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Monday,
June 21, 2004
Part II
Securities and
Exchange
Commission
17 CFR Parts 200 and 240
Alternative Net Capital Requirements for
Broker-Dealers That Are Part of
Consolidated Supervised Entities;
Supervised Investment Bank Holding
Companies; Final Rules
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SECURITIES AND EXCHANGE FOR FURTHER INFORMATION CONTACT: maintain the integrity of the securities
COMMISSION With respect to amendments to financial markets by improving oversight of
responsibility rules and books and broker-dealers and providing an
17 CFR Parts 200 and 240 records requirements, contact Michael incentive for broker-dealers to
[Release No. 34–49830; File No. S7–21–03] A. Macchiaroli, Associate Director, at implement strong risk management
(202) 942–0132, Thomas K. McGowan, practices. Furthermore, by supervising
RIN 3235–AI96 Assistant Director, at (202) 942–4886, the financial stability of the broker-
David Lynch, Financial Economist, at dealer and its affiliates on a
Alternative Net Capital Requirements (202) 942–0059, Rose Russo Wells, consolidated basis, the Commission may
for Broker-Dealers That Are Part of Attorney, at (202) 942–0143, Bonnie L. monitor better, and act more quickly in
Consolidated Supervised Entities Gauch, Attorney, at (202) 942–0765, or response to, any risks that affiliates and
AGENCY: Securities and Exchange Matthew B. Comstock, Attorney, at (202) the ultimate holding company may pose
Commission (‘‘Commission’’). 942–0156, Division of Market to the broker-dealer.
Regulation, Securities and Exchange These amendments are intended to
ACTION: Final rule.
Commission, 450 Fifth Street, NW., reduce regulatory costs for broker-
SUMMARY: We are adopting rule Washington, DC 20549–1001. dealers by allowing very highly
amendments under the Securities With respect to general questions, capitalized firms that have developed
Exchange Act of 1934 that establish a contact Linda Stamp Sundberg, robust internal risk management
voluntary, alternative method of Attorney Fellow, at (202) 942–0073, practices to use those risk management
computing deductions to net capital for Division of Market Regulation, practices, such as mathematical risk
certain broker-dealers. This alternative Securities and Exchange Commission, measurement models, for regulatory
method permits a broker-dealer to use 450 Fifth Street, NW., Washington, DC purposes. A broker-dealer’s deductions
mathematical models to calculate net 20549–1001. for market and credit risk probably will
capital requirements for market and SUPPLEMENTARY INFORMATION: The be lower under the alternative method
derivatives-related credit risk. A broker- Securities and Exchange Commission is of computing net capital than under the
dealer using the alternative method of amending § 200.19 and Rules 30–3, standard net capital rule.
computing net capital is subject to 15c3–1, 17a–4, 17a–5, 17a–11, 17h–1T,
A. Broker-Dealer Requirements
enhanced net capital, early warning, and 17h–2T under the Securities
recordkeeping, reporting, and certain Exchange Act of 1934 (‘‘Exchange Act’’). The alternative method of computing
other requirements, and must We proposed amendments on net capital responds to the firms’
implement and document an internal consolidated supervised entities for requests to align their supervisory risk
risk management system. Furthermore, comment in October of 2003.1 management practices and regulatory
as a condition to its use of the capital requirements more closely.
I. Introduction Under the alternative method, firms
alternative method, a broker-dealer’s
The Commission is amending Rule with strong internal risk management
ultimate holding company and affiliates
15c3–1 2 (the ‘‘net capital rule’’) under practices may utilize mathematical
(referred to collectively as a
the Securities Exchange Act of 1934 (the modeling methods already used to
consolidated supervised entity, or
‘‘Exchange Act’’) to establish a manage their own business risk,
‘‘CSE’’) must consent to group-wide
voluntary, alternative method of including value-at-risk (‘‘VaR’’) models
Commission supervision. This
computing net capital for certain broker- and scenario analysis, for regulatory
supervision would impose reporting
dealers. Under the amendments, a purposes.
(including reporting of a capital
broker-dealer that maintains certain A broker-dealer that applies to the
adequacy measurement consistent with
minimum levels of tentative net capital Commission for an exemption from the
the standards adopted by the Basel and net capital may apply to the standard net capital rules also must
Committee on Banking Supervision), Commission for a conditional comply with specific requirements
recordkeeping, and notification exemption from the application of the designed to address various types of
requirements on the ultimate holding standard net capital calculation. As a risks that the broker-dealer assumes. A
company. The ultimate holding condition to granting the exemption, the broker-dealer is eligible to use the
company (other than an ‘‘ultimate broker-dealer’s ultimate holding alternative method of computing net
holding company that has a principal company 3 must consent to group-wide capital only if it maintains tentative net
regulator’’) and its affiliates also would Commission supervision.4 The capital 5 of at least $1 billion and net
be subject to examination by the amendments should help the capital of at least $500 million.6 If the
Commission. In addition, we have Commission to protect investors and tentative net capital of a broker-dealer
modified the proposed rule
calculating net capital under this
amendments on Commission 1 Exchange Act Release No. 48690 (Oct. 24, 2003),
alternative method falls below $5
supervision of an ‘‘ultimate holding 68 FR 62872 (Nov. 6, 2003) (‘‘Proposing Release’’).
billion, the broker-dealer must notify
company that has a principal regulator’’ 2 17 CFR 240.15c3–1.
the Commission and the Commission
to avoid duplicative or inconsistent 3 We will review, on a case-by-case basis, the
broker-dealer’s designation of its ultimate holding then would consider whether the
regulation. Finally, we are amending the company in its application to use the alternative broker-dealer must take appropriate
risk assessment rules to exempt a method of computing net capital. remedial action.7
broker-dealer using the alternative We use the term ‘‘ultimate holding company’’ in In addition, a broker-dealer that uses
method of computing net capital from the final rules, rather than the term ‘‘holding
the alternative method must have in
those rules if its ultimate holding company’’ that we used in the proposed rules.
