United States General Accounting Office

GAO Report to the Chairman, Committee on

Banking, Housing, and Urban Affairs,

U. S. Senate, and the Chairman,

Committee on Banking and Financial

Services, House of Representatives

July 1998 RISK-BASED CAPITAL

Regulatory and

Industry Approaches to

Capital and Risk

GAO/GGD-98-153

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-275428 

July 20, 1998

The Honorable Alfonse M. D’Amato

Chairman

The Honorable Paul S. Sarbanes

Ranking Minority Member

Committee on Banking, Housing, and Urban Affairs

United States Senate

The Honorable James A. Leach

Chairman

The Honorable John J. LaFalce

Ranking Minority Member

Committee on Banking and Financial Services

House of Representatives

Recent years have seen dynamic changes in the financial services industry.

As firms have improved their internal measurement of risk, regulators

have responded by reexamining their capital regulations. This report

summarizes the results of our self-initiated review of regulatory capital

requirements and financial firms’ approaches to relating capital to risk.

Our review focused on regulatory views of the purpose of capital and

current regulatory capital requirements, approaches to risk measurement

and capital allocation used today by some of the largest financial firms,

and regulatory risk-based capital initiatives.

Risk-based capital, although already being used to some degree by

regulators of banks, securities broker-dealers, futures commission

merchants, and life insurers, is evolving as advances in financial theory

and technology enable firms to better understand, measure, and manage

their risk. We identify a number of issues concerning future regulatory

risk-based capital initiatives of interest to regulators and financial firms.

We are sending copies of this report to the Acting Comptroller of the

Currency; the Chairmen of the Board of Governors of the Federal Reserve

System, the Federal Deposit Insurance Corporation, and the Securities and

Exchange Commission; the Chairperson of the Commodity Futures

Trading Commission; the Director of the Office of Thrift Supervision; the

Secretary of the Treasury; and the President of the National Association of

Insurance Commissioners. We will also make copies available to others on

request.

Page 1 GAO/GGD-98-153 Risk-Based Capital
B-275428 

This report was prepared under the direction of Lawrence D. Cluff,

Assistant Director, Financial Institutions and Markets Issues. Other major

contributors are listed in appendix XI. If you have any questions, please

call me on (202) 512-8678.

Thomas J. McCool

Director, Financial Institutions

 and Markets Issues

Page 2 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

Purpose Recent years have seen dynamic changes in the financial services industry.

Through growth, mergers, and acquisitions, coupled with regulatory

reevaluation of acceptable activities, financial institutions in different

financial sectors are increasingly competing directly for the same business

by offering similar products and undertaking similar activities. Advances

in financial theory and technology have enabled financial firms to

understand, measure, and manage the financial risks they face in their

business activities far more effectively than in the past.

As firms have improved their internal measurement of risk, financial

regulators have responded by reexamining their capital regulations that

require firms to hold minimum levels of capital as a buffer against

unexpected losses. Some regulators have already responded to changes in

their industries by developing capital standards that attempt to better

correlate required regulatory capital with the actual risks firms face in

their activities, while other regulators are considering similar changes.1

This report is intended to inform Members of Congress and others of both

regulatory capital requirements and financial firms’ approaches to risk

measurement. More specifically, the objectives of this report are to

describe, for the banking, securities, futures, and life insurance sectors,

(1) regulatory views on the purpose of capital and current regulatory

requirements; (2) the approaches of some large financial firms to risk

measurement and capital allocation; and (3) issues in capital regulation

and initiatives being considered for changes to regulatory capital

requirements.

Background For financial purposes, capital is generally defined as the long-term

funding for a firm that cushions the firm against unexpected losses. Losses

are caused by exposure to various risks the financial firm faces in its

business activities. Although there are different categorizations of risks, in

this report, GAO focuses on a set of risks that banks, securities, futures, and

life insurance regulators and firms GAO interviewed most frequently

identified as the ones they were most concerned with—credit, market,

1

The term financial regulators refers here to the following: for banks, the Office of the Comptroller of

the Currency, the Federal Reserve System, the Federal Deposit Insurance Corporation, and state

banking regulators; for securities broker-dealers, the Securities and Exchange Commission (SEC) and

state securities regulators; for futures commission merchants, the Commodity Futures Trading

Commission (CFTC); and for insurance companies, state insurance departments. The Office of Thrift

Supervision, which regulates thrift institutions, is not a focus of this report because the report does not

cover thrifts.

Page 3 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

liquidity, operational, and business/event; and, for insurance companies

only, insurance/actuarial risk.2

Financial regulators set minimum standards for the capital that firms are

to hold to protect against these risks. Regulatory capital requirements

serve to protect customers or depositors and help ensure the stability of

financial markets to which they apply by limiting firm failures and

resulting losses to customers, depositors, or other firms; they also can

affect the efficiency of the financial system by influencing how firms

structure and conduct their business. Minimum capital requirements are a

tool regulators use in their monitoring activities to identify when

regulatory action against a firm is warranted to protect customers or

depositors and financial markets. Moreover, financial regulators recognize

that a capital requirement is only one, though an essential one, of a larger

set of prudential tools used to help protect customers and ensure the

stability of financial markets that they regulate.

Large financial firms increasingly have complex structures, including

parents, affiliates, and subsidiaries.3

 These component firms may have one

or more financial regulators or, in some cases, no regulator. Banks and

their holding companies are regulated on a consolidated basis; but, in the

securities, futures, and life insurance sectors, only the SEC-registered

broker-dealers, CFTC-registered futures commission merchants, and the

underwriters or sellers of insurance are regulated, even though these

entities are usually part of a larger holding company.

In the past 20 years, a series of market shocks in combination with

advances in modern financial theory and information technology

stimulated the use of new techniques to help firms, particularly large,

diversified ones, better evaluate risks and returns. They also resulted in

2

Credit risk arises from the potential that a borrower or counterparty (each party to a financial

transaction is a counterparty to the other) will fail to perform on an obligation. Market risk arises from

broad movements in prices, such as interest rates, commodity prices, stock prices, or foreign

exchange rates. Liquidity risk is the potential that a firm will be unable to meet its obligations as they

come due because of an inability to liquidate assets or to obtain adequate funding. Operational risk

arises from the potential that inadequate information systems, operational problems, breaches in

internal controls, or fraud results in an unexpected loss. Business/event risk is the risk of losses due to

events, such as credit rating downgrades, breaches of law or regulation, or factors beyond the control

of the firm. Insurance/actuarial risk is the risk that an insurance underwriter covers in exchange for

premiums, such as the risk of premature death.

3

In this report, GAO refers to these as large, diversified financial firms.

Page 4 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

the creation of new financial products, particularly derivatives.4

Derivatives permit financial market participants to better manage risk by

transferring the risk from entities less willing or able to manage it to those

more willing and able to do so. These advances, as well as certain

regulatory changes, also spurred competition among different types of

financial firms. As a result, firms in traditionally different financial sectors

are competing more directly with one another, providing similar products

and, hence, facing similar risks in their activities.

To achieve its objectives, GAO reviewed a wide variety of documents and

interviewed federal and state financial regulators; academics; rating

agencies; self-regulatory organizations (SRO);5

 consultants; trade

associations; and a total of 16 large firms in the commercial banking,

securities, futures, and life insurance sectors. GAO developed a set of

common questions that was used for its discussions with firms in these

sectors.

Results in Brief Capital requirements differ by financial regulator due to differences in the

regulators’ purpose. In the view of bank regulators, the primary purposes

of bank capital standards are to maintain the safety and soundness of the

banking and payment systems and to protect the deposit insurance funds.6

For securities broker-dealers and futures commission merchants,7 SEC and

CFTC view the primary purposes of capital requirements as protecting

customers and other market participants from losses caused by a firm

failure and protecting the integrity of their markets. Life insurance

company regulators view capital standards for life insurers as a way to

4

Derivatives are financial products that enable risk to be shifted from one entity to another. The value

of the derivative is based on an underlying reference rate, index, or asset, such as stocks, bonds,

commodities, interest rates, foreign currency exchange rates, and various market indexes. See

Financial Derivatives: Actions Needed to Protect the Financial System (GAO/GGD-94-133, May 18,

1994) and Financial Derivatives: Actions Taken or Proposed Since May 1994 (GAO/GGD/AIMD-97-8,

Nov. 1, 1996).

5

On a day-to-day basis, the securities and futures sectors supervise themselves through SROs.

Securities and futures subsidiaries of larger firms belong to SROs, which include stock exchanges,

futures exchanges, and recognized securities or futures associations. SROs establish rules to govern

member conduct and trading, set qualifications for certain market participants, monitor daily trading

activity, examine their members’ financial health and compliance with rules, and investigate alleged

violations of those rules.

6

Regarding depository institutions, this report focuses on only commercial banks. It does not focus on

thrifts, because their capital rules for credit risk are similar to those of commercial banks and thrifts

are generally not engaged in trading activities like those of the other financial firms mentioned above.

7

Broker-dealers are firms that buy or sell stocks, bonds, and other securities for customers or for

themselves. Futures commission merchants are firms that buy and sell futures contracts as agents for

customers.

Page 5 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

help limit insurance company failures and to protect policy

holders/claimants.8

 In each industry, firms that do not meet minimum

regulatory capital requirements are subject to regulatory action.

Historically, regulators have also based capital regulation on the

traditional risks in each financial sector. Bank capital requirements have

emphasized credit risk, which has long been the predominant risk for

banks because of their lending activities. Capital requirements for

securities broker-dealers and futures commission merchants focused on

market risk because of the effect changing market prices have on the value

of their traded assets and, potentially, customer accounts. In addition to

credit risk, capital requirements for life insurers also focused on actuarial

risk, which stems from the unique nature of this sector’s traditional

business.

Within the past decade, both the banking and life insurance sectors

adopted new capital requirements that are specifically designed to be

more sensitive to exposure to multiple risks. U.S. banking regulators first

adopted quantitative credit risk standards that incorporated a formula

designed to reflect different gradations of risk. More recently, they issued

rules specifically focused on the market risk in the trading portfolios of

large banks which took effect in January 1998. The life insurance industry

adopted risk-based rules that are formula-based and require that capital be

held against exposure to specific risks faced by life insurers.

Securities broker-dealers and futures commission merchants continue to

operate under what are called net capital rules that SEC and CFTC use in

order to protect customers and other market participants in the financial

markets from losses due to firm failures, not from bad investments. These

rules are not specifically called “risk-based” like those developed for

banking and insurance. However, they explicitly require regulated firms to

adjust their capital holdings to account for risks in their activities.

Unlike regulators, whose focus on the capital levels of firms is driven by

regulatory public purposes, firms analyze their use of capital to help

ensure that they can achieve their business objectives. Capital is provided

by investors and by the firm through retained earnings. It enables financial

firms to continue to fund operations, earn profits, and grow. It also

provides a cushion to absorb unexpected losses. To attract and keep

investors, a firm tries to manage the trade-off between decreasing risks

8

Regarding the insurance industry, GAO focuses only on life insurance companies because some of

their activities are the most similar to banks, securities broker-dealers, and futures commission

merchants.

Page 6 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

and increasing returns. To better assess this trade-off, a number of large

diversified firms are using complex risk measurement techniques. Some of

these techniques are applied on a firmwide basis, and some are more

quantified and statistical than others. Market and insurance/actuarial risks

tend to be most amenable to the use of statistical models. Credit and

liquidity risks also have quantifiable elements. Operational and

business/event risks are very difficult to quantify and are not as readily

measured.

Although many large firms GAO spoke with use the results of their risk

measurements to set limits on trading activities, some go farther and use

them to allocate capital within the firm. These techniques have limitations;

however, firms and regulators believe they significantly improve firms’

ability to measure and manage their risks. Financial regulators of large

banks, securities broker-dealers, and futures commission merchants are

increasingly using or are considering the use of firms’ own estimates of

risk in setting capital requirements.

Through discussions with industry representatives, regulators, and others

and review of pertinent literature, GAO identified three principal issues

pertaining to regulatory capital requirements that are important when

considering possible future changes to these requirements. First, what are

the competitive implications for firms stemming from differences in the

capital rules of different financial regulators? Second, do differences

between regulators’ and firms’ measurement of risks, their views of how to

manage those risks, and their estimates of needed capital, create

incentives to manage risks inappropriately? Third, how will financial

regulators administer capital rules when the largest firms’ operations are

increasingly complex and growing differences exist between large and

small firms?

Regulatory agencies and SROs are exploring or have proposed a number of

initiatives for modifying or changing current capital requirements in the

banking, securities, futures, and life insurance sectors. The banking

initiatives under consideration range from allowing banks to use credit

ratings to determine risk-based capital assessments for some products to

allowing banks to set their own target capital levels and then penalizing

them if they do not meet their targets. SEC and CFTC are monitoring and

evaluating the Derivatives Policy Group’s (DPG) voluntary efforts to relate

capital to risks.9 SEC is exploring the use of a statistical modeling approach

9

The Derivatives Policy Group comprises the six U.S. securities firms most active in the

over-the-counter, as opposed to exchange-traded, derivatives market—CS First Boston, Goldman

Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Salomon Brothers.

Page 7 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

to calculate net capital requirements to better reflect market risks in

broker-dealer activities. In addition, SEC and CFTC are exploring whether

the regulatory structure should be changed for over-the-counter (OTC)

derivatives dealers. Life insurance regulators are working to modify the

interest rate risk component of their risk-based capital requirements, but

they have no current plans to change their formula-based approach to

setting capital requirements for other risks.

GAO Analysis

Regulatory Capital

Requirements Reflect

Differences in Regulatory

Purposes of Capital

Although there has been a significant amount of convergence in the

activities of the largest U.S. banks, securities broker-dealers, futures

commission merchants, and life insurance companies, firms in each of

these sectors still have different primary financial regulators with different

oversight purposes and different regulatory requirements.

Differences in regulatory capital requirements reflect differences in the

regulators’ views of the purposes of capital and the different historical

risks faced by firms in each of the sectors. Bank capital regulation is

focused on the continued operation of the banking system and helps

ensure that overall payment services and credit provision to customers

will not be disrupted. Securities and futures capital regulations are based

on whether the liquidation value of a firm, in the event of a failure, would

result in sufficient resources to ensure that the claims of customers and

other market participants will be met. State insurance regulators impose

capital requirements to try to limit insurance company failures to ensure

the long-run viability of insurance companies so that they can meet

policyholders’ claims in the future.

Financial regulators issue rules to be used in determining minimum capital

requirements for the firms they oversee; and in varying ways these rules

take into account the risks the firms face. Both the banking and life

insurance sectors have requirements that are specifically designed to be

more sensitive to exposure to certain risks. Bank regulators from

industrialized countries adopted rules for credit risk exposure for

internationally active banks in 1988 under the auspices of the Bank for

International Settlements. Known as the Basle Accord, the rules were fully

Page 8 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

implemented in 1992.10 U.S. federal bank regulators chose to apply these

rules to all U.S. banks. The rules are formula-based and apply risk-weights

to reflect different gradations of risk to each asset category. Since 1992,

there have been a number of amendments, but the most significant one

established risk-based capital requirements to cover market risk in bank

securities and derivatives trading portfolios. The rule requires that large

banks with a significant amount of market risk use their own internal

models to provide a measure of the firm’s “value-at-risk.”11 The rule

establishes minimum requirements for constructing these models, and it

specifies how much capital is to be held against market risk. This

requirement, which took effect in January 1998, generally pertains only to

the largest 15 to 20 U.S. banks with extensive trading activity.

Both SEC and CFTC use net capital rules to limit excessive leverage by the

firms they regulate. In addition, they require regulated entities to calculate

similar measures of net capital that represent the expected net value of

their assets and liabilities during a liquidation. The net capital rules of both

regulators measure capital according to standard accounting practices and

then adjust this amount to reflect the liquidity of the firm’s assets (called

“haircuts”) to protect against the possible losses a broker-dealer or futures

commission merchant could incur if it were liquidated. SEC requires a

broker-dealer to maintain the greater of a specified minimum dollar

amount or a specified percentage of net capital in two financial ratios. The

first SEC ratio, which is usually used by smaller broker-dealers, is based on

the ratio of net capital to aggregate indebtedness—the amount owed to

customers and other parties with claims against the broker-dealer. The

second SEC minimum ratio, which is usually used by large broker-dealers,

is based on the ratio of net capital to customer receivables—funds owed to

the broker-dealer. Under this requirement, if the firm is also a futures

commission merchant, it is also required to satisfy the CFTC minimum

capital requirement, which is based on the ratio of net capital to

segregated funds—a measure of funds owed to the customers by the

futures commission merchant. As one step toward a more risk-based

approach, in February 1997, SEC approved the use of a statistical model to

10The Bank for International Settlements was established in 1930 in Basle, Switzerland. Its objectives

are to promote cooperation of central banks, to provide additional facilities for international

operations, and to act as trustee for international financial settlements. The Basle Accord was

formulated by the Basle Committee on Banking Supervision. Its members are representatives of the

central banks and supervisory authorities of Belgium, Canada, France, Germany, Italy, Japan,

Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.

11“Value-at-risk” represents an estimate of the maximum amount by which the value of an institution’s

position in a risk category could decline due to general market movements during a fixed holding

period, measured with a specified confidence interval.

Page 9 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

calculate capital requirements for listed options and their hedge positions,

effective September 1, 1997.12

The National Association of Insurance Commissioners (NAIC)13 approved

risk-based capital rules for life insurance companies in 1992. These rules

are designed to measure exposure to four major categories of risk used by

the insurance industry—asset, insurance, interest rate, and all other

business risk.14 The approach is risk weighted, reflecting different

gradations of risk, and is similar in concept to the banking industry’s credit

risk requirements. The rules require life insurance companies to hold

capital against their exposure to the risks listed above.

Bankers, regulators, and industry and rating agency officials GAO spoke

with generally believe the current risk-based capital standards for banks

are an improvement over the former requirements, but they still have

limitations. For example, many of them believe the standards for credit

risk are crude and imprecise because the risk-weights are not adjusted for

asset quality within broad categories of assets. Representatives of

securities firms and other industry participants GAO spoke with felt that

because the current requirements of the net capital rule do not correlate

well with actual risks in these firms’ activities, this constrains their

business decisions and affects both the firms’ structure and where they

conduct certain activities, such as derivatives. In addition, in their view,

the net capital rule does not deal well with risk-reducing strategies such as

hedging. Life insurance regulators believe the main strength of the life

insurance risk-based capital rules is that the rules enable regulators to

close a failing company more quickly and easily than they could in the

past. Life insurance industry officials GAO spoke with said that the current

requirements do not cover all risks equally well and that some changes are

needed.

12Positions refers to an investor’s stake (buying or selling) in a market or particular security. To hedge

is to reduce risk by taking a position that offsets existing or anticipated exposure to a change in

market prices. Options are contracts that grant the purchaser the right, but not the obligation, to buy

or sell a specific amount of the underlying at a particular price within a specified period. Listed options

are exchange-traded.

13NAIC is the organization of insurance regulators from the 50 states, the District of Columbia, and the

4 U.S. territories. NAIC’s basic purpose is to encourage consistency and cooperation among the

various states and territories as they individually regulate the insurance industry.

14Asset risks are the risks of asset defaults and decreases in market value. Insurance risks, which are

unique to the insurance industry, are the risk of underpricing or unfavorable developments in mortality

or morbidity. Interest rate risk for insurance companies is the chance that a change in interest rates

will result in an insurer not earning enough return on its investments to meet its interest obligations

under its various insurance and annuity contracts. The all other business risk category encompasses

risks not included elsewhere in the standards.

Page 10 GAO/GGD-98-153 Risk-Based Capital
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Some Large Financial

Firms Are Using Complex

Risk Measurement

Techniques to Manage

Risks Internally

For firms, capital is a source of long-term funding and provides a cushion

to absorb unexpected losses. For the investors in a firm, the capital they

invest is put at risk of loss in order to earn a return. For a firm’s managers,

maintaining the optimal amount of capital is key to maintaining the firm as

an ongoing business. To attract and keep investors, a firm tries to manage

the trade-off between decreasing risks and decreasing returns.

Bondholders and stockholders assess this risk-return trade-off differently.15

Bondholders generally seek to limit a firm’s risk because they receive a

fixed return (as long as the firm is viable). Stockholders generally are

willing to accept a higher level of risk because they can receive a higher

return as a result of successful risk-taking by the firm.

Over the last decade or so, advances in measuring risk more precisely

have led some of the larger, more complex firms in the financial sectors to

use new techniques to better manage their risks. In some cases, these risk

measurement techniques fit into a larger risk management system.

According to the firms GAO interviewed, such systems are used for a

variety of purposes, including to set limits on risk-taking, to allocate

internal capital according to the measured risk in firm activities, and to

better assess profit performance in relation to the risks being taken.

All of the financial service firms GAO spoke with said that advances in

technology have enabled them to refine their risk measurement techniques

in recent years. Depending on their own requirements that stem from their

business mix, these firms may have computer-based risk measurement

systems that feed into firm decisions on risk management. Market risk

analysis is often the most statistically sophisticated form of risk analysis

these firms do. Some firms in each of these sectors said they use internal

models to determine the firm’s “value-at-risk,” which is a measurement of

their market risk exposure. Several of the large securities firms GAO spoke

with have developed risk measurement computer systems that monitor the

risks being taken in different parts of the firm. Capital is then allocated in

accordance with the degree of risk being undertaken by each different part

of the firm. In conjunction with the use of value-at-risk models, many of

the firms GAO spoke with said they also use stress testing,16 scenario

15The stockholders’ returns include dividends out of profits from operations and capital gains based on

the market value of their shares. Bondholders’ returns, in contrast, are based on interest, repayment of

principal, and capital gains on the bond.

16Stress tests measure the potential impact of various large market movements on the value of the

firm’s portfolio. Such tests are a useful tool for identifying exposures that appear to be relatively small

in the current environment but that grow more than proportionally with changes in risk factors.

Page 11 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

analysis,17 and backtesting18 as risk management tools. The results of these

tests give an indication of the firm’s sensitivity to market movements.

The firms GAO spoke with tend to use a variety of techniques, some more

statistical and quantifiable than others, to measure credit risk. Liquidity

risks are not modeled on a statistical basis, because this risk generally

occurs due to a sudden or unexpected event. Instead, liquidity stresses

tend to be analyzed using worst-case scenarios developed by each firm.

Models for insurance/actuarial risks are more likely statistical in nature

and apply many of the same techniques that are used in modeling market

risk. Operational and business/event risks are the most difficult risks to

measure due to the lack of data necessary for such measurements. One

large bank GAO spoke with said that it is using proxies for these two risks

in its quantitative risk measurement techniques. Nonetheless, all firms GAO

spoke with agree that they have the least confidence in the results of their

operational and business/event risk analyses.

Most of the firms GAO spoke with said they have a firmwide risk

management framework in place to identify and control risk, and all of

their approaches emphasize the importance of top-level management

involvement in risk management in their firms. Most of these firms have

risk management committees made up of senior managers of the firms.

Although they use advanced risk measurement techniques, they all

stressed that management judgment and good internal controls are more

important than the risk measurement numbers for effective risk

management.

In Response to Issues in

Capital Regulation, Some

Regulatory Change Is

Being Considered in Each

Financial Sector

Through discussions with industry representatives, regulatory officials,

and others and a review of the pertinent literature, GAO identified and

categorized a number of issues that are relevant to possible changes in the

regulatory capital requirements. The principal issue in the first category,

differences among financial regulators, is that although financial firms that

were traditionally in different sectors are increasingly offering similar

products and taking on similar risks, differences in capital regulation

across their primary regulators may have competitive implications for the

firms. Issues in the second category, differences between firms and

regulators in their approaches to capital and risk, include the concern that

because regulatory capital requirements are not adequately sensitive to the

17Scenario analysis generates forward-looking “what-if” simulations for specified changes in market

factors that quantify revenue implications of such scenarios for the firm.

18Backtesting is used retrospectively to evaluate the accuracy of assumptions by comparing system

predictions with actual trading results.

Page 12 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

risks inherent in particular products or activities, they may create

inappropriate incentives for firms in managing their risk. Another issue is

the concern that the increased use by regulators of financial firms’ internal

estimates of risk to set regulatory capital requirements may be

inappropriate, because the firms and regulators have different purposes

for capital. Issues in the third category, administrative, include whether it

makes sense to apply the same approach to capital regulation to firms of

all sizes and degrees of complexity, as well as how the regulators can

effectively oversee the increasing use of statistical models for regulatory

purposes.

Financial regulators are considering some degree of change to regulatory

capital requirements in banking, securities, futures, and life insurance.

Some of these changes would make regulatory capital requirements more

sensitive to the risks in firm activities, while others would represent more

fundamental changes in the regulators’ approaches to capital regulation. In

November 1997, bank regulators issued proposed revisions to the

risk-based capital standards that would use credit ratings from rating

agencies and possibly alternative approaches to match the risk-based

capital assessments for certain products more closely to a bank’s relative

risk of loss in asset securitizations.19 Also, in banking, research is being

done into an internal models-based approach for credit risk that could

potentially supplement or replace the current formula-based requirements.

The “precommitment” approach, if adopted, would represent a more

fundamental change to capital requirements. In this approach, a bank

would commit to manage its trading portfolio to limit market risk losses

over a subsequent interval to a specified amount. If the bank exceeded its

limit, it would face penalties that could range from public disclosure to

additional capital requirements or monetary fines.

The New York Clearing House conducted a 1-year pilot test of the

precommitment approach that was designed to assist the bank regulators

and the participants in evaluating and assessing the usefulness and

viability of the approach for regulatory capital purposes. Although views

of industry analysts differ on the value of such an approach, the 10 bank

and bank holding company pilot participants believe that it is a viable

alternative to the internal models approach and that it provides strong

incentives for prudent risk management and more efficient capital

allocation compared to existing capital standards.

19Asset securitization is the process by which loans and other assets are pooled and used as collateral

for one or more classes of securities, which are then sold. Securitization provides an efficient

mechanism for banks to sell loan assets and thereby to make the loan assets more liquid.

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There are a number of new risk-based initiatives for securities and futures

firms. Since 1995, under the auspices of DPG, six securities firms have been

participating in a program in which they use their own models to calculate

their “capital at risk”20 on their over-the-counter derivative activities and

voluntarily report the results to their primary regulators. In December

1997, SEC issued a concept release21 soliciting comments on how the

existing haircut structure could be modified and whether the net capital

rule should be amended to allow firms to use statistical models in setting

capital requirements for a broker-dealer’s proprietary positions. Much of a

broker-dealer’s OTC derivatives activities are currently conducted in

unregulated entities. In order to allow broker-dealers to take better

advantage of counterparty netting22 and to adjust the capital rule to better

reflect the risks of OTC derivatives, SEC, in a December 1997 initiative,

issued a proposed rule that would create a new class of broker-dealers,

called OTC derivatives dealers, whose derivatives business would be

subject to modified regulatory capital, margin, and other requirements.

Also in December 1997, in order to better match capital charges with

actual market risk hedging practices employed by broker-dealers, SEC

proposed amendments to the net capital rule that would treat most types

of interest rate products as part of a single portfolio and would recognize

hedges among a number of instruments. As part of its comprehensive

regulatory reform efforts to update its oversight of both exchange and

off-exchange markets, CFTC published a concept release in May 1998 on

issues relating to the OTC derivatives market.

