthermore, by supervising the financial stability of the broker- dealer and its affiliates on a consolidated basis, the Commission may monitor better, and act more quickly in response to, any risks that affiliates and the ultimate holding company may pose to the broker- dealer.
We use the term ''ultimate holding company'' in the final rules, rather than the term ''holding company'' that we used in the proposed rules.
These amendments are intended to reduce regulatory costs for broker-dealers by allowing very highly capitalized firms that have developed robust internal risk management practices to use those risk management practices, such as mathematical risk measurement models, for regulatory purposes. A broker-dealer's deductions for market and credit risk probably will be lower under the alternative method of computing net capital than under the standard net capital rule.
A. Broker-Dealer Requirements
The alternative method of computing net capital responds to the firms' requests to align their supervisory risk management practices and regulatory capital requirements more closely. Under the alternative method, firms with strong internal risk management practices may utilize mathematical modeling methods already used to manage their own business risk, including value-at-risk (''VaR'') models and scenario analysis, for regulatory purposes.
A broker-dealer that applies to the Commission for an exemption from the standard net capital rules also must comply with specific requirements designed to address various types of risks that the broker-dealer assumes. A broker-dealer is eligible to use the alternative method of computing net capital only if it maintains tentative net capital 5 of at least $1 billion and net capital of at least $500 million.6 If the tentative net capital of a broker-dealer calculating net capital under this alternative method falls below $5 billion, the broker-dealer must notify the Commission and the Commission then would consider whether the broker-dealer must take appropriate remedial action.7
In addition, a broker-dealer that uses the alternative method must have in place comprehensive internal risk management procedures that address market, credit, liquidity, legal, and
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operational risk at the firm. These requirements are designed to help ensure the integrity of the broker-dealer's risk measurement, monitoring, and management process and to clarify accountability, at the appropriate organizational level, for defining the permitted scope of activity and level of risk. Furthermore, a broker-dealer must provide the Commission with specified financial, operational, and risk management information on a monthly, quarterly, and annual basis.
B. Ultimate Holding Company Requirements
As a condition to a broker-dealer's use of the alternative method of computing net capital, the rule amendments require a broker-dealer's ultimate holding company, if that ultimate holding company does not have a principal regulator, to consent to certain undertakings. In particular, the ultimate holding company must:
Provide information about the financial and operational condition of the ultimate holding company. Specifically, it must provide the Commission with certain capital and risk exposure information provided to the ultimate holding company's senior risk managers. This information would include market and credit risk exposures, as well as an analysis of the ultimate holding company's liquidity risk;
Comply with rules regarding the implementation and documentation of a comprehensive, group-wide risk management system for identifying, measuring, and managing market, credit, liquidity, legal, and operational risk;
Consent to Commission examination of the ultimate holding company and its material affiliates; and
As part of its reporting requirements, compute, on a monthly basis, group-wide allowable capital and allowances for market, credit, and operational risk in accordance with the standards (''Basel Standards'') 8 adopted by the Basel Committee on Banking Supervision (''Basel Committee'').
In response to comments about bank holding companies, we have revised the proposed rules for an ultimate holding company that has a principal regulator. Generally, under the final rules, this type of ultimate holding company is not subject either to Commission examination or those rules requiring internal risk management controls outside of the broker-dealer and is subject to reduced reporting, recordkeeping, and notification requirements.
The rule amendments also respond to international developments. Affiliates of certain U.S. broker-dealers that conduct business in the European Union (''EU'') have stated that they must demonstrate that they are subject to consolidated supervision at the ultimate holding company level that is ''equivalent'' to EU consolidated supervision.9 Commission supervision incorporated into these rule amendments is intended to meet this standard. As a result, we believe these amendments will minimize duplicative regulatory burdens on firms that are active in the EU as well as in other jurisdictions that may have similar laws.
II. Proposing Release and Comments
The Commission proposed rule amendments in October 2003 that would have established a voluntary, alternative method for computing net capital charges for certain broker-dealers. In the Proposing Release, the Commission solicited both general comments on the proposal and specific comments on each rule amendment.
The Commission received 20 comment letters in response to the proposed rule amendments: Five from broker-dealers or broker-dealer holding companies, five from bank holding companies subject to supervision by the Board of Governors of the Federal Reserve System (''Federal Reserve'') or a non-domestic ''comprehensive consolidated supervisor,'' one from a securities industry representative, six from U.S. and international banking industry representatives, two from individuals, and one from another regulator.
The majority of commenters endorsed the Commission's initiative to permit certain broker-dealers to use the alternative method of computing net capital. These commenters supported the alternative capital calculation for broker-dealers that have developed mathematical models for measuring risk and group-wide internal risk management control systems to control risk. One commenter, however, questioned the use of models to the extent that it would lower broker-dealer capital requirements, and some commenters questioned the Commission's statutory authority to adopt the proposal.
The commenters that supported the proposal suggested that the Commission modify the proposed rule amendments in various ways. Bank holding companies generally supported the alternative capital computation, but expressed concern that the proposal could impose duplicative and inconsistent requirements on holding companies and their affiliates that are subject to comprehensive consolidated supervision by the Federal Reserve and non-domestic financial regulators.
Generally, commenters addressed various aspects of the methods for calculating deductions for market and credit risk at the broker-dealer level and allowable capital at the ultimate holding company level. They also stated that the Commission should be flexible in permitting firms to use interim methods to calculate allowable capital at the ultimate holding company level until implementation of the New Basel Capital Accord. Some commenters urged the Commission to take measures to ensure the confidentiality of information that the Commission obtains as a result of the proposed rules and rule amendments. Commenters also suggested that the Commission align CSE reporting requirements with public company and other reporting requirements.
Comments on specific rule amendments and the Commission's response to those comments are discussed below in the descriptions of the final rule amendments.
III. Final Rule Amendments
A. General
After considering the comment letters, we are adopting rule amendments that provide broker-dealers with a voluntary, alternative method of computing net capital that permits very highly capitalized broker-dealers to use their internal mathematical models for net
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capital purposes, subject to specified conditions. Generally, we revised the rule amendments related to the broker-dealer's and the ultimate holding company's computation of net capital and allowable capital, respectively. We also revised the rule amendments with respect to broker-dealers that are affiliated with ultimate holding companies that have principal regulators.
As stated in the Proposing Release, the Commission has broad authority under Exchange Act section 15(c)(3) to adopt rules and regulations regarding the financial responsibility of broker-dealers that we find are necessary or appropriate in the public interest or for the protection of investors.10 The Commission has promulgated various rules under this provision regarding net capital requirements 11 and protection of customer property.12 As part of our oversight of broker-dealers, we receive financial and risk management information about broker-dealers, their holding companies, and their affiliates. The rules and the information received have assisted the Commission and the self-regulatory organizations (''SROs'') in identifying, at an early stage, firms that are experiencing financial problems.
The principal purposes of Exchange Act Rule 15c3-1 (the ''net capital rule'') are to protect customers and other market participants from broker-dealer failures and to enable those firms that fall below the minimum net capital requirements to liquidate in an orderly fashion without the need for a formal proceeding or financial assistance from the Securities Investor Protection Corporation. The net capital rule requires different minimum levels of capital based upon the nature of the firm's business and whether the broker-dealer handles customer funds or securities.
Ultimate holding companies that own large broker-dealers also may own many other entities. These affiliated entities may engage in both securities and non-securities activities worldwide. Broker-dealer holding company structures vary and may be quite complex. Depending upon the nature of these structures, broker-dealers may incur risks because of their affiliation with unregistered entities. For example, a broker-dealer's access to short-term funding may be affected by the insolvency of an affiliate. In addition, management at the ultimate holding company level may attempt to divert capital from the broker- dealer, to the extent permitted by the net capital rule, to support an affiliate experiencing financial difficulty. While this shift of assets alone would not violate the net capital rule, it could make it more likely that the firm would fail during volatile market conditions.
To help ensure that the Commission can obtain information necessary to monitor the financial well-being of a broker-dealer, a broker-dealer may use the alternative method of computing net capital only if its ultimate holding company agrees to provide the Commission's with additional information about the financial condition of the ultimate holding company and its affiliates. For an ultimate holding company that does not have a principal regulator, this financial information includes a monthly computation of group-wide allowable capital and allowances for market, credit, and operational risk calculated in accordance with the Basel Standards. This type of ultimate holding company also must provide the Commission with specified financial, operational, and risk management information on a monthly, quarterly, and annual basis. Moreover, an ultimate holding company that does not have a principal regulator must implement and maintain a consolidated internal risk management control system and procedures to monitor and manage group-wide risk, including market, credit, funding, operational, and legal risks, and make and maintain certain books and records. Both the ultimate holding company and its affiliates that do not have principal regulators must consent to Commission examination.
Under the final rules, an ultimate holding company that has a principal regulator is subject to substantially fewer requirements than one that does not have a principal regulator. As a condition to its affiliated broker-dealer's use of the alternative method of computing net capital, this category of ultimate holding company consents to provide the Commission, on a quarterly basis, with the capital measurements that it submits to its principal regulator, consolidated and consolidating balance sheets and income statements, and certain regular risk reports provided to the persons responsible for managing group-wide risk. Annually, an ultimate holding company that has a principal regulator must provide audited consolidated balance sheets and income statements and capital measurements, as submitted to its principal regulator. An ultimate holding company that has a principal regulator also is subject to more limited undertaking and information requirements related to the broker-dealer's application for exemption from the standard net capital rule as well as reduced notification and recordkeeping requirements.
We have included what we believe are prudent parameters for measurement of a broker-dealer's deductions for market and credit risk and allowances for risk for its ultimate holding company, although in some cases these parameters may be more conservative than some firms may believe are necessary to account for risk. For example, we have adopted, as proposed, rules that require the VaR model used to calculate market risk for the broker-dealer to be based on a ten business-day movement in rates and prices and calculated using a 99% confidence level. The VaR measure then must be multiplied by a factor of at least three. These parameters are based on our experience and existing Commission rules and rules of other regulatory agencies where there are similar risk factors in the regulated entities.