4 If a broker-dealer were the ultimate parent place comprehensive internal risk
company does not have a principal company of its affiliate group, it would be management procedures that address
regulator. The rule amendments are considered the ultimate holding company for market, credit, liquidity, legal, and
intended to improve our oversight of purposes of these amendments. The ultimate
broker-dealers and their ultimate holding company may not be a natural person.
5 See 17 CFR 240.15c3–1(c)(15).
Nothing in these amendments is intended to create
holding companies. a preference for one organizational structure over 6 17 CFR 240.15c3–1(a)(7)(i).
EFFECTIVE DATE: August 20, 2004. another. 7 17 CFR 240.15c3–1(a)(7)(ii).
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operational risk at the firm. These by the Basel Committee on Banking individuals, and one from another
requirements are designed to help Supervision (‘‘Basel Committee’’). regulator.
ensure the integrity of the broker- In response to comments about bank The majority of commenters endorsed
dealer’s risk measurement, monitoring, holding companies, we have revised the the Commission’s initiative to permit
and management process and to clarify proposed rules for an ultimate holding certain broker-dealers to use the
accountability, at the appropriate company that has a principal regulator. alternative method of computing net
organizational level, for defining the Generally, under the final rules, this capital. These commenters supported
permitted scope of activity and level of type of ultimate holding company is not the alternative capital calculation for
risk. Furthermore, a broker-dealer must subject either to Commission broker-dealers that have developed
provide the Commission with specified examination or those rules requiring mathematical models for measuring risk
financial, operational, and risk internal risk management controls and group-wide internal risk
management information on a monthly, outside of the broker-dealer and is management control systems to control
quarterly, and annual basis. subject to reduced reporting, risk. One commenter, however,
recordkeeping, and notification questioned the use of models to the
B. Ultimate Holding Company requirements. extent that it would lower broker-dealer
Requirements The rule amendments also respond to capital requirements, and some
As a condition to a broker-dealer’s use international developments. Affiliates of commenters questioned the
of the alternative method of computing certain U.S. broker-dealers that conduct Commission’s statutory authority to
net capital, the rule amendments require business in the European Union (‘‘EU’’) adopt the proposal.
a broker-dealer’s ultimate holding have stated that they must demonstrate The commenters that supported the
company, if that ultimate holding that they are subject to consolidated proposal suggested that the Commission
company does not have a principal supervision at the ultimate holding modify the proposed rule amendments
regulator, to consent to certain company level that is ‘‘equivalent’’ to in various ways. Bank holding
undertakings. In particular, the ultimate EU consolidated supervision.9 companies generally supported the
holding company must: Commission supervision incorporated alternative capital computation, but
• Provide information about the into these rule amendments is intended expressed concern that the proposal
financial and operational condition of to meet this standard. As a result, we could impose duplicative and
the ultimate holding company. believe these amendments will inconsistent requirements on holding
Specifically, it must provide the minimize duplicative regulatory companies and their affiliates that are
Commission with certain capital and burdens on firms that are active in the subject to comprehensive consolidated
risk exposure information provided to EU as well as in other jurisdictions that supervision by the Federal Reserve and
the ultimate holding company’s senior may have similar laws. non-domestic financial regulators.
risk managers. This information would II. Proposing Release and Comments Generally, commenters addressed
include market and credit risk various aspects of the methods for
The Commission proposed rule
exposures, as well as an analysis of the calculating deductions for market and
amendments in October 2003 that
ultimate holding company’s liquidity credit risk at the broker-dealer level and
would have established a voluntary,
risk; allowable capital at the ultimate holding
alternative method for computing net
• Comply with rules regarding the company level. They also stated that the
capital charges for certain broker-
implementation and documentation of a Commission should be flexible in
dealers. In the Proposing Release, the
comprehensive, group-wide risk permitting firms to use interim methods
Commission solicited both general
management system for identifying, to calculate allowable capital at the
comments on the proposal and specific
measuring, and managing market, ultimate holding company level until
comments on each rule amendment.
credit, liquidity, legal, and operational The Commission received 20 implementation of the New Basel
risk; comment letters in response to the Capital Accord. Some commenters
• Consent to Commission proposed rule amendments: Five from urged the Commission to take measures
examination of the ultimate holding broker-dealers or broker-dealer holding to ensure the confidentiality of
company and its material affiliates; and companies, five from bank holding information that the Commission
• As part of its reporting companies subject to supervision by the obtains as a result of the proposed rules
requirements, compute, on a monthly Board of Governors of the Federal and rule amendments. Commenters also
basis, group-wide allowable capital and Reserve System (‘‘Federal Reserve’’) or a suggested that the Commission align
allowances for market, credit, and non-domestic ‘‘comprehensive CSE reporting requirements with public
operational risk in accordance with the consolidated supervisor,’’ one from a company and other reporting
standards (‘‘Basel Standards’’) 8 adopted securities industry representative, six requirements.
from U.S. and international banking Comments on specific rule
8 The central bank governors of the Group of Ten
industry representatives, two from amendments and the Commission’s
countries (‘‘G–10 countries’’) established the Basel
Committee in 1974 to provide a forum for ongoing
response to those comments are
cooperation among member countries on banking year-end 2006, and implementation of the most discussed below in the descriptions of
supervisory matters. Its basic consultative papers advanced approaches by year-end 2007. the final rule amendments.
are: the Basel Capital Accord (1988), the Core 9 EU ‘‘consolidated supervision’’ consists of a
Principles for Effective Banking Supervision (1997), series of quantitative and qualitative rules, imposed III. Final Rule Amendments
and the Core Principles Methodology (1999). The at the level of the ultimate holding company,
Basel Standards establish a common measurement regarding firms’ internal controls, capital adequacy, A. General
system, a framework for supervision, and a intra-group transactions, and risk concentration.