In 1995, two futures exchanges, which are SROs, informally proposed to

CFTC a risk-based capital approach that would base capital requirements

on “funds at risk” as opposed to the current “funds required to be

segregated” approach.23 CFTC consulted with the exchanges on the

parameters of their risk model and positively received the exchanges’

proposals. In November 1997, the exchanges adopted a risk-based capital

requirement for their members effective January 1, 1998.

20“Capital-at-risk” as defined by DPG is conceptually the same as “value-at-risk” used elsewhere in this

report.

21A concept release is a paper issued by regulators to elicit discussion and comment from the industry

and others on a potential regulatory change.

22Netting is an agreed-upon offsetting of positions or obligations by trading partners that can reduce a

large number of individual obligations or positions to a smaller number.

23Funds-at-risk are the initial margin requirements imposed by the various exchanges on all open

positions held at those exchanges. Segregation means to keep customer assets physically and

accountably separate from assets owned by the futures commission merchant.

Page 14 GAO/GGD-98-153 Risk-Based Capital
Executive Summary

Life insurance regulators seem generally satisfied with the current

risk-based capital approach for this sector; however, some changes are

being studied. Regulators and industry officials told GAO that refinements

are being made on an as-needed basis to the risk-based capital formulas;

and industry groups are studying alternative, possibly model-based,

approaches to the interest rate risk component. They told GAO that they

currently have no plans to significantly modify the formula-based

approach to the other risk-based capital components at this time.

Recommendations GAO is not making recommendations in this report.

Agency Comments The Office of the Comptroller of the Currency, the Board of Governors of

the Federal Reserve System, the Federal Deposit Insurance Corporation,

the Securities and Exchange Commission, and the Commodity Futures

Trading Commission provided written comments on a draft of this report.

Their comments are discussed in chapter 1. The agencies generally

believed the report was comprehensive and balanced. In their comments,

the Office of the Comptroller of the Currency, the Federal Deposit

Insurance Corporation, and the Securities and Exchange Commission

expand on a number of points made in the report pertaining to their

industries. The National Association of Insurance Commissioners

provided oral comments in which it characterized the report as

reasonable. These organizations also provided technical comments, which

have been incorporated where appropriate.

Page 15 GAO/GGD-98-153 Risk-Based Capital
Contents

Letter 1

Executive Summary 3

Chapter 1 

Introduction

20

Background 21

Various Agencies Are Responsible for Regulating the Capital of

Banks, Securities Broker-Dealers, FCMs, and Life Insurers

25

The Financial Services Industry Is Changing in Response to a

Variety of Developments

35

Objectives, Scope, and Methodology 38

Chapter 2 

Regulatory Capital

Requirements Differ

by Type of Regulated

Entity

41

The Purpose of Regulatory Capital Differs by Type of Regulated

Entity

42

Regulatory Capital Requirements Differ by Industry Sector,

Reflecting Differences in Regulatory Purposes and Dominant

Activities Within Sectors

45

Industry Representatives See Progress in Recent Revisions to

Capital Standards but Cite Problems With These and Other

Capital Rules

67

Capital Rules for Large, Diversified Firms Underscore

Importance of These Firms’ Risk Measurement Practices

71

Chapter 3 

Some Large,

Diversified Financial

Firms Are Measuring

Risks With

Mathematical Models

73

Financial Firms Use Capital to Help Manage the Trade-Off

Between Return and Risk

73

Firms Are Using Models to Measure and Limit Risk-Taking and

Determine Their Capital Allocations

75

Measuring and Managing All Risks on a Firmwide Basis 89

General Principles of Firmwide Risk Management 89

Chapter 4 

Issues and Initiatives

in Capital Regulation

92

Differences in Regulatory Objectives and Approaches May Have

Unintended Competitive Implications

93

Differences Exist Between Regulators’ and Firms’ Estimates of

Risk and Needed Capital

94

Page 16 GAO/GGD-98-153 Risk-Based Capital
Contents

Increased Regulatory Use of Firm Estimates of Risk Raises Issues

Regarding the Appropriateness of These Estimates for Regulatory

Capital Purposes

96

Increasing Complexity of Large Firms’ Activities Raises Issues

Regarding Administration of Capital Requirements

98

Financial Regulators and SROs Are Exploring Ways to Make

Capital Requirements More Sensitive to Risk

100

New Approaches to Capital Regulation Are Also Being Explored 110

Appendixes Appendix I: Bank Risk-Based Capital Standards 116

Appendix II: Key SEC Financial Responsibility Rules 130

Appendix III: Regulatory Actions and Other Provisions of the Life

Risk-Based Capital Model Act

154

Appendix IV: Risk-Adjusted Return on Capital 166

Appendix V: Financial Firms Inteviewed by GAO 169

Appendix VI: Comments From the Office of the Comptroller of

the Currency

170

Appendix VII: Comments From the Federal Reserve Board 174

Appendix VIII: Comments From the Federal Deposit Insurance

Corporation

175

Appendix IX: Comments From the Securities and Exchange

Commission

178

Appendix X: Comments From the Commodity Futures Trading

Commission

184

Appendix XI: Major Contributors to This Report 186

Tables Table 1.1: A Comparison of the Regulatory and Oversight

Authority Concerning Capital of Federal Regulators of

Commercial Banks, Securities Broker-Dealers, and FCMs and

State Regulators of Life Insurers

31

Table 2.1: Primary Purposes of Regulatory Capital 45

 Table 2.2: Risk-Based Capital Ratios for Six Large Bank Holding

Companies, as of December 31, 1997

53

Table 2.3: Capital Information for Five Large U.S. Broker-Dealers

and Their Holding Companies

59

 Table I.1: The Calculation of the Credit Risk-Based Capital Ratio 120

 Table I.2: The Calculation of the Risk-Based Capital Ratio for

Market and Credit Risk

123

Table II.1: Alternative Strategy-Based Haircut Methodology for

Listed Options

146

Page 17 GAO/GGD-98-153 Risk-Based Capital
Contents

Table II.2: Alternative Strategy-Based Haircut Methodology for

Unlisted Options

147

Table II.3: Commodities and Commodities Futures Haircuts 148

 Table II.4: Broker-Dealer’s Trial Balance as of December 31, 1997 149

 Table II.5 Broker-Dealer’s Balance Sheet as of December 31,

1997

150

 Table II.6: Broker-Dealer’s Net Capital Computation as of

December 31, 1997

151

Table II.7: SEC Minimum Net Capital Requirements For Brokers

and Dealers

152

 Table III.1: Summary of the Components of the Life Insurance

Risk-Based Capital Formula and Their Relationship to Risk

Categories C-0 through C-4

155

Table III.2: Risk Factors for Life Insurance In Force 161

Table III.3: Regulatory Actions Triggered by Different Total

Adjusted Capital Levels Under the Risk-Based Capital for

Insurers Model Act

164

Figures Figure 1.1: Simplified Structure of a Hypothetical Bank Holding

Company

26

Figure 1.2: Simplified Structure of a Hypothetical Nonbank

Financial Holding Company

28

Figure I.1: Summary of Four Section 38 Capital Categories and

Ratio Requirements

129

Figure II.1: SEC Net Capital Formulation 132

Page 18 GAO/GGD-98-153 Risk-Based Capital
Contents

Abbreviations

ACLRBC Authorized Control Level Risk-Based Capital

AI aggregate indebtedness

AVR asset valuation reserve

CBOT Chicago Board of Trade

CEA Commodity Exchange Act

CFTC Commodity Futures Trading Commission

CME Chicago Mercantile Exchange

DPG Derivatives Policy Group

FCM futures commission merchant

FDIC Federal Deposit Insurance Corporation

FDICIA Federal Deposit Insurance Corporation Improvement Act

FRS Federal Reserve System

GAAP Generally Accepted Accounting Principles

GARP Generally Accepted Risk Principles

NAIC National Association of Insurance Commissioners

OCC Office of the Comptroller of the Currency

OECD Organization for Economic Cooperation and Development

OTC cover-the-counter

RAROC risk-adjusted return on capital

SEC Securities and Exchange Commission

SIPC Securities Investor Protection Corporation

SPAN Standardized Portfolio Analysis of Risk

SRO self-regulatory organization

TAC Total Adjusted Capital

TIMS Theoretical Intermarket Margining System

VAR value-at-risk

Page 19 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

Through rules known as capital requirements, financial regulators1 set

minimum levels for capital that banks and bank holding companies,2

securities broker-dealers,3 futures commission merchants (FCM),4 and life

insurance companies5

 hold as a cushion against unexpected losses that

can result from risks faced by these firms in their business activities.

Regulatory capital requirements are one tool financial regulators use to

help protect customers from losses and ensure the stability of financial

markets. In addition to serving these general regulatory purposes, capital

requirements can affect the way the financial system functions by

influencing how market participants allocate capital resources and

conduct business.

Capital requirements can also have competitive effects within the financial

services industry, to the extent that capital requirements differ among

competing financial institutions and firms. Today, regulators in all sectors

have either adopted or are considering changes in capital requirements

that compared to earlier approaches, more quickly and precisely respond

to changes that occur in a firm’s actual risk profile.6

 In addition, some

regulators are considering more fundamental changes that would simplify

capital regulation. Changes in capital regulation are being undertaken or

considered in a highly dynamic financial services industry that is itself

undergoing change in response to competitive pressures as well as

1

The term financial regulators refers here to the following: for banks, the Office of the Comptroller of

the Currency (OCC), the Federal Reserve System (FRS), the Federal Deposit Insurance Corporation

(FDIC), and state banking regulators; for securities broker-dealers, the Securities and Exchange

Commission (SEC) and state securities regulators; for futures commissions merchants, the Commodity

Futures Trading Commission (CFTC); and, for insurance companies, state insurance departments.

2

The bank holding company structure consists of a parent company with one or more subsidiaries that

may include banks, thrifts, and other entities providing services that the regulator considers closely

related to banking. This report focuses only on commercial banks. It does not focus on thrifts because

their capital rules for credit risk are similar to those of commercial banks and thrifts are generally not

engaged in trading activities like those of the other financial firms mentioned above.

3

Brokers are persons who engage in the business of effecting transactions in securities for the account

of others, but does not include banks. Dealers are persons who engage in the business of buying and

selling securities for their own account, through a broker or otherwise, but does not include banks or

persons insofar as they buy or sell securities for their own accounts, either individually or in some

fiduciary capacity, but not as part of a regular business. Broker-dealers combine the functions of

brokers and dealers. See Section 3(a)(4) and (5) of the Securities Exchange Act of 1934.

4

An FCM is an individual, association, partnership, corporation or trust that solicits or accepts orders

for the purchase or sale of any commodity for future delivery on or subject to the rules of any contract

market and that accepts payment from or extends credit to those whose orders are accepted.

5

In this report, we focus only on life insurance companies because their activities are the most similar

to those of banks, securities broker-dealers, and FCMs.

6

The results of such changes in capital requirements are referred to in banking and life insurance as

“risk-based capital.”

Page 20 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

advances in telecommunications, computer technology, and financial

analysis—all of which have led to new and innovative financial products

and services. This report is provided to help Members of Congress and

others understand current regulatory capital requirements, developments

in those requirements, issues these developments raise, and financial

firms’ approaches to risk measurement.

Background Banks, securities broker-dealers, FCMs, and life insurance companies

increase the efficiency of the economy by facilitating the flow of savings to

investment and providing other financial services.7

 As discussed in chapter

3 of this report, these financial firms use capital to manage the trade-off

between risks and returns in order to increase the firms’ efficiency and

maximize the returns for stockholders. The capital that a financial firm

holds serves a number of firm-specific purposes—chiefly to provide

long-term funding of operations and to protect the firm by serving as a

cushion to absorb unexpected losses.

For public purposes, regulators of banks, securities broker-dealers, FCMs,

and life insurance companies promulgate capital regulations that set

mandatory minimum levels for capital that the firms are to hold as a

cushion against unexpected losses. The specific public purposes differ

somewhat among the regulators. Generally speaking, however, the

financial regulators seek to protect customers of the financial firms from

losses and help ensure the stability of financial markets and systems that

they regulate. Chapter 2 of this report discusses the capital standards set

for banks, securities broker-dealers, FCMs, and life insurance companies

and the more specific purposes of each of the financial regulators in

setting regulatory capital requirements.

Traditionally, banks, securities broker-dealers and FCMs, and life insurance

companies were engaged in mostly different businesses and faced

different risks. After the stock market crash of 1929, Congress created a

regulatory and industry structure that separated banking, investment

banking, and other financial institutions. Banks were restricted to taking

deposits, making loans, and other activities closely related to banking.

7

In modern financial theory, financial firms enhance the efficiency of the economy by providing means

of wholesale and retail payments, holding funds for customers or depositors in the form of savings

accounts or life insurance policies, providing brokerage services for securities that permit investors to

sell financial assets and purchase or invest in other assets, underwriting security issuances by business

so that business can acquire investment funds when they are needed and investors can purchase newly

issued securities, lending funds as a principal, providing equity capital, or providing risk management

services for clients such as futures and foreign exchange services so that business can limit or accept

risk taking as called for by their business strategies.

Page 21 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

Broker-dealers (the SEC-regulated portion of investment banks) were

restricted to brokering securities, underwriting new security issues, and

trading securities. Insurance companies continued to be regulated by the

states, and their activities were limited to insurance sales and

underwriting. As discussed later in this chapter, significant changes have

occurred in the financial services industry within the past two decades. As

a result, firms that were in traditionally separate sectors are more directly

competing with one another; providing similar products; and, hence,

facing similar risks in their activities.

Capital Is the Source of

Funding That Cushions a

Firm Against Losses That

Arise From Risks

Capital is most generally defined as the long-term source of funding for a

firm that earns a return for investors (debt and equity) and cushions the

firm against losses. Such funding is contributed largely by (1) equity

stockholders in anticipation of profits and (2) the firm’s own returns in the

form of retained earnings. In some instances, long-term debt is also

considered capital.

Losses cushioned by capital arise from risks that firms face in their

business activities. In our work, we found no definitive list of risk

categories applicable to all firms covered in our review. For example, the

Federal Reserve uses a list of six risk categories, and OCC delineates nine.

A group of leading individuals from firms and regulators developed what

they termed Generally Accepted Risk Principles (GARP), which lists six risk

categories.8

 Most of the financial firms we spoke with told us they use four

categories of risk; some said they use as few as three. The listings of risks

we reviewed covered much the same causes of possible loss, but they

varied in how risks were grouped and in the nomenclature used. This

report generally focuses on the following six categories, because

regulators and the representatives of financial firms we interviewed

identified them as the risks of greatest concern.

• Credit risk is the potential for financial loss resulting from the failure of a

borrower or counterparty9

 to perform on an obligation. Credit risk may

arise from either an inability or unwillingness to perform as required by a

8

The Federal Reserve uses credit, market, liquidity, operational, legal, and reputational risks. OCC uses

strategic, reputational, credit, interest rate, liquidity, price, foreign exchange, transaction, and

compliance. GARP uses credit, market, portfolio concentration, liquidity, operational, and

business/event risks.

9

In any financial transaction, each party is the counterparty to the other.

Page 22 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

loan, a bond, an interest rate swap,10 or any other financial contract. All

financial firms face credit risk. For example, banks face credit risks in

loans and bonds, insurance companies face credit risks in corporate and

municipal bonds, and securities broker-dealers and FCMs face credit risks if

other firms that they deal with do not meet their contractual obligations.

• Market risk is the potential for financial losses due to the increase or

decrease in the value or price of an asset resulting from broad movements

in prices, such as interest rates, commodity prices, stock prices, or the

relative value of currencies (foreign exchange). Because all financial firms

hold assets, all financial firms face market risks. However, they may not all

face all types of market risks.

• Liquidity Risk is the potential for financial losses due to the inability of a

firm to meet its obligations on time because of an inability to liquidate

assets or obtain adequate funding, such as might occur if most depositors

or other creditors were to withdraw their funds from a firm. This is

referred to as “funding liquidity risk.” Liquidity risk also refers to the

potential that a firm cannot easily reverse negative financial positions or

offset specific exposures without significantly lowering market prices

because of inadequate market depth or market disruptions (“market

liquidity risk”). Financial firms face liquidity risk inasmuch as the loss of

revenues due to interruptions of cash inflows affects a firm’s ability to

cover its liabilities as they come due.

• Operational Risk is the potential for unexpected financial losses due to

inadequate information systems, operational problems, breaches in

internal controls, or fraud. Operational risk is associated with problems of

accurately processing or settling transactions and taking or making

deliveries on trades in exchange for cash, and with breakdowns in

controls and risk limits. Individual operating problems are considered

small-probability but potentially high-cost events for well-run firms.

Operational risk includes many risks that are not easily quantified but

control of which is crucial to the firm’s successful operation. Operational

risk can be addressed through prudent management oversight of firm

operations, including the establishment of internal controls.11 All firms

face some type of operational risk.

• Business/event risk is the potential for financial losses due to events not

covered above, such as credit rating downgrades (which affect a firm’s

access to funding); breaches of law or regulation (which may result in

10A swap is an agreement between counterparties to make periodic payments to each other for a

specified period. In a simple interest rate swap, one party makes payments based on a fixed interest

rate, while the counterparty makes payments based on a variable rate. The contractual payments are

based on a notional amount that for most interest rate swaps is never actually exchanged.

11Internal controls have limitations and provide reasonable assurance, not absolute assurance, that

internal control objectives will be met.

Page 23 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

heavy penalties or other costs); or factors beyond the control of the firm,

such as major shocks in the firm’s markets. Included in business/event risk

is a shift in legal status or changes in regulations. All types of financial

firms face business/event risk.

• Insurance/actuarial risk is the risk of financial losses that an insurance

underwriter takes on in exchange for premiums, such as the risk of

premature death. Although this risk is most commonly associated with

insurance companies, it can exist in other firms. For example, banks are

authorized to underwrite credit life insurance, which is subject to actuarial

risk.

These risks can be discussed on a risk-by-risk basis, but the potential

effect on a firm’s overall financial condition or risk profile cannot be

obtained by summing the risks in each category, because risks interact in

various ways. That is, the net potential loss from a combination of risks

could be greater or less than the sum of potential losses from each

individual risk, depending upon the economic relationship among the risks

involved. The economic relationship among a firm’s risks depends on the

correlation among prices of assets—that is, how the prices move in

relation to one another—and the business strategies and holdings of the

firm.

Because the traditional activities of banks, securities broker-dealers, FCMs,

and life insurers differed, each of these types of financial firms once

tended to have a correspondingly distinct type of risk profile. The

predominant risk for banks was credit risk, for securities broker-dealers

and FCMs it was market risk, and for life insurance companies it was

insurance/actuarial risk. However, for a variety of reasons discussed later

in this chapter, the activities and risks of large, diversified financial firms

in the highly competitive financial services industry are becoming

increasingly similar.

Page 24 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

Various Agencies Are

Responsible for

Regulating the Capital

of Banks, Securities

Broker-Dealers,

FCMs, and Life

Insurers

The scope of authority and oversight practices of financial regulatory

agencies vary in a number of ways. The activities of banks, bank holding

companies, securities broker-dealers, FCMs, and life insurance companies

are regulated and overseen by a number of different types of agencies and

organizations.12 Bank holding companies are regulated by the Board of

Governors of the Federal Reserve System (Federal Reserve Board), and

banks are regulated on an individual institution basis by various federal

and state agencies. Securities broker-dealers and FCMs are regulated by

SEC13 and CFTC,

14 respectively. State agencies and self-regulatory

organizations (SRO)15 are also involved in supervising broker-dealers and

FCMs. Life insurance companies are regulated and overseen by state

regulatory agencies. No formal/statutory holding company regulatory

oversight currently exists for securities firms, futures firms, or insurance

companies in the United States at the federal level.

Authority of the Financial

Regulatory Agencies Varies

in Scope

Many of the largest financial legal entities are part of a holding company

structure that generally has affiliates conducting business activities in the

formerly more separate sectors of banking, life insurance, securities

trading, and futures trading sectors. In this report, we often refer to these

holding company structures as large, diversified firms.

The dominant form of banking structure in the United States is the holding

company. A number of the larger bank holding companies have

12This report focuses on regulation of capital requirements and thus does not provide a comprehensive

description of the authority or activities of these regulators.

13The definition of a security subject to SEC regulation includes instruments, such as stocks, corporate

and treasury bonds, notes, mutual funds, and securities options. SEC’s mission is to administer federal

securities laws and issue rules and regulations to provide protection for investors and to help assure

that the securities markets are fair and honest. This is accomplished primarily by promoting adequate

and effective disclosure of information to the investing public. SEC also regulates firms engaged in the

purchase or sale of securities, people who provide investment advice, and investment companies.

14The Commodity Exchange Act gives CFTC exclusive jurisdiction, with certain exceptions, over the

regulation of the nation’s futures and options markets, including on- and off-exchange transactions in

futures and options. Futures are contracts that obligate the holder to buy or sell a specific amount or

value of an underlying asset, reference rate, or index at a specified price on a specified future date.

Options are contracts that grant the purchaser the right, but not the obligation, to buy or sell a specific

amount of the underlying at a particular price within a specified period. Listed options are

exchange-traded. CFTC is responsible for ensuring the economic utility of these markets by guarding

the integrity of the markets; protecting market users from fraud and other trading abuses; monitoring

the markets to detect and prevent price distortions and manipulation; and fostering open, competitive,

efficient, and financially sound markets.

15SROs play an extensive role in the regulation of the U.S. securities and futures industries. They assist

SEC and CFTC in implementing and enforcing federal securities and commodities laws. SROs include

all of the U.S. securities and commodities exchanges, the National Association of Securities Dealers,

the National Futures Association, and the Municipal Securities Rulemaking Board.

Page 25 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

established nonbank subsidiaries that engage in securities underwriting

and brokerage services, insurance sales, and futures trading, as well as

other nonbanking activities permitted because they are deemed to be

closely related to the business of banking and to produce a public benefit.16

 Figure 1.1 is a simplified illustration of a hypothetical holding company

with wholly owned banking and nonbanking subsidiaries and the

regulators that oversee the various entities.

Figure 1.1: Simplified Structure of a Hypothetical Bank Holding Company

Parent Bank

Holding Company

(Federal Reserve)

State

Nonmember

Bank

(FDIC and state)

Insurance

Subsidiary

(state)

State Savings

and Loan

Association

(OTS and state)

Federal Savings

and Loan

Association

(OTS)

National Bank

(OCC)

State Member

Bank

(Federal Reserve

and state)

Futures

Commission

Merchant

(CFTC)

Parent Thrift

Holding Company

(OTS)

Securities

Broker-Dealer

(SEC)

Mortgage

Company

(OCC)

Bolding denotes regulator

Source: GAO.

16Section 4 of the Bank Holding Company Act of 1956 generally prohibits bank holding companies from

owning or controlling any company that is not a bank. The law, however, lists several exemptions to

this rule. The most important of these authorizes the Federal Reserve Board to approve the acquisition

or formation of a nonbank affiliate where the board determines that the activities of the affiliate are

“so closely related to banking. . . as to be a proper incident thereto” and would produce a public

benefit. 12 U.S.C. S 1843. Section 16 of the Glass-Steagall Act limits the securities activities of national

banks essentially to brokerage services. Section 20 prohibits member banks from affiliating with

organizations engaged principally in securities activities, although with approval of the Federal

Reserve, a bank holding company may engage in limited securities activities through a subsidiary

which is called a section 20 subsidiary.

Page 26 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

Many large U.S. securities broker-dealers, life insurers, and FCMs have also

expanded their range of activities by establishing holding companies at the

top of their corporate structures. When creating or acquiring affiliates,

these other types of financial firms are not limited to creating or acquiring

those that engage in activities related to their own. Banks are allowed to

affiliate only with companies engaging in activities closely related to

banking and must demonstrate some public benefit in creating or

acquiring an affiliate, but other types of financial firms have no such

limitations. Figure 1.2 shows a simplified structure of a hypothetical

nonbank17 financial holding company with affiliates engaged in banking

activities (through a thrift institution),18 securities and futures trading, and

life insurance sales, among many other types of activities.

17A nonbank is a financial firm that does not have a bank charter.

18U.S. unitary thrift holding companies, unlike bank holding companies, may be owned by, or own, any

type of financial services or other business. Thrifts also have broader powers than banks in areas such

as insurance and real estate development and are regulated by the Office of Thrift Supervision.

Page 27 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

Figure 1.2: Simplified Structure of a Hypothetical Nonbank Financial Holding Company

(Parent)

Holding Company

Parent Company

Merchant

Bank Corporation

Futures

Management 

Corporation

(Futures commission

merchant)

(CFTC- and SROregulated)

A

International

Funding

Corporation

Japan 

Incorporated

(Broker-dealer)

(regulated in 

Japan)

German Bank

Corporation

(Bank)

(regulated in 

Germany)

United Kingdom

Incorporation

(Broker-dealer)

(regulated in

United

Kingdom)

Dutch Bank

Corporation

(Bank)

(regulated in The 

Netherlands)

Special

Financing

Incorporation

(Swaps and foreign

currencies)

Commercial Paper

Funding

Corporation

Bank and Trust

Company

(Nonbank bank)

(FDIC- and stateregulated)

International

Holding Company

Page 28 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

Government

Securities

Incorporated

(Government

securities dealer)

(SEC- or Treasuryand SRO- regulated)

Holding Company

A

Federal Savings

and Loan

Association

(OTS)

U.S. Broker-Dealer

(SEC, SRO, and

state-regulated)

Asset Management

Company

(Investment

adviser)

(SEC- and stateregulated)

Canadian 

Investment

Corporation

(Canadian 

investment dealer)

(regulated in

Canada)

Options/Futures

Management

Corporation

(Proprietary

investments)

Life Insurance

Company

(state- licensed

and regulated)

Mortgage Bankers

Corporation

(Mortgage bankers)

Real Estate 

Company

(Real estate and

mortgage broker)

Physical 

Commodities

Management

Corporation

Real Estate

Investment

Incorporation (Real 

estate investment 

and management)

Bolding denotes regulator

( ) Denotes type of business

Source: GAO.

Page 29 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

Bank Holding Companies

Are Regulated on a

Consolidated Basis; and

Other Types of Regulated

Entities on an Individual

Basis

As summarized in table 1.1, the regulatory and oversight authorities of

financial regulatory agencies differ. The Bank Holding Company Act of

1956 authorized the Federal Reserve Board to regulate bank holding

companies on a consolidated basis. This gives the Federal Reserve Board

regulatory and examination authority over all activities of the bank

holding company. Affiliates that are banks are supervised by one or more

of the federal banking agencies listed in table 1.1. Among other things, this

means that capital standards apply at the holding company level and bank

level. In addition, FDIC insures bank depositors and has authority to

terminate deposit insurance for any FDIC-insured institution.

In contrast to the regulatory authority of the Federal Reserve Board, SEC

and CFTC are authorized to regulate only those entities that themselves

engage in activities involving securities and futures, respectively, and not

the affiliates of those entities.19 Unlike banks, Congress has not passed

legislation authorizing SEC or CFTC to supervise holding companies of

securities broker-dealers or FCMs, respectively. However, SEC and CFTC risk

assessment rules promulgated pursuant to the Market Reform Act of 1990

and The Futures Trading Practices Act of 1992, respectively, enable those

agencies to collect from the regulated entity information about the

activities and financial condition of its affiliates and parent firms to assess

the risks they pose to the regulated entity’s financial and operational

condition, including net capital, liquidity, and the ability to finance

operations.20 These rules do not provide either agency with the legal

regulatory authority to examine or set regulatory capital requirements

over the parent or affiliates of the SEC-registered broker-dealer or the

CFTC-registered FCM, although they do give both agencies a supervisory role

with respect to those affiliates.