B. Amendments to Paragraphs (a) and (c) of Rule 15c3-1
1. Minimum and Early Warning Capital Requirements
We are revising proposed paragraph (a)(7) of Rule 15c3-1. As proposed, paragraph (a)(7) of Rule 15c3-1 would have permitted the Commission to approve, in whole or part, a broker-dealer's application, or amendment to an application, to use the alternative method of computing net capital. Proposed paragraph (a)(7) also would have required the broker-dealer to maintain at all times tentative net capital of at least $1 billion and net capital of at least $500 million.
In the Proposing Release, we requested comment on whether the proposed required minimum levels of tentative net capital and net capital described in proposed paragraph (a)(7) of Rule 15c3-1 should be raised or lowered. One commenter stated that we should permit a broker- dealer with tentative net capital of less than $1 billion to use the alternative net capital computation if it is an affiliate of an international bank with consolidated capital of over $1 billion. Another commenter asserted that ''the Commission should permit other broker-dealers in the CSE group-wide affiliate structure'' to use the alternative method of computing net capital even if those broker- dealers do not meet the minimum capital levels. These comments, however, do not take into account certain regulatory and
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bankruptcy considerations.13 Accordingly, we are adopting the $1 billion tentative net capital and $500 million net capital requirements as proposed, but are setting forth these requirements in paragraph (a)(7)(i) of Rule 15c3-1 in the final rules.
We also are adding a new requirement to paragraph (a)(7) of Rule 15c3-1, as adopted. The final rules incorporate changes to the proposed rules that may allow firms to take smaller deductions for market and credit risk than the proposed rules would have permitted. Consequently, the final rules add paragraph (a)(7)(ii), which requires a broker- dealer to notify the Commission if the broker-dealer's tentative net capital falls below $5 billion. This $5 billion early warning requirement is based upon the staff's experience and the current levels of net capital maintained by the broker-dealers most likely to apply to use the alternative method of computing net capital. Upon written application, however, the Commission may exempt, either unconditionally or on specified terms and conditions, a broker-dealer from the $5 billion early warning requirement. To obtain an exemption, the broker- dealer must satisfy the Commission that because of the special nature of the firm's business, its financial positions, its internal risk management systems, and its compliance history, among other factors, application of the requirement is unnecessary or inappropriate in the public interest or for the protection of investors.
We also are revising Rule 15c3-1 to add paragraph (a)(7)(iii). Paragraph (a)(7)(iii) generally requires a broker-dealer that computes deductions for market and credit risk under Appendix E to comply with Rule 15c3-4 14 as though it were an OTC derivatives dealer. Paragraph (a)(7)(iii) replaces proposed amendments to Rule 15c3-4 and is discussed in greater detail in the section of this release that addresses that rule.
The requirements of paragraph (a)(7), as revised, are intended to help ensure that a broker-dealer maintains prudent amounts of liquid assets against various risks that it assumes and that it maintain a robust internal risk management system. The current haircut structure seeks to ensure that broker-dealers maintain a sufficient capital base to account for operational, leverage, and liquidity risk, in addition to market and credit risk. We expect that use of the alternative net capital computation will reduce deductions for market and credit risk substantially for broker-dealers that use that method. Moreover, inclusion in net capital of unsecured receivables and securities that do not have a ready market under the current net capital rule will reduce the liquidity standards of Rule 15c3-1. Thus, the alternative method of computing net capital and, in particular, its requirements that broker-dealers using the alternative method of computing maintain minimum tentative net capital of at least $1 billion, maintain net capital of at least $500 million, notify the Commission that same day if their tentative net capital falls below $5 billion, and comply with Rule 15c3-4 are intended to provide broker-dealers with sufficient capital reserves to account for market, credit, operational, and other risks.
2. Entities That Have Principal Regulators
We are revising proposed paragraph (c)(13) of Rule 15c3-1. Proposed paragraph (c)(13) would have defined an ''entity that has a principal regulator'' as a person (other than a natural person) that is not a registered broker-dealer (other than a broker-dealer registered under section 15(b)(11) of the Exchange Act) and that belongs to one of two categories. Proposed paragraph (c)(13)(i), the first category, would have included insured depository institutions, entities registered with the Commodities Futures Trading Commission, or licensed or regulated insurance companies. Proposed paragraph (c)(13)(ii), the second category, would have included bank holding companies, savings and loan holding companies, and foreign banks that do business in the U.S. The proposed rules would have required entities in this second category to have in place appropriate arrangements to ensure that information provided to the Commission was sufficiently reliable for the purposes of proposed Appendix E and proposed Appendix G. The proposed rules also would have required these entities to be primarily in the insured depository institutions business (excluding their insurance and commercial businesses).
Several commenters stated that the Commission should revise the proposed rules to minimize duplicative or inconsistent requirements for holding companies that are subject to another regulator's consolidated supervision.15 Commenters also stated that the Commission could better use its resources to supervise holding companies that do not otherwise have principal regulators. Moreover, commenters urged the Commission to provide as much clarity as possible, both for regulated entities and consolidated supervisors, about provisions intended to avoid duplicative or inconsistent requirements.
In response to these comments, we are adopting a revised definition of ''entity that has a principal regulator'' and adding a definition of an ''ultimate holding company that has a principal regulator.'' Creation of two definitions should help to clarify the scope of paragraph (c)(13) of Rule 15c3-1. We will not examine any entity that has a principal regulator and we will use the reports that it files with its principal regulator for our regulatory purposes, to the greatest extent possible.
Under the revised definition in paragraph (c)(13)(i) of Rule 15c3- 1, an entity that has a principal regulator includes certain functionally regulated affiliates of the ultimate holding company that are not registered as a broker or dealer.16 Entities that have principal regulators include insured depository institutions; futures commission merchants or introducing brokers registered with the Commodity Futures Trading Commission; entities registered with or licensed by a State insurance regulator that issues any insurance, endowment, or annuity policy or contract; and certain foreign banks.17
Paragraph (c)(13)(i) also includes Edge Act and Agreement Corporations, provided they are not primarily in the securities business. We added these entities to the definition of entity that has a principal regulator because they are subject to supervision by the Federal Reserve. Under these rules, the Commission may examine Edge Act and Agreement Corporations that primarily are in the securities business.18
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We also added paragraph (c)(13)(i)(F) of Rule 15c3-1 to the final rules. Under this paragraph, the Commission may determine if other types of entities subject to comprehensive supervision by other regulators qualify as entities that have principal regulators.19
The new definition of ultimate holding company that has a principal regulator in paragraph (c)(13)(ii) recognizes the concept of comprehensive, consolidated supervision. Any financial holding company or a company that is treated as a financial holding company under the Bank Holding Company Act of 1956 20 will be considered an ultimate holding company that has a principal regulator. Accordingly, any U.S. holding company or foreign bank that has elected financial holding company status will be an ultimate holding company that has a principal regulator.
By adopting this new definition of an ultimate holding company that has a principal regulator, we are recognizing the comprehensive, consolidated supervision of both the Federal Reserve and non-domestic bank regulators. In addition, because we will consider the entity that elected to be treated as a financial holding company to be an ultimate holding company that has a principal regulator, we will not need to look for a higher holding company level within a consolidated group. We also understand that all of the banking organizations that have expressed interest in the CSE proposal would qualify as financial holding companies or as companies that are treated as financial holding companies.
A bank holding company may elect to become a financial holding company and be eligible to engage in expanded financial activities if it is ''well capitalized'' and ''well managed.'' 21 In connection with financial holding company elections by foreign banks, the Federal Reserve also evaluates any foreign bank that operates a branch or agency, or owns or controls a commercial lending company in the United States under capital and management standards that are comparable to the standards applicable to U.S. banks and gives due regard to the principle of national treatment and equality of competitive opportunity.22 For these foreign banking organizations, the Federal Reserve also reviews whether they are subject to comprehensive consolidated supervision.23 The Federal Reserve has found that home country supervision is an important element in determining if a bank is well managed.24
Based on these requirements, we would not examine financial holding companies or companies that are treated as financial holding companies. In addition, under the rules as adopted, these entities are subject to a streamlined application process, fewer periodic reporting requirements, and may submit to the Commission the same measurement of capital that they submit to their primary regulator. Inclusion of these entities in the definition of ''ultimate holding company that has a principal regulator'' is intended reduce duplicative or inconsistent regulation because these entities already are subject to the reporting and examination requirements of the Federal Reserve.
Under paragraph (c)(13)(ii)(B), the Commission may determine that other persons also should be included as ultimate holding companies that have principal regulators if it finds that the persons are subject to consolidated, comprehensive supervision; there are in place appropriate arrangements so that information provided to the Commission is sufficiently reliable for the purposes of determining compliance with Appendix E and Appendix G; and based on the persons' businesses, it is appropriate to consider the persons ultimate holding companies that have principal regulators for the purposes of Appendix E and Appendix G. An affiliated broker-dealer of a domestic entity or a foreign bank that has not elected to be treated as a financial holding company could apply to use the alternative method of computing net capital. Paragraph (c)(13)(ii)(B) permits us to consider whether, in appropriate circumstances, the Commission should treat the domestic entity or foreign bank as an ultimate holding company that has a principal regulator.25
3. Tentative Net Capital
We are adopting an amended definition of tentative net capital. The proposed amendment to paragraph (c)(15) of Rule 15c3-1 would have defined ''tentative net capital'' for a broker-dealer using the alternative method of computing net capital as the net capital of the broker or dealer before deductions for market and credit risk computed pursuant to Appendix E to Rule 15c3-1 or paragraph (c)(2)(vi) of Rule 15c3-1, if applicable, and increased by the balance sheet value (including counterparty net exposure) resulting from transactions in derivative instruments that otherwise would be deducted by virtue of paragraph (c)(2)(iv) of Rule 15c3-1.