minimum standard for capital adequacy for Without a demonstration of ‘‘equivalent’’
After considering the comment letters,
international banks in the G–10 countries. The supervision, U.S. securities firms have expressed we are adopting rule amendments that
Basel Committee is currently developing a new concerns that an affiliate institution located in the provide broker-dealers with a voluntary,
international agreement (the ‘‘proposed New Basel EU either may be subject to additional capital alternative method of computing net
Capital Accord’’). It expects to issue a final version charges or be required to form a sub-holding
of the New Basel Capital Accord by the end of June company in the EU. See ‘‘Directive 2002/87/EC of
capital that permits very highly
2004, with an effective date for implementation of the European Parliament and of the Council of 16 capitalized broker-dealers to use their
the standardized and foundation approaches by December 2002.’’ internal mathematical models for net
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capital purposes, subject to specified the extent permitted by the net capital broker-dealer’s application for
conditions. Generally, we revised the rule, to support an affiliate experiencing exemption from the standard net capital
rule amendments related to the broker- financial difficulty. While this shift of rule as well as reduced notification and
dealer’s and the ultimate holding assets alone would not violate the net recordkeeping requirements.
company’s computation of net capital capital rule, it could make it more likely We have included what we believe
and allowable capital, respectively. We that the firm would fail during volatile are prudent parameters for measurement
also revised the rule amendments with market conditions. of a broker-dealer’s deductions for
respect to broker-dealers that are To help ensure that the Commission
market and credit risk and allowances
affiliated with ultimate holding can obtain information necessary to
for risk for its ultimate holding
companies that have principal monitor the financial well-being of a
broker-dealer, a broker-dealer may use company, although in some cases these
regulators.
As stated in the Proposing Release, the alternative method of computing net parameters may be more conservative
the Commission has broad authority capital only if its ultimate holding than some firms may believe are
under Exchange Act section 15(c)(3) to company agrees to provide the necessary to account for risk. For
adopt rules and regulations regarding Commission’s with additional example, we have adopted, as proposed,
the financial responsibility of broker- information about the financial rules that require the VaR model used
dealers that we find are necessary or condition of the ultimate holding to calculate market risk for the broker-
appropriate in the public interest or for company and its affiliates. For an dealer to be based on a ten business-day
the protection of investors.10 The ultimate holding company that does not movement in rates and prices and
Commission has promulgated various have a principal regulator, this financial calculated using a 99% confidence
rules under this provision regarding net information includes a monthly level. The VaR measure then must be
capital requirements 11 and protection of computation of group-wide allowable multiplied by a factor of at least three.
customer property.12 As part of our capital and allowances for market, These parameters are based on our
oversight of broker-dealers, we receive credit, and operational risk calculated in experience and existing Commission
financial and risk management accordance with the Basel Standards. rules and rules of other regulatory
information about broker-dealers, their This type of ultimate holding company agencies where there are similar risk
holding companies, and their affiliates. also must provide the Commission with factors in the regulated entities.
The rules and the information received specified financial, operational, and risk
B. Amendments to Paragraphs (a) and
have assisted the Commission and the management information on a monthly,
(c) of Rule 15c3–1
self-regulatory organizations (‘‘SROs’’) quarterly, and annual basis. Moreover,
in identifying, at an early stage, firms an ultimate holding company that does 1. Minimum and Early Warning Capital
that are experiencing financial not have a principal regulator must Requirements
problems. implement and maintain a consolidated
The principal purposes of Exchange internal risk management control We are revising proposed paragraph
Act Rule 15c3–1 (the ‘‘net capital rule’’) system and procedures to monitor and (a)(7) of Rule 15c3–1. As proposed,
are to protect customers and other manage group-wide risk, including paragraph (a)(7) of Rule 15c3–1 would
market participants from broker-dealer market, credit, funding, operational, and have permitted the Commission to
failures and to enable those firms that legal risks, and make and maintain approve, in whole or part, a broker-
fall below the minimum net capital certain books and records. Both the dealer’s application, or amendment to
requirements to liquidate in an orderly ultimate holding company and its an application, to use the alternative
fashion without the need for a formal affiliates that do not have principal method of computing net capital.
proceeding or financial assistance from regulators must consent to Commission Proposed paragraph (a)(7) also would
the Securities Investor Protection examination. have required the broker-dealer to
Corporation. The net capital rule Under the final rules, an ultimate maintain at all times tentative net
requires different minimum levels of holding company that has a principal capital of at least $1 billion and net
capital based upon the nature of the regulator is subject to substantially capital of at least $500 million.
firm’s business and whether the broker- fewer requirements than one that does
In the Proposing Release, we
dealer handles customer funds or not have a principal regulator. As a
requested comment on whether the
securities. condition to its affiliated broker-dealer’s
proposed required minimum levels of
Ultimate holding companies that own use of the alternative method of
computing net capital, this category of tentative net capital and net capital
large broker-dealers also may own many
ultimate holding company consents to described in proposed paragraph (a)(7)
other entities. These affiliated entities
provide the Commission, on a quarterly of Rule 15c3–1 should be raised or
may engage in both securities and non-
basis, with the capital measurements lowered. One commenter stated that we
securities activities worldwide. Broker-
that it submits to its principal regulator, should permit a broker-dealer with
dealer holding company structures vary
consolidated and consolidating balance tentative net capital of less than $1
and may be quite complex. Depending
sheets and income statements, and billion to use the alternative net capital
upon the nature of these structures,
certain regular risk reports provided to computation if it is an affiliate of an
broker-dealers may incur risks because
the persons responsible for managing international bank with consolidated
of their affiliation with unregistered
group-wide risk. Annually, an ultimate capital of over $1 billion. Another
entities. For example, a broker-dealer’s
holding company that has a principal commenter asserted that ‘‘the
access to short-term funding may be
regulator must provide audited Commission should permit other
affected by the insolvency of an affiliate.