State insurance departments are authorized to regulate insurance activities

and those firms that sell insurance products. They are not authorized to

regulate or examine parents or affiliates of the regulated entities.

19For example, the Securities Exchange Act of 1934 requires that any persons or firms who engage in

the business of buying and selling securities for their own account and/or for customers must register

with SEC as broker-dealers. Similarly, the Commodity Exchange Act requires that any persons or firms

who engage in the business of buying or selling contracts for the purchase or sale of any commodity

for future delivery (including commodity options and other risk-shifting instruments), for their own

account and/or for customers, must register with CFTC as an FCM or Introducing Broker. Introducing

brokers are firms that solicit and accept commodity futures and options orders but do not accept

customer funds.

20Rules 17h-1T and 17h-2T for SEC and Rules 1.14 and 1.15 for CFTC.

Page 30 GAO/GGD-98-153 Risk-Based Capital
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Table 1.1: a Comparison of the Regulatory and Oversight Authority Concerning Capital of Federal Regulators of

Commercial Banks, Securities Broker-Dealers, and FCMs and State Regulators of Life Insurers

Regulator

Financial entity subject to regulatory

authority Scope of supervisory/oversight authority

Office of the Comptroller of the Currency

(OCC)

National banks and federal branches and

federally licensed agencies of foreign

banks with U.S. operations.

National banks; also, under delegated

authority of the Federal Reserve, may

participate in examining all activities of

nonbank affiliates of OCC-regulated banks

and their bank holding companies.

Federal Reserve System (FRS) State-chartered banks that are FRS

membersa and bank holding companies

and their nonbank subsidiaries; also, the

combined U.S. operations of foreign

banking organizations.

All activities of regulated state-chartered

banks that are FRS members, bank holding

companies, and their non-bank affiliates.

Federal Deposit Insurance Corporation

(FDIC)b

Federally insured state-chartered banks

that are not members of FRS.a

Backup examination authority for all

federally insured banks. Under delegated

authority of the Federal Reserve, may

participate in examining all activities of

nonbank affiliates of FDIC-regulated banks

and their bank holding companies.

Securities and Exchange Commission (SEC) SEC-registered broker-dealers.c Only registered broker-dealers—not

affiliates or parent holding companies.

Commodity Futures Trading Commission

(CFTC)

CFTC-registered futures commission

merchants (FCM).d

Only registered FCMs—not affiliates or

parent holding companies.

State insurance departments Insurance companies domiciled and

licensed to operate in the state.

Only regulated insurance companies—not

affiliates or parent holding companies.

Note: State regulators also oversee state-chartered banks and securities broker-dealers. The

Office of Thrift Supervision oversees thrifts; however, we do not focus on thrifts in this report, so

they are not included in this table.

aThese banks are also overseen by state-level banking authorities.

bFDIC administers the Bank Insurance Fund and the Savings Association Insurance Fund.

cBroker-dealers must also comply with requirements of the various exchanges and industry

associations, such as the New York Stock Exchange and the National Association of Securities

Dealers, which are self-regulatory organizations under the Securities Exchange Act of 1934.

dFCMs must also comply with rules imposed by the various exchanges, such as the Chicago

Mercantile Exchange and the Chicago Board of Trade, as well as the National Futures

Association—all self-regulatory organizations under the Commodity Exchange Act.

Source: GAO analysis of applicable regulations.

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Capital Regulation Is One

of Many Tools Financial

Regulators Use to Ensure

Stability of the Financial

System and Markets

Through capital standards and other regulations, regulators of banks,

securities broker-dealers, FCMs, and life insurers seek to help ensure public

confidence in financial institutions and markets by protecting customers’

funds and limiting losses to various deposit and guarantee funds that

further protect customers’ funds. As for securities broker-dealers and

FCMs, regulators seek to ensure that registered entities will have a pool of

liquid assets available on a daily basis to meet their obligations to

customers and other market participants. Capital

regulation—requirements that firms hold minimum amounts of capital—is

one tool in a kit of many that financial regulators use to help ensure

stability and public confidence in the financial system and markets. It is

supported by supervision—the monitoring, inspecting, and examining of

regulated entities—and enforcement. In some cases, it is also supported by

segregation of customer funds or by insurance protection of those funds.

The oversight activities of financial regulators are similar in some respects

and different in others. Each regulator is to promulgate rules (including

regulatory capital requirements), monitor firms’ financial condition,

perform examinations, and take appropriate actions to enforce relevant

regulations and statutes. The oversight activities of SEC and CFTC differ

most significantly from those of bank regulators and state insurance

regulators because of differing purposes of the regulation. SEC and CFTC,

with the assistance of SROs, protect investors and ensure the integrity of

the securities and futures markets; bank regulators and state insurance

regulators ensure the safety and soundness of entities they regulate.

Supervision of regulated entities in the banking, securities, futures, and life

insurance sectors includes off-site monitoring of financial reports and

on-site examination visits. In banking, supervisors are to track the

financial condition of their banks on a continuing basis and between

on-site examinations. A principal off-site technique banking supervisors

use for monitoring the activities and financial condition of their banks is

the review of detailed financial statements (Call Reports) that the banks

submit quarterly. In addition, the banking regulators use computerized

monitoring systems that use Call Report data to compute, for example,

financial ratios, growth trends, and peer group comparisons. Banking

supervisors also meet with bank senior management from time to time to

discuss the current condition of the bank and plans the bank has for the

future. Monitoring is a complement to on-site examinations, which lie at

the heart of the supervisory process. The purpose of bank on-site

examinations is for examiners to evaluate the bank’s overall risk exposure

with particular emphasis on what is known as its CAMELS—the adequacy

Page 32 GAO/GGD-98-153 Risk-Based Capital
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Introduction

of its capital, and asset quality, the quality of its management and internal

control procedures, the strength of its earnings, the adequacy of its

liquidity, and its sensitivity to market risk. Banks are usually examined at

least once during each 12-month period and more frequently if they have

serious problems. In addition, well-capitalized banks with total assets of

less than $250 million can be examined on an 18-month cycle.

In contrast to regulation of banks, regulation of the securities and futures

markets is a combination of direct regulation and oversight by federal

agencies and indirect regulation and oversight by SROs (e.g., the New York

Stock Exchange, the National Association of Securities Dealers).

Securities broker-dealers and FCMs are required to become members of an

SRO and, as SRO members, must comply with SRO rules and regulations. SRO

rules and regulations are promulgated under the SEC or CFTC standards and

requirements. Securities SRO rules and regulations are often more stringent

than SEC rules and require SEC’s approval. SROs must register with SEC or

CFTC and are subject to SEC or CFTC oversight. SROs establish rules to govern

member conduct and trading, set qualifications for certain market

participants, monitor daily trading activity, examine their members’

financial health and compliance with rules, and investigate alleged

violations of those rules and securities and futures laws. SEC oversees the

regulatory and supervisory activities of the securities industry’s SROs. CFTC

oversees the compliance activities of the futures industry’s SROs, which

include the U.S. commodity exchanges and the National Futures

Association. Both SEC and CFTC also develop, implement, interpret, and

enforce statutes and regulations to protect customer funds, prevent

trading and sales practice abuses, and ensure the financial integrity of

firms holding customer funds. Additionally, SEC and CFTC conduct direct

audits of clearing organizations and firms handling customer money to

ensure compliance with the capital and segregation rules.

In contrast to banking, securities, and futures regulation, regulation of the

insurance industry is primarily a state, not federal, responsibility. In

general, state legislatures set the rules under which insurance companies

are to operate, including capital standards; and state insurance regulators

are to monitor the health and solvency of the regulated insurance

companies. To help coordinate their activities, state insurance regulators

have established a central structure—the National Association of

Insurance Commissioners (NAIC), an organization whose members are the

heads of the insurance departments of 50 states, the District of Columbia,

and 4 U.S. territories and possessions. NAIC’s basic purpose is to encourage

consistency and cooperation among the various states and territories as

Page 33 GAO/GGD-98-153 Risk-Based Capital
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Introduction

they individually regulate the insurance industry. To that end, NAIC

promulgates model insurance laws and regulations for state consideration

and provides a framework for multistate examinations of insurance

companies.

State regulators use a number of basic methods to assess the financial

strength of insurance companies, including reviewing and analyzing

annual financial statements, doing periodic on-site financial examinations,

and monitoring key financial ratios. Supervision of life insurers is the

responsibility of insurance departments in each state, with the primary

responsibility residing with the “domiciliary” regulator, that is, the

regulator in the state where the company is domiciled.21 The domiciliary

regulator is responsible for conducting periodic on-site examinations and

for reviewing the required annual and quarterly financial reports.

Examiners monitor the financial health of the insurer, along with

compliance with rules and regulations, and look for evidence of any

unsafe business practices. Regulators in states where the company is

licensed and operating, other than the domiciliary state, may participate in

on-site examinations with the domiciliary state if they choose. These

examinations are called zone examinations. In most states, the typical

interval between on-site examinations is 3 to 5 years unless regulators

have reason to believe problems exist that could affect the company’s

viability.

Financial regulators may take both informal supervisory and/or formal

enforcement actions to ensure that regulated entities undertake corrective

steps for identified problems. In banking, such informal actions may

include a request that a bank adopt a board resolution or agree to the

provisions of a memorandum of understanding to address the problems. If

necessary, financial regulators may take formal enforcement actions to

compel the management and directors of troubled entities to address

problems. Formal enforcement actions in banking include written

agreements, cease and desist orders, prompt corrective action directives,

termination of deposit insurance, revocation of a bank charter, and closing

of the bank. Other actions include assessing fines, such as civil money

penalties; and removing an officer or director from office and permanently

barring him or her from the banking industry.

SEC and CFTC have the authority to take supervisory and enforcement

actions against the entities they regulate. Their enforcement tools include

21The insurer may or may not be headquartered or even operating in the state in which it is domiciled

for regulatory purposes, although it usually is.

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Introduction

court injunctions; temporary restraining orders; and various administrative

proceedings and sanctions, such as assessment of civil monetary penalties,

disgorgement orders, censure, suspension and revocation of registration,

and cease and desist orders.

Additionally, SEC staff provide informal regulation of broker-dealers

through no-action letters. In the no-action process, a broker-dealer

requests interpretive relief from SEC staff regarding certain transactions or

activities. In a typical no-action letter, the staff states that it will not

recommend that SEC take enforcement action if the requesting party

executes transactions or engages in activities in the limited context stated

by the staff. In SEC’s view, limitations in no-action letters related to

risk-management issues balance regulatory flexibility with the need to

avoid undue risk. The letters are made available to the public and

informally address regulatory concerns that by necessity are not detailed

in securities statutes.

As with other financial regulators, insurance regulators have an array of

informal and formal actions that can be employed to correct problems

identified through the supervisory process. These actions often begin with

informal discussions of regulatory concerns with company officials. If

problems are not resolved promptly, regulators have a number of more

formal tools available, including administrative actions; court orders and

injunctions; and culminating with the power to take regulatory control of a

company, remove the officers, and either sell or liquidate it. Many of the

authorities held by state insurance regulators are enhanced when the

Risk-Based Capital Insurers Model Act has been adopted in a particular

state. When adopted, this act gives the state’s chief insurance regulator the

explicit authority to take regulatory action based on an insurer’s

risk-based capital level.

The Financial

Services Industry Is

Changing in Response

to a Variety of

Developments

Since the late 1970s, significant changes have been occurring in the

financial services industry due to a number of market shocks, combined

with advances in financial theory and information technology. The

interaction of these factors has led to significant expansion of such

financial products as derivatives and asset-backed securities,22 improved

methods to measure and manage risks, increased competition in financial

services, and mergers of financial firms within and across financial

22Derivatives are financial contracts whose market value is determined by the value of an underlying

asset, reference rate, or index. Asset-backed securities are created from securitized assets, such as

auto loans, credit card receivables, mortgages, equipment leases, and corporate bonds. Asset

securitization is the process by which loans and other receivables are pooled, reconstituted into one or

more classes or positions, and then sold.

Page 35 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

sectors. In addition, these factors have encouraged some firms to offer

risk management services to other financial and nonfinancial firms. This

risk management has often been based on the use of derivatives and

asset-backed securities to repackage risks and returns.

The creation and growth in derivatives, huge increases in trading

activities, and the development of new secondary markets, along with the

creation of asset-backed securities, have fundamentally changed the

financial landscape. Derivatives and asset-backed securities have

permitted financial market participants to better manage market risk by

transferring the risk from entities less willing to bear it to those more

willing to do so. Derivatives have stimulated trading generally because

they gave financial market participants a lower cost way to hedge

investments or to take speculative positions.23 In addition, derivatives

products markets have grown rapidly. For example, the International

Swaps and Derivatives Association estimates that as of December 31, 1996,

the combined notional amount of globally outstanding interest rate swaps

and other over-the-counter (OTC) derivatives had grown to $25.45 trillion

from $3.45 trillion on December 31, 1990.24

Advances in information technology and financial theory have helped

reduce various barriers to competition. The increased speed and lower

costs in communicating and transmitting data over large geographical

distances eliminated such distance as an obstacle to competition.

Moreover, new financial theories and faster computers helped financial

firms handle large amounts of data at low cost and analyze the risks and

returns created by new financial products. Swaps and other derivatives,

which have been growing rapidly, are an example of such technology- and

theory-dependent products. Since the tools and skills underlying them

were not unique to any one sector of the financial services industry, no

one sector has a monopoly on their use; thus, the list of major derivatives

dealers includes banks, securities firms, and insurance companies.25

Regulators also have acted in ways to promote greater competition in the

financial services industry. For example, the Federal Reserve Board has

approved a number of additional activities for banks to offer, including

providing investment advice, underwriting insurance related to the

23To hedge is to reduce risk by taking a position that offsets existing or anticipated exposure to a

change in market prices. Position refers to an investor’s stake (buying or selling) in a market or a

particular security. To speculate is to take risk by taking a position in hope of realizing a profit.

24OTC derivatives are customized contracts that are not traded on exchanges.

25See GAO/GGD/AIMD-97-8, Nov. 1, 1996, for a list of major derivatives dealers.

Page 36 GAO/GGD-98-153 Risk-Based Capital
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Introduction

extension of credit, tax planning and preparation, data processing, and

operating a credit bureau or collection agency. The Federal Reserve Board

also approved bond and stock underwriting powers for Section 20

subsidiaries of bank holding companies. Effective in March 1997, the

Federal Reserve Board enhanced these powers when it increased from 10

to 25 percent the share of total revenues a bank holding company’s

Section 20 subsidiary may derive from corporate equity and debt

underwriting. On the basis of these decisions, banks have increasingly

acquired or created securities broker-dealer affiliates or subsidiaries.26 OCC

has amended its regulations to permit subsidiaries of national banks to

engage in activities that OCC determines—on a case-by-case application

basis—to be “part of or incidental to the business of banking.”

In addition to banks entering underwriting, an area associated with

securities firms, a number of large securities firms have entered a

traditional province of banks: commercial loans to corporate borrowers.

Recently, securities firms have made and traded such loans, which are

commonly linked with securities underwriting. Such services enable the

firm to provide a customer with a full range of its financing needs. In a

number of instances, banks and securities firms have joined together to

provide such loan and security facilities for customers.

Increasing competition also affects insurance companies and insurance

products. During the past several years, life insurance companies

increasingly have moved away from traditional whole life and term

insurance products and have focused instead on asset growth or

investment products such as variable annuities. These products compete

with stocks and bonds, retirement vehicles offered by banks, and stock

mutual funds and are often sold by financial planners and securities

brokers.

As part of this competition, large, diversified financial firms are

increasingly operating in what once were separate banking, insurance, and

securities sectors, as discussed earlier. Banks have acquired investment

banks; and many types of firms have acquired thrifts, which are similar to

banks but can be owned by anyone. For example, a number of insurance

companies have applied for thrift licenses. Securities firms have acquired

firms that have enabled them to engage in banking activities. For example,

in 1997, Merrill Lynch & Company, Inc., and the Travelers Group, Inc.,

which includes insurance companies and securities firms, both received

26For example, in 1997, the Bankers Trust New York Corporation bought Alex Brown & Sons, Inc. (a

stock brokerage firm), and NationsBank Corporation affiliated with Montgomery Securities.

Page 37 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

federal thrift charters. In addition, insurance companies have acquired

securities firms. For example, the Travelers Group acquired Salomon

Brothers, Inc. (primarily a securities trading firm) in November 1997, and

it already owned Smith Barney and Company (primarily a retail brokerage

firm). In addition, in April 1998, the Travelers Group and Citicorp

announced their intention to merge and create a new entity that is to be

called Citigroup. This would be the biggest corporate merger in history;

however, there are questions about the implications of current banking

laws for the merger. If the laws are not changed, it is possible the new

entity would have to divest itself of certain operations, either in insurance

or banking.

Objectives, Scope,

and Methodology

To help Congress and others better understand current regulatory capital

requirements, developments in those requirements, and regulatory issues

these developments raise, the objectives of this report are to describe, for

the banking, securities, futures, and life insurance sectors of the financial

services industry, (1) regulatory views of the purpose of capital and

current regulatory requirements; (2) the approaches of some large,

diversified financial firms to risk measurement and capital allocation; and

(3) issues in capital regulation and initiatives being considered for changes

to regulatory capital requirements.

To achieve these objectives, we interviewed

• officials from financial regulators, including OCC, the Federal Reserve

Board, the Federal Reserve Bank of New York, FDIC, SEC, CFTC, and the

Office of Thrift Supervision; and the Departments of Insurance for New

York and Illinois;

• academics and consultants who are considered experts in the financial

services field;

• rating agencies’ analysts, including A.M. Best, Standard and Poor’s, and

Moody’s Investors Service;

• officials of SROs, including the Chicago Board of Trade, the Chicago Board

of Trade Clearing Corporation, the Chicago Mercantile Exchange, the

National Futures Association, the New York Stock Exchange, and the

National Association of Securities Dealers;

• officials of trade and industry associations, including the American

Academy of Actuaries, the American Bankers Association, the American

Council on Life Insurance, the Independent Bankers Association of

America, the Institute of International Finance, NAIC, the New York

Clearing House Association, and the Securities Industry Association; and

Page 38 GAO/GGD-98-153 Risk-Based Capital
Chapter 1 

Introduction

• officials of 16 large, diversified firms in the commercial banking,

securities, futures, and insurance industries (see app. V for a listing of

these firms).

In addition, we reviewed U.S. government, international organization,

trade association, academic, industry, and private firm documents,

including regulations, annual and other published reports, papers and

articles, industry journals, and information available at various sites on the

world wide web.

To determine the development of risk measurement and capital allocation

systems in firms, we interviewed and obtained information from a number

of large, diversified firms in the commercial banking, securities, futures,

and insurance sectors (see app. V for a listing of these firms). We did not

test the adequacy of any of the risk measurement and capital allocation

systems discussed in this report. In selecting firms for this review, on

recommendations from SEC, we chose securities firms that were part of the

Derivatives Policy Group (DPG).27 We chose commercial banks that

appeared likely to be required to meet the market risk capital

requirements that took effect on January 1, 1998,28 and life insurance

companies that have been involved in the development of risk-based

capital standards for that industry. The securities firms we visited are large

holding companies and include both SEC-registered broker-dealers and

CFTC-registered FCMs.29 We interviewed officials who could speak about

risk management and capital allocation systems for the consolidated

financial firm.

We developed and used a set of common questions in our discussions with

these firms. In these interviews, we obtained information about the

following:

• the most important risks faced by these firms,

• their risk measurement and capital allocation systems and methodologies,

27DPG was organized in 1994 to address the public policy issues raised by the OTC derivatives

activities of unregistered affiliates of SEC-registered broker-dealers and CFTC-registered FCMs. It

comprises the six U.S. securities firms with the highest volume of over-the-counter derivatives

activities (CS First Boston, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and

Salomon Brothers).

28The 5 U.S. bank holding companies we interviewed are among the top 10 largest bank holding

companies in the United States. As of December 31, 1997, the total assets of the 5 bank holding

companies comprised 57 percent of the total assets of the 10 largest bank holding companies.

29As part of DPG, the securities firms we visited represent five of the six largest derivatives dealers in

the United States.

Page 39 GAO/GGD-98-153 Risk-Based Capital
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Introduction

• their internal risk management structures and uses of internal risk

measurement information,

• the impact of current capital requirements on their operations, and

• possible future directions in capital regulation.

We did our work in Washington, D.C.; New York; and Chicago between

November 1996 and April 1998 in accordance with generally accepted

government auditing standards.

We obtained written comments on a draft of this report from OCC, the

Federal Reserve Board, FDIC, SEC, and CFTC. These comments are reprinted

in appendixes VI, VII, VIII, IX, and X. The agencies generally believed the

report was comprehensive and balanced. In their comments, OCC, FDIC, and

SEC expand on a number of points made in the report pertaining to their

industries. On June 2, 1998, the Washington Counsel of NAIC provided us

with oral comments in which he characterized the report as reasonable.

These organizations also provided technical comments, which have been

incorporated where appropriate.

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Chapter 2 

Regulatory Capital Requirements Differ by

Type of Regulated Entity

Just as the financial regulators serve differing statutory purposes, they

differ in their views on the purpose of regulatory capital. Bank capital

standards are focused on maintaining the safety and soundness of banks,

and capital is calculated on a going-concern basis. Capital standards for

securities broker-dealers and FCMs are focused on protecting customers in

the event of a broker-dealer or FCM failure and are calculated on a

liquidation basis. Capital standards for life insurers are to help limit

failures and protect claimants, and capital is calculated on a going-concern

basis.1

In addition to reflecting differences in the regulators’ views on the purpose

of capital, regulatory capital requirements also reflect differences in what

have been historically the dominant risks associated with the regulated

entities. The bank capital requirements that apply to all banks have

emphasized credit risk, because credit risk has long been the most

important and predominant risk for banks, which traditionally invested the

largest part of their funds in bank loans. Recently, regulators added a

market risk capital requirement for banks engaged in trading activities that

create market risks. Capital requirements for securities broker-dealers and

FCMs traditionally focused on liquidity and market risks and the effect of

changing market prices on the value of their assets, in keeping with the

dominant risk in their activities. Capital requirements for life insurers

focus on traditional risks, such as actuarial risk which is unique to the

insurance industry, as well as other risks related to their assets and

liabilities.

Current capital requirements reflect a variety of efforts to relate capital

requirements to risks inherent in firms’ activities. These include efforts to

modify current rules to better reflect actual risks in firm activities as well

as efforts to take advantage of new risk measurement techniques that are

more sensitive to correlation among prices of assets and can more

precisely measure risks. Industry representatives with whom we spoke,

who generally favor changing regulatory capital requirements to more

precisely account for risks in their activities, see progress in recent

changes made to regulatory capital requirements. However, they also have

concerns and see needs for additional improvement.

1

Going-concern value is the value of a company as an operating business to another company or

individual. The liquidating value of a company is the value of its assets. The difference between

going-concern and liquidating value is often termed goodwill. Goodwill is generally understood to

represent the value of a well-respected business name or other such factors expected to translate into

greater than normal earning power.

Page 41 GAO/GGD-98-153 Risk-Based Capital
Chapter 2 

Regulatory Capital Requirements Differ by

Type of Regulated Entity

The Purpose of

Regulatory Capital

Differs by Type of

Regulated Entity

Although the agencies that oversee banks, securities broker-dealers, FCMs,

and life insurance companies all seek to protect customers and ensure the

smooth functioning of the markets they regulate, their statutory purposes

differ in various ways. The differences in regulatory purpose are reflected

in the regulators’ views of the purpose of regulatory capital.

Bank Capital Standards

Focus on Safety and

Soundness of Banks, and

Capital Is Calculated on a

Going-Concern Basis

As shown in table 2.1, the regulatory purpose of agencies that oversee

banks is to help ensure the safety and soundness of the banking and

payments systems and minimize losses to the deposit insurance fund; and

the Federal Reserve Board also has responsibility to help ensure the

stability of the U.S. financial system. In this regard, regulators view capital

as performing several important functions. It is there to absorb losses,

thereby allowing banks to continue to operate as going concerns during

periods when operating losses or other adverse financial results are being

experienced. Capital also helps to promote public confidence, restrict

excessive asset growth, and provide protection to depositors and the Bank

Insurance Fund administered by FDIC. Depositors who are protected by

deposit insurance may be less careful in their choice of banks. This

behavior may, in turn, permit insured banks to operate less conservatively

than they would without deposit insurance to shield them from depositors’

concerns about the banks’ safety and soundness. The consequences of

both the banks’ and depositors’ behavior is called “moral hazard.”

Regulators use capital requirements to mitigate the moral hazard that

arises from deposit insurance protection.

In addition, bank regulatory capital requirements are a measure regulators

can use as a starting point in regularly assessing the financial condition of

banks. A reduction in capital that causes the institution to approach the

minimum required ratio is seen as a symptom warning regulators that an

institution’s financial health is threatened and that regulatory intervention

may be needed to protect depositors and other parties. Under the Prompt

Corrective Action guidelines enacted as part of the Federal Deposit

Insurance Corporation Improvement Act (FDICIA) of 1991, banking

supervisors are required to increase intervention as a bank’s capital ratio

falls through various predetermined ratios before the bank runs out of

capital. This intervention is meant to reduce the likelihood of bank

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Chapter 2 

Regulatory Capital Requirements Differ by

Type of Regulated Entity

failures, reduce the cost of failures that occur, and thus deter or minimize

systemic risk.2

Minimum capital requirements also help protect the Bank Insurance Fund,

which guarantees depositors will receive par value up to $100,000 per

depositor per insured institution3

 if regulators close a bank and FDIC must

liquidate it.4

 For deposits exceeding the $100,000 limit, FDIC is to provide

reimbursements based on the value of the assets sold when the bank is

closed and liquidated. Bank compliance with capital requirements protects

the Bank Insurance Fund because higher capital requirements reduce the

likelihood of bank failure and thus reduce the losses that FDIC is likely to

incur in covering guaranteed deposits from failed banks. FDICIA imposed a

requirement that a bank whose tangible equity5

 falls to 2 percent (or less)

of assets is deemed to be “critically undercapitalized” and generally is to

be placed in conservatorship or receivership within 90 days of becoming

critically undercapitalized. Although bank regulation, including capital

standards, attempts to reduce the likelihood of failures, it is not meant to

forestall all failures.

Bank capital standards are focused on safety and soundness, and

regulatory capital is calculated on a going-concern basis—that is, with the

assumption that the bank will continue operating. In this way, bank capital

regulation is focused on the continued operation of the banking system

and is meant to ensure that payment services and the provision of loans to

all customers, both large and small, will not be disrupted.

2

Systemic risk could occur if the failure of a financial institution led to the failure of other financial

institutions. In a worst-case scenario, these subsequent failures could result in a cascade of failures

and impairment of the operations of the financial system and, ultimately, the overall economy. Direct

regulatory oversight of bank holding companies is designed to help deter the failure of a financially

weakened large banking institution that could create systemic problems.

3

All accounts owned by an individual in a single banking institution are aggregated for deposit

insurance purposes and covered up to $100,000 per depositor per insured institution. If a depositor has

both checking and savings accounts in the same institution, both accounts taken together would be

insured up to $100,000. However, if an individual has a joint account with another person in the same

bank, this joint account would be separately insured up to $100,000. There is no limit to the number of

insured accounts an individual may have in different banking institutions. See Deposit Insurance: A

Strategy for Reform (GAO/GGD-91-26, Mar. 4, 1991).