We are amending the definition of tentative net capital to include securities for which there is no ready market, as that term is defined under paragraph (c)(2)(11) of the net capital rule. This modification is necessary because, as discussed below, we eliminated the requirement that a security have a ready market to qualify for capital treatment using VaR models. Under the final rules, a broker-dealer may include securities for which there is no ready market in calculating tentative net capital under the alternative method only if the Commission has approved the use of mathematical models for purposes of calculating deductions to net capital for those securities pursuant to Appendix E.
C. Broker-Dealer Requirements Under Appendix E
Appendix E to Exchange Act Rule 15c3-1 describes the alternative method of computing net capital that a broker-dealer may use, including related application requirements. It also imposes requirements regarding internal risk management controls and reporting, and describes additional supervisory conditions that the Commission may impose on the broker-dealer in appropriate circumstances.26 Under the final rules, once a broker-dealer has submitted an application, the Commission will review how the firm manages its market, credit, liquidity and
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funding, legal, and operational risk, and its mathematical models, to determine if the broker-dealer has met the requirements of Appendix E and is complying with other applicable rules. The Commission also will review whether the broker-dealer's ultimate holding company is complying with the terms of the undertaking that it agrees to provide as a condition of the broker-dealer's use of the alternative method of computing net capital.
1. Application
Under proposed paragraph (a) of Appendix E, a broker-dealer would have applied to the Commission for an exemption from the standard net capital rule and for permission to calculate certain deductions for market and credit risk in accordance with Appendix E.27 Proposed paragraph (a) described the various types of information that the broker-dealer would have submitted to allow the Commission to determine whether an exemption from the net capital rule was necessary or appropriate in the public interest or for the protection of investors.
a. Information To Be Submitted by the Broker-Dealer
As proposed, paragraph (a)(1) of Appendix E would have required a broker-dealer that applied to use the alternative method of computing net capital to include with its application financial, risk management, and other information about the firm. Specifically, broker-dealers would have been required to submit to the Commission a description of their internal risk management control system and how that system satisfies the requirements of Rule 15c3-4, together with a description of the method the broker-dealer intended to use to calculate deductions to net capital. We did not receive substantive comments on this rule related to information to be submitted about the broker-dealer and paragraph (a)(1) of Appendix E has been adopted as proposed.28
b. Confidential Treatment
A broker-dealer's application for exemption from the standard net capital rule and all submissions in connection with the application will be accorded confidential treatment, to the extent permitted by law. We received comments expressing some concern with the Commission's ability to maintain the confidentiality of documents and information filed with the Commission under these rules. Under the final rules, broker-dealers and ultimate holding companies will submit information to the Commission based on their understanding that the information will remain confidential. The information that we expect to receive from these entities is, by its nature, competitively sensitive. For example, we understand that broker-dealers and their holding companies have a commercial interest in their risk models, risk management systems and processes, and data that they obtain through use of these models, systems, and processes. We also have been advised that if the Commission were unable to afford confidential protection to the information that we expect to receive from broker-dealers and their ultimate holding companies, firms may hesitate to apply for the exemption from the standard net capital rule and consent to Commission supervision at the ultimate holding company level. This result would undermine and jeopardize the viability of the CSE system.
The Freedom of Information Act (''FOIA'') provides at least two exemptions under which the Commission has authority to grant confidential treatment for applications filed under this rule. First, FOIA Exemption 4 provides an exemption for ''trade secrets and commercial or financial information obtained from a person and privileged or confidential.'' 29 As specified in paragraph (a)(5) of new Appendix E, ''all information submitted in connection with the application will be accorded confidential treatment to the extent permitted by law.'' The information to be filed with the Commission concerns firms' trading strategies, risk profiles, financial positions, and other information that is protected from disclosure under Exemption 4.
Second, FOIA Exemption 8 provides an exemption for matters that are ''contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions.'' Similarly, Commission Rule 80(b)(8), Commission Records and Information, implementing Exemption 8, states that the Commission generally will not publish or make available to any person matters that are ''contained in, or related to, any examination, operating, or condition report prepared by, on behalf of, or for the use of, the Commission, any other Federal, state, local, or foreign governmental authority or foreign securities authority, or any securities industry self-regulatory organization, responsible for the regulation or supervision of financial institutions.'' 30 Significantly, the courts have ruled consistently that Exemption 8 provides categorical protection for information related to such reports.
c. Commission Review
Paragraph (a)(6) of proposed Appendix E would have permitted the Commission to approve a broker-dealer's application to use the alternative method of computing net capital, subject to the imposition of any conditions or limitations that the Commission found were necessary or appropriate in the public interest or for the protection of investors, after a review of whether the broker-dealer met the requirements of Appendix E; the broker-dealer was in compliance with other, applicable Exchange Act provisions or rules or rules of a self- regulatory organization; and the ultimate holding company was in compliance with applicable terms of its undertaking, which are conditions for the approval. We did not receive comments on this provision and the Commission is redesignating paragraph (a)(6) as paragraph (a)(7) of Appendix E and adopting it as proposed, with one exception.31 We clarify in paragraph (a)(7), as adopted, that the Commission also must approve amendments to a broker-dealer's application to use the alternative method of computing net capital. Furthermore, note that paragraph (a)(1)(ix)(D), which describes the undertaking that an ultimate holding company that has a principal regulator must provide as a condition of its affiliated broker-dealer's exemption from the standard net capital rule, limits the conditions that the Commission may place on an ultimate holding company that has a principal regulator in
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approving the broker-dealer's exemption application.32
Paragraph (a)(7) of proposed Appendix E would have required a broker-dealer to amend and resubmit to the Commission its application for exemption from the standard net capital rule if the broker-dealer desired to change materially a mathematical model used to calculate deductions for market or credit risk or its internal risk management control system. We did not receive comment on this requirement and are redesignating paragraph (a)(7) as paragraph (a)(8) and adopting it as proposed.
Paragraph (a)(8) of proposed Appendix E would have required a broker-dealer to report any material changes to its or its ultimate holding company's corporate structure. The final rules do not include this notification requirement because it is redundant. The Commission will receive notification of the changes as part of the regular filings that the ultimate holding company submits under paragraph (b) of Appendix G.
Paragraph (a)(9) of proposed Appendix E would have required a broker-dealer to notify the Commission 45 days before it ceased using the alternative method of computing net capital under Appendix E. Under the proposed paragraph, the Commission could have ordered a shorter or longer notification period upon broker-dealer consent or if the Commission found that a shorter or longer period was necessary or appropriate in the public interest or for the protection of investors. We did not receive any comments on this requirement. We are redesignating paragraph (a)(9) as paragraph (a)(10) and adopting it as proposed.
Paragraph (a)(10) of proposed Appendix E would have permitted the Commission, by order, to revoke a broker-dealer's exemption from the standard net capital rule under Appendix E if the Commission found that the exemption no longer was necessary or appropriate in the public interest or for the protection of investors. A broker-dealer that no longer could use Appendix E would have been required to compute its capital charges using the standard haircut method.
A commenter suggested that the Commission's authority to revoke a broker-dealer's exemption from the standard net capital rule ''should clarify that any limitations or remedial action must be narrowly circumscribed to address the relevant deficiency.'' The commenter also asserted the Commission should limit revocation of the exemption ''to instances in which the Commission finds a material capital deficiency or a substantial pattern of material non-compliance.''
In response to comments received, we are amending paragraph (a)(10). We also are redesignating paragraph (a)(10) as paragraph (a)(11) in Appendix E, as adopted. Paragraph (a)(11) adds a description of the factors that the Commission will rely evaluate in determining whether to revoke a broker-dealer's exemption from the net capital rule. Specifically, the Commission will consider the compliance history of the broker-dealer related to its use of models, the financial and operational strength of the broker-dealer and its ultimate holding company, and the broker-dealer's compliance with its internal risk management controls.
2. Risk Management Control System
Under proposed paragraph (b) of Appendix E, a broker-dealer using the alternative method of computing net capital would have been required to establish, document, and maintain an internal risk management control system that met the requirements of Sec. 240.15c3- 4.33 The rule amendments, as adopted, do not include this requirement. Proposed paragraph (b) is omitted as unnecessary because the broker-dealer must comply with Rule 15c3-4 under Rule 15c3- 1(a)(7)(iii), as adopted.
3. Computation of the Deduction for Market Risk
Commenters generally supported the method for calculating a broker- dealer's deductions for market risk described in paragraph (c) of proposed Appendix E. They raised several issues with respect to specific provisions for calculating the deduction, however. We address those issues in the sections that follow.
As a preliminary matter, we note that a broker-dealer must compute its deduction for market risk monthly. Paragraph (c) of proposed Appendix E would have required a daily computation of the deduction for market risk. Commenters raised a question as to whether a broker-dealer would be required to make daily capital computations and, if so, stated that daily computations would be unnecessary and burdensome. We have revised these sections to clarify that as part of their risk management practices, firms must compute VaR and current exposures daily. We note, however, that a broker-dealer must be in compliance with net capital requirements at all times.
Under paragraphs (c)(1) and (2) of proposed Appendix E, the deduction for market risk would have been equal to the amount of the sum of the following: (i) For positions for which the Commission has approved the use of VaR models, the VaR of those positions multiplied by the appropriate multiplication factor; (ii) for positions for which the Commission has approved the use of scenario analysis, the greatest adverse movement of the positions, or some multiple thereof based on liquidity or, if greater, a minimum deduction; and (iii) for all other positions, a deduction under the standard haircut method of paragraph (c)(2)(vi) Rule 15c3-1.