consolidated balance sheets and income broker-dealers in the CSE group-wide
In addition, management at the ultimate
statements and capital measurements, as affiliate structure’’ to use the alternative
holding company level may attempt to
submitted to its principal regulator. An method of computing net capital even if
divert capital from the broker-dealer, to
ultimate holding company that has a those broker-dealers do not meet the
10 15 U.S.C. 78o(c)(3). principal regulator also is subject to minimum capital levels. These
11 17 CFR 240.15c3–1. more limited undertaking and comments, however, do not take into
12 17 CFR 240.15c3–3. information requirements related to the account certain regulatory and
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bankruptcy considerations.13 alternative net capital computation will Commenters also stated that the
Accordingly, we are adopting the $1 reduce deductions for market and credit Commission could better use its
billion tentative net capital and $500 risk substantially for broker-dealers that resources to supervise holding
million net capital requirements as use that method. Moreover, inclusion in companies that do not otherwise have
proposed, but are setting forth these net capital of unsecured receivables and principal regulators. Moreover,
requirements in paragraph (a)(7)(i) of securities that do not have a ready commenters urged the Commission to
Rule 15c3–1 in the final rules. market under the current net capital provide as much clarity as possible,
We also are adding a new requirement rule will reduce the liquidity standards both for regulated entities and
to paragraph (a)(7) of Rule 15c3–1, as of Rule 15c3–1. Thus, the alternative consolidated supervisors, about
adopted. The final rules incorporate method of computing net capital and, in provisions intended to avoid
changes to the proposed rules that may particular, its requirements that broker- duplicative or inconsistent
allow firms to take smaller deductions dealers using the alternative method of requirements.
for market and credit risk than the computing maintain minimum tentative In response to these comments, we are
proposed rules would have permitted. net capital of at least $1 billion, adopting a revised definition of ‘‘entity
Consequently, the final rules add maintain net capital of at least $500 that has a principal regulator’’ and
paragraph (a)(7)(ii), which requires a million, notify the Commission that adding a definition of an ‘‘ultimate
broker-dealer to notify the Commission same day if their tentative net capital holding company that has a principal
if the broker-dealer’s tentative net falls below $5 billion, and comply with regulator.’’ Creation of two definitions
capital falls below $5 billion. This $5 Rule 15c3–4 are intended to provide should help to clarify the scope of
billion early warning requirement is broker-dealers with sufficient capital paragraph (c)(13) of Rule 15c3–1. We
based upon the staff’s experience and reserves to account for market, credit, will not examine any entity that has a
the current levels of net capital operational, and other risks. principal regulator and we will use the
maintained by the broker-dealers most reports that it files with its principal
2. Entities That Have Principal regulator for our regulatory purposes, to
likely to apply to use the alternative Regulators
method of computing net capital. Upon the greatest extent possible.
written application, however, the We are revising proposed paragraph Under the revised definition in
Commission may exempt, either (c)(13) of Rule 15c3–1. Proposed paragraph (c)(13)(i) of Rule 15c3–1, an
unconditionally or on specified terms paragraph (c)(13) would have defined an entity that has a principal regulator
and conditions, a broker-dealer from the ‘‘entity that has a principal regulator’’ as includes certain functionally regulated
$5 billion early warning requirement. a person (other than a natural person) affiliates of the ultimate holding
To obtain an exemption, the broker- that is not a registered broker-dealer company that are not registered as a
dealer must satisfy the Commission that (other than a broker-dealer registered broker or dealer.16 Entities that have
because of the special nature of the under section 15(b)(11) of the Exchange principal regulators include insured
firm’s business, its financial positions, Act) and that belongs to one of two depository institutions; futures
its internal risk management systems, categories. Proposed paragraph commission merchants or introducing
and its compliance history, among other (c)(13)(i), the first category, would have brokers registered with the Commodity
factors, application of the requirement is included insured depository Futures Trading Commission; entities
unnecessary or inappropriate in the institutions, entities registered with the registered with or licensed by a State
Commodities Futures Trading insurance regulator that issues any
public interest or for the protection of
Commission, or licensed or regulated insurance, endowment, or annuity
investors.
We also are revising Rule 15c3–1 to insurance companies. Proposed policy or contract; and certain foreign
add paragraph (a)(7)(iii). Paragraph paragraph (c)(13)(ii), the second banks.17
(a)(7)(iii) generally requires a broker- category, would have included bank Paragraph (c)(13)(i) also includes Edge
dealer that computes deductions for holding companies, savings and loan Act and Agreement Corporations,
market and credit risk under Appendix holding companies, and foreign banks provided they are not primarily in the
E to comply with Rule 15c3–4 14 as that do business in the U.S. The securities business. We added these
proposed rules would have required entities to the definition of entity that
though it were an OTC derivatives
entities in this second category to have has a principal regulator because they
dealer. Paragraph (a)(7)(iii) replaces
in place appropriate arrangements to are subject to supervision by the Federal
proposed amendments to Rule 15c3–4
ensure that information provided to the Reserve. Under these rules, the
and is discussed in greater detail in the
Commission was sufficiently reliable for Commission may examine Edge Act and
section of this release that addresses
the purposes of proposed Appendix E Agreement Corporations that primarily
that rule.
The requirements of paragraph (a)(7), and proposed Appendix G. The are in the securities business.18
proposed rules also would have
as revised, are intended to help ensure
required these entities to be primarily in 16 This reference is to brokers or dealers registered
that a broker-dealer maintains prudent
the insured depository institutions under section 15(b)(11) of the Act (15 U.S.C.
amounts of liquid assets against various 78o(b)(11)).
business (excluding their insurance and
risks that it assumes and that it maintain 17 This category is limited to a foreign bank as
commercial businesses).
a robust internal risk management Several commenters stated that the
defined in section 1(b)(7) of the International
system. The current haircut structure Banking Act of 1978 (12 U.S.C. 3101(7)) that has its
Commission should revise the proposed headquarters in a jurisdiction for which any foreign
seeks to ensure that broker-dealers rules to minimize duplicative or bank has been approved by the Federal Reserve to
maintain a sufficient capital base to inconsistent requirements for holding conduct business pursuant to the standards set forth
account for operational, leverage, and companies that are subject to another in 12 CFR 211.24(c), provided such foreign bank
liquidity risk, in addition to market and represents to that Commission that it is subject to
regulator’s consolidated supervision.15 the same supervisory regime as the foreign bank
credit risk. We expect that use of the previously approved by the Federal Reserve.