4

The Federal Deposit Insurance Act, as amended by the Federal Deposit Insurance Corporation

Improvement Act of 1991, requires federal regulators to take specific action against banks and thrifts

that have capital levels below minimum standards. In an earlier report, we discuss these requirements

and their implementation. See app. I of this report and Bank and Thrift Regulation: Implementation of

FDICIA’s Prompt Regulatory Action Provisions (GAO/GGD-97-18, Nov. 21, 1996).

5

Tangible equity is the sum of common stock, surplus, and retained earnings, net of Treasury stock and

currency translation adjustments, with intangible assets subtracted.

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Capital Standards for

Broker-Dealers and FCMs

Focus on Protecting

Customers and Their

Markets and Are

Calculated on a Liquidation

Basis

As shown in table 2.1, the primary regulatory purposes of the SEC and CFTC

capital standards are to ensure that broker-dealers and FCMs will have a

pool of liquid assets available on a daily basis to meet their obligations to

customers and other market participants. This protection of customers

does not shield customers from investment losses if the market value of

the investment is less than the purchase price, and the protection is

consistent with SEC’s and CFTC’s overall concern with ensuring the integrity

of the securities and futures markets, respectively. These agencies’

regulatory capital requirements are designed to provide assurance that

broker-dealers and FCMs can fulfill their obligations to customers and other

market participants in the event a broker-dealer or FCM is closed. The

amounts owed to customers are based on credit balances (or cash) in

customer accounts and the market value of customers’ securities and

futures positions at the broker-dealer or FCM.

Minimum capital requirements also help protect the Securities Investor

Protection Corporation (SIPC), a nonprofit membership corporation

created by Congress under the Securities Investor Protection Act of 1970.

Within certain limits, SIPC will return to customers cash and securities held

at liquidated SIPC member broker-dealers. SIPC protects each customer up

to $500,000 for claims for cash and securities, although claims for cash are

limited to $100,000 per customer. The cash limit historically has tracked

the bank-insured deposits amount. SIPC does not protect investors from

declines in the market value of their securities. Successful functioning of

the net capital rule results in the orderly liquidation of a failing firm;

prevents the need for federal court intervention; and reduces strains on

SIPC’s resources, including the SIPC membership assessment fund from

which customers are paid.

Capital Standards for Life

Insurers Are to Help Limit

Failures and Protect

Claimants

Generally speaking, state insurance regulators are to monitor the health

and solvency of regulated life insurers in order to protect claimants. For

state insurance regulators, the purposes of capital are similar to the

purposes of capital for bank regulators. State insurance regulators impose

capital requirements to try to limit life insurance company failures and

thus help ensure the long-run viability of these insurance companies so

that they can meet policyholders’ claims in the future. However, state

regulators regulate only insurance companies and not the insurance

groups or the often large, diversified financial firms that own insurance

companies. Generally, however, insurance regulators do have the

responsibility of approving mergers or acquisitions of insurance

companies.

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Table 2.1: Primary Purposes of

Regulatory Capital Entity type Primary purposes of regulatory capital

Banks and bank holding

companies

• To help ensure the safety and soundness of the banking

and payments systems 

• To minimize losses to the deposit insurance funds

Broker-dealers • To protect customers and other market participants

from losses due to broker-dealer failure

• To ensure the integrity of the securities markets

FCMs • To protect customers and other market participants

from losses due to the failure of the FCM

• To ensure the integrity of the commodities markets

Insurance

companies

• To monitor the health and solvency of regulated insurers

to protect claimants

Source: GAO analysis of applicable regulations.

Regulatory Capital

Requirements Differ

by Industry Sector,

Reflecting Differences

in Regulatory

Purposes and

Dominant Activities

Within Sectors

Current regulatory capital requirements for the banking, securities,

futures, and life insurance sectors vary in how they take into account the

risks of regulated entities in determining minimum capital standards. The

capital requirements differ, although the rules for securities broker-dealers

and FCMs are similar. These differences reflect differing regulatory

purposes, as discussed earlier, or differences in the types of activities and

risks that are, or have been, dominant for the various types of regulated

entities. To one degree or another, all of the regulators have adopted some

form of “risk-based” capital regulation. However, due to differences in

their purposes or in the historic risks faced by the regulated entities, the

actual methods for assessing risks and determining capital levels continue

to differ across regulators.

Bank Regulatory Capital

Requirements Emphasize

Credit Risk and Certain

Market Risks

Initial bank risk-based capital requirements primarily emphasized credit

risk, reflecting the predominance of lending activities by banks. In 1988,

regulators in the United States and other countries who were part of the

Basle Committee on Banking Supervision6

 agreed to the Basle Accord, an

internationally developed capital standards framework for internationally

active banks. The accord’s requirements were initiated in the United States

in March 1990, with a 2-year phase-in period ending in full implementation

6

The Bank for International Settlements was established in 1930 in Basle, Switzerland. Its objectives

are to promote cooperation of central banks, to provide additional facilities for international

operations, and to act as trustee for international financial settlements. The Basle Committee on

Banking Supervision meets under the auspices of the Bank for International Settlements. It is made up

of the heads of supervision from the central banks and supervisory authorities of Belgium, Canada,

France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United

Kingdom, and the United States.

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in 1992. These requirements pertained primarily to credit risk; however,

they were amended in 1996 to incorporate market risk requirements for

specific types of assets that are often traded in internationally active

banks. In addition to the risk-based requirements, U.S. banking regulators

also have minimum leverage capital requirements. These leverage capital

standards were established prior to—and have been retained even after

the implementation of—the risk-based capital standards. Also, in 1991,

FDICIA created a capital-based framework for bank oversight and

enforcement based on the use of increasingly stringent forms of prompt

corrective action as an institution’s leverage and risk-based capital ratios

decline. (See app. I for a more detailed discussion of bank risk-based

capital requirements.)

Credit Risk Standards Under

the Basle Accord

The 1988 accord’s standards, which bank regulators and others describe as

“risk-based,” require banks to hold capital to cushion against potential

losses arising primarily from credit risk.7

 Although the accord pertains to

internationally active banks, U.S. banking regulators have required all U.S.

banks and bank holding companies, since 1992, to hold capital equal to at

least 8 percent of the total value of their on-balance sheet assets and

off-balance sheet items,8

 after adjusting this value by a measure of the

relative risk (known as risk-weighting).9

According to regulatory guidelines on capital adequacy, the final

supervisory judgment of a bank’s capital adequacy may differ from the

conclusions that might be drawn solely from the risk-based capital ratio.

This is because the ratio does not incorporate other factors that can affect

a bank’s financial condition, such as interest rate exposure, liquidity risks,

the quality of loans and investments, and management’s overall ability to

7

Recently adopted regulatory capital requirements for both banks and life insurers are often referred to

as “risk-based” capital requirements, a term that is not generally used to describe capital requirements

for securities broker-dealers and FCMs. However, current capital requirements for all types of

regulated financial entities variously take account of risks in the entities’ business.

8

An off-balance sheet item is a financial contract that can create credit losses for the bank but is not

reported on the balance sheet under standard accounting practices. An example of such an off-balance

sheet position is a letter of credit or an unused line of credit, which commits the bank to making a loan

in the future that would be on the balance sheet and thus create a credit risk.

9

The risk-based capital guidelines apply on a consolidated basis to banks and bank holding companies

with consolidated assets of $150 million or more. For bank holding companies with less than

$150 million in consolidated assets, the guidelines are to be applied on a bank-only basis, unless the

parent bank holding company is engaged in nonbanking activity involving significant leverage, or the

parent company has a significant amount of outstanding debt that is held by the general public.

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monitor and control financial and operating risks.10 The guidelines

establish minimum ratios of capital to risk-weighted assets; banks are

generally expected to operate well above these minimum ratios.

Banks are required to meet a total risk-based capital requirement equal to

8 percent of risk-weighted assets. At a minimum, a bank’s capital must

consist of core capital, also called tier 1 capital, of at least 4 percent of

risk-weighted assets. Core capital includes common stockholders’ equity,

noncumulative perpetual preferred stock, and minority equity investments

in consolidated subsidiaries.11 The remainder of a bank’s total capital can

also consist of supplementary capital, known as tier 2 capital. This can

include items such as general loan and lease loss allowances, cumulative

preferred stock, certain hybrid (debt/equity) instruments, and

subordinated debt with a maturity of 5 years or more. The regulation limits

the amount of various items included in tier 1 and tier 2 capital. For

example, the amount of supplementary (tier 2) capital that is recognized

for purposes of the risk-based capital calculation cannot exceed

100 percent of tier 1 capital.

These capital standards were developed because regulators in the United

States and in other countries wanted to address more adequately the

credit risks posed by certain bank activities. By working with various

countries to develop an international standard, regulators also attempted

to encourage banks to strengthen their capital positions while minimizing

any competitive inequality that might arise if requirements differed across

countries. According to the original 1987 consultative paper issued by the

Basle Committee, the target ratio of 8 percent capital to risk-adjusted

assets represented a higher level of capital than banks in various countries

were generally holding at the time.12 Recognizing this, the 1988 Basle

Accord allowed 4 years for banks to come into full compliance with the

required amount.

10Capital Adequacy Guidelines, Reg. H (12 C.F.R. pt. 208) App. A, Board of Governors of the Federal

Reserve System as amended Dec. 31, 1993. OCC’s regulation is at 12 C.F.R. pt. 3.10 and 3.11. FDIC’s

regulation is at 12 C.F.R. pt. 325.

11Perpetual preferred stock means preferred stock that does not have a maturity date and cannot be

redeemed at the option of the holder. Cumulative perpetual preferred stock requires all dividends to be

paid on it before payment of any common stock dividends. Dividends are not cumulative for

noncumulative perpetual preferred stock. Banks are allowed to include in their core capital only

noncumulative perpetual preferred stock. For bank holding company calculations, both cumulative

and noncumulative perpetual preferred stock qualify for inclusion in tier 1. However, the aggregate

amount may not exceed 25 percent of the sum of all core capital elements, including cumulative

perpetual preferred stock.

12Consultative Paper: Proposals for International Convergence of Capital Measurement and Capital

Standards, Committee on Banking Regulations and Supervisory Practices, BIS (Basle, Switzerland:

Dec. 1987).

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The risk-weights for credit risk attempt to account for the relative

riskiness of a transaction on the basis of its broad characteristics, such as

a type of obligor (e.g., government vs. bank vs. a private sector borrower)

and whether the transaction is on- or off-balance sheet. Assets with a

relatively low likelihood of default are assigned lower risk-weights than

assets thought to have a higher likelihood of default. Although the amount

at risk is often associated with changing asset prices, the credit risk

calculation does not use market price information to evaluate risks, except

in the case of derivatives contracts. Because bank loans, which dominate

credit risks, generally are not traded, market price information cannot be

regularly observed and thus used to evaluate risk. Instead, the risk-weights

for credit risk are broad categories arrived at through consensus among

members of the Basle Committee.

Under the credit risk rules, the adjustments of asset values to account for

the relative riskiness of a counterparty involve multiplying the asset values

by certain risk weights, which are percentages ranging from 0 to

100 percent. A zero risk-weight reflects little or no credit risk. For

example, if a bank holds a claim on the U.S. Treasury, a Federal Reserve

Bank, or the central government or central bank of another qualifying13

Organization for Economic Cooperation and Development (OECD)

country,14 this asset is multiplied by a factor of 0 percent, which results in

no capital being required against the credit risk from this transaction.

For an obligation owed by another commercial bank in an OECD country, a

bank must multiply the amount of this obligation by 20 percent, which has

the effect of requiring the bank to hold capital equal to 1.6 percent of the

value of the claim on the other bank. Loans fully secured by a mortgage on

a 1-4 family residential property carry a risk weight of 50 percent, thus

requiring the bank to hold capital equal to 4 percent of the value of the

mortgage. For an unsecured obligation owed by a private corporation or

individual, such as a loan without collateral, a bank must multiply the

amount of the unsecured obligation by 100 percent, which requires the

bank to hold capital equal to a full 8 percent of the value of the unsecured

obligation.

The U.S. regulations place all credit risks into one of four broad categories

and treat each product in a given category as if it carries equal levels of

13In July 1994, the Basle Committee amended the accord concerning the qualification for OECD

risk-weighting. See appendix I for a further explanation.

14OECD includes members from 29 countries. Its goals are to achieve high economic growth,

contribute to sound economic expansion, and contribute to the expansion of world trade.

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credit risk—that is, the capital requirement for each asset in the category

is based on the same percentage risk-weight. Although these

risk-weightings are based primarily on the type of obligor, qualifying

collateral (such as cash and government securities) and qualifying

guarantees (including bank and government guarantees) are also

recognized.

To adjust for credit risks created by financial positions not reported on the

balance sheet, the regulations provide conversion factors to express

off-balance sheet items as an equivalent on-balance sheet item, as well as

rules for incorporating the credit risk of interest-rate, exchange-rate, and

other off-balance sheet derivatives. These positions are converted into a

credit equivalent amount, and then the standard loan risk-weight for the

type of customer is applied. The risk-weight is applied according to the

type of obligor, except that in the case of derivatives the maximum

risk-weight is 50 percent.

Final Rule to Address Market

Risk Adopted for Dealer Banks

In September 1996, U.S. bank regulators issued a final rule based on the

Basle Committee’s January 1996 amendment to the Basle Accord designed

to incorporate market risks into the risk-based capital standards.15 As

applied by U.S. bank regulators, the purpose of the amendment was to

ensure that banks with significant exposure to market risk maintain

adequate capital to support that exposure. Because the market risk rule

applies to assets that are commonly traded in public markets and marked

to market,16 the risk calculations are based, in part, on measuring expected

movements in prices and the risks in the current financial position of the

institution.

U.S. rules apply to any bank or bank holding company whose trading

activity equals 10 percent or more of its total assets or whose trading

activity equals $1 billion or more. In addition, a bank regulator can include

an institution that does not meet the criteria if deemed necessary for

safety and soundness purposes or can exclude institutions that meet the

applicability criteria. At the end of 1996, 17 banks and 17 bank holding

15Amendment to the Capital Accord to Incorporate Market Risk, Basle Committee on Banking

Supervision, Jan. 1996.

16Marking to market means that the value of a financial product on the books of an institution is

regularly expressed in terms of its fair value. Some assets, such as stocks and bonds, which are

regularly traded on exchanges, can be marked to market easily on the basis of current market prices.

Other assets, such as commercial loans provided by banks, are more difficult to mark to market

because each loan is unique and there is no active secondary market generating fair prices or values

for such loans.

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companies met these criteria.17 The new rules became mandatory

January 1, 1998, but banks could have begun implementing them as of

January 1, 1997.

The final market risk rule requires that institutions adjust their risk-based

capital ratio to take into account both the general market18 and specific

risk of all “covered positions” both on- and off-balance sheet.19 The rule

does not cover all market risks faced by banks. For example, interest rate

risk on nontrading assets such as commercial loans and mortgages is not

included.

The rule requires that banks use their own internal models to measure

their daily “value-at-risk” (VAR) for covered positions.20 VAR reflects

changes in prices; price volatility or variability; and correlation among the

prices of financial assets (that is, the extent to which asset prices move

together). A bank’s internal model may use any generally accepted VAR

measurement technique, but the regulation requires the level of

sophistication and accuracy of the model to be commensurate with the

nature and size of the bank’s covered positions.21

To adapt banks’ internal models for regulatory purposes, bank regulators

developed minimum qualitative and quantitative requirements that all

banks subject to the market risk standard are to use in calculating their

VAR estimate for determining their risk-based capital ratio. The qualitative

requirements reiterate the basic elements of sound risk management. For

example, banks subject to the market risk capital requirements are

17The Federal Reserve notes that the 17 banks that met the market risk criteria held 98 percent of the

trading positions (assets plus liabilities) held by all U.S. commercial banks at the end of 1996. Fourteen

of the 17 holding companies that met the criteria were associated with banks that met the criteria.

18General market risk means changes in the market value of covered positions resulting from broad

market movements, such as changes in the general level of interest rates, equity prices, foreign

exchange rates, or commodity prices. Specific risk means changes in the market value of specific

positions due to factors other than broad market movements and includes such risks as the credit risk

of an instrument’s issuer.

19Covered positions means all positions (both debt and equity) in a bank’s trading account and all

foreign exchange and commodity positions, whether or not in the trading account.

20Value-at-risk represents an estimate of the maximum amount by which the value of an institution’s

positions could decline due to general market movements during a fixed holding period, measured

with a specified confidence interval.

21The U.S. market risk approach was based on internal models produced by each bank. The Basle

Accord permitted two alternative approaches—a bank could develop its own internal model or apply a

standardized approach written into the accord. The standardized approach assigned risk to assets on

the basis of their characteristics, such as interest rates or terms to maturity. U.S. banks are to use only

the internal models approach.

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required to have a risk control unit that reports directly to senior

management and is independent of business trading units.

According to the final rule, the quantitative requirements are designed to

ensure that an institution has adequate levels of capital and that capital

charges22 are sufficiently consistent across institutions with similar

exposures. These requirements call for each bank to use common

parameters when using its internal model for generating its estimate of

VAR. These common parameters include, among others: daily calculation;

an assumed holding period of 10 days; a 99 percent confidence level; the

use of empirically verified correlation between risk types; and the use of at

least 1 year of historical data, with the data updated at least once every 3

months.

The total market risk charge is the sum of the general market and specific

risk charges. The market risk charge starts from the estimate of VAR.

Because the VAR models may not capture unusual market events, the

general market risk charge is then the higher of the previous day’s VAR, or

the average daily VAR over the last 60 business days multiplied by at least 3.

The specific risk charge can be determined by a bank’s internal model if

the model is approved by the regulator, or by calculations specified in the

regulation if the model is not approved. The charge for specific risk is

added to the general market risk amount to obtain the total market risk

capital charge.

For banks subject to the market risk charge, the market risk regulation

includes an additional tier of qualifying capital—tier 3. Tier 3 capital is

unsecured subordinated debt that is fully paid up, has an original maturity

of at least 2 years, and is redeemable before maturity only with approval

by the regulator.23

The final rule also requires banks to conduct periodic backtesting

beginning in January 1999. More specifically, banks will be required to

compare daily VAR estimates generated by internal models against actual

daily trading results to determine how effectively the VAR measure

identified the boundaries of losses, consistent with the predetermined

statistical confidence level. The regulation will require bank regulators to

22In the market risk amendment, the calculated capital charge is a conservative estimate of possible

losses due to market volatility.

23To be included in the definition of tier 3 capital, the subordinated debt is to include a lock-in clause

precluding payment of either interest or principal (even at maturity) if the payment would cause the

issuing bank’s risk-based capital ratio to fall or remain below the minimum requirement.

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use the backtesting results to adjust the multiplication factor (multiplier)

used to determine the bank capital requirement.24

Capital Leverage Ratio

Supplements Credit and Market

Risk Measures

In addition to the risk-based capital requirements, U.S. banks are subject

to a minimum leverage ratio, which is a requirement that tier 1 capital be

equal to a certain percentage of total assets,25 regardless of the type or

riskiness of the assets. Leverage ratios have been part of bank regulatory

requirements since the 1980s. They were continued after the introduction

of risk-based capital requirements, as a cushion against risks not explicitly

covered in the risk-based capital requirements, such as operational

weaknesses in internal policies, systems, and controls. According to FDIC,

leverage standards also help to restrict excessive asset growth and

minimize potential moral hazards by ensuring that any asset growth is

funded by a commensurate amount of owners’ equity.

Since the early 1990s, banks have been specifically required to hold tier 1

capital equalling between 3 and 5 percent of their total assets, depending

on a regulatory assessment of the strength of their management and

controls. The amount of capital held by a bank is not to be less than this

leverage ratio. However, if the risk-based capital calculation yields a

higher capital requirement, the higher amount is the minimum level

required.

Capital Levels of Regulated

Banks Currently Tend to

Exceed Required Minimum

Requirements

In 1997, the risk-based capital ratios for the six large banks we spoke with

all exceeded the minimum 8 percent total requirement, as shown in table

2.2. In addition, the ratios for tier 1 capital, which is considered the

strongest form of capital, exceeded the 4 percent minimum requirement at

all of the banks. According to regulatory officials, the risk-based capital

ratios of almost all U.S. banks exceed the minimum required levels.

According to FDIC, fewer than 10 percent of U.S. banks actually report

risk-based capital figures by completing the Call Report Risk-Based

Capital forms. When calculating their capital ratios, banks are permitted to

perform a simple test that, once passed, negates the need to do the more

complicated calculations. Over 90 percent of banks pass this de minimis

test, and an algorithm approximates their risk-based capital level.

24For example, if a bank exceeds its VAR estimate 10 or more times in the previous 250 business days,

its multiplier could be increased from 3 to 4.

25For purposes of the leverage ratio, the federal regulators define “total assets” for banks as the

average of total assets reported in the Call Report, minus any assets that are deducted in determining

tier 1 capital.

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Bank regulators told us they believe prompt corrective action has been

influential in keeping bank capital levels up.26 In addition, several years of

record-breaking earnings have facilitated financial firms’ capital

accumulation.

Table 2.2: Risk-Based Capital Ratios for Six Large Bank Holding Companies, as of December 31, 1997a

Total risk-based capital Tier 1 risk-based capital

Dollars in billions

Bank holding company

Dollar

amount

Percentage

of total

risk-weighted

assets

Dollar

amount

Percentage

of total

risk-weighted

assets

BankAmerica Corporation $26.6 11.6% $17.3 7.5%

Bankers Trust New York Corp. 11.0 14.1 6.4 8.3

Canadian Imperial Bank of Commercea 14.5 9.8 10.2 7.0

The Chase Manhattan Corp. 33.3 11.6 22.6 7.9

Citicorp 31.1 12.3 21.1 8.3

First Chicago NBD Corp. 12.7 11.7 8.5 7.9

Note: All figures rounded.

aThe fiscal year for the Canadian Imperial Bank of Commerce ended on October 31, 1997. The

capital ratios in the table above for the Canadian Imperial Bank of Commerce were calculated

using regulatory guidelines for Canadian banks. Under U.S. rules, its ratios would have been

8.8 percent for total capital and 6.4 percent for tier 1 capital.

Source: 1997 Annual Reports of the bank holding companies in table.

Securities and Futures

Regulatory Capital

Requirements Emphasize

Liquid Capital to Meet

Customer Obligations in

the Event of Firm Failure

As discussed earlier, regulators of securities broker-dealers and FCMs seek

to protect customers of the firms they oversee as well as to protect the

integrity of their markets. The regulatory foundation of customer

protection efforts includes capital requirements in the form of net capital

rules27 and customer protection and funds segregation rules,28 which are

designed to protect the regulated entity’s customers and thereby other

market participants from monetary losses and delays that can occur when

26According to FDIC, its risk-based assessment rules provide an incentive for insured institutions to

exceed the minimum required capital levels. Insured institutions that are “well capitalized” pay at a

lower premium rate than institutions that are merely adequately capitalized (meet the minimum

requirements), or are less than adequately capitalized. To be well capitalized, an institution must have

a total risk-based capital ratio of 10 percent or more, a tier 1 ratio of 6 percent, and a leverage ratio of

5 percent.

27SEC Rule 15c3-1 and CFTC Rule 1.17.

28SEC Rule 15c3-3 and CFTC Rules 1.20-1.30.

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the regulated entity fails.29 The objective of protecting investors does not

extend to the protection of the going concern of broker-dealers or FCMs,

nor does it extend to the protection of investors’ holdings against market

losses. These rules, respectively, require SEC-registered broker-dealers and

CFTC-registered FCMs—the regulated entities—to continually maintain

sufficient liquid assets to protect the interest of customers and other

market participants if the firm ceases doing business, and as applicable, to

keep customer assets segregated from the regulated entity’s assets. The

rules focus specifically on the regulated entity’s financial condition and

activities. As noted above, SEC and CFTC do not have statutory authority to

regulate holding companies of broker-dealers or FCMs. The financial

condition of holding companies or other affiliates of the regulated entity

are generally not included in computation of net capital or compliance

with the customer segregation rule.30

SEC and CFTC Use Similar

Methods to Calculate Capital

SEC and CFTC calculate broker-dealer and FCM liquid capital, respectively, in

a similar manner. However, their capital requirements, which are based on

either ratios of capital to assets or capital to liabilities of the firm, are

calculated differently.

SEC’s Net Capital Rule Capital standards for brokers and dealers based upon liquidity have been

in effect since 1934 when the Securities Exchange Act was adopted.

According to SEC, it adopted the SEC Uniform Net Capital Rule31 in 1975 in

response to congressional concerns arising from the unprecedented

financial and operational crisis in the securities industry from 1967 to

1970. It is a conservative liquidity-based capital standard that requires

broker-dealers to maintain a minimum level of liquid capital sufficient to

promptly satisfy all of its obligations to customers and other market

participants, and to provide a cushion of liquid assets to cover potential

market, credit, and other risks. The rule focuses generally on the

registered broker-dealer; therefore, the assets and liabilities of a related

entity (e.g., an affiliate or parent) of the broker-dealer are generally not

taken into account in calculation of net capital.

Net Capital Requirements: With certain exceptions, the net capital rule

requires a registered broker-dealer to maintain the greater of an absolute

29CFTC imposes capital requirements on both FCMs and Introducing Brokers. Because Introducing

Brokers do not hold customer funds and do not pose a significant risk to the functions of the markets,

their capital regulations are not considered further in this report.

30An exception to this principle is when the registered broker-dealer guarantees or assumes

responsibility for the liabilities of the related unregistered entity. In such a situation, the broker-dealer

is required to consolidate into a single computation the assets and liabilities of both itself and the

guaranteed entity. See Rule 15c3-1(a)(1)(i) and Appendix C to the rule.

31SEC Rule 15c3-1 under the Securities Exchange Act of 1934.

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minimum dollar amount of net capital depending on the nature of the

broker-dealer’s business,32 or a specified minimum ratio of net capital to

either its liabilities or its customer-related receivables.

Under the SEC regulations, a broker-dealer must satisfy a minimum net

capital ratio based either on a calculated ratio of capital to indebtedness

(liabilities) or capital to customer-related receivables. Under the basic (or

aggregate indebtedness) method, the capital a broker-dealer is required to

maintain must be the greater of $250,000 or 6-2/3 percent of aggregate

indebtedness (generally all the liabilities and/or obligations of the

broker-dealer). The basic method is generally used by smaller

broker-dealers. Under the alternative method, a broker-dealer is required

to maintain capital equal to the greater of $250,000 or 2 percent of the total

amount of customer-related receivables (money owed by customers and

certain other market participants to the broker-dealer). If the

broker-dealer is also registered as an FCM with CFTC under the Commodity

Exchange Act (CEA) (i.e., dually-registered), it must maintain capital equal

to the greater of SEC’s minimum requirements, as described above; or

4 percent of the customer funds (money owed to the customers by the

FCM) that the broker-dealer is required to segregate pursuant to the act and

regulations thereunder. The alternative method tends to be used by larger

broker-dealers.

The basic and alternative methods are intended to allow a firm to increase

its customer business only to the extent that the firm’s net capital can

support such an increase.

Computing Net Capital: The process of computing a broker-dealer’s

regulatory net capital involves separating its liquid and illiquid assets.