Paragraph (b) 34 of Appendix E, as adopted, describes the method of computing a broker-dealer's deduction for market risk. A broker- dealer's deduction for market risk under paragraph (b) is an amount equal to the sum of the following: (i) For positions for which the Commission has approved the broker-dealer's use of VaR models, the VaR of those positions multiplied by the appropriate multiplication factor; (ii) for positions for which the VaR model does not incorporate specific risk, a deduction for specific risk to be determined by the Commission based on a review of the broker-dealer's application and the positions involved; (iii) for positions for which the Commission has approved the use of scenario analysis, the greatest loss resulting from the scenario over any ten-day period, or some multiple thereof based on liquidity or, if greater, a minimum deduction; and (iv) for all other positions, a deduction under Sec. 240.15c3-1(c)(2)(vi), (c)(2)(vii), and applicable appendices to Sec. 240.15c3-1. We address each of the deductions for market risk in the sections that follow.
a. Deductions for Market Risk Using VaR Models
As noted, a broker-dealer may use a VaR model to calculate its deduction for market risk for those positions for which the Commission has approved the use of VaR models. To calculate the deduction, the broker-dealer multiplies the VaR of those positions by the appropriate multiplication factor. The multiplication factor is intended to help provide adequate capital during periods of market stress or other eventualities.35 The results of quarterly backtests
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determine which of the multiplication factors contained in Table 1 of Appendix E a broker-dealer must use, except that the broker-dealer must use an initial multiplication factor of three.36
We have amended the proposed rules with regard to specified provisions of the VaR models used for computing a deduction for market risk.
i. Elimination of the VaR Phase-in Period
In response to comments received, Appendix E, as adopted, no longer includes the phase-in period for VaR models. Under paragraph (c)(3) of proposed Appendix E, the Commission would have phased in the use of VaR models to calculate deductions for net capital for three bands of positions over a period of at least 18 months. Commenters stated that implementation of VaR for calculation of deductions for market risk on a phased-in basis would impose unnecessary operational costs and inefficiencies. Elimination of the phase-in requirement is intended to promote more effective group-wide risk management and eliminate unnecessary operational costs and inefficiencies. Therefore, upon Commission approval of its VaR models, a broker-dealer may use its VaR models to calculate deductions for market risk capital for all positions for which the broker-dealer can demonstrate that its modeling procedures meet the applicable requirements in the final rules.
ii. Positions With No ''Ready Market'' Under VaR
Paragraph (c)(2) of proposed Appendix E generally would have prohibited the use of VaR models to compute deductions for market risk for positions with no ''ready market''; debt securities that are below investment grade; and any derivative instrument based on the value of these positions, unless the Commission granted the broker-dealer's application to use a VaR model for those positions. Under paragraph (c)(2)(vii) of the net capital rule, positions for which there is no ''ready market,'' as defined in section 240.15c3-1(c)(11),37 would have excluded these positions from inclusion in VaR models; that is, the positions would have been subject to a 100% deduction.
Commenters asserted that, while positions with no ready market may lack historical data sufficient to allow accurate modeling, the rules should require a broker-dealer to demonstrate that its models adequately capture the material risks associated with the categories of securities in which they transact business, not limit use of VaR to those securities that have a ready market. We agree with the commenters and, therefore, Appendix E, as adopted, does not limit a broker- dealer's use of VaR models for computing deductions for market risk to securities that have a ''ready market.''
b. Deductions for Specific Risk
Paragraph (b)(2) of Appendix E may require a deduction for specific risk because of the reliance on VaR models for regulatory purposes, particularly for determining deductions for market risk for securities with no ready market. Generally, specific risk is the risk associated with how the price-change on an individual position may differ from broad, market-wide changes in prices. If the VaR models that a broker- dealer uses to compute deductions for market risk incorporate specific risk, there is no additional deduction for specific risk in determining the deduction for market risk. If, however, the VaR models do not incorporate specific risk, paragraph (b)(2) requires a broker-dealer to include separate deductions for specific risk. The Commission will determine the deduction for specific risk on a case-by-case basis based on a review of the broker-dealer's application and the positions involved.
c. Deduction for Market Risk Using Scenario Analysis
The Commission is amending the proposed rule on calculation of deductions for market risk using scenario analysis. Under the paragraph (c)(5) of proposed Appendix E, the deduction for market risk calculated using scenario analysis generally would have been three times the greatest adverse movement resulting from the scenario analysis over any ten-day period. Paragraph (b)(3) 38 of Appendix E, as adopted, permits a broker-dealer to determine a deduction for market risk using scenario analysis for those positions for which the Commission has approved the broker-dealer's application to use scenario analysis. The deduction will be the greatest loss resulting from a range of adverse movements in relevant risk factors, prices, or spreads designed to represent a negative movement greater than, or equal to, the worst ten- day movement over the four years preceding calculation of the loss, or some multiple of that movement based on liquidity. Permitting the use of scenario analysis to calculate the deduction for market risk will provide the broker-dealer with greater flexibility in determining how it may use mathematical models to calculate market risk deductions for securities for which a deduction calculated using VaR would not be appropriate. The minimum deduction for market risk computed for positions using scenario analysis is the same under the final rules as it was in the proposed rules.
The final amendments also change the period over which the greatest adverse ten-day movements of data are evaluated. Paragraph (c)(5) of proposed Appendix E would have required the scenario to include a range of adverse movements of risk factors, prices, or spreads that move by the greatest amounts over the past five years, or a three standard deviation movement in those risk factors, prices, or spreads over a ten-day period. Commenters suggested that the period related to ten-day movements be reduced from five to four years. In response to comments received, the final amendments reduce the period over which the greatest adverse ten-day movements of data are determined to four years. This change is intended to approximate more closely a ten-day movement of prices to a 99% confidence level.
The rule as proposed would have allowed for the use of a three standard deviations alternative if historical data for use in a scenario analysis were limited. Commenters expressed concern that this requirement would restrict the use of scenario analysis when historical data is limited. We are amending the proposed rule to clarify, under paragraph (b)(3) of Appendix E, as adopted, that a broker-dealer may use implied data or price histories of similar securities to calculate the three standard deviation movement if historical data is insufficient.
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d. Deductions for Market Risk Under the Standard Net Capital Rule
Paragraph (c)(6) of proposed Appendix E would have required a broker-dealer to compute a deduction for market risk using the ''haircut method'' of the standard net capital rule for a position not subject to a deduction for market risk computed using VaR models or scenario analysis. Haircuts are calculated under paragraphs (c)(2)(vi), (c)(2)(vii), and applicable appendices of the standard net capital rule, Rule 15c3-1.39 By requiring a broker-dealer to use the haircut method of the standard net capital rule in appropriate circumstances, the Commission intended that a broker-dealer use paragraph (c)(2)(vii), if applicable. Proposed paragraph (c)(6), however, did not reference paragraph (c)(2)(vii) specifically. Paragraph (b)(4) 40 of Appendix E, as adopted, clarifies that a broker-dealer must compute deductions for market risk under both paragraphs (c)(2)(vi) and (c)(2)(vii) of the standard net capital rule, if applicable. Paragraph (c)(2)(vii), as noted, requires a 100% deduction for positions for which there is no ready market.
4. Computation of the Deduction for Credit Risk
A broker-dealer approved to calculate deductions for market risk using VaR models or scenario analysis must calculate its deduction for credit risk according to paragraph (c) 41 of Appendix E, as adopted, on credit exposures arising from the broker-dealer's positions in derivatives instruments. The deduction for credit risk is the sum of the following three categories of charges: (i) A counterparty exposure charge under paragraph (c)(1), (ii) concentration charges by counterparty under paragraph (c)(2), and (iii) a portfolio concentration charge for all counterparties under paragraph (c)(3). The deductions required for each of these categories are designed to address different components of credit risk.
a. Counterparty Exposure Charge
We are adopting the counterparty exposure charge as proposed, with the exception of the determination of counterparty credit risk weights. For each counterparty, the broker-dealer must compute a counterparty exposure charge equal to the net replacement value in the account of each counterparty that is insolvent, in bankruptcy, or has senior, unsecured long-term debt in default. For counterparties that are not insolvent, in bankruptcy, or in default, the counterparty exposure charge also includes the ''credit equivalent amount'' of the broker- dealer's exposures to the counterparty, multiplied by the credit risk weight of the counterparty, then multiplied by 8%.42 The credit equivalent amount of a broker-dealer's exposure to a counterparty is defined in paragraph (c)(4)(i) of Appendix E, as adopted, as the sum of: (1) The broker-dealer's maximum potential exposure (''MPE'') to the counterparty multiplied by the appropriate multiplication factor, and (2) the broker-dealer's current exposure to the counterparty. Under paragraph (d)(1)(v) 43 of Appendix E, as adopted, the multiplication factor applicable to MPE generally is determined based on backtesting results of the VaR model used to calculate MPE, except that the initial multiplication factor is one.
Paragraph (c)(4)(ii) of Appendix E defines MPE as VaR of the counterparty's positions with the broker-dealer, after applying netting agreements, taking into account the value of certain collateral received from the counterparty, and taking into account the current replacement value of the counterparty's positions with the broker- dealer. The broker-dealer must calculate MPE using a VaR model that meets the applicable quantitative and qualitative requirements of Appendix E. Paragraph (c)(4)(iii) of Appendix E, as adopted, defines ''current exposure'' as the replacement value of the counterparty's positions with the broker-dealer, after applying specified netting agreements 44 and taking into account the value of certain collateral 45 received from the counterparty.
In the Proposing Release, the credit risk weights would have ranged from 20% to 150%, depending on the credit rating of the counterparty, which provides a measure of credit risk. For a counterparty not rated by a nationally recognized statistical rating agency (''NRSRO''), the broker-dealer could have applied to the Commission for permission to determine a credit rating for the counterparty using internal calculations and to use that internal rating to determine the credit risk weight of the counterparty. For exposures covered by guarantees, a broker-dealer could have substituted the average of the credit risk weights of the guarantor and the counterparty for the credit risk weight of the counterparty, subject to specified conditions. These proposed credit risk weights were based on the formulas provided in the Foundation Internal Ratings-Based approach to credit risk proposed by the Basel Committee 46 and were derived using a loss given default (the percent of the amount owed by the counterparty the firm expects to lose if the counterparty defaults) of 75%.
We requested comment on the determination of credit risk weights. In particular, we requested comment on whether a broker-dealer should be permitted to apply to the Commission for permission to determine the credit risk weights of counterparties using internal calculations. We also requested comment on whether, in a calculation of credit risk weights based on internal estimates of annual probabilities of default, the proposed table appropriately matched credit risk weights to annual probabilities of default.