15 See, e.g., Letter from Messrs. Michael J. Alix 18 The Federal Reserve charters an ‘‘Edge Act
13 Bankruptcy or other statutes, rules, and and Mark W. Holloway, Co-Chairs, CSE Steering Corporation’’ to engage in international banking.
regulations may restrict transfers from an entity in Committee of the Securities Industry Association, to Section 25A of the Federal Reserve Act (12 U.S.C.
bankruptcy. Jonathan G. Katz, Secretary, U.S. Securities and 611–633). A state charters an ‘‘Agreement
14 17 CFR 240.15c3–4. Exchange Commission, dated February 27, 2004. Continued
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We also added paragraph (c)(13)(i)(F) connection with financial holding as an ultimate holding company that has
of Rule 15c3–1 to the final rules. Under company elections by foreign banks, the a principal regulator.25
this paragraph, the Commission may Federal Reserve also evaluates any
3. Tentative Net Capital
determine if other types of entities foreign bank that operates a branch or
subject to comprehensive supervision agency, or owns or controls a We are adopting an amended
by other regulators qualify as entities commercial lending company in the definition of tentative net capital. The
that have principal regulators.19 United States under capital and proposed amendment to paragraph
The new definition of ultimate management standards that are (c)(15) of Rule 15c3–1 would have
holding company that has a principal comparable to the standards applicable defined ‘‘tentative net capital’’ for a
regulator in paragraph (c)(13)(ii) to U.S. banks and gives due regard to broker-dealer using the alternative
recognizes the concept of the principle of national treatment and method of computing net capital as the
comprehensive, consolidated equality of competitive opportunity.22 net capital of the broker or dealer before
supervision. Any financial holding For these foreign banking organizations, deductions for market and credit risk
company or a company that is treated as the Federal Reserve also reviews computed pursuant to Appendix E to
a financial holding company under the whether they are subject to Rule 15c3–1 or paragraph (c)(2)(vi) of
Bank Holding Company Act of 1956 20 comprehensive consolidated Rule 15c3–1, if applicable, and
will be considered an ultimate holding supervision.23 The Federal Reserve has increased by the balance sheet value
company that has a principal regulator. found that home country supervision is (including counterparty net exposure)
Accordingly, any U.S. holding company an important element in determining if resulting from transactions in derivative
or foreign bank that has elected a bank is well managed.24 instruments that otherwise would be
financial holding company status will deducted by virtue of paragraph
Based on these requirements, we
be an ultimate holding company that (c)(2)(iv) of Rule 15c3–1.
would not examine financial holding We are amending the definition of
has a principal regulator. companies or companies that are treated
By adopting this new definition of an tentative net capital to include
as financial holding companies. In securities for which there is no ready
ultimate holding company that has a addition, under the rules as adopted,
principal regulator, we are recognizing market, as that term is defined under
these entities are subject to a paragraph (c)(2)(11) of the net capital
the comprehensive, consolidated streamlined application process, fewer
supervision of both the Federal Reserve rule. This modification is necessary
periodic reporting requirements, and because, as discussed below, we
and non-domestic bank regulators. In may submit to the Commission the same
addition, because we will consider the eliminated the requirement that a
measurement of capital that they submit security have a ready market to qualify
entity that elected to be treated as a to their primary regulator. Inclusion of
financial holding company to be an for capital treatment using VaR models.
these entities in the definition of Under the final rules, a broker-dealer
ultimate holding company that has a ‘‘ultimate holding company that has a
principal regulator, we will not need to may include securities for which there
principal regulator’’ is intended reduce is no ready market in calculating
look for a higher holding company level duplicative or inconsistent regulation
within a consolidated group. We also tentative net capital under the
because these entities already are alternative method only if the
understand that all of the banking subject to the reporting and examination
organizations that have expressed Commission has approved the use of
requirements of the Federal Reserve. mathematical models for purposes of
interest in the CSE proposal would
Under paragraph (c)(13)(ii)(B), the calculating deductions to net capital for
qualify as financial holding companies
Commission may determine that other those securities pursuant to Appendix
or as companies that are treated as
persons also should be included as E.
financial holding companies.
A bank holding company may elect to ultimate holding companies that have
C. Broker-Dealer Requirements Under
become a financial holding company principal regulators if it finds that the
Appendix E
and be eligible to engage in expanded persons are subject to consolidated,
comprehensive supervision; there are in Appendix E to Exchange Act Rule
financial activities if it is ‘‘well 15c3–1 describes the alternative method
capitalized’’ and ‘‘well managed.’’ 21 In place appropriate arrangements so that
information provided to the of computing net capital that a broker-
Commission is sufficiently reliable for dealer may use, including related
Corporation’’ to engage in international banking
activities. The Agreement Corporation enters into the purposes of determining compliance application requirements. It also
an ‘‘agreement’’ with the Federal Reserve to limit with Appendix E and Appendix G; and imposes requirements regarding internal
its activities to those that an Edge Act Corporation based on the persons’ businesses, it is risk management controls and reporting,
may undertake. Section 25 of the Federal Reserve and describes additional supervisory
Act (12 U.S.C. 601–604a). The purpose of both Edge
appropriate to consider the persons
Act Corporations and Agreement Corporations is to ultimate holding companies that have conditions that the Commission may
aid in financing and stimulating foreign trade. principal regulators for the purposes of impose on the broker-dealer in
These entities may engage only in international Appendix E and Appendix G. An appropriate circumstances.26 Under the
banking or other financial transactions related to
affiliated broker-dealer of a domestic final rules, once a broker-dealer has
international business. The Board of Governors submitted an application, the
approves or denies applications to establish Edge entity or a foreign bank that has not
Act Corporations and also examines both Edge Act elected to be treated as a financial Commission will review how the firm
and Agreement Corporations and their subsidiaries. holding company could apply to use the manages its market, credit, liquidity and
19 The Commission will determine if there are in
alternative method of computing net
place appropriate arrangements so that information 25 This paragraph also governs the application of
that the person provides to the Commission is capital. Paragraph (c)(13)(ii)(B) permits a savings and loan holding company as defined in
sufficiently reliable for the purposes of determining us to consider whether, in appropriate Section 10(a)(1)(D) of the Home Owners’ Loan Act
compliance with Appendices E and G, and it is circumstances, the Commission should (12 U.S.C. 1467a(1)(D)).
appropriate to deem the person to be an entity that treat the domestic entity or foreign bank 26 We have replaced old Appendix E. Old
has a principal regulator considering all relevant Appendix E outlined a phase-in schedule for
circumstances, including the person’s mix of increased minimum net capital requirements for
business. 22 12 U.S.C. 1843(l)(3) and 12 CFR 225.90. broker-dealers. The increased net capital minimums
20 12 U.S.C. 1840 et seq. 23 12 CFR 225.92(e). were fully effective as of July 1, 1994. Exchange Act
21 12 U.S.C. 1843(l)(1) and 12 CFR 225.81(b). 24 Id. Release No. 31511.