Liquid assets are assets that can be converted easily into cash with

relatively little loss of value. Assets that are considered illiquid are given

no value when net capital is computed (a 100 percent capital charge). Only

liquid assets count in the calculation of net capital, because a

broker-dealer must have sufficient capital to close its business within a

short time frame and have sufficient liquid assets to meet its liabilities,

including those of customers.

32For example, firms that hold customer funds or securities (i.e., carrying firms) have a minimum

capital requirement of $250,000, whereas firms that serve as agents for customers and generally do not

hold customer funds and securities (i.e., introducing firms) have a minimum capital requirement of

$5,000. These levels of minimum dollar amounts were designed to protect customers against the

riskiness of a particular business conducted by a broker-dealer. See appendix II.

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To begin computing net capital, U.S. Generally Accepted Accounting

Principles (GAAP)33 equity must be determined by subtracting the

broker-dealer’s GAAP liabilities from its GAAP assets.34 Certain subordinated

liabilities are added back to GAAP equity because the net capital rule allows

them to count toward capital, subject to certain conditions.35 Deductions

are taken from GAAP equity for illiquid assets, such as the value of

exchange seats and fixed assets. Unsecured receivables are also deducted

from GAAP equity. The net capital rule further requires prescribed

percentage deductions from GAAP equity, called “haircuts.”36 Haircuts

provide a capital cushion to reflect an expectation about possible losses

on proprietary securities and financial instruments held by a broker-dealer

resulting from adverse events. The amount of the haircut on a position is a

function of, among other things, the position’s market risk liquidity. A

haircut is taken on a broker-dealer’s proprietary position because the

proceeds received from selling assets during a liquidation depend on the

liquidity and market risk of the assets. Less liquid assets and assets with

greater price volatility are more likely to take longer to sell and to be sold

at a loss. Thus, the less liquid the position, the greater the haircut on the

position. Haircuts generally recognize limited correlation among prices

33GAAP are accounting rules and conventions defining acceptable practices in preparing financial

statements. GAAP’s aim is to provide uniformity in financial statements reporting.

34Broker-dealer assets include cash; money owed by customers and other broker-dealers; securities

held in proprietary trading and investment accounts; and fixed assets like buildings, furniture, and

equipment. Broker-dealer liabilities include money owed to customers and other broker-dealers, bank

loans, debt securities issued by the broker-dealer, or funds loaned to it by the parent company.

35The rule permits certain subordinated liabilities to be included as part of the regulatory net capital of

a broker-dealer. In order to count toward net capital, among other things, these subordinated liabilities

(1) must be subordinated to the claims of all present and future creditors, including customers;

(2) must be approved for inclusion as net capital by the broker-dealer’s self-regulatory organization;

(3) may not be repaid if the repayment would reduce net capital below certain required amounts; and

(4) must have an initial term of 1 year or more.

36Haircuts are intended to reflect the inherent risks within a broker-dealer’s trading and investment

positions and provide a margin of safety against losses incurred by a broker-dealer. Through the

issuance of no-action position letters, SEC officials in the Division of Market Regulation can reduce

the capital charge for a particular type of transaction. An approved no-action position can be used by

any market participant for the participant’s benefit. SEC issues no-action letters in response to

requests by broker-dealers, industry groups, and SROs for its staff members’ views on whether they

would recommend enforcement action if the particular set of facts and circumstances as outlined in

the request letter were to occur. No-action letters do not make rulings on whether the particular

circumstances are legal or illegal—the letters only state whether the Division of Market Regulation

staff would or would not recommend an enforcement action to the Commission under those specific

circumstances. Examination staff use these no-action letters when calculating a particular

broker-dealer’s compliance with net capital requirements. CFTC also issues no-action positions

regarding capital requirements for FCMs.

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that can affect the actual values received when assets are liquidated.37 The

final figure, after all adjustments are made, is referred to as net (or liquid)

capital. This figure is then compared to the minimum requirement to

determine capital compliance. See appendix II for greater discussion of

the SEC net capital rule.

CFTC’s Net Capital Rule Liquid capital for FCMs is generally calculated in the same way that SEC

calculates a broker-dealer’s liquid capital. That is, CFTC generally makes

similar liquidity (illiquid assets deductions) and risk (haircuts for trading

and investment positions)38 adjustments to GAAP net worth as does SEC in

determining the amount of liquid capital. (See app. II for more detail on

the calculation.)

CFTC’s capital requirements, like SEC’s, are based on the firms’ business

activities and apply only to the registered FCMs. However, unlike SEC’s,

CFTC’s requirement is based on the amount of required segregated

customer funds,39 (subject to certain adjustments),40 rather than aggregate

indebtedness or customer-related receivables. The amount of required

segregated funds is based primarily on margin requirements for the

commodity contracts held by the FCM’s customers. Margin requirements

are set by each exchange for each commodity contract traded on the

exchange and represent the customers’ guarantee of performance. The

amount of margin per commodity varies depending on the market value of

the contract and volatility of the price of the underlying commodity. The

amount of segregated funds on deposit is determined primarily by the

Standard Portfolio Analysis of Risk (SPAN) margining system, a VAR based

statistical model designed to evaluate the total risk in a portfolio of related

futures and options positions. Therefore, the CFTC’s capital requirements

are, in large measure, risk-based. In addition, the deductions or haircuts

for proprietary positions in futures or commodity option positions are

applied to the margin requirement calculated under SPAN. All funds held by

37SEC has adopted a risk-based methodology using theoretical option pricing models to calculate

haircuts for listed options and related hedge positions. See appendix II.

38CFTC’s capital rule defers to SEC’s haircuts on proprietary securities positions to reflect the market

risk in such positions. SEC’s capital rule defers to CFTC’s haircuts on proprietary futures and options

positions. CFTC’s capital charges for proprietary futures and options positions are based on futures

exchanges’ margin requirements and are portfolio risk-based.

39Segregated customer funds typically include cash, securities held for customers or representing

investments of customer funds deposited in segregated funds, bank accounts, margin on deposit with

clearing organizations of contract markets, unrealized gains on futures contracts, and the market value

of long options.

40See intra note 41.

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FCMs but owed to customers are required to be segregated from the firm’s

funds and treated as belonging to customers.

Under CFTC’s net capital rule (Rule 1.17), FCMs must maintain adjusted net

capital in an amount that is no less than the greater of (a) a prescribed

minimum fixed-dollar amount of $250,000; (b) a variable minimum amount

of 4 percent of customer funds required to be segregated, subject to

certain adjustments;41 (c) the amount of adjusted net capital required by a

registered futures association of which it is a member; or (d) if the FCM is

also a registered broker-dealer, which is known as being

“dually-registered,” the amount required under SEC’s net capital rule.

Under CFTC’s capital rule, an FCM calculates adjusted net capital as the

amount by which current assets (cash and other assets that are reasonably

expected to be realized as cash in a year) exceed its adjusted liabilities

(the FCM’s total liabilities minus certain subordinated liabilities) and

various regulatory charges or adjustments—such as percentage reductions

in the market value of certain proprietary positions and undermargined

customer accounts.42

Adjusted net capital is intended to provide a cushion for market and credit

risks and to give a firm with customer accounts time to transfer accounts

and liquidate the accounts of the defaulting customers in an orderly

manner.

Capital Levels of Regulated

Firms Currently Tend to

Exceed the Regulatory

Minimum Requirement

Some regulators and firm representatives told us that because a

broker-dealer must cease conducting a securities business if its net capital

falls below the minimum requirement, broker-dealers generally maintain

capital greater than the minimum requirement (a.k.a. excess capital). As

shown in table 2.3, the amount of excess net capital held by the five large

securities firms in our study, which are all dually-registered as FCMs,

ranged from $974 million to $1.845 billion. Some of the firm

representatives we interviewed stated that one reason they held such large

amounts of excess capital is that their counterparties required them to do

so in order to be willing to conduct business with them.

41Pursuant to Rule 1.17(a)(1)(i)(B), this factor is 4 percent of the customer funds required to be

segregated pursuant to CEA and the rules thereunder, plus the “foreign futures or foreign options

secured amounts” (see Rule 1.3(rr)), less the market value of commodity options purchased by

customers on or subject to the rules of a contract market or a foreign board of trade.

42An undermargined customer account is a margin account in which the customer’s equity is below its

required amount.

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Table 2.3: Capital Information for Five Large U.S. Broker-Dealers and Their Holding Companies

Dollars in millions

Date of data Parent company

Total

consolidated

capitala

Principal U.S.

broker-dealerb Net capitalc

Excess net

capitald

12/26/97 Merrill Lynch & Co., Inc. $51,419 Merrill Lynch Pierce

Fenner & Smith, Inc.

$2,249 $1,845

11/30/97 Lehman Brothers

Holdings, Inc.

24,784 Lehman Brothers Inc. 1,484 1,359

11/30/97 Morgan Stanley, Dean

Witter, Discover & Co.

38,748 Morgan Stanley & Co. Inc. 2,186 1,753

11/28/97 The Goldman Sachs

Group, L.P.

21,774 Goldman, Sachs & Co. 1,770 1,370

12/31/97 Salomon Smith Barney

Holdings, Inc.e

27,592 Salomon Brothers Inc. 1,047 974

aTotal consolidated capital represents the sum of the parent company’s GAAP ownership equity

and long-term borrowings. For the Goldman Sachs Group, L.P. (a partnership), it represents the

sum of the parent company’s GAAP partners’ capital and long-term borrowings.

bIn terms of total assets. All of the principal U.S. registered broker-dealers are also registered with

CFTC as FCMs (i.e., dually-registered).

cNet capital represents the amount of capital maintained by a U.S. registered broker-dealer

pursuant to Rule 15c3-1 under the Securities Exchange Act of 1934 (the Exchange Act).

dExcess net capital represents the amount of capital held by a U.S. registered broker-dealer that

is greater than the amount of capital that is required to be maintained by a U.S. registered

broker-dealer pursuant to Rule 15c3-1 under the Exchange Act as of the date indicated.

eSalomon Smith Barney Holdings, Inc. is a wholly owned subsidiary of the Travelers Group, Inc.

Source: The Goldman Sachs Group L.P. 1997 Annual Review, 1997; the 1997 Annual Reports for

the other parent companies; and the 1997 U.S. broker-dealers’ annual statements of financial

condition (audited).

Early Warning Capital

Triggers

In addition to the minimum base requirements, the regulatory net capital

rules and the rules of the various SROs establish early warning capital

levels that exceed the minimum requirement. These capital triggers allow

regulators and SROs to identify at early stages broker-dealers and FCMs that

are experiencing financial difficulties and to take corrective actions to

protect customers and the marketplace. Broker-dealers and FCMs are

required to promptly notify their regulators when early warning violations

occur. SROs are required to notify SEC and CFTC and place restrictions on

the activities of regulated entities whose net capital falls to the early

warning levels.43 For example, under the SEC net capital rule, a

43SEC Rule 17a-11 and Rule 15c3-1(e) under the Securities Exchange Act of 1934.

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broker-dealer that uses the alternative method of calculating net capital

may not withdraw equity capital in any form to pay shareholders if its net

capital is less than 5 percent of its customer-related receivables.

When an FCM’s adjusted net capital falls below its early warning level,

which is generally 150 percent of the minimum net capital amount, it must

promptly notify CFTC.

44 In addition, CFTC requires FCMs to report to CFTC

when a series of events, on a net basis, causes a 20 percent or greater

reduction in their net capital.

As soon as a broker-dealer’s or FCM’s net capital amount falls below the

minimum net capital level, the firm must immediately cease conducting

business and it must either demonstrate that it has come back into

compliance with net capital requirements or liquidate its operations.

Closing a broker-dealer or FCM before insolvency makes the firm a viable

merger candidate because of its residual value and generally allows the

regulated entity’s customers and other market participants to be fully

compensated when the firm is liquidated.

The SEC Net Capital Rule

Amendment Relates Capital

Charges More Closely to Risks

in Listed Options

After a 2-year test period using the Options Clearing Corporation’s

Theoretical Intermarket Margining System (TIMS),45 SEC amended its net

capital rule in early 1997 to allow broker-dealers to use theoretical option

pricing models46 (i.e., statistical models) to calculate required capital

charges for exchange-traded (i.e., listed) equity, index, and currency

options and their related hedged positions.47 At this time, the only

approved vendor and options pricing model is the Options Clearing

Corporation and its TIMS. According to SEC, this methodology will relate

capital charges (haircuts) on these instruments more closely to the market

risk inherent in these broker-dealer options positions. This methodology

permits the risk calculations for listed options to reflect market prices,

price volatility, and correlation among asset prices.

44CFTC Rule 1.12. For dually-registered firms, the CFTC early warning capital trigger is the greater of

(1) 150 percent of the greatest of the amounts calculated pursuant to CFTC Rule 1.17(a)(1)(i)(A-C) or

(2) the amount specified in SEC Rule 17a-11(b).

45TIMS is used to measure the market risk associated with participants’ positions and to establish

clearing house margin requirements.

46A broker-dealer may use the Options Clearing Corporation’s TIMS or any other model maintained and

operated by any third-party source and approved by a designated examination authority to determine

theoretical options prices and related haircuts. See appendix II for additional discussion.

47See SEC Release No. 34-38248 (Feb. 6, 1997).

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According to the regulations, this methodology is a two-step process. In

the first step, third-party source models and vendors approved by a

designated examining authority (i.e., an SRO) are to be used to estimate the

potential gain and loss on the individual portfolios of the broker-dealers.

In the second step, such approved vendors are to provide, for a fee, a

service by which the broker-dealer may download the results generated by

the option pricing models to allow the broker-dealers to then compute the

required haircut for their individual portfolios. (See app. II for greater

discussion of the salient features of the methodology.) Adoption of this

methodology is the first time SEC has formally permitted the use of

statistical models, which reflect price volatility and correlation, for setting

regulatory capital requirements. The effective date of the amendment was

September 1, 1997.

SEC, CFTC, and some SROs are exploring other possible approaches to more

closely relate regulatory capital charges to the actual risks inherent in a

firm’s operations. These initiatives are discussed in chapter 4.

SEC and CFTC Both Have

Customer Segregation

Rules to Protect Customer

Assets

Both SEC and CFTC have rules that require the segregation of customer

funds from firm funds. The SEC rule complements its net capital rule and is

designed to prevent the misallocation or misuse of customer funds and

securities. The CFTC rule also complements its net capital rule and provides

for the safeguard of customer funds by requiring that they are segregated

from the FCM’s own funds.

SEC’s Rule Is Designed to

Safeguard Customer Assets

The SEC customer protection rule48 attempts to prevent the misallocation

or misuse of customer funds and customer securities by broker-dealers.

The rule applies to carrying firms because they hold customer assets. The

rule, working in conjunction with SEC’s net capital rule, is designed to

protect the regulated entity’s customers from monetary losses and delays

that can occur when the regulated entity fails.

48Rule 15c3-3 under the Securities Exchange Act of 1934.

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The customer protection rule has two parts: (1) possession or control49 of

all customers’ fully paid and excess margin securities,50 and (2) special

reserve bank account. The first part is to prevent broker-dealers from

using customer securities to finance the firm’s proprietary activities,

because all customers’ fully paid and excess margin securities must be in

possession or control of the broker-dealer. The rule also requires the

broker-dealer to maintain a system capable of tracking fully paid and

excess margin securities daily. The broker-dealer is required to keep all

customer fully-paid and excess margin securities segregated from the

broker-dealer’s assets and maintained free of all claims or liens.

The second part of the customer protection rule involves customer cash

kept at broker-dealers. When customer cash—the amount the firm owes

customers (credits)—exceeds the amount customers owe the firm

(debits), the broker-dealer must keep the difference in a special reserve

bank account. The broker-dealer is to calculate the amount of the

difference weekly using the reserve formula specified in the rule. If debits

exceed credits, then no deposit is required. Broker-dealers may not use

customer margin securities and cash to finance their operations or

proprietary trading activities, except to finance other customers’

transactions. Also, creditors of a failed securities broker-dealer cannot

claim assets from the broker-dealer’s customer property account.

CFTC’s Rule Is Designed to

Safeguard Customer Funds

Section 4d(2) of the CEA and CFTC rules 1.20-1.30 provide for the

safeguarding of customer funds51 by requiring such funds to be segregated

49“Possession” of securities means the securities are physically located at the broker-dealer. “Control”

of securities means the securities are located at one of the approved “control” locations.

Rule 15c3-3 specifies the locations in which a security will be considered in possession or control of

the broker-dealer. This includes those securities that are held at a clearing corporation or depository,

free of any lien; carried in a Special Omnibus Account under the Federal Reserve Board Regulation T

with instructions for segregation; a bona fide item of transfer of up to 40 days; in the custody of foreign

banks or depositories approved by SEC; in a custodian bank; in transit between offices of the

broker-dealer; or held by certain subsidiaries of the broker-dealer.

50Fully paid securities are securities that are purchased in transactions for which the customer has

made full payment. Excess margin securities in a customer account are margin securities with a

market value in excess of 140 percent of the account debit balance (the amount the customer owes the

firm for the purchase of the securities). For example, a customer buys $80,000 worth of securities on

50-percent margin, and the broker-dealer loans the customer $40,000 (debit balance). The amount of

the customer margin securities that can be pledged as collateral for a bank loan is $56,000 (140 percent

times $40,000). Because only $56,000 of the $80,000 of customer securities can be pledged to the bank

as collateral, the remaining $24,000 of securities are excess-margin securities that must be segregated

and held in safekeeping by the broker-dealer.

51CFTC Rule 1.3(gg) defines “customer funds” to mean all money, securities, or property received by

an FCM on behalf or owed to customers used (1) to margin, guarantee, or secure futures contracts; or

(2) as the premium on CFTC-regulated exchange traded options, and money accruing to customers as a

result of such futures and options contracts.

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from funds belonging to the FCM. Similar to the SEC rule, the CFTC

segregation rule complements its net capital rule and exists to ensure that

FCMs do not mix customer funds with theirs. In the event of a firm’s

insolvency, under the rule, customer funds would be clearly identified as

belonging to customers and would not be available to creditors of the firm.

The rule requires that funds belonging to an FCM’s customers be separately

accounted for; segregated as belonging to commodity futures or option

customers; and, when deposited with any bank, trust company, clearing

organization, or another FCM, deposited under an account name that

clearly identifies them as such and shows that they are segregated as

required by the act and regulations. Also, each FCM is required to obtain

and retain an acknowledgment from such bank, trust company, clearing

organization, or FCM that it was informed that the customer funds

deposited therein are those of commodity or option customers and are

being held in accordance with the provisions of the act and regulations.

On a daily basis, FCMs are to compute the customer funds they are required

to segregate on the basis of funds received from customers and the daily

mark to market of customer positions. CFTC’s segregation rule requires that

100 percent of each customer’s funds be segregated from FCM’s funds.

Unlike securities broker-dealers, FCMs generally cannot use one customer’s

funds to finance another customer’s transactions. Thus, CFTC’s segregation

requirements serve to provide protection through the deposit of all

customer funds in segregated accounts.52

Under SEC requirements, generally the net amount owed to customers is

deposited in a bank account with the assumption that money receivable

from the broker-dealer’s customers will be collected and paid to the

customers having credit balances in their accounts, and any shortfall will

be covered by the amount deposited in the bank account set up for

customers. In addition, SIPC provides insurance protection for securities

customers of broker-dealers in the event there are not enough funds on

deposit in the bank account. The commodities industry does not have a

customer account government-sponsored insurance program that protects

against losses due to FCM insolvency.

52According to the Chicago Mercantile Exchange (CME), the customer segregation requirements are

designed to protect customers from the consequences of an FCM’s failure, but they do not always

provide sufficient protection should the default be caused by another customer of that firm. In CME’s

view, protection against customer-caused defaults rests with the FCM’s management and the

importance placed on its internal risk management controls.

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Together, these customer protection rules are designed to protect

(1) customers and other market participants of broker-dealers and FCMs

from monetary losses and delays that can occur when the regulated

broker-dealer or FCM fails by facilitating the orderly unwinding of a failed

firm through liquidation; and (2) the integrity of the securities and futures

markets.

Insurance Regulatory

Requirements Are to

Ensure the Long-Run

Viability of Insurers So

Policyholders’ Claims Can

Be Honored

According to NAIC, capital requirements have been used as an important

tool in limiting insolvency costs throughout the history of insurance

regulation. Initially, states enacted statutes that required a specified

minimum amount of capital and surplus for an insurance company to enter

the business or to remain in the business.53 In some states, a single dollar

amount of minimum capital and surplus was applicable to all insurers,

regardless of the lines of insurance they wrote. This requirement was, in

effect, an entrance requirement and generally did not vary with the size of

the insurer or the risks that a company accepted. Thus, the minimum

amount of required regulatory capital was unlikely to bear any relationship

to the amount of risk on the books of any particular insurer.

In the latter half of the 20th century, according to NAIC, changes within the

insurance industry itself and the economic environment in which it

operated raised questions about the long-term viability of traditional

insurance products and led insurers to offer new products. These products

included variable annuities, variable life insurance, universal life

insurance, single-premium deferred annuities, and guaranteed investment

contracts.54 In NAIC’s view, competition among sellers of these products led

life insurers to seek higher returns on their investment portfolios, and

some of them sought such returns without sufficient consideration of the

accompanying higher investment risks.

53The life insurance industry designates its capital as capital stock, which represents funds paid into

the company by shareholders; and as surplus, which is the remaining excess of assets over liabilities.

54An annuity is a contract written by an insurance company to provide income benefits for a specified

number of years, or for life. In a deferred annuity, the premiums are paid currently but benefits are

scheduled to begin at a later date. A variable annuity is a contract in which annual units are purchased,

often through a retirement plan account. The number of units varies with unit cost, and the benefits

vary directly with the experience of assets that back the contract. A single-premium deferred annuity

is a deferred annuity contract purchased with a single premium. Whole life insurance is a plan that

combines protection and a growing cash value. Variable life insurance is a form of whole life insurance

in which the cash value varies, depending on the investment performance in a separate account.

Universal life is a form of life insurance that combines accumulating cash value with a varying rate of

return. A guaranteed investment contract is one in which the insurance company accepts a specified

amount of money from a qualified retirement plan and agrees to refund the money at a fixed date in

the future.

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According to NAIC, an increase in the number and size of life insurer

insolvencies from the 1960s through the 1980s led insurance regulators to

believe they needed new tools to deal with changes in the industry

resulting from new products and investment strategies. Because most

states required a fixed minimum amount of capital regardless of the risks

undertaken in a company’s insurance and investment operations,

regulators believed that the traditional statutory insurance capital

requirements that were in place were not sufficiently flexible.

By 1990, according to NAIC, a number of states were experimenting with

risk-based capital formulas for regulatory purposes. NAIC became

interested in risk-based capital in 1989. Its working group and advisory

committee developed and tested the life risk-based capital formula, which

was approved by NAIC in December 1992, to be used for the first time with

the 1993 annual statement filed in March 1994.

Application of the

Risk-Based Capital

Requirement to Life

Insurance Companies

According to NAIC, the risk-based capital formula is intended to determine

the minimum amount of capital an insurer needs to avoid triggering

regulatory action. The amount of capital required varies with the risk an

insurer is assuming in its insurance and investment operations, as well as

the normal risks to which all businesses are subject. The formula requires

companies to hold minimum percentages of various assets and liabilities

as capital, with these percentages based on the historical variability of the

value of those assets and liabilities. Companies are free to make their own

capitalization decisions commensurate with their own level of risk

tolerance as long as the level is above the regulatory minimum risk-based

capital thresholds. In NAIC’s view, its formula, in effect, imposes a

minimum and uniform degree of risk aversion on all companies, but the

formula also allows companies to operate freely at any given level above

the minimum threshold.

The NAIC life insurance risk-based formula classifies all of the risks into

four major categories: asset risk, insurance risk, interest rate risk, and all

other business risk.55 The formula consists of a series of risk factors that

are to be applied, usually as multipliers, to selected assets, liabilities, or

other specific company financial data to establish the minimum capital

needed to bear the risk arising from that item (similar to risk-weights in

banking).

55These risk categories are given the designations of C-0 to C-4, which are used by the insurance

industry. Asset risk is divided into risk of default from affiliated investments and all other asset risks.

These two categories are given the designation C-0 and C-1. The other three categories of risk are

denoted by C-2, C-3, and C-4, respectively.

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• The asset risks are the risks of asset defaults and decreases in market

value. For example, the risk factor for cash in the formula is 0.003, which

indicates that an insurer must maintain capital equal to three-tenths of

1 percent of its cash holdings to absorb the risk of loss in cash in a bank

failure. At the other end of the range, the multiplier for publicly traded

common stocks is 0.300, which indicates a requirement for capital equal to

30 percent of the value of the stocks to protect against downturns in the

market. The formula also includes charges for risks arising from the

ownership of subsidiaries and affiliates, which vary with the nature of

these entities. According to NAIC data, asset risks represent by far the

largest proportion of risk among the four categories faced by the life

insurance industry as a whole.

• The insurance risks, which are unique to the insurance industry, are the

risk of underpricing or unfavorable developments in mortality or

morbidity. NAIC developed a series of risk factors to determine the capital

necessary to absorb those risks that are to be applied to the net amount at

risk (face amount less reserves) for life insurance. According to NAIC data,

insurance risks are second in magnitude among the four categories of

risks for the life insurance industry as a whole. However, for a large

number of relatively small companies, this component is the dominant

risk-based capital risk.

• NAIC defines interest rate risk as the chance that a change in interest rates

will result in an insurer not earning enough return on its investments to

meet its interest obligations under its various insurance and annuity

contracts. There is also a risk that changes in interest rates will spur

disintermediation.56 The interest rate risk depends on how closely the

assets and liabilities are matched in time. The formula is concerned with

the risks related to annuity and pension business. Interest rate risk is third

in magnitude among the four categories of risk for the life insurance

industry as a whole.

• The all-other-business-risk category encompasses risks not included

elsewhere in the formula. In developing the risk-based capital formula, the

working group recognized that all companies are subject to some risks,

such as litigation, that are not contemplated in the parts of the formula

used for other categories. However, the group concluded that the

derivation of appropriate risk factors for most of these risks was not

possible. Also, these risks vary from one company to another. Initially,

NAIC decided that the only risk factor to be included in the risk-based

capital formula would be a charge for the risk of guaranty fund

assessments.

56Disintermediation is the movement of funds from a financial intermediary (i.e., an insurance

company) to a higher yielding investment in the general market.

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In addition, the risk-based capital formula also requires the performance

of sensitivity tests to indicate how sensitive the formula is to changes in

certain risk factors. These tests require the company to recalculate its

risk-based capital using revised risk factors for certain specified risks and

to report the difference between the basic calculations and the sensitivity

tests. The purpose of the tests is to provide additional information for

company management and regulators.

In NAIC’s view, the true impact of the risk-based capital system is in the

Risk-Based Capital for Insurers Model Act (the Model Act), which NAIC

developed and recommended that the states adopt. When adopted by a

state, this act gives the state’s chief insurance regulator the authority to

act on the results generated by the risk-based capital formula.57

The act requires each insurer to file a report with NAIC; the commissioner

of the insurer’s domiciliary state; and the commissioner of any state in

which the insurer is licensed, if that state’s insurance commissioner

requests it in writing. In their annual reports, insurers are also required to

report their Authorized Control Level Risk-Based Capital, which is the

total risk-based capital an insurer needs to hold to avoid being taken into

conservatorship. (See app. III for additional information on life risk-based

capital regulations.)