Several commenters stated that broker-dealers should be allowed to calculate credit risk weights based on internal estimates of annual probabilities of default, but that a 75% loss given default assumption was too conservative. One commenter stated that the loss given default percentage should be a function of the issuer, industry type, and debt class.
Based on comments received, we are permitting a broker-dealer to request Commission approval to determine counterparty credit risk weights using internal calculations under paragraph (c)(4)(vi)(E) of Appendix E, as adopted. These internally calculated credit risk weights are in addition to the credit risk weights contained in paragraphs (c)(4)(vi)(A) through (C) of Appendix E, as adopted. Paragraph (c)(4)(vi)(E) does not include any specific maturity adjustment factor, although we note that the Basel Standards use a maturity
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adjustment factor of 2.5 years in their standard approach. Furthermore, in the Proposing Release, we requested comment on whether a proposed table of credit risk weights appropriately matched credit risk weights to annual probabilities of default. Commenters responded that the matches were not appropriate. Accordingly, rather than provide a table of credit risk weights corresponding to internal estimates of annual probabilities of default in the final rule, we will evaluate the method of determining credit risk weights the broker-dealer proposes in its application.
b. Concentration Charge by Counterparty
The Commission is adopting paragraph (c)(2) of Appendix E, the concentration charge by counterparty,47 as proposed.48 This charge accounts for the additional risk resulting from a relatively large exposure to a single party. The charge consists of concentration charges by counterparty that generally would apply when the current exposure of the broker-dealer to a single counterparty exceeds 5% of the tentative net capital of the broker-dealer. The amount of the concentration charge is larger for counterparties with lower credit ratings and ranges from 5% to 50% of the amount of the current exposure of the broker-dealer to the counterparty in excess of 5% of the broker- dealer's tentative net capital. The 5% criterion is based on the OTC derivatives dealer rules and the experience of Commission staff.
c. Portfolio Concentration Charge
The Commission is adopting an amended portfolio concentration charge under paragraph (c)(3) 49 of Appendix E. The portfolio concentration charge for credit risk addresses the risk of holding a relatively large amount of unsecured receivables. Proposed paragraph (d)(9) would have required firms to take a portfolio concentration charge across all counterparties equal to the amount, if any, that the broker-dealer's aggregate current exposure arising from transactions in derivative instruments across all counterparties exceeded 15% of the broker-dealer's tentative net capital. Commenters expressed concern that the portfolio concentration charge would be onerous because it would attach at a relatively low threshold and, consequently, restrict the scope of derivatives activity that could be booked in the broker- dealer in a capital-efficient manner. In response to comments received, the Commission has increased the threshold at which the portfolio concentration charge attaches. Under these final rules, a broker-dealer is subject to a charge on the amount, if any, that the broker-dealer's aggregate current exposure for all counterparties for unsecured exposures exceeds 50%, rather than 15%, of the broker-dealer's tentative net capital. Based on staff experience, we believe that the threshold at which the portfolio concentration charge attaches should help a broker-dealer maintain sufficient liquid capital while allowing the broker-dealer to book derivative transactions in a capital- efficient manner.
5. Qualitative and Quantitative Standards Applicable to Calculations Under Models
Paragraph (e) 50 of proposed Appendix E set forth the qualitative and quantitative requirements that broker-dealers would have been required to comply with to calculate deductions using VaR models.51 These requirements were intended to make the capital charges based on the VaR measures a more accurate measure of losses that could occur during periods of market stress. We derived the requirements from the OTC derivatives dealer rules and our experience in implementing those rules. The qualitative requirements, listed in paragraph (e)(1) of proposed Appendix E, would have required that: (i) The VaR models used to calculate deductions for market and credit risk be the same models used to report market and credit risk to the firm's senior management and be integrated into the internal risk management system of the firm; (ii) the VaR models be reviewed by the firm periodically and annually by a registered public accounting firm, as that term is defined in the Sarbanes-Oxley Act of 2002; 52 and (iii) for purposes of computing market risk, the multiplication factor be determined based on quarterly backtesting of the VaR models used to calculate market risk and by reference to Table 1 of Appendix E.
The proposed quantitative standards would have required each model to: (i) Use a 99 percent, one-tailed confidence level with price changes equivalent to a ten business-day or one-year movement in rates and prices for purposes of determining market and credit risk, respectively; (ii) use an effective historical observation period of at least one year in length that included periods of market stress; and (iii) take into account and incorporate all significant, identifiable market risk factors applicable to the firm's positions.53
In the Proposing Release, we requested comment on the proposed use of mathematical models for regulatory capital purposes, including the proposed quantitative and qualitative requirements and the proposed backtesting procedures for the models. One commenter stated that one year might not contain periods of market stress. To address this concern, the rule as adopted, in addition to the one-year minimum, provides that the broker-dealer must consider the effects of market stress in its construction of the model.
Paragraph (e)(1)(iv) 54 of proposed Appendix E would have required broker-dealers to determine multiplication factors for purposes of computing the credit equivalent amount of the firm's exposure to a counterparty based on results of backtesting of the model used to calculate MPE. This paragraph would have required firms to conduct the backtesting by comparing, for at least 40 counterparties, the daily change in current exposure based on the end of the previous day's positions with the corresponding MPE for the counterparty generated by the model.
One commenter stated that because MPE is based on a one-year time horizon, it is inconsistent to compare it with a one-day change in current exposure. The commenter also stated that the Commission should allow the use of VaR models based on information implied from market prices for one-year horizon potential exposure calculations. According to the commenter, the potential exposure models that utilize implied parameters are in widespread use in the financial industry. We will consider whether a firm should be
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permitted to use implied parameters in potential exposure calculations if the firm requests consideration of this issue in its application.
Furthermore, in response to comments received and to strengthen and improve the backtesting requirement we have amended both paragraphs (d)(1)(v)(A) and (B) of Appendix E, as adopted. Under these paragraphs as amended, the MPE horizon is ten business days, rather than one day. The ten-day requirement is consistent with the VaR models broker- dealers use. In conducting backtesting, the broker-dealer must compare the change in current exposure to the counterparty based on its positions held at the beginning of the ten-business day period to the corresponding ten-business day MPE for the counterparty generated by the VaR model.
Moreover, we re-evaluated the requirement that the broker-dealer compare at least 40 counterparties in conducting conduct backtesting. Based on that re-evaluation and staff experience, we determined that to help ensure a sufficient number of data points and, therefore, an appropriate sample for backtesting, the broker-dealer must compare at least 80 counterparties under paragraph (d)(1)(v)(A) of Appendix E, as adopted, rather than 40 counterparties, as proposed.
Paragraph (e)(2)(ii) of proposed Appendix E would have required the VaR model to use a time horizon of one year for purposes of determining MPE. Several commenters stated that the time horizon should be ten business days if the position is marked to market daily and a written agreement enforceable against the counterparty provides that the broker-dealer or its affiliate may call for additional collateral daily.
In response to comments received, a broker-dealer may use a time horizon of not less than ten business days to calculate MPE under paragraph (d)(2)(ii) 55 of Appendix E, as adopted. Generally, if collateral is not posted to, and held by, the broker-dealer, the broker-dealer must use the one-year time horizon when calculating MPE. If, however, there is a valid collateral agreement, the Commission may approve a shorter time horizon based on a review of the broker-dealer's procedures for managing collateral. The broker-dealer also must be able to mark the collateral to market daily and have the ability to call the collateral daily. This modification of the time horizon requirement should help a broker-dealer to maintain a liquid capital base while promoting operational efficiency.
6. Additional Conditions for Noncompliance With Appendices E and G, Model Failures, or Control Failures
We are revising paragraph (f) of proposed Appendix E and redesignating it as paragraph (e) of Appendix E, as adopted. Paragraph (f) of proposed Appendix E would have permitted the Commission, in specified circumstances, to condition a broker-dealer's continued use of the alternative method of computing net capital on the broker- dealer's or its ultimate holding company's compliance with additional conditions. Additional conditions imposed on the broker-dealer could have included, but would not have been limited to, restrictions on the scope of the broker-dealer's business, submission of a plan to increase its net capital or tentative net capital, or calculation of some or all of its deductions for market and credit risk according to the standard net capital method of Rule 15c3-1.
Paragraph (e) of Appendix E, as adopted, clarifies in the rule text that we may require a broker-dealer to calculate some or all of its deductions to net capital under paragraph (c)(2)(vii) of the standard net capital rule, if applicable. As noted above, we stated in Proposing Release that we intended a broker-dealer using the alternative method of computing net capital to use the haircut method of the standard net capital rule to compute appropriate deductions to net capital when the alternative method could not be applied. A broker-dealer calculates haircuts under paragraphs (c)(2)(vi), (c)(2)(vii), and applicable appendices of Rule 15c3-1. Although we did not reference paragraph (c)(2)(vii) in the proposed rule text, we indicated that haircuts were to be used to compute deductions to net capital in specified circumstances, thus requiring a broker-dealer to make the computation under paragraph (c)(2)(vii), if appropriate, together with (c)(2)(vi) and applicable appendices of Rule 15c3-1.
As noted, paragraph (f) of proposed Appendix E also would have permitted the Commission to impose certain additional requirements on the broker-dealer's ultimate holding company, subject to specified conditions. One commenter stated that if the ultimate holding company is a bank holding company that complies with its regulator's capital requirements on a consolidated basis, any capital remedies should be imposed on the broker-dealer and not on the ultimate holding company. Another commenter stated that if the Commission has concerns about the risk models or procedures in the ultimate holding company's capital calculation, it should address the concerns by imposing additional capital charges on the broker-dealer, not by requiring a change in the risk models or procedures.
Paragraph (e) of Appendix E, as adopted, clarifies that the Commission only may impose additional conditions on an ultimate holding company that does not have a principal regulator. If the Commission has concerns with respect to the risk models or risk management system of an ultimate holding company that has a principal regulator, the Commission may impose additional regulatory requirements on the broker- dealer.