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funding, legal, and operational risk, and rule and all submissions in connection the Commission generally will not
its mathematical models, to determine if with the application will be accorded publish or make available to any person
the broker-dealer has met the confidential treatment, to the extent matters that are ‘‘contained in, or related
requirements of Appendix E and is permitted by law. We received to, any examination, operating, or
complying with other applicable rules. comments expressing some concern condition report prepared by, on behalf
The Commission also will review with the Commission’s ability to of, or for the use of, the Commission,
whether the broker-dealer’s ultimate maintain the confidentiality of any other Federal, state, local, or foreign
holding company is complying with the documents and information filed with governmental authority or foreign
terms of the undertaking that it agrees the Commission under these rules. securities authority, or any securities
to provide as a condition of the broker- Under the final rules, broker-dealers and industry self-regulatory organization,
dealer’s use of the alternative method of ultimate holding companies will submit responsible for the regulation or
computing net capital. information to the Commission based on supervision of financial institutions.’’ 30
1. Application their understanding that the information Significantly, the courts have ruled
Under proposed paragraph (a) of will remain confidential. The consistently that Exemption 8 provides
Appendix E, a broker-dealer would have information that we expect to receive categorical protection for information
applied to the Commission for an from these entities is, by its nature, related to such reports.
exemption from the standard net capital competitively sensitive. For example,
c. Commission Review
rule and for permission to calculate we understand that broker-dealers and
certain deductions for market and credit their holding companies have a Paragraph (a)(6) of proposed
risk in accordance with Appendix E.27 commercial interest in their risk models, Appendix E would have permitted the
Proposed paragraph (a) described the risk management systems and processes, Commission to approve a broker-
various types of information that the and data that they obtain through use of dealer’s application to use the
broker-dealer would have submitted to these models, systems, and processes. alternative method of computing net
allow the Commission to determine We also have been advised that if the capital, subject to the imposition of any
whether an exemption from the net Commission were unable to afford conditions or limitations that the
capital rule was necessary or confidential protection to the Commission found were necessary or
appropriate in the public interest or for information that we expect to receive appropriate in the public interest or for
the protection of investors. from broker-dealers and their ultimate the protection of investors, after a
holding companies, firms may hesitate review of whether the broker-dealer met
a. Information To Be Submitted by the to apply for the exemption from the the requirements of Appendix E; the
Broker-Dealer standard net capital rule and consent to broker-dealer was in compliance with
As proposed, paragraph (a)(1) of Commission supervision at the ultimate other, applicable Exchange Act
Appendix E would have required a holding company level. This result provisions or rules or rules of a self-
broker-dealer that applied to use the would undermine and jeopardize the regulatory organization; and the
alternative method of computing net viability of the CSE system. ultimate holding company was in
capital to include with its application The Freedom of Information Act compliance with applicable terms of its
financial, risk management, and other (‘‘FOIA’’) provides at least two undertaking, which are conditions for
information about the firm. Specifically, exemptions under which the the approval. We did not receive
broker-dealers would have been Commission has authority to grant comments on this provision and the
required to submit to the Commission a confidential treatment for applications Commission is redesignating paragraph
description of their internal risk filed under this rule. First, FOIA (a)(6) as paragraph (a)(7) of Appendix E
management control system and how Exemption 4 provides an exemption for and adopting it as proposed, with one
that system satisfies the requirements of ‘‘trade secrets and commercial or exception.31 We clarify in paragraph
Rule 15c3–4, together with a description financial information obtained from a (a)(7), as adopted, that the Commission
of the method the broker-dealer person and privileged or also must approve amendments to a
intended to use to calculate deductions confidential.’’ 29 As specified in broker-dealer’s application to use the
to net capital. We did not receive paragraph (a)(5) of new Appendix E, alternative method of computing net
substantive comments on this rule ‘‘all information submitted in capital. Furthermore, note that
related to information to be submitted connection with the application will be paragraph (a)(1)(ix)(D), which describes
accorded confidential treatment to the the undertaking that an ultimate holding
about the broker-dealer and paragraph
extent permitted by law.’’ The company that has a principal regulator
(a)(1) of Appendix E has been adopted
information to be filed with the must provide as a condition of its
as proposed.28
Commission concerns firms’ trading affiliated broker-dealer’s exemption
b. Confidential Treatment strategies, risk profiles, financial from the standard net capital rule, limits
A broker-dealer’s application for positions, and other information that is the conditions that the Commission may
exemption from the standard net capital protected from disclosure under place on an ultimate holding company
Exemption 4. that has a principal regulator in
27 From time to time, the broker-dealer will Second, FOIA Exemption 8 provides
submit amendments to its application. For example, an exemption for matters that are 30 See 5 U.S.C. 552(b)(4).
the broker-dealer will be required to submit an ‘‘contained in or related to examination, 31 In its undertaking, an ultimate holding
amendment to its application if it materially operating, or condition reports prepared company agrees to comply with the applicable
amends a VaR model that it uses to calculate a provisions of Appendices E and G as a condition
deduction for market or credit risk.
by, on behalf of, or for the use of an
to the broker-dealer’s use of the alternative method
28 As described below, however, the Commission agency responsible for the regulation or of computing net capital. Appendix E, for example,
has amended the undertaking provisions of supervision of financial institutions.’’ requires a broker-dealer to include specified
paragraph (a)(1) to describe separately the Similarly, Commission Rule 80(b)(8), information from the ultimate holding company
requirements for an undertaking that a broker- Commission Records and Information, with the broker-dealer’s application to compute
dealer must submit for an ultimate holding deductions for market and credit risk under
company that does not have a principal regulator implementing Exemption 8, states that Appendix E. If the ultimate holding company did
and an ultimate holding company that has a not produce the requisite information, it would not
principal regulator. 29 See 5 U.S.C. 552(b)(4). be in compliance with the terms of its undertaking.