Industry

Representatives See

Progress in Recent

Revisions to Capital

Standards but Cite

Problems With These

and Other Capital

Rules

The interviews we conducted with representatives of large, diversified

firms; industry and rating agency officials; and regulators indicated

generally positive views regarding revisions made to capital rules in

banking and life insurance in the past several years to more precisely

account for their actual risks (“risk-based” capital requirements).

Representatives of banks and life insurers said that the changes were a

step in the right direction. However, some of these representatives also

said that further improvements were needed. Representatives of many of

the large financial firms we interviewed generally said that the current

requirements of the net capital rule did not correlate well with actual risks.

Several of these representatives said that the net capital rule affected their

decisions about where to conduct certain activities, such as derivatives.

57According to NAIC, as of March 1998, of the 51 insurance jurisdictions, which includes the District of

Columbia but excludes the 4 U.S. territories, 50 have adopted laws, regulations, or bulletins that are

considered to be substantially similar to the Model Act. The remaining jurisdiction, New York, has

adopted a similar law that applies to life insurers.

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Bank “Risk-Based” Capital

Requirements Are Seen as

a Regulatory Improvement

but Also Raise Concerns

About Accuracy of Risk

Measurement

Bankers, regulators, and industry and rating agency officials we spoke

with generally believe the current risk-based capital standards for banks

are an improvement over the former requirements, but they still have

limitations. For example, one regulator and one rating agency commented

that although the current credit risk standards are crude, they are much

better than the previous leverage ratio requirement, which did not vary

with any differences in risk levels. In the view of the Chairman of the

Federal Reserve Board, the risk-based capital accord of 1988 had

shortcomings, but it was a genuine step forward at the time it was

developed. In the view of the Comptroller of the Currency, the accord

highlighted and ultimately helped reverse the slippage in bank capital

levels worldwide. It focused attention on the whole concept of risk as a

tool for both bank managers and bank supervisors and advanced the

effectiveness of bank supervision worldwide. It gave official recognition to

the growing importance of off-balance sheet activities in bank operations.

Some bank officials we spoke with commented that the current credit risk

standards are nonetheless crude and imprecise. The primary reason for

this is because the risk-weights are not adjusted for asset quality within

each broad class of assets. Institute of International Finance officials said

that the credit risk rules offered perverse incentives to banks to take on

riskier loans in that they encourage banks to go up the yield curve in

pursuit of a return on capital. This means that the bank is making more

long-term loans, which tend to have higher interest rates than do

short-term loans, thus simultaneously increasing interest rate risk and

potential returns. The Federal Reserve Board Chairman noted a number of

weaknesses in the risk-based capital structure for credit risk, including its

inability to adjust weights for hedging, portfolio diversification, and

management controls. Such adjustments are based on changing price

volatility and correlation among prices. Another weakness noted by

regulators is that the current risk-based structure does not consider all

types of risk. Also, it is not flexible enough to respond to new market

developments and products.

Officials of one bank told us that they do not manage to regulatory capital

levels, because the credit risk-based capital requirements provide the

wrong incentives by not distinguishing among the quality of products in

the same asset class. Officials of two banks commented that they are not

constrained by regulatory capital requirements, because assets can always

be securitized so capital will not have to be held against them, or they can

move to riskier assets in each credit risk category to obtain higher returns.

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An official of another bank felt that the credit risk standards needed to be

realigned to match current credit management practices in the industry.

Many bankers we spoke with generally felt the new market risk

requirements, which are based on price volatility and correlation, were a

step in the right direction and represented a recognition of standard risk

management practices and principles. However, one bank told us that

even this new requirement will require it to hold unrealistic levels of

capital due to the multipliers imposed on the bank’s internal model.

One regulator commented that a limitation of the new market risk

requirement is that it covers market risk in a bank’s trading book, but not

in its banking book, which is where a lot of banks have exposure to

market risk. Others commented that in practice, managers adjust their

books daily, but the regulatory use of VAR is calculated with a 10-day

holding period; thus, they believe it ignores this day-by-day adjustment

process. Two rating agencies commented that even after the inclusion of

market risk, other important risks to banks, such as operational and

liquidity risks, are not quantified.

Regulatory Capital

Requirements for

Securities Firms Raise

Concerns About

Inefficiencies in These

Entities

SEC believes the current haircut58 approach of the net capital rule has

several advantages. First, it requires an amount of capital that will be

sufficient as a provision against losses, even for unusual events. Second, it

is an objective, although conservative, measurement of risk in positions

that allows the regulator to compare firms to one another. Third, the

current methodology enables examiners to readily determine whether a

firm is properly calculating haircuts.

SEC believes there are also weaknesses associated with determining capital

charges on the basis of fixed percentage haircuts. For example, the

current method of calculating net capital by deducting fixed percentages

from the market value of securities can allow only limited types of hedges

without becoming unreasonably complicated. In this way, the rule does

not account for historical price correlation between foreign securities and

U.S. securities or between equity securities and debt securities. By failing

to recognize offsets from these correlations between and within asset

classes, the fixed percentage haircut method may cause firms with large,

diverse portfolios to reserve capital that actually overcompensates for

market risk.

58See footnote 36 for an explanation of haircuts.

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Representatives of the securities firms, rating agencies, and industry

association officials we spoke with generally felt that the current net

capital rule’s requirements do not correlate well with the actual risks in

the activities of firms. Industry officials told us that the current net capital

rule does not deal well with hedging or other risk-reducing strategies,

which are based on price volatility and correlation. Representatives of two

firms commented that regulatory capital rules constrain their business

decisions, because they require the firms to hold what they view as

excessive capital for certain activities. Three firms told us that the net

capital rule has an impact on where they do certain business activities,

such as derivatives transactions, foreign exchange, and bridge financing.

Some industry officials said they are forced to conduct these business

activities in unregulated entities due to the high haircuts imposed by the

net capital rule if a broker-dealer were to conduct these activities.59

Representatives of another firm said the regulatory structure drives the

holding company structure, which they consider to be an inefficient and

expensive business structure. Firm representatives told us they have

businesses in many countries, and they are required to provide

information to each country regulator. No authority regulates all of the

activities of these firms; therefore, even though firms provide a lot of

information to regulators, no regulator knows the condition of the entire

firm. One rating agency commented that broker-dealers have shifted risks

to other parts of the firm in response to net capital requirements.

Representatives of three futures SROs commented that the strengths of

CFTC’s net capital rule are that it is easily understood, easily calculated, and

easily verified by regulatory auditors. Weaknesses they saw in the rule

were that (1) it applies only to funds of domestic customers on deposit

with FCMs, so it misses noncustomers and foreign customers; (2) it misses

coverage of some risks found in affiliates and internationally; (3) it creates

incentives for FCMs to return excess margin funds to customers because

such funds can increase an FCM’s segregation requirement and therefore its

capital requirement; and (4) it does not deal well with the complexities of

exotic instruments.

Life Insurance Risk-Based

Capital Requirements Are

Seen as a Step Forward,

but Concerns Remain

Life insurance companies, rating agencies, insurance regulators, and

insurance association officials we spoke with generally felt risk-based

capital requirements were a step forward, but improvements were needed.

Insurance regulators commented that the main strength of the

59See chapter 4 for a discussion of a recent SEC proposal to create “limited purpose” broker-dealers

that is to address this issue.

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requirements is that they permit regulators to close a failing company.

Similarly, representatives of two firms said that an advantage of these

requirements is that they provided regulators a tool they could use before

a firm had to be closed by allowing for graduated regulatory action.

Representatives of one firm said that the effect of the requirements was to

get weaker companies to increase their capital levels. Representatives of

another firm commented that the most important aspects of risk-based

capital requirements are their objectivity (auditability) and completeness.

Representatives of one rating agency commented that the insurance

risk-based capital requirements have raised awareness of risk in the

industry. Representatives of two rating agencies said they saw a favorable

trend in capitalization after the insurance risk-based capital requirements

were adopted. One regulator commented that the risk-based capital

requirements act as a floor, and firms tend to hold more capital.

Life insurance industry officials whom we spoke with generally said that

the current requirements do not cover all risks equally well and that some

changes are needed. (See ch. 4 for initiatives under consideration.) These

officials saw other limitations in the risk-based capital standards,

including that the model is static, it is a lagging indicator, it does not

address parent/affiliated company relationships, it has difficulty

quantifying risks in new products, it does not deal well with diversification

or with derivatives-based risks, it is not strong on interest rate risk, and it

concentrates too much on credit risk. One regulator commented that

because the risk-based capital formula does not address risks evenly, firms

have an incentive to alter their business.

Capital Rules for

Large, Diversified

Firms Underscore

Importance of These

Firms’ Risk

Measurement

Practices

As discussed earlier in this chapter, regulators are increasingly using the

results of risk measurement systems of large, diversified firms in

calculations that determine regulatory capital requirements, thus

attempting to better link capital with firms’ actual risk. Specifically, bank

regulators use the market risk measures of large banks in setting the

market risk component of risk-based capital. Also, SEC has recently

allowed firms to use option pricing models to calculate some capital

charges. Along with other options, SEC and CFTC are exploring possible

further reliance upon the results of firms’ risk measurement systems in

capital regulation. These explorations are described in chapter 4.

Current and possible future use of firms’ estimates of risk in regulatory

determination of capital requirements makes the firms’ risk measurement

practices an important element of capital regulation for legislative and

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regulatory policymakers to understand. Chapter 3 describes the

approaches being used by some large, diversified firms to measure and

manage risk.

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Unlike regulators, whose focus on the capital levels of firms is driven by

regulatory public purposes, firms analyze their use of capital to help

ensure that they can achieve their business objective—maximizing the

value of the capital provided by stockholders. To do this they must

measure and manage risks, returns, and capital.

A number of large, diversified financial firms are measuring some risks

and returns on a firmwide basis. Among other things, these measurements

are designed to enable them to determine the trade-offs among risks and

returns that would best enable them to maximize the value of equity

capital. Individual risks are often measured by means of a variety of

complex quantitative and statistical models that use computer programs to

analyze financial data and determine risks. Although different firms use

similar overall financial approaches when considering the risks they face,

the actual statistical models that the firms use are firm-specific—that is,

each firm bases its model on its own data and financial activities. The

extent to which large, diversified firms measure and model each risk

varies according to the risks inherent in their business activities and their

ability to quantify those risks. Market and insurance/actuarial risks tend to

be most amenable to the use of statistical models. Credit and liquidity

risks also have quantifiable elements. Operational and business/event risks

are very difficult to quantify and are not as readily measured; however,

some firms are developing measurements of these risks.

Regulators and firms alike recognize that models have limitations;

however, they believe that using such models can improve a firm’s ability

to understand, measure, and manage risks, thereby decreasing the

likelihood of some unanticipated risks and losses. Under widely circulated

general risk management principles, which were developed in conjunction

with financial regulators, firmwide measurement of risk is an integral part

of a unified, firmwide risk management system. Such principles include

setting limits on trading or other activities and determining capital

requirements for business lines on the basis of the measured risks,

whenever possible.

Financial Firms Use

Capital to Help

Manage the Trade-Off

Between Return and

Risk

Modern finance theory suggests that capital provided by investors enables

financial firms to fund operations, earn profits, and grow. It also provides

firms with a cushion to absorb unexpected losses. Firms need to attract

capital from investors by offering a mix of returns and risks that is

competitive with the mix available in other investments.

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Both equity investors (stockholders) and bondholders consider return and

risk in their decisions to invest in firms. To attract and keep equity capital

investors, a firm tries to manage the trade-off between increasing returns

and decreasing risks. The trade-off exists because increasing returns, at a

given level of risk, generally increases stock values; increasing risks at a

given level of return generally is viewed as lowering stock value.

Equity stockholders’ returns are based on the firm’s dividends and capital

gains on the stock. A firm using a risky but successful strategy can

increase stockholder returns as long as the costs of borrowed funds are

less than the return to equity. In contrast, bondholders’ returns are based

on interest paid by the firm and capital gains on its bonds. The returns to

bondholders are limited, and a successful risky strategy does not increase

bondholders’ returns.

Equity stockholders’ risks are the volatility of returns and, in the extreme

case, losses in bankruptcy or liquidation when assets are sold to satisfy the

claims of the firm’s bond and other debt holders. Generally, bondholders’

risk is the chance that a firm’s risky strategies will fail and it will not be

able to repay interest and principal. In the event of a bankruptcy or

liquidation, the value of the assets may not cover the outstanding

principal. Because stockholders can obtain larger returns from risky and

successful strategies and bondholders cannot obtain added returns from

such strategies, bondholders are less likely to encourage or accept

increased risk-taking by a firm. Furthermore, if the firm undertakes risky

strategies, bondholders may require a higher interest rate as compensation

for the increased risk. The higher interest rate decreases the funding

advantage of debt financing and lowers profits for stockholders.

Bondholders depend on, among other things, credit rating agencies for

evaluations of the creditworthiness of bonds based, in part, on a firm’s

leverage.1

 When a firm receives high ratings, such as an investment grade

rating from credit rating agencies, the market then allows the firm to pay a

lower interest rate on its debt, which lowers costs. Consequently, firms

often manage their operations to receive investment grade credit ratings.

Several firms that we spoke with told us that they manage their firms to a

1

Leverage is the relationship of a firm’s debt to equity, as expressed in the debt-to-equity ratio.

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AA investment rating, which is the second highest investment grade rating.2

While maximizing stock values, firm management also needs to address

the concerns of regulators and others. Regulators’ concerns are important,

because regulators can limit firms’ operating freedom by forcing them to

allocate capital according to the regulators’ concerns over risk and can

require firms to cease doing business, if capital levels fall below the

minimum capital requirement. Managers also need to take into

consideration the interests of many other parties concerned with the

performance of the firm. Employee interests are important, because

changing compensation packages can create incentives for excessive risk

taking. In addition, financial firms undertake many transactions with each

other. It is in each party’s interest to consider the capital levels (relative to

risks) in its trading partner or counterparty, because a poorly capitalized

entity might fail to complete its financial obligations under a financial

contract.

Firms Are Using

Models to Measure

and Limit Risk-Taking

and Determine Their

Capital Allocations

Advances in financial theory and information technology have enabled

large financial firms to track and evaluate some risks on a more

quantitative basis than they could before. Some firms are measuring

certain risks on a firmwide basis. According to the financial literature we

reviewed and several of the firm representatives we spoke with, large,

diversified firms are increasingly doing this because of heightened

competition among firms and increased scrutiny of risk management

practices by regulators.

Firms can use such tracking and measuring to set limits on risk-taking,

evaluate the return and risks of specific activities, and allocate capital

accordingly—that is, to ensure that the estimated returns are large enough

given the estimated risks. As discussed later in this chapter, these

activities are embedded in general risk management principles that lay out

a management approach and in tools that are designed to ensure that a

firm is appropriately addressing its risks. These principles form the basis

of a firm’s risk management system that can, among other things, provide

timely information on trading positions, risks, and risk-adjusted

2

According to major credit rating agencies, Standard & Poor’s and Moody’s, AAA/Aaa through BBB/Baa

ratings are investment grade. AAA/Aaa are the highest ratings and indicate that the capacity to repay

debt is extremely strong. AA/Aa ratings indicate a very strong capacity to repay and differ from AAA

only in a small degree. “A” ratings indicate a strong capacity to repay, although with somewhat more

susceptibility to adverse effects of changes in circumstances and economic conditions than in the

higher rated categories. BBB/Baa ratings indicate an adequate capacity to repay but with somewhat

more susceptibility to adverse effects of changes in circumstances and economic conditions than in

higher rated categories.

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performance measures.3 Such principles also encourage firms to develop

risk-adjusted performance measures to track the risk-return trade-off. For

example, these general principles are embedded in SEC oversight under the

DPG and in bank regulators’ capital regulations.

A general framework for risk-adjusted performance measures that is used

by a number of the larger firms is called the risk-adjusted return on capital

(RAROC) system.4 RAROC is the risk-adjusted profitability of a particular

business activity per dollar of equity capital allocated to an activity. This

means that at any given level of profit and risk, if managers increase

capital allocated to an activity, the RAROC for that activity will tend to

decrease. Consequently, RAROC directly measures and takes into account

the risk, return, and capital trade-off.

Some Firms Measure

Market Risk With

Statistical and Other

Financial Models

As markets become more competitive, as new financial instruments create

new mixes of risks and return, and as markets remain volatile and

uncertain, managers need improved tools to consider risks and manage

them. Therefore, the ability to set limits on trading activity or manage risks

is especially important to large financial firms. Generally, models can help

managers limit risks and are used to set limits on traders and trading

activities. In addition, models can be used to determine needed capital

levels on the basis of the measured risks.

In the banking, securities, futures, and life insurance sectors, some large

firms measure market risk with statistical financial models supplemented

by, or in combination with, other types of models. Statistical models apply

past data on price changes to determine losses that might occur in the

future; they are often used to measure market risks, such as trading in

securities, derivatives, and foreign currencies. Such risks are not equally

important for all types of financial firms. For example, market risks are

important for large securities firms and banks undertaking trading of

financial assets. Life insurance companies must often consider interest

rate risk (a type of market risk) when underwriting annuities and other

investment products that they sell. In contrast, many banks and insurance

companies consider credit risks to be more important. Basically, the

3

A risk-adjusted performance measure permits a manager to quantitatively relate the return to the risk

associated with a product or business decision. One common risk-adjusted performance measure is

the ratio of expected profits over the risk, measured as volatility of profits. The measure can improve

for one of two reasons; returns can increase at a given risk level or risk can decrease for a given

return.

4

RAROC is discussed in more detail in appendix IV.

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relative importance of different risks for a firm depends on the products it

offers, the business strategies it uses, and the markets it serves.

Models have important limitations; nonetheless, in the views of the firm

representatives and industry experts we spoke with, they improve a

manager’s ability to measure and manage risks, thus decreasing the

likelihood of losses due to measured risks that could deplete the capital

cushion provided by management to cover losses.

Value-At-Risk (VAR) Models

Are Used to Measure and

Manage Market Risks

A firm’s “value-at-risk” (VAR) is an estimate of the maximum amount that a

firm can lose on a particular portfolio a certain percent of the time over a

particular period of time. Empirically, this loss can be measured by

statistical models as a confidence interval, that is, the percent of the time a

certain loss is not likely to be exceeded. This confidence interval implies a

corresponding probability that the certain loss is likely to be exceeded a

certain percentage of the time. The amount of capital needed to cover this

confidence interval is often called economic capital-at-risk.

Using the confidence interval approach, a firm might specify a 1-day time

horizon with a 99 percent confidence interval—the percent of the time that

a specified loss is not likely to be exceeded. This calculation might yield a

$1 million loss that on average would not be exceeded more than 1 out of

every 100 trading days. To ensure that this 1-in-100 chance of a $1 million

loss would not create a financial problem, the firm could assign a

$1 million capital buffer. If the firm wants to lessen the chance that the

allocated level of capital will be exhausted, it could increase the

confidence interval, increase the capital set aside, or change its trading

strategy to create less risk. In contrast, if the firm wanted to increase the

expected profits, it could decrease the confidence interval, lower the

capital set aside to cover possible losses, or change its trading strategy to

create greater expected profits while accepting the added risks.

According to the modeling literature,5

 the four main approaches to VAR

modeling are the correlation or parametric method, the historical method,

the historic simulation method, and Monte Carlo simulation. VAR models

can be based predominantly on the correlations among asset prices and

the effects of such correlations on the risk in the firm. In addition, VAR

estimates can be based on historic simulation or Monte Carlo simulations

that show how changes in several fundamental economic variables or

factors would affect the financial condition of the firm.

5

“Value at Risk—New Approaches to Risk Management,” Katerina Simons, New England Economic

Review, Sept./Oct. 1996.

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VAR Estimates Can Be Based

on Correlation Among Asset

Prices and Returns

Most VAR models depend on statistical analyses of past price movements

that determine returns on the assets. The VAR approach evaluates how

prices and price volatility behaved in the past to determine the range of

price movements or risks that might occur in the future. This VAR approach

is based on price variances and, in some cases, covariances among the

prices that create market risks.6

 This approach uses statistical estimates of

the variances of asset prices and the covariances among asset prices to

summarize the overall market risk faced by the firm.

The correlation method assumes that the statistical distribution of asset

returns is normally distributed and that the variance-covariance matrix

completely describes the distribution. Assuming a normal statistical

distribution simplifies the analysis and the computation of the VAR

estimates, because it assumes that returns are symmetrically distributed

around the mean and the dispersion of returns above and below the mean

are similar.7

VAR Estimates Based on the

Historical Method Use Actual

Historic Returns to Determine

Losses

The historical method rejects the use of the normal distribution, because

much empirical research on the statistical properties of asset returns

suggests that returns are not normally distributed. The evidence suggests

that high and low returns are more likely to occur than would be predicted

if a normal curve assumption were used. Evidence also suggests that in

many cases, the actual returns are more likely to be negative than would

be predicted if a normal curve assumption were used. In the historic

method, the VAR is calculated by finding the lowest returns in the historic

data. Using historic data tends to produce higher VAR estimates. This

occurs because, empirically, the normal curve assumption underestimates

the likelihood of larger losses. Implementing the historical approach

requires added historic data that can be expensive to obtain or even

nonexistent.

6

Variances and covariances are statistical measures of how prices vary over time. The variance refers

to the variability or volatility of the price of a specific asset, and the covariance refers to the variability

or volatility of the relative prices of two assets at the same time.

7

In financial theory, the standard deviation is used as a measure of risk because the theory often

assumes that risks are distributed along a normal probability distribution—often called a bell-shaped

curve. The standard deviation is a statistical measure of the degree to which an individual value in a

probability distribution varies from the mean or expected value of the distribution. In normal

distributions, knowing the standard deviation permits an analyst to directly determine the confidence

interval. In practice, many financial risks are not distributed normally. As a result, the standard

deviation of the distribution does not directly suggest the probability that a certain loss will be

exceeded.

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VAR Estimates Based on the

Historic Simulation Approach

Use Information on Returns

and Risk Factors to Calculate

the VAR

The returns on particular instruments often cannot be used to determine

the VAR estimate. If an institution is large and complex, it may be

impractical to maintain historic data on all of its instruments.

Furthermore, historic data may not be available on new or innovative

instruments that the institution is introducing. In such cases, VAR models

must include information about the historic distribution of economic risk

factors that will determine the risk created by new instruments. Such risk

factors are the fundamental economic creators of risk. For example, for a

bond denominated in a foreign currency, the risk factors are foreign

exchange rates and interest rates. For a Standard & Poor’s 500 option, the

relevant risk factors are its volatility, the dividend yield on the index, and

the risk-free interest rates. In the case of banks, when new instruments are

present, the bank can develop a VAR model based on the statistical

distribution of risk factors and the current composition of the bank’s

portfolio of activities both on and off the balance sheet. However, the use

of historic simulation is limited by the bank’s inability to change

assumptions about fundamental risk factors.

VAR Estimates Based on Monte

Carlo Simulations Can Evaluate

the Effects of Changing

Numerous Fundamental Risk

Factors

Firms often are subject to several risks at one time. To address the

simultaneous effects of several risks, firms tend to develop Monte Carlo

simulations. VAR models based on Monte Carlo simulations start with

management identifying a series of changes in several fundamental risk

factors that can simultaneously affect the firm. The analysis of the effects

of these factors is determined in a mathematical model in which equations

show how changes in the fundamental risk factors affect the firm’s cash

flows, financial condition, and remaining capital.

On the basis of statistical analyses of how market prices have varied in the

past, the Monte Carlo approach to VAR estimation is designed to show how

the firm will perform in the future by letting managers evaluate how the

firm would perform under thousands of different economic conditions.

Monte Carlo approaches to VAR estimation also display the effects of

nonlinear risks—risks that grow more than proportionately with

movements in the underlying risk factor. Such risks are found in

derivatives contracts and in the options embedded in financial products.8

8

Market risks can vary linearly or nonlinearly with prices. Examples of linear or direct risks are losses

that can occur if the price of foreign currencies, a bond, or a stock decreases. Linear losses are directly

proportional to price movements. Nonlinear risks are not proportional in that for some price

movements in one direction, no losses are incurred by the firm; but for larger price movements in the

same direction, large losses can occur. Nonlinear risks are generally associated with options contracts

or financial products with options built in. Mortgages are an example of a financial product with

embedded options. When interest rates decline a small amount, mortgage prepayments may not

accelerate. But when interest rates drop by a large amount, prepayments can accelerate quite quickly

and create financial losses for firms holding mortgages at rates well above current market rates.

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Identifying such risks can help the firm to identify the mix of conditions

and strategies that would cause the greatest harm. On the basis of the

Monte Carlo estimates of VAR, the firm can adjust trading limits to avoid

excessive risks or create a better risk-return trade-off.

Backtesting Is Used to

Determine the Accuracy

of VAR Models

VAR models are commonly backtested to evaluate the accuracy of

assumptions by comparing predictions with actual trading results.

Backtests determine whether and how well the models’ results compare to

a firm’s historic daily trading results. Backtests provide information

retrospectively about the past accuracy of an internal model by comparing

a firm’s daily VAR measures with its corresponding daily trading profits and

losses. Any VAR-set limit that is exceeded by trading losses at a greater

frequency than indicated by the chosen confidence level indicates that the

model is not measuring expected losses well enough.

VAR-Based Models Have

Limitations

According to the financial literature and our interviews, the limitations of

the VAR model include a dependence on past data to estimate possible

future losses and possible errors caused by simplifying statistical

assumptions.

The VAR calculation and estimated losses from VAR models are based on the

past behavior of prices and price volatility. If price patterns are changing

now or will change in the future, estimates of potential losses based on

past price changes will be incorrect. As a result, the risk managers at the

firms told us they must continually update their statistical estimates and

monitor for changing price patterns that affect losses predicted by VAR

models.

Some VAR calculations are simplified by assuming returns are distributed

normally. Such simplifications ease data needs, lower computational

costs, and are easier for those less familiar with advanced statistical

modeling techniques to understand. However, such assumptions can result

in the model underestimating the probability and extent of large losses. To

avoid this problem, several of the firm representatives we interviewed said

that they use Monte Carlo simulations when necessary because such

simulations take returns that are not normally distributed into

consideration.

Simplifying assumptions also limits the ability of some VAR models to

measure risks that do not vary directly or linearly with price changes. For

example, gains or losses on stocks held in portfolios vary directly or

linearly with market prices. As the market prices of stocks increase, the

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value of the stock or foreign currencies held by a firm increases in direct

proportion. Such direct, linear relationships also exist in foreign currency

trading, a common activity of many large, diversified financial firms.

In contrast, losses on options and financial contracts with embedded

options can be nonlinear and need not move proportionately or linearly

with interest rates or other prices. Options have risks that are nonlinear;

for small price movements there may be no losses for the firm, but for

larger price movements the firm can suffer large losses. Similarly, interest

rate risks in certain financial products can be nonlinear. For example, for

small declines in interest rates, mortgage prepayments will not accelerate.

However, for large declines in interest rates, prepayments can accelerate

quickly and create large and nonlinear losses for a firm holding mortgages.

Representatives of several firms told us that nonlinear effects in certain

other types of financial options affect the accuracy of VAR modeling.

Stress Tests and Scenario

Analysis Are Used to Determine

How Large Changes in

Economic Conditions Could

Lead to a Firm Failure

Firms use stress tests and scenario analyses to help validate or

cross-check the reliability of VAR models. Stress tests measure the

potential impact of various large market movements on the value of a

firm’s portfolio. Such tests are a useful tool for identifying exposures that

appear to be relatively small in the current environment but that grow

more than proportionally with changes in risk factors. Scenario analysis

generates forward-looking “what-if” simulations for specified changes in

market factors that quantify revenue implications of such scenarios for the

firm.