Paragraph (e) of Appendix E, as adopted, outlines circumstances under which the Commission may impose additional conditions on the broker-dealer or the ultimate holding company that does not have a principal regulator. First, as discussed above, we added a provision that states that the Commission may impose additional conditions if the broker-dealer must notify the Commission under paragraph (a)(7)(ii) of Rule 15c3-1 that its tentative net capital is below $5 billion. Notification is necessary because this event indicates that the broker- dealer or ultimate holding company might be approaching financial difficulty. Second, we added a provision that allows the Commission to impose additional regulatory requirements on the broker-dealer or an ultimate holding company that does not have a principal regulator if the broker-dealer fails to comply with Appendix E. The authority to impose these requirements is essential to the Commission's ability to address risks to the broker-dealer.
7. Recordkeeping
The Commission did not propose amendments to Rule 17a-3 because that rule already requires a broker-dealer to create and maintain records sufficient for the Commission to examine the broker-dealer adequately, regardless of whether the broker-dealer uses the alternative or standard method of computing net capital. Broker-dealers currently must make various records, including blotters containing an itemized daily record of all purchases and sales of securities, and all receipts and deliveries of securities, cash, and other debits and credits. Under the existing requirements in Rule 17a-3, a broker-dealer can provide the Commission with a separate record of all transactions between itself and all affiliates in the affiliate group. Consistent with the Commission's supervision of inter-group transactions,
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the Commission may obtain and review a record of inter-group transactions as part of its supervisory reviews under Rule 17a-3.
D. Ultimate Holding Company Requirements
Under the rule amendments, an ultimate holding company is subject to requirements under both Appendix E and Appendix G. Appendix E primarily requires the ultimate holding company to submit specified information to the Commission with the broker-dealer's application to use the alternative method of computing net capital. Appendix G outlines the ultimate holding company's obligations with respect to calculation of allowable capital, allowances for certain capital charges, and certain recordkeeping and reporting requirements.
1. Ultimate Holding Company Requirements Under Appendix E
Under Appendix E as proposed, a broker-dealer's ultimate holding company would have submitted specified information to the Commission with the broker-dealer's application to use the alternative method of computing net capital. This information would have been similar to the information that we presently obtain under the OTC derivatives dealer rules, under the risk assessment rules, and voluntarily from the DPG firms and other broker-dealers. We have found this information to be useful in gaining insight into the financial condition, internal risk management control system, risk exposure, and activities of the broker- dealer and its ultimate holding company and material affiliates.56 The information provided in these documents would have been key considerations in determining the continued viability of the broker- dealer because serious adverse conditions at the ultimate holding company or a material affiliate likely would have exposed the broker- dealer to liquidity or other risks.
In response to comments received, we have revised the final rules to set forth separately the requirements for information that an ultimate holding company that has a principal regulator must submit to the Commission from the requirements for information that an ultimate holding company that does not have a principal regulator must submit to the Commission. These requirements are addressed below in detail.
a. Ultimate Holding Company Undertaking
As a condition to a broker-dealer's use of the alternative method of computing net capital, proposed paragraph (a)(1)(viii) of Appendix E would have required the broker-dealer to include with its application a written undertaking by the broker-dealer's ultimate holding company. Other than with respect to holding companies subject to group-wide supervision by other regulators, we did not receive specific comments on these proposed requirements. Nevertheless, we are revising paragraph (a)(1)(viii) to reflect that we no longer are amending Rule 15c3-4. Moreover, we have revised the final rules to set forth separately, in paragraph (a)(1)(ix), the requirements for an undertaking submitted by an ultimate holding company that has a principal regulator.
i. Ultimate Holding Company That Does Not Have a Principal Regulator
As a condition to its use of the alternative method for computing net capital, paragraph (a)(1)(viii) of Appendix E, as adopted, requires a broker-dealer to file a written undertaking by its ultimate holding company, signed by a duly authorized person at the ultimate holding company, in which the ultimate holding company agrees, among other things, to:
Comply with all applicable provisions of Appendices E and G to Rule 15c3-1;
Comply with the provisions of Rule 15c3-4 with respect to a group-wide internal risk management control system for the affiliate group as if it were an OTC derivatives dealer. Paragraph (a)(1)(viii)(C) is discussed in greater detail in the section of this release that addresses Rule 15c3-4;
As part of its group-wide internal risk management control system, to establish, document, and maintain procedures for the detection and prevention of money laundering and terrorist financing; 57
Permit the Commission to examine the books and records of any affiliate of the ultimate holding company, if the affiliate is not an entity that has a principal regulator; 58
If the disclosure to the Commission of any information required as a condition for the broker-dealer to use Appendix E is prohibited by law or otherwise, cooperate with the Commission as needed, including by describing any secrecy laws or other impediments that could restrict the ability of material affiliates from providing information to the Commission and by discussing the manner in which the broker-dealer and the ultimate holding company propose to provide the Commission with adequate assurances of access to information; and
Acknowledge that the Commission may implement additional supervisory conditions if the ultimate holding company fails to comply in a material manner with any provision of its undertaking.
Paragraphs (a)(1)(viii)(I) and (J) of proposed Appendix E would have required an ultimate holding company, as a condition to a broker- dealer's use of the alternative method of computing net capital, to consent in its undertaking to submit to the Commission, in advance of making them, any material changes to mathematical models and other methods used to calculate allowances for market, credit, and operational risk, and any material changes to the internal risk management control system for the affiliate group.
We are adopting these requirements as paragraph (a)(9) of Appendix E. We redesignated as paragraph (a)(9) the obligation to submit to the Commission specified material changes for prior approval to emphasize that the obligation is ongoing. Furthermore, to avoid unnecessary or duplicative requirements, paragraph (a)(9) of Appendix E, as adopted, applies only to ultimate holding companies that do not have principal regulators.
ii. Undertaking for an Ultimate Holding Company That Has a Principal Regulator
A number of commenters urged the Commission to reduce certain requirements applicable to ultimate holding companies that already are subject to another regulator's consolidated supervision. These commenters asserted that the requirements, including the undertaking
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required as part of the application process, could lead to the imposition of duplicative and possibly inconsistent requirements on these ultimate holding companies by the Commission and their current regulators.
In response to these comments and to avoid duplicative or inconsistent requirements, the Commission has amended paragraph (a)(1) to create a new sub-paragraph (ix) that specifies the more limited undertaking that a broker-dealer must submit if its ultimate holding company has a principal regulator, as that term is defined in new paragraph 15c3-1(c)(13). This undertaking, however, still enables the Commission to obtain information sufficient to evaluate the risk that the ultimate holding company may pose to the broker-dealer.
As a condition to its use of the alternative method for computing net capital, paragraph (a)(1)(ix) of Appendix E, as adopted, requires a broker-dealer to file a written undertaking by its ultimate holding company that has a principal regulator, signed by a duly authorized person at the ultimate holding company, in which the ultimate holding company agrees, among other things, to:
Comply with applicable provisions of Appendices E and G to Rule 15c3-1;
Make available to the Commission information about the ultimate holding company that the Commission finds necessary to evaluate the financial and operational risk within the ultimate holding company and to evaluate compliance with the conditions of eligibility of the broker-dealer to compute net capital under the alternative method of Appendix E; and
Acknowledge that the Commission may impose additional supervisory conditions on the broker-dealer, described in detail below, if the ultimate holding company fails to comply in a material manner with any provision of its undertaking. b. Information To Be Submitted by the Ultimate Holding Company
Paragraph (a)(2) of proposed Appendix E would have required an ultimate holding company to consent to provide specified information to the Commission with an affiliated broker-dealer's application as a condition of the broker-dealer's use of the alternative method of computing net capital. Among other things, the ultimate holding company would have consented to include an organizational chart that identified the ultimate holding company, the broker or dealer, and the material affiliates. According to some commenters, the Commission ''may wish to only require broker-dealers to submit an organizational chart that identifies the holding company, the broker-dealer, and the material, unregulated affiliates of the broker-dealer * * * and such other affiliate organizational information as it may request from time to time.'' These commenters suggested that the Commission eliminate the alphabetical list in paragraph (a)(2)(ii) of Appendix E, as proposed, because large financial services firms may have hundreds of affiliates and information and the commenters believed that information on these affiliates would not assist the Commission in its understanding of the risks to broker-dealers.
Paragraph (a)(2)(ii) of Appendix E, as adopted, retains the requirement that the ultimate holding company consent to provide an alphabetical list to the Commission of its affiliates (the ''affiliated group''). The Commission needs a comprehensive list of entities that make up the affiliate group to understand, as completely as possible, the organizational structure of which the broker-dealer is a part. Moreover, management of the ultimate holding company should have ready access to a comprehensive list of affiliates and a designation of whether the affiliates have a financial regulator as part of its internal risk management systems.
We also are making technical amendments to paragraph (a)(2)(iii) of Appendix E, as adopted. Paragraph (a)(2)(iii) of Appendix E, as proposed, would have required an ultimate holding company to consent to provide ''an organizational chart that identifies the holding company, the broker or dealer, and the material affiliates of the broker or dealer.'' Paragraph (a)(2)(ii), both as proposed and adopted, requires that the ultimate holding company consent to provide information about affiliates material to the ultimate holding company, not the broker- dealer. Likewise, we intended paragraph (a)(2)(iii) to require an ultimate holding company to provide an organizational chart that identifies the material affiliates of the ultimate holding company, not the broker-dealer. Accordingly, paragraph (a)(2)(iii) of Appendix E, as adopted, requires the ultimate holding company's organizational chart to identify affiliates material to the ultimate holding company.
Commenters also suggested that an ultimate holding company that has a principal regulator should not be required to provide all of the information to the Commission that proposed paragraph (a)(2) of Appendix E would have required. According to the commenters, an ultimate holding company that has a principal regulator already might provide some of the information required under proposed paragraph (a)(2) to its principal regulator and, therefore, the information requirements could lead to duplicative or inconsistent requirements.