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approving the broker-dealer’s exemption commenter also asserted the a broker-dealer must be in compliance
application.32 Commission should limit revocation of with net capital requirements at all
Paragraph (a)(7) of proposed the exemption ‘‘to instances in which times.
Appendix E would have required a the Commission finds a material capital Under paragraphs (c)(1) and (2) of
broker-dealer to amend and resubmit to deficiency or a substantial pattern of proposed Appendix E, the deduction for
the Commission its application for material non-compliance.’’ market risk would have been equal to
exemption from the standard net capital In response to comments received, we the amount of the sum of the following:
rule if the broker-dealer desired to are amending paragraph (a)(10). We also (i) For positions for which the
change materially a mathematical model are redesignating paragraph (a)(10) as Commission has approved the use of
used to calculate deductions for market paragraph (a)(11) in Appendix E, as VaR models, the VaR of those positions
or credit risk or its internal risk adopted. Paragraph (a)(11) adds a multiplied by the appropriate
management control system. We did not description of the factors that the multiplication factor; (ii) for positions
receive comment on this requirement Commission will rely evaluate in for which the Commission has approved
and are redesignating paragraph (a)(7) as determining whether to revoke a broker- the use of scenario analysis, the greatest
paragraph (a)(8) and adopting it as dealer’s exemption from the net capital adverse movement of the positions, or
proposed. rule. Specifically, the Commission will some multiple thereof based on
Paragraph (a)(8) of proposed consider the compliance history of the liquidity or, if greater, a minimum
Appendix E would have required a broker-dealer related to its use of deduction; and (iii) for all other
broker-dealer to report any material models, the financial and operational positions, a deduction under the
changes to its or its ultimate holding strength of the broker-dealer and its standard haircut method of paragraph
company’s corporate structure. The final ultimate holding company, and the (c)(2)(vi) Rule 15c3–1.
rules do not include this notification broker-dealer’s compliance with its Paragraph (b) 34 of Appendix E, as
requirement because it is redundant. internal risk management controls. adopted, describes the method of
The Commission will receive computing a broker-dealer’s deduction
2. Risk Management Control System for market risk. A broker-dealer’s
notification of the changes as part of the
regular filings that the ultimate holding Under proposed paragraph (b) of deduction for market risk under
company submits under paragraph (b) of Appendix E, a broker-dealer using the paragraph (b) is an amount equal to the
Appendix G. alternative method of computing net sum of the following: (i) For positions
Paragraph (a)(9) of proposed capital would have been required to for which the Commission has approved
Appendix E would have required a establish, document, and maintain an the broker-dealer’s use of VaR models,
broker-dealer to notify the Commission internal risk management control the VaR of those positions multiplied by
45 days before it ceased using the system that met the requirements of the appropriate multiplication factor;
alternative method of computing net § 240.15c3–4.33 The rule amendments, (ii) for positions for which the VaR
capital under Appendix E. Under the as adopted, do not include this model does not incorporate specific
proposed paragraph, the Commission requirement. Proposed paragraph (b) is risk, a deduction for specific risk to be
could have ordered a shorter or longer omitted as unnecessary because the determined by the Commission based
notification period upon broker-dealer broker-dealer must comply with Rule on a review of the broker-dealer’s
consent or if the Commission found that 15c3–4 under Rule 15c3–1(a)(7)(iii), as application and the positions involved;
a shorter or longer period was necessary adopted. (iii) for positions for which the
or appropriate in the public interest or Commission has approved the use of
3. Computation of the Deduction for
for the protection of investors. We did scenario analysis, the greatest loss
Market Risk
not receive any comments on this resulting from the scenario over any ten-
requirement. We are redesignating Commenters generally supported the day period, or some multiple thereof
paragraph (a)(9) as paragraph (a)(10) and method for calculating a broker-dealer’s based on liquidity or, if greater, a
adopting it as proposed. deductions for market risk described in minimum deduction; and (iv) for all
Paragraph (a)(10) of proposed paragraph (c) of proposed Appendix E. other positions, a deduction under
Appendix E would have permitted the They raised several issues with respect § 240.15c3–1(c)(2)(vi), (c)(2)(vii), and
Commission, by order, to revoke a to specific provisions for calculating the applicable appendices to § 240.15c3–1.
broker-dealer’s exemption from the deduction, however. We address those We address each of the deductions for
standard net capital rule under issues in the sections that follow. market risk in the sections that follow.
Appendix E if the Commission found As a preliminary matter, we note that
a broker-dealer must compute its a. Deductions for Market Risk Using
that the exemption no longer was
deduction for market risk monthly. VaR Models
necessary or appropriate in the public
interest or for the protection of Paragraph (c) of proposed Appendix E As noted, a broker-dealer may use a
investors. A broker-dealer that no longer would have required a daily VaR model to calculate its deduction for
could use Appendix E would have been computation of the deduction for market market risk for those positions for which
required to compute its capital charges risk. Commenters raised a question as to the Commission has approved the use of
using the standard haircut method. whether a broker-dealer would be VaR models. To calculate the deduction,
A commenter suggested that the required to make daily capital the broker-dealer multiplies the VaR of
Commission’s authority to revoke a computations and, if so, stated that those positions by the appropriate
broker-dealer’s exemption from the daily computations would be multiplication factor. The
standard net capital rule ‘‘should clarify unnecessary and burdensome. We have multiplication factor is intended to help
that any limitations or remedial action revised these sections to clarify that as provide adequate capital during periods
must be narrowly circumscribed to part of their risk management practices, of market stress or other eventualities.35
address the relevant deficiency.’’ The firms must compute VaR and current The results of quarterly backtests
exposures daily. We note, however, that
32 Refer to section (D)(a)(ii) of this release for a 34 The final rules redesignate paragraph (c) of
discussion of the undertaking for an ultimate 33 See
infra, discussion of proposed amendments proposed Appendix E as paragraph (b).
holding company that has a principal regulator. to Rule 15c3–4. 35 17 CFR 240.15c3–1e(b)(1).