Stress tests are based on a series of mathematical equations that show

how changes in fundamental economic factors would affect the financial

statements of the firm over time. Stress tests determine whether large

changes in underlying key factors would lead to losses that could put the

financial firm at risk of failing. The level of key economic factors used in

the stress test can be based on (1) past economic situations in which key

economic variables have affected a firm’s financial condition or

(2) management’s judgment. When using past economic situations to

determine the level of key economic variables, risk managers may use the

results of statistical analyses to help decide what factors to use in the test

and how large the stress should be. The values or the risk factors used in

the stress tests can be based on management’s judgments and statistical

analyses of the variability of the risk factors in the past. Some stress tests

apply Monte Carlo simulations to determine how often and how quickly a

firm will fail when subject to stressful economic environments.

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All Market Risk Models Have

Limits and Benefits

The financial literature and our interviews with risk managers told us that

all models are limited to the extent that they rely on historic data and

pricing patterns that may not reflect future economic conditions and risks.

In addition, all models are limited by the quality of the data available, the

computation power available, and the ability of analysts to develop

mathematical models to accurately reflect financial risks and returns as

economic conditions change. Several of the risk managers we met with

stressed the importance of the risk factors used in a firm’s internal

modeling. Because a firm’s internal system cannot effectively track all of

the risks the firm is exposed to, risk managers choose those they believe

are the most significant, such as equity and foreign exchange positions and

the yield curve slope.9

Models also offer benefits. Managers using models are able to take a more

disciplined approach to the overall operations of the firm. Models

encourage and permit risk managers to simultaneously consider the risks

and returns in individual assets or portfolios and their interactions, which,

in combination determine the overall risks and returns of the firm from

market risks.

Our interviews with industry association officials who tend to represent

smaller financial firms suggest that small companies may be more likely to

hold assets until maturity and less likely to realize the market losses in

their portfolios when the market value of assets decreases. According to

these officials, these companies may not find it necessary to undertake

such market risk modeling, because their risks and long-run profits are not

driven by changes in market prices and returns. Instead, their risks may be

concentrated in credit risk, insurance risk, and operational risks, which

have not been quantified or modeled as extensively as market risks.

Firms Measure Credit Risk

in a Variety of Ways

Traditional credit risk management at banks, securities firms, and

insurance companies has most often been based on analysis of

standardized information reports and judgments by experienced credit

officers of the creditworthiness of borrowers and any collateral against the

loan or bond. On the basis of such judgments, firm managers have set

limits on financial positions and developed plans to manage credit risks.

Increasingly at large, diversified firms, traditional credit risk management

approaches have been augmented by credit-scoring models for certain

9

The yield curve is a graph showing the structure of interest rates by plotting the yields of all bonds of

the same quality with maturities ranging from the shortest to the longest available. The resulting curve

shows if short-term interest rates are higher or lower than long-term rates. Analysts study the yield

curve carefully in order to make judgments about the direction of interest rates.

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classes of homogeneous loans, such as credit card, automobile, and

residential mortgages. In even fewer firms, models have also been applied

to evaluating the credit of companies with publicly traded stock.

Traditional Credit Analysis Traditional credit analysis is based on standardized reports and credit

officer judgments. In most firms, the credit quality of a particular loan is to

be judged by a reviewing officer and placed into one of several credit

categories. Categories range from risk-free or low risk to potential or full

loss. In rating creditworthiness, credit risk is exclusively the risk of a loss

on a loan due to a default and is not the risk due to price volatility.

A particular loan can be reassessed on the basis of either the changing

condition of the borrower or changes in the economy that may affect the

likelihood that the loan will be repaid on a timely basis. When considering

the risks from a particular loan or financial position with a firm, lenders

generally consider all the positions with that firm, because a credit

problem in one position with a firm will usually be associated with credit

risks for all positions of the entire firm. For example, in a situation where

a firm has several financial interactions with a bank, such as a commercial

loan, a mortgage, and a foreign exchange transaction, if one of these

interactions appears uncreditworthy, it can affect the others.

Commercial banks, securities firms, and life insurance companies that we

interviewed told us they used the traditional approach to credit analysis.

Each firm said it applied a consistent evaluation and rating scheme to all

credit decisions. The firm produced aggregated results on the overall

credit portfolio. A typical bank might use a rating system with up to 10

rating categories that are defined from low to high risk. Consistent

application and updating of the ratings are part of the process. In some

firms, both the borrower and the instrument are rated separately. Part of

the rating addresses covenants or limitations in the contract and collateral

used to secure the contract.

Given consistent application of the ratings by its credit officers, a bank can

produce a report of the credit risk in its loan portfolio at any time. The

report changes as loans enter and exit the system and as ratings of

particular loans change over time. According to one source, this credit

quality report is most meaningful when credits are monitored and

periodically reviewed by a risk management group or function.

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Insurance companies tend to be very focused on credit risk. Because

insurance companies’ credit risk often appears in bonds and other traded

instruments, rating the instruments is one way to address credit risk.

Credit ratings needed by the insurance companies are often performed by

the Securities Valuation Office of NAIC.

10

In many financial firms, credit analysis traditionally was done on a

loan-by-loan basis. Such an approach ignored the fact that all loans in the

same region or industry tended to become less creditworthy at the same

time. However, given sectoral losses of the 1980s in real estate and the

petroleum industry, firms are increasingly concerned that many loans

concentrated in the same region or industry may create losses at nearly

the same time. To address these concerns, some firms are undertaking

concentration reports by industry, and work is under way to improve the

industry classification codes needed to produce concentration reports.

Some Firms Are Using Credit

Scoring Models to Determine

Credit Risk

Credit scoring applies formal statistical procedures to the credit decision

process. Credit scoring models, based on statistical analyses, use data on

the borrower found in credit reports and loan application information to

determine whether or not a loan is likely to be repaid. In addition, credit

scoring can be used to adjust terms on the loan such as downpayments

and interest rates. Such models are often used in underwriting credit cards

and mortgages. Credit scoring is most applicable to classes of loans in

which there are numerous loans that are frequently underwritten with

similar terms. Within each class, the loans are relatively small compared to

the total holdings in the class, made frequently, and easily statistically

analyzed because the loans have relatively homogeneous characteristics.

This homogeneity occurs because the loans are not custom-tailored to the

borrower or to the collateral asset.

Some Firms Are Using Stock

Prices and Portfolio Credit

Models to Measure Credit Risk

Some banks and consulting firms that we spoke to have developed a

portfolio approach that rates the creditworthiness of loans to larger

corporations whose bonds and stocks are traded regularly in the financial

markets.11 This approach addresses the correlations among the

creditworthiness ratings of individual assets in the portfolio.

10The Securities Valuation Office was established in 1951 to assign risk ratings to bonds held in

investment portfolios of insurance companies. At that time, most of the bonds held by insurers were

private placements that were not rated by private rating agencies. Currently, however, the Securities

Valuation Office uses the private ratings unless there is a split rating, i.e., conflicting ratings for the

same issue from different private raters. In these cases, as well as in the increasingly infrequent cases

of private placements without a public credit rating, the Securities Valuation Office is to conduct its

own analysis and assign a rating.

11Both consultants and large banks have developed credit ratings that are based on stock prices, and

some large banks either directly develop such ratings or use consultants to undertake such ratings.

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In the first step, the portfolio approach uses the traditional approach of

rating each loan or financial instrument on a case-by-case basis to

generate its inputs by determining the credit risk from each obligor

(borrower from the bank). In the next step, the portfolio approach

accounts for the credit risk across the portfolio based on the correlation of

credit quality across obligors. In this way, this approach takes into account

and quantifies the benefits of portfolio diversification. It is similar to the

portfolio approach already used in market risk modeling such as VAR.

The portfolio approach to credit risk may depend on stock and bond price

information and ratings by credit rating agencies, such as Standard and

Poor’s. Using statistical methods, the portfolio approach estimates the

probability of default on an instrument and the probable loss from that

instrument if a default occurs. The approach uses the credit rating from a

credit rating agency or the internal credit rating by a bank evaluating its

own loans. Credit rating agency ratings and bank loan evaluations are

based on reviews of the financial books and other pertinent information

gathered during the rating or loan application process when a firm is

issuing bonds or applying for a loan. Such ratings are not driven by market

prices or by the volatility of market prices.

The portfolio approach also uses market information on stock prices to

estimate the total probability of default on the basis of the correlations of

defaults among the component loans in the portfolio. By taking these

market prices into account, the portfolio credit rating can directly take

into account the correlation among credit risks because it can address the

correlation among stock prices. Such correlation information permits risk

managers to develop more economically efficient portfolios by improving

expected profits or lowering the risk of losses from the total loan

portfolio. As with market risk modeling, assumptions about the probability

distributions and the correlation among the risks affect the estimated

potential losses due to credit risk embedded in any particular portfolio.

The portfolio approach to credit risk enables a risk manager to

• quantify and control credit concentration risk;

• consider concentrations on the basis of industry rating category, type of

instrument, or other factors;

• interpret credit risk in terms of needed capital as is done in market risk

calculations; and

• evaluate investment decisions more precisely in terms of risks, returns,

and capital.

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Many Firms Use

Worst-Case Cash Flow

Simulations to Measure

Liquidity Risk

Liquidity risk analyses are most concerned with the effect of a sudden

crisis that arises when lines of credit may be closed, assets can be sold

only at a loss, and other new funding sources cannot be found. In a

liquidity crisis, a firm must be able to sustain itself and obtain cash as

needed when the markets, in general, appear much less willing to buy

assets from the institution or make loans to the firm experiencing the

crisis.

Many firms develop worst-case simulations (i.e., stress tests) or models to

investigate the implications of a severe loss, which affects credit ratings,

or a systemwide crisis that would affect all sources of liquidity due to a

flight to quality12 throughout the economy. The worst-case “scenarios” are

based on simulations of firm cash flows.

In each worst-case cash flow analysis, a firm would attempt to estimate

the immediate funding shortfall associated with a severe loss and a crisis

that is systemwide. In a worst-case analysis, a firm attempts to measure

the speed with which it can acquire needed liquidity during a crisis. Such

liquidity might be based on liquidating assets—that is, shrinking its

balance sheet—or estimating sources of funds that would still be available

during a crisis. The results of such worst-case analyses or simulated crises

are often reported in estimated days of exposure or days of a funding

crisis. On the basis of the liquidity problems that arise in worst-case

simulations, managers can alter current operations to forestall liquidity

problems in a crisis, adjust the liquidity of current asset holdings, or create

more secure lines of credit.

Such simulations are not used to forecast future problems but rather as a

planning tool to understand what a liquidity crisis might entail. In the view

of a number of firm representatives we spoke with, such simulations or

worst-case studies are imprecise but essential to a firm in the event of a

substantial change or deterioration of its financial condition. Some firms

we spoke with used such simulations to determine what backup lines of

credit, which cannot be cancelled, are needed to ensure liquidity or

funding during a crisis.

One large securities firm suggested that financial firms can fail in a crisis

when liquidity is lost even though other fundamental risks might not be

present. Another large firm emphasized that broker-dealers depend on

12Flight to quality occurs in financial markets when investors rearrange their asset holdings to include

only the most creditworthy or least risky assets. During such situations, financially weaker firms may

find that they have lost access to credit lines—liquid funds from creditors or banks—and thus be

unable to fund operations. Such closing of credit lines can force a firm to fail.

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liquidity when managing market or trading risk because, without

liquidity—the ability to buy and sell financial assets without large

losses—hedging and other risk-reducing strategies do not work. Firms’

representatives told us their firms often maintain an equity cushion above

regulatory capital levels to ensure the constant availability of sufficient

cash to deal with liquidity problems or to undertake a large and potentially

profitable deal. Another large, diversified firm emphasized that during

crises, investor flights to quality occur and firms without strong credit

ratings may not be able to refinance short-term debt or fund operations.

Firms that maintain high levels of capital are generally considered to be

more creditworthy.

Other firms told us that liquidity is an amorphous term and cannot be

addressed by VAR or other mathematical models. A representative of a

large industry group said that liquidity risk is somewhat quantifiable but

not to the same extent as credit and market risk.

According to several insurance industry analysts, liquidity is not as big a

concern with many life insurance companies as it is with other financial

institutions because life insurance policy liabilities are less liquid than life

insurers’ assets. Life insurance companies issue policies that have high

surrender charges that tend to limit redemptions. A decade ago, when

interest rate movements created options that encouraged early

redemptions, illiquidity was more of a problem for life insurance

companies. New policies are now written that are designed to bring

returns on products into accord with market rates. In addition, policy

loans are often charged variable rates that track the market instead of

fixed rates in order to prevent losses.13

Life Insurers Use

Statistical Models to

Measure

Insurance/Actuarial Risk

In the past, life insurance companies generally used conservative static

assumptions regarding loss distributions and interest rates. This approach

was ill equipped to deal with the interest rate volatility of the late 1970s,

according to several insurance company representatives we spoke with.

Life insurance policies are full of options—settlement options, policy loan

options, over-deposit privileges and surrender or renewal on the part of

the insured, and discretionary dividend options on the part of the insurer.

13Many insurance companies use financial consultants specializing in insurance company risk analysis

for their analyses and stress testing. The scenario testing includes about 50 to 100 scenarios that either

increase or decrease all interest rates by the same amount or change short- and long-term interest

rates by different amounts. Such changes in the interest rates test for interest rate risk. A worst-case

scenario cash flow test is also undertaken.

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When interest rates are volatile, these options increase in value and thus

are more likely to be exercised.

Traditional actuarial valuation methods that assume interest rate stability

incorrectly value these options when interest rates are volatile because the

companies do not consider or calculate the economic value of the options.

By assuming stable interest rates, insurance companies tended to

underprice their policies. Today, the standard valuation techniques deal

explicitly with the interest rate risk options embedded in policies. These

standard valuation techniques use statistical modeling approaches such as

VAR based on correlations and Monte Carlo simulations discussed earlier in

connection with market risks.

Most Firms Said They Did

Not or Could Not Measure

Business/Event and

Operational Risk

Although the firms we interviewed emphasized that business risk and

operational risk were crucial concerns, most acknowledged that they did

not or could not effectively measure these risks. Several firms described

how they were measuring market, credit, and liquidity risks and explained

that their firms did not measure other risks, such as operational or

business risks. Several suggested that they were not convinced that

operational and business risks could ever be measured to the same degree

that market, credit, and liquidity risks were measured. In almost all the

interviews we conducted, including all those with regulators, we were told

that because measurement of business/event and operational risk is

difficult, managers’ judgments are crucial to managing these risks.

A securities-based firm said that most failures in this industry were not

created by market risks; rather, operational problems led to the failures.

One bank’s risk manager suggested that business risk was an amorphous

term and thus could not be measured or placed in a mathematical or

statistical model. This bank does, however, include business risk in its

Risk-Adjusted-Return on Capital (RAROC) system. A manager of a large and

complex insurance-based financial firm said he was not yet comfortable

with how his firm measured such risks. Another bank, which said it is

vigorously trying to model its risks, told us that it has not yet quantified

operational risk. A major consultant to the financial services industry

concluded that operational risks are hard to quantify because the risks are

embedded in (1) the operating and accounting systems, (2) the models,

(3) staff behavior, (4) the compensation systems that create incentives to

undertake various activities that affect both firm and employee risks and

returns, and (5) the managers’ abilities to foresee the consequences of the

interactions among these factors. Officials of one bank we interviewed

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told us they were quantifying business/operational risk by using revenue

volatility as a proxy for impact of risk on business results.

Measuring and

Managing All Risks on

a Firmwide Basis

In practice, risk measurement approaches differ across the risks faced by

firms, and not all risks are quantified to the same extent. For example,

under widely circulated general risk management principles, firms are to

monitor and manage all risks but are expected to explicitly measure and

manage only market, credit, and liquidity risks, as discussed above. Firms

monitor and measure other risks using a more qualitative approach

because, to date, quantification of these other risks has not progressed

enough to be commonly used even at large, diversified firms.

Because financial firms are as yet unable to quantify and model all risks, a

fully quantified approach to determine needed capital has not yet been

developed. Nonetheless, the general framework called RAROC has been

developed for such firmwide risk assessments across all risks and

products (see app. IV for a discussion of this framework). However, as

long as no common basis exists for measuring all risks, firms cannot fully

integrate their risk measurement and management systems in a firmwide,

cross-risk, and cross-product analysis. Thus, given the different

approaches and levels of sophistication currently available for measuring

and managing risks, managers’ judgment and effective risk management

approaches remain a crucial determinant of risks, returns, and needed

capital levels in each financial firm.

General Principles of

Firmwide Risk

Management

As mentioned earlier, firmwide risk measurement is an integral part of a

unified, firmwide risk management system under widely circulated general

risk management principles. Our discussions with regulators and

representatives of large, diversified financial firms indicated that these

firms accept the approach of the general risk management principles and

are applying these principles in the design of their internal risk control

function. However, to date, not all firms we spoke with have fully

implemented the risk and capital measurement systems laid out by the

principles.14

14Such general risk management principles have been adopted by bank regulators in the risk-based

capital market risk component discussed in chapter 2 and appendix I.

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General Risk Management

Principles Are Designed to

Ensure That a Firm Is

Appropriately Addressing

Its Risks

General risk management principles lay out a management approach and

tools that are designed to ensure that a firm is appropriately addressing its

risks. There is a common set of five broad risk management principles:15

1. A structured framework is to be established to link a firm’s business

strategy and operations to its risk management objectives.

2. Centralization of the risk management function in one dedicated staff

office is needed.

3. Risk measurement, risk reporting, and risk controls are needed to

permit managers and others to evaluate the implications of the risks,

returns, and capital levels in the firm.

4. Operations systems are needed to support the risk management

function.

5. Risk management systems are needed to provide needed data on a

timely basis.

Under these principles, the firm’s risk management strategy is to be based

on a framework of responsibilities and functions driven by the board down

to operating levels, which covers all aspects of risk. The basis for this

principle is the view that unless the board is fully integrated in the risk

management approach, the firm’s managers and employees will not be

fully committed to risk management. To emphasize the importance of risk

management, the principles state that a risk management group composed

of senior managers is to be created.

In accordance with the principles, the risk management function is to be

fully integrated into a firm’s operations. The day-to-day responsibility for

risk monitoring and risk evaluation is to rest with the risk management

function, which is to report to a risk management group—a special

committee of senior managers. The role of the risk management function

is to implement policies associated with specific risks, such as market

risk, credit risk, liquidity risk, operational risk, and business/event risk. Its

purpose is also to ensure that trading is within approved limits and that

15Principles of risk management have been developed by various industry and regulatory bodies,

including the Bank for International Settlements, the International Organization of Securities

Commissions, DPG, U.S. bank regulators, and a group assembled by Coopers & Lybrand. All of these

are broadly similar. The list here is from Coopers & Lybrand, termed Generally Accepted Risk

Principles.

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risk limits and policies are properly understood and evaluated before

transactions are undertaken.

The principles lay out a framework for risk measurement, reporting, and

control of risks; quantification of market, credit, and liquidity risks; and

development of the capability to aggregate and monitor exposures on a

firmwide basis. The principles require a firm to set a comprehensive set of

limits to ensure that risk exposures remain within agreed-upon boundaries

set by the board or risk management group. In addition, the firm needs a

mechanism for evaluating firm performance on a risk-adjusted basis to

address the trade-off between return and risk. That is, the firm must

develop a method to simultaneously measure and manage the trade-offs

that can exist between return and risk on a firmwide, business-unit, and

product-specific basis.

The principles call for a risk management system to generate, on a timely

basis, information on the firm’s trading positions, risks, and risk-adjusted

performance measures. Such information is to be available to the risk

management group; risk management function; and other end users of the

information, such as traders, credit risk departments, or managers of

trading units.

Under the principles, firms are to develop a comprehensive set of

operational controls, because firms engaged in trading activities often

encounter difficulties as a result of operational control problems rather

than measurement problems. Such operational controls are meant to

ensure that risk limits are set by the board and, once set, are not violated.

To guard against operational problems, it is important for firms to

rigorously establish controls that limit risk-taking and unauthorized

activities throughout the firm, according to the principles.

Firm officials we met with consistently mentioned these principles and

provided firm-specific examples to illustrate their importance. For

example, many firms and analysts emphasized that although their

approach to risk management is constantly evolving, it is of paramount

importance that senior management determines the level of risk that the

firm will accept and communicates this information firmwide.

Representatives of several firms commented that a central committee,

which reports to the chief executive officer, monitors their risks. Firm

representatives stressed that numbers are important, but good

communication, internal controls, and management judgment are what

really matter.

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Issues and Initiatives in Capital Regulation

Through our interviews with industry representatives, regulators, and

others as well as our review of pertinent literature and other documents,

we sought to identify significant issues in capital regulation. We group the

issues we identified into the following three categories:

• differences among financial regulators in terms of the risks each focuses

on and the purposes of its capital rules;

• differences between regulators’ and firms’ estimates of risks and needed

capital, and in their views of risk and how it should be managed, and

• concern about how regulatory capital rules are administered.

The principal issue in the first category is that as firms that have

traditionally been in different sectors of the financial services industry

increasingly offer similar products and take on similar risks, differences in

capital regulation among their regulators may have unintended

competitive implications for these firms.

Issues in the second category include a concern that current regulatory

capital requirements that are not adequately sensitive to the risks inherent

in a firm’s particular products or activities may create inappropriate risk

management incentives for firms and, in extreme cases, could even lead to

increased risk-taking. A related issue concerns the possible increased use

by regulators of a firm’s internal estimates of risk in setting regulatory

capital requirements, because financial firms and regulators have

somewhat different purposes for capital and tolerances for risk.

The third category, administrative issues, includes questions about

whether it makes sense to apply the same approach to capital regulation

for firms of all sizes and degrees of complexity. It also includes questions,

such as how can the regulators properly oversee the validity of the internal

statistical models that firms use to meet regulatory capital requirements.

As competition within and among different financial sectors has increased

and as large, diversified firms have improved their ability to measure and

manage risks and capital, financial regulators are responding by exploring

possible changes to capital requirements. Many initiatives aim to make

capital requirements more sensitive to the risks firms face in their

activities; other initiatives represent fundamentally different approaches to

capital regulation.

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Differences in

Regulatory Objectives

and Approaches May

Have Unintended

Competitive

Implications

In an environment of increasing competition across financial sectors and

national borders, large, diversified financial firms increasingly offer similar

products that pose similar risks. At the same time, individual firms and

their affiliates are regulated by a variety of domestic and foreign

regulators, and some are unregulated. Differences in corporate legal

systems and markets also contribute to international differences. Concern

about differing capital requirements for firms with similar products posing

similar risks is one part of an ongoing “level playing field” debate in

financial modernization. On a level playing field, firms and markets

compete without advantages that result from government backing (such as

government-backed deposit insurance) or disadvantages that result from

burdensome regulation.

At the same time, regulators acknowledge that differences in regulatory

purposes have implications for capital requirements that could limit

achievement of a level playing field. As discussed in chapter 2, the specific

objectives of the various financial regulators and their approaches to

regulation differ. For example, bank regulators are concerned with

maintaining the safety and soundness of the banking and payments system

and protecting the deposit insurance funds; and securities and futures

regulators are concerned with investor protection and ensuring the

integrity of the securities and futures markets, respectively.

Financial regulators and other experts we interviewed discussed the

appropriateness of having similar capital requirements for banks, which

are covered by government-backed insurance funds, and other firms that

are not; or whether it is appropriate for capital requirements of banks,

which are part of the payments system, to be similar to capital

requirements for firms that are not. Traditionally, bank regulation has

been more concerned with systemic risk than has regulation of other

financial entities. Some experts have argued that capital regulation must

be stricter on entities that pose greater systemic risk than on those that do

not.

Also, financial regulators were concerned that different domestic and

foreign capital standards for the various types of financial firms create

incentives for firms to change operations in ways that change their

regulator, such as moving business overseas, to avoid or offset capital

requirements they believe are costly and excessive. Different regulators

may have different capital standards for the same product. In some

situations, a firm facing the higher capital standard has an incentive to

move its activities in that product line into an affiliate that has a different

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regulator or one that is unregulated. However, in banking, all affiliates

within the holding company fall under the holding company capital

standards. If a bank believes the standards are too high for a certain

product, it may choose to abandon that product line; or it may restructure

its transactions to provide a similar service that carries a lower capital

requirement.

Differences Exist

Between Regulators’

and Firms’ Estimates

of Risk and Needed

Capital

An important issue for regulators is how to establish capital requirements

that meet their purposes without requiring either excessive or insufficient

capital for the risks involved. To a large degree, to increase the value of

the shareholders’ equity in competitive markets, large, diversified financial

firms have increasingly used statistical and mathematical models to

measure and manage economic risks and to determine their optimum

capital levels. As firms have been able to apply more sophisticated risk

measurement tools, some said they have become increasingly aware of a

discrepancy between their internal estimates of risk and the capital

needed to support certain activities and the regulatory capital

requirements for those activities. Even though firms may hold more total

capital than regulatory minimums call for, regulatory capital requirements

may impose higher capital levels for some activities than the firms believe

to be appropriate.

The difference between amounts of capital allocated by some financial

firms and regulatory capital requirements reflect, in part, differences

between the firms’ primary objectives and the purpose of regulators. As

discussed in chapters 2 and 3, financial firms and regulators agree that

capital serves as a buffer against unexpected losses. However, the primary

use of capital for firms is to maximize the value of their shares for

stockholders by choosing the best mix of risk and returns. Regulators, on

the other hand, impose minimum capital requirements to serve the public

interest.

Currently, financial regulators use a “building block” approach in setting

capital requirements—that is, capital requirements are determined largely

on the basis of broad classes of risk, and the total capital requirement is

the sum of requirements for each risk. Many firms and regulators have

argued that this building block approach is inappropriate, because the

total risk in the firm is based on the interactions of all risks in the firm’s

portfolio, and risks need not be additive. We did not identify any firms that

were yet able to hedge across different risks—for example, hedging credit

exposures and market exposures against each other. However, some firms

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said they have developed hedging strategies that allow them to decrease

risks by hedging the same risk within and across portfolios—for example,

hedging interest rate or foreign exchange risk in different portfolios within

the firm. These risk-reducing strategies are often not recognized in

existing building block regulatory approaches to setting minimum capital

requirements. Thus, because these approaches do not recognize the

possibility that total risk may be less than the sum of individual risks if

risks offset each other, they could lead to excessive capital requirements.

In both the banking and securities/futures sectors, capital regulations

contain formulas that apply single risk-weightings to a broad range of

riskiness within a single category. For example, in banking, the same

8 percent capital requirement is imposed on all unsecured loans to private

commercial borrowers regardless of individual creditworthiness, with the

result that a high-risk/high-return loan carries no more regulatory capital

than a low-risk/low-return loan. As a result, the regulation might give firms

an incentive to seek the highest returns within a broad class regardless of

underlying risk; or to adjust activities (e.g, develop new products and/or

change operations or corporate structures) in a way that reduces or

escapes capital requirements. In other words, firms may adjust business to

achieve the lowest regulatory capital cost rather than an optimal balance

of risk and capital. Also, the securities net capital rule requires registered

broker-dealers to apply a 100-percent haircut to any portion of the trading

profits, to the extent the profits are unsecured, reflecting SEC’s emphasis

on liquidity in its net capital rule.