To avoid potentially duplicative or inconsistent requirements, paragraph (a)(2), as adopted, applies only to an ultimate holding company that does not have a principal regulator. The Commission has revised the rules to set forth separately, in paragraph (a)(3), the documents that an ultimate holding company that has a principal regulator must submit. The following sections describe the requirements under paragraphs (a)(2) and (a)(3).
i. Ultimate Holding Company That Does Not Have a Principal Regulator
Paragraph (a)(2) of Appendix E, as adopted, specifies the information that an ultimate holding company that does not have a principal regulator must submit, as a condition of Commission approval, with the broker-dealer's application for exemption from the standard net capital rule. That information includes the following:
A narrative description of the business and organization of the ultimate holding company;
An alphabetical list of the affiliates of the broker- dealer (''affiliate group''), with an identification of the financial regulator, if any, with whom the affiliate is registered and a designation of those affiliates that are material to the ultimate holding company (''material affiliates'');
An organizational chart that identifies the ultimate holding company, the broker-dealer, and the material affiliates;
Consolidated and consolidating financial statements;
Certain sample capital calculations made according to Appendix G to Rule 15c3-1;
A description of the categories of positions held by the ultimate holding company and affiliates;
A description of the methods the ultimate holding company intends to use for computing allowances for market,59 credit, and operational risk;
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A description of any differences between the models used by the ultimate holding company and those used by the broker-dealer to compute deductions for specified risks on the same instrument or counterparty;
A description of the risk management control system the ultimate holding company uses to manage group-wide risk and how that system satisfies the requirements of Rule 15c3-4; and
Sample risk reports that the ultimate holding company provides to its senior management.
ii. Ultimate Holding Company That Has a Principal Regulator
New paragraph (a)(3) of Appendix E, as adopted, specifies the more limited information that an ultimate holding company that has a principal regulator must include, as a condition of Commission approval, with the broker-dealer's application for exemption from the standard net capital rule. That information includes the following:
A narrative description of the business and organization of the ultimate holding company;
An alphabetical list of the affiliates of the broker- dealer with an identification of the financial regulator, if any, by whom the affiliate is regulated and a designation of those affiliates that are material to the ultimate holding company;
An organizational chart that identifies the ultimate holding company, the broker-dealer, and the material affiliates;
Consolidated and consolidating financial statements;
A capital measurement report as provided to its principal regulator;
A description of any differences between the models used by the ultimate holding company and those used by the broker-dealer to compute capital charges on the same instrument or counterparty; and
Sample risk reports that the ultimate holding company provides to its senior management.
Receipt of these documents is intended to provide the Commission with insight into the ultimate holding company and the risks that it may pose to the broker-dealer without intruding upon the jurisdiction of the ultimate holding company's principal regulator.
Because each ultimate holding company manages its internal risk differently, the Commission, during the application process, must assess each ultimate holding company's business and internal risk management control systems to determine if approval of the application is appropriate. The ultimate holding company information that we require a broker-dealer to file as a condition of approval of the application for the exemption from the standard net capital rule allows us to evaluate these management control systems.
iii. Other Information
Paragraph (a)(3) of proposed Appendix E 60 would have required a broker-dealer to provide supplemental information about it or its ultimate holding company upon Commission request. The Commission would have requested supplemental information to complete its review of the broker-dealer's application to use the alternative method of computing net capital. In certain circumstances, such as consideration of the particular business or organizational structure of the ultimate holding company and its affiliates, the Commission could have conditioned its approval on obtaining additional information or documents necessary to assess adequately the risks to the ultimate holding company and to the broker-dealer. Accordingly, we are adopting paragraph (a)(4) of Appendix E as proposed. Paragraph (a)(4) requires a broker-dealer to supplement it application with other information or documents relating to the internal risk management control system, mathematical models, and financial position of the broker-dealer or the ultimate holding company that the Commission may request to complete its review of the application.
2. Ultimate Holding Company Requirements Under Appendix G
As a condition of Commission approval, the ultimate holding company of a broker-dealer applying to use the alternative method of computing net capital must undertake to comply with the requirements listed in Appendix G to Rule 15c3-1, as required by paragraphs (a)(1)(viii) or (a)(1)(ix) of Appendix E. Under Appendix G, the ultimate holding company that does not have a principal regulator must compute allowable capital and allowances for market, credit, and operational risk on a consolidated basis for the affiliated group; provide the Commission with certain monthly, quarterly, and annual reports; maintain certain books and records relating to the ultimate holding company's consolidated and consolidating financial reports and internal risk management controls; and notify the Commission upon the occurrence of certain events. These conditions are designed to help the Commission assess the financial and operational health of the ultimate holding company and its potential impact on the risk exposure of the broker- dealer. a. Calculation of Allowable Capital and Allowances for Market, Credit, and Operational Risk by an Ultimate Holding Company That Does Not Have a Principal Regulator
Under paragraph (a) of Appendix G, as adopted, an ultimate holding company must calculate allowable capital and allowances for market, credit, and operational risk on a consolidated basis for the affiliate group as a condition of the broker-dealer's use of the alternative method of computing net capital. The calculations are designed to be consistent with the Basel Standards, which should allow for greater comparability of ultimate holding companies to international securities firms and banking institutions and allow monitoring of the financial condition of the affiliate group, which may impact the financial stability of the broker-dealer.
We believe the rules contain prudent parameters for measuring allowable capital and risk allowances for the ultimate holding company. For example, the rules limit the amount of subordinated debt that may be included in allowable capital, require the VaR model used to calculate the allowance for market risk to be based on a ten business- day movement in rates and prices, and require the VaR measure to be multiplied by a factor of at least three.
i. Group-Wide Allowable Capital Calculation a. Components of Allowable Capital
Under paragraph (a)(1) of proposed Appendix G, the ultimate holding company would have calculated allowable capital on a consolidated basis for the affiliate group. Consistent with the Basel Standards, allowable capital would have included common shareholders' equity (less goodwill, deferred-tax assets, and certain other intangible assets), certain cumulative and non-cumulative preferred stock,61 and certain properly subordinated debt. As set forth in detail in the rule, the cumulative and non-cumulative
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preferred stock and subordinated debt would have been subject to additional limitations based on comparisons of the individual components of allowable capital.
In response to comments received, the Commission has expanded the definition of allowable capital in paragraph (a)(1) of Appendix G, as adopted, to include hybrid capital instruments and certain deferred-tax assets. Commenters noted that the Basel Standards and the Federal Reserve's definition of Tier 1 and Tier 2 capital include hybrid capital instruments and certain deferred-tax assets. To be more consistent with both the Basel Standards and the Federal Reserve's definition of Tier 1 and Tier 2 capital, an ultimate holding company may include in allowable capital both those hybrid capital instruments that the Federal Reserve allows for inclusion in Tier 2 capital and specified deferred-tax assets, subject to certain limitations.62 This increased consistency should promote greater comparability of financial information among firms.
Paragraph (a)(1)(iii)(B) of proposed Appendix G would have permitted inclusion of subordinated debt in allowable capital subject to specified criteria intended to help assure that the subordinated debt provides a long-term source of working capital to the holding company and that it has many of the characteristics of capital. We did not receive comments on inclusion of subordinated debt in allowable capital and we adopt paragraph (a)(1)(iii)(B) of Appendix G as proposed.
In the Proposing Release, the Commission solicited comment on whether long-term debt, subject to appropriate limitations, should be included in allowable capital. A number of commenters argued in favor of inclusion. Those commenters noted that economic considerations primarily determine the type of debt issued, including the term, structure, and cost of borrowing. Some broker-dealer affiliates of holding companies, consequently, have relied upon long-term debt for management of their capital structures.
Other commenters suggested that long-term debt be included as allowable capital during a phase-out period. They suggested that a swift phase-out of long-term debt would be difficult. If each of the ultimate holding companies interested in this program simultaneously issued subordinated debt to replace long-term debt, these new, large issues could impact capital markets negatively, increasing funding costs.
To maintain consistency with the Basel Standards, holding companies may not include long-term capital in allowable capital. We understand, however, that an ultimate holding company might not be able to convert significant amounts of long-term debt to subordinated debt quickly without incurring significant costs and causing market disruptions. Accordingly, as part of the broker-dealer's application to compute deductions for specified risks under Appendix E, an ultimate holding company may request to phase-out the inclusion of long-term debt as allowable capital over a period of up to three years, if the long-term debt meets the criteria specified in paragraph (a)(1)(iii)(C) of Appendix G, as adopted. We believe that the three-year phase-out period is appropriate based on staff experience. After three years, a broker- dealer may submit an amendment to its application and request that the Commission grant the ultimate holding company up to two additional years to complete the phase-out of long-term debt. The Commission will determine if the amount of the ultimate holding company's long-term debt and market conditions warrant an extension. b. The ''Aggregate'' or ''Building Block'' Approach to Calculation of Allowable Capital
Some commenters suggested that the Commission permit calculation of allowable capital using the ''aggregate,'' or ''building block,'' approach, rather than a calculation on a consolidated basis. Under the building block approach, an ultimate holding company would have sufficient allowable capital if available capital exceeds the sum of its subsidiaries' functional regulatory capital requirements.
In response to comments received, the broker-dealer may request in its initial application that the ultimate holding company be permitted to use the building block approach to computing allowable capital.63 The request must describe a proposed building block allowable capital calculation approach that is consistent with the methods described in the Joint Forum's July 2001 paper entitled, ''Capital Adequacy Principles.'' 64 Use of these principles is appropriate because they outline internationally agreed-upon standards for calculating consolidated capital.