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determine which of the multiplication excluded these positions from inclusion period. Paragraph (b)(3) 38 of Appendix
factors contained in Table 1 of in VaR models; that is, the positions E, as adopted, permits a broker-dealer to
Appendix E a broker-dealer must use, would have been subject to a 100% determine a deduction for market risk
except that the broker-dealer must use deduction. using scenario analysis for those
an initial multiplication factor of Commenters asserted that, while positions for which the Commission has
three.36 positions with no ready market may approved the broker-dealer’s application
We have amended the proposed rules lack historical data sufficient to allow to use scenario analysis. The deduction
with regard to specified provisions of accurate modeling, the rules should will be the greatest loss resulting from
the VaR models used for computing a a range of adverse movements in
require a broker-dealer to demonstrate
deduction for market risk. relevant risk factors, prices, or spreads
that its models adequately capture the
designed to represent a negative
i. Elimination of the VaR Phase-in material risks associated with the
movement greater than, or equal to, the
Period categories of securities in which they
worst ten-day movement over the four
In response to comments received, transact business, not limit use of VaR years preceding calculation of the loss,
Appendix E, as adopted, no longer to those securities that have a ready or some multiple of that movement
includes the phase-in period for VaR market. We agree with the commenters based on liquidity. Permitting the use of
models. Under paragraph (c)(3) of and, therefore, Appendix E, as adopted, scenario analysis to calculate the
proposed Appendix E, the Commission does not limit a broker-dealer’s use of deduction for market risk will provide
would have phased in the use of VaR VaR models for computing deductions the broker-dealer with greater flexibility
models to calculate deductions for net for market risk to securities that have a in determining how it may use
capital for three bands of positions over ‘‘ready market.’’ mathematical models to calculate
a period of at least 18 months. b. Deductions for Specific Risk market risk deductions for securities for
Commenters stated that implementation which a deduction calculated using VaR
of VaR for calculation of deductions for Paragraph (b)(2) of Appendix E may would not be appropriate. The
market risk on a phased-in basis would require a deduction for specific risk minimum deduction for market risk
impose unnecessary operational costs because of the reliance on VaR models computed for positions using scenario
and inefficiencies. Elimination of the for regulatory purposes, particularly for analysis is the same under the final
phase-in requirement is intended to determining deductions for market risk rules as it was in the proposed rules.
promote more effective group-wide risk for securities with no ready market. The final amendments also change the
management and eliminate unnecessary Generally, specific risk is the risk period over which the greatest adverse
operational costs and inefficiencies. associated with how the price-change ten-day movements of data are
Therefore, upon Commission approval on an individual position may differ evaluated. Paragraph (c)(5) of proposed
of its VaR models, a broker-dealer may from broad, market-wide changes in Appendix E would have required the
use its VaR models to calculate prices. If the VaR models that a broker- scenario to include a range of adverse
deductions for market risk capital for all dealer uses to compute deductions for movements of risk factors, prices, or
positions for which the broker-dealer market risk incorporate specific risk, spreads that move by the greatest
can demonstrate that its modeling there is no additional deduction for amounts over the past five years, or a
procedures meet the applicable specific risk in determining the three standard deviation movement in
requirements in the final rules. deduction for market risk. If, however, those risk factors, prices, or spreads over
the VaR models do not incorporate a ten-day period. Commenters suggested
ii. Positions With No ‘‘Ready Market’’
specific risk, paragraph (b)(2) requires a that the period related to ten-day
Under VaR
broker-dealer to include separate movements be reduced from five to four
Paragraph (c)(2) of proposed deductions for specific risk. The years. In response to comments
Appendix E generally would have Commission will determine the received, the final amendments reduce
prohibited the use of VaR models to deduction for specific risk on a case-by- the period over which the greatest
compute deductions for market risk for case basis based on a review of the adverse ten-day movements of data are
positions with no ‘‘ready market’’; debt broker-dealer’s application and the determined to four years. This change is
securities that are below investment positions involved. intended to approximate more closely a
grade; and any derivative instrument ten-day movement of prices to a 99%
based on the value of these positions, c. Deduction for Market Risk Using confidence level.
unless the Commission granted the Scenario Analysis The rule as proposed would have
broker-dealer’s application to use a VaR allowed for the use of a three standard
model for those positions. Under The Commission is amending the deviations alternative if historical data
paragraph (c)(2)(vii) of the net capital proposed rule on calculation of for use in a scenario analysis were
rule, positions for which there is no deductions for market risk using limited. Commenters expressed concern
‘‘ready market,’’ as defined in section scenario analysis. Under the paragraph that this requirement would restrict the
240.15c3–1(c)(11),37 would have (c)(5) of proposed Appendix E, the use of scenario analysis when historical
deduction for market risk calculated data is limited. We are amending the
36 Paragraph (e)(2)(iii) of proposed E would have using scenario analysis generally would proposed rule to clarify, under
required the VaR model to use an effective have been three times the greatest paragraph (b)(3) of Appendix E, as
historical observation period of at least one year adverse movement resulting from the
and to include periods of market stress in that adopted, that a broker-dealer may use
historical observation period. One commenter
scenario analysis over any ten-day implied data or price histories of similar
observed that a one-year period might not contain securities to calculate the three standard
periods of market stress. To address this concern, bona fide offers to buy and sell so that a price
under paragraph (d)(2)(iii) of Appendix E, as
deviation movement if historical data is
reasonably related to the last sales price or current
adopted, a broker-dealer must consider the effects bona fide competitive bid and offer quotations can insufficient.
of market stress in its construction of the model. be determined for a particular security almost
37 Under § 240.15c3–1(c)(11), ‘‘[t]he term ‘ready instantaneously and where payment will be 38 Paragraph (c)(5) of proposed Appendix E has
market’ shall include a recognized established received in settlement of a sale at such price within been redesignated as paragraph (b)(4) under
securities market in which there exists independent a relatively short time conforming to trade custom.’’ Appendix E, as adopted.
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