In aggregating the capital requirements of its subsidiaries, an ultimate holding company would use the existing capital adequacy calculations prepared for each entity according to the methodology prescribed by its principal regulator. Unregulated entities, including both subsidiaries and the ultimate holding company, would be subject to proxy capital requirements calculated according to the Basel Standards. The ultimate holding company then would compare the sum of the capital requirements to total capital resources.
ii. Group-Wide Calculation of Allowance for Market Risk
Paragraph (a)(2) of proposed Appendix G would have required daily calculation of a group-wide allowance for market risk. Commenters requested that the Commission no longer require an ultimate holding company to calculate a group-wide allowance for market risk daily because an ultimate holding company only must report this information to the Commission monthly. In response to comments received, paragraph (a)(2) of Appendix G, as adopted, no longer requires computation of the allowance for market risk on a daily basis. Rather, paragraph (c)(4) of Appendix G, as adopted, requires an ultimate holding company to compute and report its group-wide allowance for market risk monthly. Nevertheless, as part of the qualitative and quantitative requirements for the use of models, an ultimate holding company must compute VaR on a daily basis as part of its internal risk management system.
We also are modifying paragraph (a)(2)(i) of Appendix G to clarify the method that an ultimate holding company must use to calculate allowances for market risk using VaR models. Under Appendix G, as adopted, an ultimate holding company calculates a group-wide allowance for market risk on all proprietary positions using a VaR model, then multiplies the VaR of those positions by an appropriate multiplication factor to provide an adequate measure of capital during periods of market stress. The VaR model used must meet the qualitative and quantitative requirements of paragraph (d) of Appendix E, as adopted.65 Likewise, the ultimate holding company must use a multiplication factor from
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Table 1 of paragraph (d) of Appendix E. The use of VaR is intended to be generally consistent with the calculation of the deduction for market risk for a broker-dealer under Appendix E and with the calculation of allowances for market risk under the Basel Standards.
iii. Group-Wide Calculation of Allowance for Credit Risk
We are modifying certain requirements for calculating the allowance for credit risk under paragraph (a)(3) of Appendix E, as adopted. Paragraph (a)(3) of proposed Appendix G would have required an ultimate holding company to calculate an allowance for credit risk for certain assets on the consolidated balance sheet and certain off-balance sheet items under either paragraph (a)(3)(i) or paragraph (a)(3)(ii). An ultimate holding company would have calculated the allowance for credit risk under paragraph (a)(3)(i) by multiplying the credit equivalent amount of each asset or off-balance sheet item by the appropriate credit risk weight 66 of that asset or off-balance sheet item, then multiplying that result by 8%.67 We are adopting the calculation of the allowance for credit risk in paragraph (a)(3)(i) of Appendix G as proposed, although we are revising the methods of determining the credit equivalent amount and credit risk weights.
Paragraph (a)(3)(i)(A)(2) of proposed Appendix G would have required a 5% credit conversion factor for margin loans. Several commenters stated that this factor was too high. According to one commenter, most margin loans are held in broker-dealers, where the application of customer margin requirements often exceed Federal Reserve requirements, and actual losses over many decades have been very small. Another commenter stated that the proposed conversion factor should be eliminated. A commenter also asserted that 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.
After considering the comments, we are not including the 5% credit conversion factor for margin loans contained in proposed paragraph (a)(3)(i)(A)(2). An ultimate holding company may apply to use the VaR- based exposure treatment under paragraph (a)(3)(i)(B) as a ''similar collateralized transaction.'' For unrated counterparties, the Commission could determine, after a review of the description of the margin loans in the application of the broker-dealer, that the margin loans could be treated as a pool with a very low loss history. In this case, the ultimate holding company could use internal estimates of exposure at default that consider the loss history for the pool.
Under proposed paragraph (a)(3)(i)(B), the credit equivalent amount of the ultimate holding company's exposure to a counterparty would have consisted of the ultimate holding company's current exposure to the counterparty and its maximum potential exposure, multiplied by the appropriate multiplication factor. We are adopting paragraph (a)(3)(i)(B) as proposed.
We are revising the definitions of ''current exposure'' and ''maximum potential exposure'' and adopting those revised definitions in paragraphs (a)(3)(i)(D) and (a)(3)(i)(E), respectively, of Appendix G. Paragraph (a)(3)(i)(C) of proposed Appendix G would have defined an ultimate holding company's current exposure to a counterparty as the current replacement value of a counterparty's positions, after applying specified netting agreements with the counterparty, taking into account the value of collateral from the counterparty, and subtracting the fair market value of any credit derivatives that specifically changed the exposure to the counterparty.
Under paragraph (a)(3)(i)(D) of Appendix G, as adopted, the definition of current exposure does not include a provision under which the ultimate holding company must subtract the fair market value of any credit derivatives that specifically change the exposure to a counterparty. Subtraction of the fair market value of credit derivatives could have reduced the allowance for credit risk without consideration of the ultimate holding company's credit risk exposure to the credit derivative counterparty. As part of the broker-dealer's application to use the alternative method for computing net capital or in an amendment to the application, however, the ultimate holding company may request Commission approval to reduce allowances for credit risk through the use of credit derivatives.68 Under paragraph (a)(3)(i)(D) of Appendix G, as adopted, the Commission will consider credit risk exposure to the credit derivative counterparty in determining whether to approve the ultimate holding company's application to reduce the allowance for credit risk through the use of credit derivatives.
The Commission also is revising the definition of maximum potential exposure under paragraph (a)(3)(i)(E) of Appendix G, as adopted. Paragraph (a)(3)(i)(D) of proposed Appendix G would have defined the MPE of a member of the affiliate group to a counterparty as the increase in the net replacement value of the counterparty's positions with the member of the affiliate group, after applying certain netting agreements, taking into account the value of certain collateral pledged to and held by the member of the affiliate group, and subtracting the fair market value of any credit derivatives that specifically change the ultimate holding company's exposure to the counterparty (as long as the credit derivatives are not used to change the credit risk weight of the counterparty) that is obtained using an approved VaR model meeting the applicable qualitative and quantitative requirements of paragraph (e) of Appendix E.69
As adopted, paragraph (a)(3)(i)(E) does not require an ultimate holding company to subtract the fair market value of any credit derivatives that change the ultimate holding company's exposure to a counterparty in calculating MPE. The Commission revised this language for the same reasons described in the section on the
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amendments to current exposure. Furthermore, under paragraph (a)(3)(i)(E), as adopted, an ultimate holding company must calculate MPE for repurchase agreements, reverse repurchase agreements, stock lending and borrowing, and similar collateralized transactions using a time horizon of not less than five days, rather than five days, as proposed. This revision clarifies that the Commission intended the time horizon to be a minimum period instead of an absolute period.
We note that under Appendix G, as adopted, an ultimate holding company may calculate MPE using a VaR model that meets the applicable qualitative and quantitative requirements of paragraph (d), rather than by using a ''notional add-on'' under the Basel Standards. We believe that the VaR approach is a more precise method of calculating MPE than using a ''notional add-on.'' Large U.S. broker-dealers and their affiliates with comprehensive internal risk management systems generally already have systems in place to calculate MPE using VaR models.
The Commission also is revising the methods of determining credit risk weights contained in paragraph (a)(3)(i)(F) of proposed Appendix G. Under proposed paragraph (a)(3)(i)(F), an ultimate holding company would have been required to use credit risk weights published by the Basel Committee. Paragraph (a)(3)(i)(F) of Appendix G, as adopted, permits an ultimate holding company to determine credit risk weights based on internal calculations, including internal estimates of the maturity adjustment. These determinations must be consistent with the Basel Standards. The ultimate holding company must follow the standards set forth in paragraph (c)(4)(vi)(E) of Appendix E in determining credit risk weights based on internal calculations.
Paragraph (a)(3)(i)(G) of proposed Appendix G would have permitted an ultimate holding company to determine credit ratings using internal calculations for counterparties that are not rated by an NRSRO. We are adopting paragraph (a)(3)(i)(G) of Appendix G as proposed, although we note that the ultimate holding company must follow the standards set forth in paragraph (c)(4)(vi)(D) of Appendix E in determining credit ratings based using internal calculations and that those determinations must be consistent with the Basel Standards. We are amending the provisions related to determination of credit risk weights and credit ratings applicable to the ultimate holding company to align them with the credit risk weight and credit risk provisions applicable to the broker-dealer. This alignment is intended to promote managerial and cost efficiencies.
Paragraph (a)(3) of proposed Appendix G would have required an ultimate holding company to calculate the group-wide allowance for credit risk daily. Commenters suggested that daily computation of the group-wide allowance for credit risk was unnecessary because the ultimate holding company only must report this information to the Commission monthly. In response to comments received, paragraph (a)(3) of Appendix G, as adopted, no longer requires daily computation of the allowance for credit risk. Rather, paragraph (c)(4) of Appendix G, as adopted, requires an ultimate holding company to compute and report its group-wide allowance for credit risk monthly. Nevertheless, as part of the qualitative and quantitative requirements for the use of models, an ultimate holding company must compute current exposure daily as part of its internal risk management system.
The Commission adopts the remaining provisions of paragraph (a)(3) of Appendix G as proposed.
iv. Group-Wide Calculation of Allowance for Operational Risk
Proposed paragraph (a)(4) would have required the calculation of the allowance for operational risk to be consistent with the proposed New Basel Capital Accord. The Basel Committee has proposed three methods for calculating an allowance for operational risk: The basic approach, the standardized approach, and the advanced measurement approach. The basic and standardized approach calculations are based on fixed percentages. Under the basic approach, the allowance is 15% of consolidated annual revenues, net of interest expense, averaged over the past three years. For the standardized approach, the allowance for operational risk is a percentage of revenues, net of interest expense, ranging from 12% to 18% for each of eight business lines. The advanced measurement approach requires a system for tracking and controlling operational risk and provides that the allowance for operational risk is the largest operational loss that might be expected over a one-year period with 99.9% confidence.
Commenters argued that the basic and standardized approaches to calculating operational risk under The New Basel Capital Accord are not risk-based and that the advanced measurement approach is too subjective (because of scarce data and skewing from infrequent extreme events) to be used to compute an allowance for operational risk. In addition, another commenter asserted that the proposed capital regime should include a flexible framework with respect to any calculation of operational risk.
We are adopting rules governing allowances for operational risk as proposed. It is important to account for the operational risk that the ultimate holding company and its affiliates may pose to the broker- dealer. Moreover, the rules are intended to provide ultimate holding companies with flex