Moreover, if capital requirements are not adequately sensitive to risk, they

may require either too much or too little regulatory capital for the

activities being covered. For example, capital requirements that require

firms to hold more capital than they believe to be warranted by the risk

can cause them to reorganize their structures, resulting in less regulated

financial markets as firms move operations outside of regulated entities.

Because securities firms consider the 100-percent haircut for OTC

derivatives transactions excessive, for example, they book much of their

OTC derivatives business in unregulated affiliates to escape capital

requirements and other regulatory oversight for these derivatives

activities. Some regulators and we have expressed concern about the lack

of regulatory oversight in OTC derivatives activities.1

1

See Financial Derivatives: Actions Needed to Protect the Financial System (GAO/GGD-94-133, May 18,

1994); and Financial Derivatives: Actions Taken or Proposed Since May 1994 (GAO/GGD/AIMD-97-8

Nov. 1, 1996).

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On the other hand, capital requirements that are too low to protect against

risk may result in firms holding only the required amount of capital. As a

result, they may not be sufficiently cushioned against potential losses. At

the same time, a relatively low capital requirement may induce some

institutions to hold excessive amounts of the asset, thus increasing their

exposure to the risk. For example, the calculation of bank capital ratios

does not explicitly include the interest rate risk inherent in mortgages and

other interest-sensitive assets; this may cause banks to hold more of these

assets and fewer assets for which the capital requirement more fully

captures all the risks.

Increased Regulatory

Use of Firm Estimates

of Risk Raises Issues

Regarding the

Appropriateness of

These Estimates for

Regulatory Capital

Purposes

Although financial regulators are already using firms’ estimates of risk in

limited ways, concerns about regulatory insensitivity to risk are leading

some regulators to consider increased use of firms’ own estimates of risk

for setting regulatory capital requirements. Through our interviews and

our review of the literature on risk measurement, we identified a number

of concerns with regard to increased regulatory capital requirements that

are based on each firm’s own risk estimates. First, the current risk

measures used by firms are limited in that they do not measure all risks

the firms face. Second, some risk measurement systems may measure

some risks incompletely. Third, models used by specific firms are tailored

to what each firm sees as its risk measurement needs, so they are not

necessarily comparable. Fourth, increasing regulatory use of firm risk

estimates could cause firms to modify their models to reduce their

regulatory capital requirements.

Firm Risk Measurements

Are Limited in Various

Ways

Both the literature and representatives of all of the firms we interviewed

agreed that a firm’s risk measurement systems are limited in that they do

not accurately measure all of the firm’s risks. Many of the representatives

said that because their firms’ risk measures and models address some

categories of risks (for example, market and credit risks) and not others

(for example, operational and business/event risks), their firms continue

to use judgments to determine the overall capital levels they need.

In addition to limitations resulting from firms not measuring the same

types of risk, some models may not correlate the same type of risk (such

as credit or market risk) across the entire firm. In this way, such models

may not fully measure all risks within a risk type included in the model.

However, as discussed earlier, some firms said they do measure some

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risks on a consolidated basis—taking into account correlations of the

same type of risk wherever it exists in the consolidated firm.

Moreover, models may fail to capture major unique market events of low

probability that could pose considerable risk, such as currency

devaluations in emerging markets. According to some of the firms’

representatives we interviewed, the firms’ risk estimates address expected

losses, but they cannot accurately account for the unexpected losses the

firm may face. VAR modeling is often based on day-to-day risks and

historical experience and assumes that managers regularly readjust their

portfolios as risks change. However, the representatives noted that such

models can easily miss low-probability events that could result in large

losses, which could pose considerable risk. For this reason, the capital

levels indicated by the models may not cover losses during a major market

event, such as a financial crisis in an emerging market. Moreover, even if

the models were capable of totally accurate risk measurement, regulators,

who, for example, are likely to be concerned with the systemic risk posed

by a low-probability, high-loss event, may require more capital for certain

risks than the firms would set aside for that risk.2

Use of Firms’ Internal

Models Raises Questions

of Consistency and

Dependability

The financial regulators we spoke with are concerned with the

consistency of capital requirements across the firms they regulate. When

regulators depend on firm-specific models or measures to set capital

levels, however, capital requirements may not be consistent across firms

with similar risk levels. Each firm that uses internal models may well

reflect in its own model the firm’s unique characteristics, such as the

particular risk factors it faces. Thus, even when regulators specify the use

of common procedures for developing internal models, such as those in

the market risk capital requirement for banks, the internal models firms

produce differ because each firm designs its model to measure what it

sees as its own risk profile. Because a firm’s model was designed for use

with a specific risk profile, another firm’s model applied to the same

profile might produce a different risk estimate. In addition, both the

consistency and the accuracy of these models depend on the quality of the

raw data used.

The financial regulators are concerned about the dependability of the

results of firms’ risk measurement systems, in terms of the accuracy of the

results and the transparency in the firms’ use of internal models. To help

2

This discrepancy between firm-set capital levels and regulatory minimums need not be unique to firms

that use statistical models to set capital levels.

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ensure that the capital set aside for various risks accurately reflects the

firm’s risks of possible losses, it is important for risk measures and models

to truly reflect management’s own best judgment about the design and use

of the models and for the model inputs to be complete and accurate.

With regard to transparency in the use of firm-specific internal models,

regulators and other experts are concerned that their use of firm-specific

risk measures to set minimum capital requirements could give firms an

incentive to adjust the internal models they use to determine their

minimum regulatory capital in such a way as to reduce their regulatory

capital requirements. Such behavior by firms would raise questions about

the dependability of the risk and capital measures used by the firms. Firms

might undertake such model alterations if the regulatory minimums for

certain risks exceeded the capital level managers wished to put aside for

such risks, either because their estimates of risk were lower or their risk

tolerances were greater than those set by the regulators. The regulators

said that if they could ensure that only one model existed within a firm for

a particular risk, they could be more confident that the firm’s own true

risk estimates were being used to set minimum capital requirements.

Increasing Complexity

of Large Firms’

Activities Raises

Issues Regarding

Administration of

Capital Requirements

Our interviews with industry representatives, regulators, and others and

review of the literature on capital requirements identified issues in the

administration of capital requirements. One issue concerns the

reasonableness of using the same approach to capital regulation for firms

of a similar type (e.g., banks) but with varying sizes and degrees of

complexity. That is, as the activities of large firms diverge from those of

small firms, a single standard for all firms may become increasingly

inappropriate.

As the activities of large firms become more complex, regulators and firms

are concerned about proper regulatory oversight of the use of statistical

models for regulatory purposes. Regulatory confidence in the

effectiveness of capital standards in accomplishing the regulatory purpose

depends in part on those standards being auditable and understandable,

which is significantly complicated by the use of sophisticated measures

and firm proprietary models. In the views of both regulators and other

experts, many auditors and regulators may not yet have the expertise

needed to verify the accuracy of the measures calculated in the models

used in determining minimum capital standards.3

 In addition, depending

3

A firm’s management is responsible for meeting capital standards. Internal and external auditors,

self-regulatory organizations, and regulatory agency staff are responsible for reviewing firms’

compliance with capital standards.

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on their business mix, smaller firms are less likely to have the resources or

the need to develop sophisticated models.

Part of this issue concerns the costs to the regulators if they adopt

sophisticated approaches to setting minimum capital requirements.

Financial regulators understand that their adoption of more sophisticated

regulatory capital requirements (e.g, increased use of firms’ internal

models) would mean increased regulatory costs related to hiring and

training regulatory staff.

Complexities associated with the increasing use of sophisticated measures

and firms’ proprietary models in determining capital requirements could

also pose challenges for regulators and industry representatives in

promptly analyzing and addressing policy or administrative issues in

capital standards. For example, representatives from a number of firms we

spoke with said that as their internal modeling and capital allocation

processes become more complex, it is more difficult for managers who do

not necessarily have the technical expertise to judge the quality of the

models, processes, and their results.

In the view of the Federal Reserve Chairman, no matter how complex

capital requirements become, firms will develop new products to exploit

the remaining inevitable distortions in the regulations to lower their

capital requirements. As previously discussed, examples of such

distortions are the current credit risk-based capital rules that treat all

commercial loans as if they had equal degrees of riskiness. As discussed in

the next section, some other experts argue that trying to address all of the

firms’ potential activities through increasingly sophisticated capital

regulation is impossible. They suggest that the use of simplified

regulations, such as an incentive-based approach or an approach based on

strict supervisory oversight and increased disclosure, would be a better

way to implement capital requirements.

The importance of these and other issues is apparent in the initiatives

discussed in the next section. Some of the issues have more relevance for

some of the initiatives than for others. Some of the initiatives are actual

proposals, and others are still in the exploratory stage. Because they are

all either proposals or ideas being explored, we did not evaluate them.

Most of the initiatives discussed below are attempts to make capital

requirements more sensitive to risks in firm activities, and others

represent new approaches to capital regulation. Banking regulators have

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noted, however, that in consideration of new approaches to capital

regulation, there are both statutory and international constraints on the

changes they can make. With regard to statutory constraints, because

FDICIA institutionalized regulatory capital using risk-weights plus leverage

as a matter of law, regulatory capital with a risk-based component will be

an integral part of the overall U.S. supervisory approach until it is changed

by Congress. Internationally, U.S. bank regulators have agreed to

coordinate their capital regulations with those of the other Basle

Committee members, and U.S. regulators are actively involved in the

committee’s work. Although the Basle Committee is aware of and is

studying many of the initiatives proposed in the United States, none of the

U.S. regulators we spoke with expected any unilateral new approaches or

any major changes to the Basle Accord or its approach in the near future.

Financial Regulators

and SROs Are

Exploring Ways to

Make Capital

Requirements More

Sensitive to Risk

Regulatory agencies and SROs are exploring or have proposed a number of

initiatives for modifying or changing current capital requirements in

banking, securities, futures, and life insurance that would make the

requirements more sensitive to the actual risks in firm activities. The

banking initiatives range from a proposal that would allow banks to use

credit ratings from rating agencies to determine risk-based capital

requirements for certain products to taking an approach to measuring

credit risk that is based on statistical modeling. SEC and CFTC are

monitoring and evaluating the DPG’s voluntary efforts to relate capital to

risks. In addition, SEC issued (1) a concept release4

 on the extent to which

a statistical modeling approach should be used by broker-dealers to better

reflect market risks in their activities; (2) a proposal that would create a

new class of broker-dealers, called OTC derivatives dealers, that would be

subject to modified capital requirements in connection with conducting an

OTC derivatives business; and (3) proposed amendments to the net capital

rule regarding the method of computing haircuts applicable to interest rate

products. CFTC is also exploring whether the regulatory structure should

be changed for OTC derivatives dealers. Two futures industry exchanges

have taken steps to make minimum capital requirements more risk-based

to reflect the total risks to the FCM. Although life insurance industry

regulators have no current plans to fundamentally change their

formula-based approach to setting capital requirements, they are working

to modify various components of the current risk-based capital

requirements.

4

A concept release is a paper issued by regulators to elicit discussion and comment from industry and

others on a potential regulatory change.

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Bank Regulators Are

Exploring Risk-Based

Capital Initiatives for

Credit Risk

Bank regulators have recently proposed revisions to the risk-based capital

standards that, if adopted, would affect the method used to measure the

relative exposure to credit risk for certain products. This is in response to

the concerns, discussed earlier, about the imprecise nature of the current

credit risk-based capital standards, which have created conflicts between

the regulators and banks. In addition, regulators are exploring other

modifications to the standards that would more precisely measure the

credit risks firms face in their activities.

Bank Regulators Have

Proposed Use of Credit Ratings

to Measure Relative Risk

Exposure in Certain Products

In November 1997, the banking regulators asked for comments on a

proposal that would revise the risk-based capital standards to allow the

use of credit ratings from the nationally recognized statistical rating

agencies (e.g., Moody’s Investors Service) to measure relative exposure to

credit risk and to determine the associated risk-based capital requirement

for certain products. The regulators believe the use of credit ratings would

provide a way for them to use market determinations of credit quality to

identify different loss positions for capital purposes in an asset

securitization structure.5

 Such a change might open the way for them to

determine capital requirements more precisely across a wide variety of

transactions and structures in administering the risk-based capital system.

Because credit ratings may not exist for some nontraded positions, the

regulators are also considering some alternative approaches to the use of

credit ratings—the ratings benchmark approach and the internal

information approaches. Under the first alternative, the regulators would

issue benchmark guidelines that banks would use in assessing the relative

credit risk of nontraded positions in specified standardized securitization

structures. The second alternative consists of two different internal

information approaches under which banks would use credit information

they have about the credit quality of assets underlying a position to set the

capital requirement for that position. The first, the historical loss

approach, would take into account unexpected losses over the life of the

asset pool. The second, the bank model approach, would base capital

requirements for certain positions on the internal risk assessments made

by banks’ “internal models” for measuring credit risk. Although regulators

have permitted the use of credit ratings for other purposes, these revisions

to the credit risk-based capital standards, if adopted, would be the first

5

This proposal would cover “recourse” arrangements and “direct credit substitutes” and other

securitized transactions that expose banks to credit risk. Recourse refers to any risk of credit loss that

a bank retains in connection with the transfer of its assets. Direct credit substitutes, such as a standby

letter of credit or guarantee, refers to arrangements in which a bank assumes all or part of the risk of

loss on an asset or pool of assets owned by another party, even though the bank had not owned and

sold the asset.

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time banks have been permitted to use credit ratings, benchmarks, or their

own internal risk assessments in determining credit risk-based capital

requirements.

Bank Regulators Are Also

Exploring Other Possible

Modifications to Credit Risk

Capital Requirements

According to a 1997 paper by two Federal Reserve officials, there is

increasing discussion in the banking industry as well as the regulatory

community about the possibility for further evolution of bank capital

regulation.6

 This paper was intended to provide the equivalent of a briefing

paper on some of the specific alternative proposals that have been put

forward concerning the future of capital regulation. In the view of the

authors, the paper was not intended to pass judgment—positive or

negative—on any of these alternatives, but it sought to raise issues that are

likely to be important as the discussion of the proposals continues.

In considering the possibility of such evolution, these officials believe it is

helpful to keep in mind several recent changes that they believe will

influence possible future changes. First, the overall approach to bank

supervision is also undergoing continuing review. For example, the bank

examination process has been increasingly focused on risk management

and internal controls. Second, banks today, especially large internationally

active banks, face a number of different types of risks. Some of these risks,

such as the market risk of traded instruments, are easier to quantify than

others, such as operational risk. In addition, the computer systems and

analytical abilities of these banks to measure and manage these risks are

evolving themselves.

One modification under consideration would be to continue to extend and

revise existing risk-based standards with the goal of improving the extent

to which the risk weights for credit risk reflect the true economic risk of

the underlying positions. As discussed in chapter 2, many bankers have

commented that some of the current risk-weights do not accurately reflect

the risk inherent in particular assets, and some have argued that the

current risk-based capital framework introduces distortions into the

risk-return trade-offs that banks face. Such changes may help address the

issue of inappropriate incentives being created for firms by the current

risk-weighting scheme.

However, in the view of these Federal Reserve officials, it is not clear that

it is possible to better correlate the regulatory risk calculation with true

6

“Regulatory Minimum Capital Standards for Banks: Current Status and Future Prospects,” Darryll

Hendricks and Beverly Hirtle, in Technology: Policy Implications for the Future of Financial Services,

Proceedings of the 33rd Annual Conference on Bank Structure and Competition, Federal Reserve Bank

of Chicago, May 1997.

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economic risk. In order to eliminate inefficiencies in the risk weights,

many believe it would be necessary to mark loan portfolios to market.

However, there is no consensus that this is desirable or feasible because

there is no readily available resale market for most loans and, therefore,

no current market value for them.

Some in the industry are exploring the possibility of using portfolio-based

models of credit risk for regulatory capital purposes, much as banks’

internal models of market risk are now being used. According to these

Federal Reserve officials, these credit risk models have yet to be

empirically tested. Such testing appears to require long periods due to the

time period required to observe changes in credit risks. One model, called

CreditMetrics, was introduced in 1997 and was accompanied by

statements that a primary goal was to encourage a change in regulatory

credit risk capital calculations. One problem in the development of credit

risk models noted in the paper is that data for such models are sparse.

Also, it is not clear what the appropriate holding period is in the case of

credit risk. Another issue, noted in the paper, is how far to take this

modeling—is there value in attempting to include operational risk, for

example, into such a framework?

SEC, CFTC, and Some

SROs Are Exploring

Approaches to Correlate

Regulatory Capital

Requirements More

Closely to the Risks

Inherent in a Firm’s

Operations

SEC, CFTC, and some SROs are continuing efforts to revise regulatory capital

charges to (1) reflect the economic risks being undertaken by

broker-dealers and FCMs more precisely and (2) reduce incentives for some

broker-dealers and FCMs to conduct certain activities through their

unregistered affiliates to avoid capital requirements that apply only to

registered broker-dealers and FCMs. For example, the current SEC and CFTC

capital requirements consider any net interest payments due a

broker-dealer or FCM from interest rate swaps to be unsecured receivables.

As such, they are deducted from the firm’s GAAP equity (which is the

equivalent of a 100 percent capital charge). Many broker-dealers and FCMs

consider this charge to be an excessive capital requirement. However, if

these same swaps were to be conducted in an unregistered affiliate, they

would not be subject to capital requirements.

SEC and CFTC Are Exploring

the Use of Value-At-Risk

Models for Determining Capital

Requirements for Market Risk

Value-at-Risk (VAR), a statistical modeling approach, is increasingly being

used by a few large broker-dealers in varying ways to measure, control,

and report the amount of market risk incurred in their trading activities.

According to market participants, SEC’s current net capital requirements

do not accurately reflect the economic risks being taken by a

broker-dealer’s activities, because such requirements do not incorporate

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modern finance and risk management techniques. Because the current net

capital rule generally does not recognize portfolio diversification,

correlation among asset prices, or the many hedging strategies firms

employ to reduce their risk, these market participants argue that capital

requirements and risk do not always move in the same direction; i.e., if

risks increase, then capital requirements should increase and vice versa.

Accordingly, certain broker-dealers and their industry associations have

been urging SEC to allow broker-dealers to use their internal models for

determining regulatory capital requirements for market risk (like banks).

In response to such industry urging, SEC issued a concept release in

December 1997 on the extent to which a firm’s statistical models might be

used in setting capital requirements for a broker-dealer’s proprietary

positions.

The statistical modeling approach is intended to more accurately reflect

the risk-return trade-off and the relationship between risks and regulatory

capital. In the same concept release, SEC discussed the possibility of

adopting a “precommitment” feature similar to that being considered by

banking regulators.7

The DPG Framework

Suggested How to Estimate

Capital-At-Risk but Did Not

Establish Capital Standards

In 1995, DPG member firms, in coordination with SEC and CFTC, developed a

self-regulatory framework to address public policy issues raised by the OTC

derivatives activities of “unregulated affiliates of SEC-registered

broker-dealers and CFTC-registered FCMs.” DPG’s voluntary self-regulatory

framework8

 includes, among other things, a provision for evaluating risk in

relation to capital. As noted in the framework, this initiative is considered

part of a process, not a single event. As DPG member firms and SEC and

CFTC gain insights, they anticipate further refinements to the framework.

The “risk in relation to capital” provision of the framework has two parts.

First, it suggests a way to estimate market and credit exposures associated

with OTC derivatives activities. The market risk approach is similar to the

approach used by bank regulators in that it uses internal models; but the

credit risk approach is different in that it is based on rating agency

information, not on regulatory risk-weights. Second, it advocates an

approach for evaluating those risks in relation to capital. According to the

DPG framework, capital-at-risk estimates are imperfect measures of

7

In the precommitment approach, a bank would commit to manage its trading portfolio to limit market

risk losses over a subsequent interval to a specified amount; if the bank exceeded its limit, it would

face penalties. We present more information on this approach later in this chapter.

8

Framework For Voluntary Oversight, Derivatives Policy Group, Mar. 1995.

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potential losses associated with market and credit risks.9 However, it

noted that managers and supervisors can use them to gauge capital

adequacy, and the firms have agreed to report their estimates periodically

to SEC and CFTC.

10

Although DPG firms’ estimates of capital-at-risk are not intended to be

capital standards, the estimates incorporate elements similar to some of

those used in the banks’ risk-based capital regulations. The DPG

capital-at-risk for market risk is to be generated by the DPG reporting firm’s

internal model using the same parameters (10-day price shock, 99 percent

confidence interval) required by the bank regulators. DPG, however,

rejected the use of a multiplier to link capital-at-risk to capital levels.

Moreover, for credit risk, DPG adjusts for historical default ratios as

published by the rating agencies. The DPG firms rejected the bank

regulators’ method of estimating potential future credit risk because the

bank regulators’ method is based on notional/contract amounts,11 which

the DPG firms do not consider to be meaningful measures of risk.

DPG firms consider this to be an interim approach for estimating current

and potential credit risk. They noted in the framework that they anticipate

cooperating with requests by SEC and CFTC to compute potential credit risk

using other methodologies.

Because the potential for risk of loss beyond the capital-at-risk estimate

exists, DPG firms agreed to supplement these estimates with other

potential loss estimates resulting from defined stress scenarios. The

framework also outlines a common approach to audit and verify technical

and performance characteristics because it allows the DPG firms to use

internal models that may be unique. DPG member firms developed

minimum standards and audit and verification procedures to ensure that

performance characteristics of all models used to estimate capital-at-risk

for market risk are broadly similar and rigorous.

9

“Capital-at-risk” as defined by DPG is conceptually the same as “value-at-risk” used elsewhere in this

report.

10One of the DPG firms, CS First Boston, is not required to submit information to SEC or CFTC

because it has an OTC derivatives affiliate that is regulated by the Bank of England. According to SEC,

under its risk assessment rules, it receives copies of quarterly financial reports that the affiliate files

with the Bank of England.

11The notional amount is the amount upon which payments between parties to certain types of

derivatives contracts are based. In an earlier report we reported that the amount at risk in a derivatives

transaction is generally about 3 percent of the notional amount. See OTC Derivatives: Additional

Oversight Could Reduce Costly Sales Practice Disputes (GAO/GGD-98-5, Oct. 2, 1997).

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SEC and CFTC have received annual reports from the DPG reporting firms

that summarized external auditors’ reviews of these models. However,

because no generally accepted criteria for modeling yet exist that would

allow an external auditor to give an opinion on the model’s adequacy, the

independent accountants filed reports regarding only limited agreed-upon

procedures with respect to their reviews of these models.

In the second part of the framework’s capital-at-risk component, the DPG

firms advocate, for a transitional period, an approach for evaluating

market- and credit-risk estimates in relation to capital levels. To evaluate

the adequacy of existing capital levels at DPG-member affiliates, the

framework advocates an oversight approach that encourages regulators

and senior managers to take into account the following factors: the firm’s

structure, internal controls, and risk management systems; quality of

management; risk profile and credit standing; actual daily loss experience;

ability to manage risks as indicated by the firm’s ability to perform and

document stress testing; and overall compliance with the framework’s

policies and procedures. The DPG firms anticipate that as experience is

gained with the overall DPG framework, and depending on the evolution of

thinking and policies among regulators internationally, this approach may

require further refinement or modification.

Concerns remain about using internal models for regulatory purposes

(e.g., validating the accuracy of the results). However, SEC and CFTC have

been collecting and examining data from broker-dealers’ internal models,

via DPG, to gain a better understanding of the manner in which the models

operate and the adequacy of capital charges derived from them.

SEC Is Considering Creating

OTC Derivatives Dealers

Current capital and margin requirements applicable to registered

broker-dealers impose substantial costs on the operation of an OTC

derivatives business and make it difficult for U.S. securities firms to

compete effectively with banks and foreign dealers in the OTC derivatives

markets. In December 1997, in order to allow broker-dealers to take better

advantage of counterparty netting12 and to adjust the capital rule to better

reflect the risks of OTC derivatives, SEC proposed the creation of a new

class of broker-dealers called OTC derivatives dealers. This limited

regulatory structure would be available only to entities acting primarily as

counterparties in privately negotiated over-the-counter derivatives

transactions and would be subject to modified capital, margin, and other

regulatory requirements tailored to the OTC derivatives business. For

12Netting is an agreed-upon offsetting of positions or obligations by trading partners that can reduce a

large number of individual obligations or positions to a smaller number.

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example, under the limited regulatory structure, OTC derivatives dealers

would be required to maintain at least $100 million in tentative net capital

(i.e., capital before haircuts and undue concentration charges are taken)

and at least $20 million in regulatory net capital. Also, OTC derivatives

dealers would be exempted from certain margin requirements.

SEC believes the proposed minimum of $100 million in tentative net capital

is necessary to ensure against excessive leverage and risks other than

credit or market risk, all of which are now factored into the current

haircuts, and to provide for a cushion of capital against severe market

disturbances. Under the proposal, OTC derivatives dealers would be given

the option of either taking haircuts, as currently required under SEC’s net

capital rule, or using a rule proposed to calculate capital charges for credit

risk and using a VAR model to determine capital charges for market risk.

SEC’s proposed rule would require that any VAR models meet certain

minimum qualitative and quantitative requirements.

In calculating capital charges for market risk, OTC derivatives dealers could

elect one of two methods. First, OTC derivatives dealers would be able to

use the full VAR method to calculate capital charges for market risk

exposure for transactions in eligible OTC derivatives instruments and other

proprietary positions of the OTC derivatives dealer. Under the full VAR

method, a market risk capital charge would be equal to the VAR of its

positions multiplied by a factor specified in the proposed rule. Second, an

OTC derivatives dealer could use an alternative method of computing the

market risk capital charge for equity instruments and OTC options and use

VAR for its other proprietary positions. Because OTC derivatives dealers

would be required to obtain authorization from SEC before using VAR

models, this alternative method would also be used by a firm that does not

receive SEC authorization to use a VAR model for equity instruments.

In calculating capital charges for credit risk, OTC derivatives dealers

electing to apply the proposed rule would compute a two-part charge on a

counterparty basis. First, for each counterparty, OTC derivatives dealers

would take a capital charge equal to the net replacement value in the

account of the counterparty multiplied by 8 percent, and further multiplied

by a counterparty factor ranging from 20 to 100 percent based on the

counterparty’s rating by at least two nationally recognized statistical rating

agencies. The counterparty factors would link the size of the credit risk

capital charge to the perceived risk that the counterparty may default.

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The second part of the credit risk charge would consist of a concentration

charge that would apply when the net replacement value in the account of

any one counterparty exceeds 25 percent of the OTC derivatives dealer’s

tentative net capital and would also be based on the counterparty’s rating

by at least two rating agencies. The concentration charge would equal

5 percent of the amount of the net replacement value in excess of

25 percent of the OTC derivatives dealer’s tentative net capital for

counterparties that are highly rated and would increase in relation to the

OTC derivatives dealer’s exposure to lower rated counterparties.

SEC Proposed New Net Capital

Rule Treatment for Interest

Rate Products

In addition to the OTC derivatives dealers release, in December 1997, SEC

proposed amendments to the net capital rule, Rule 15c3-1, regarding the

method of computing haircuts applicable to interest rate products. The

proposed amendments would treat most types of interest rate products as

part of a single portfolio and would recognize various hedges among a

portfolio of government securities, investment grade nonconvertible debt

securities (or corporate debt securities), certain pass-through

mortgage-backed securities, repurchase and reverse repurchase

agreements, money market instruments, futures and forward contracts on

these debt instruments, and other types of debt-related derivatives. The

proposed amendments are intended to better match capital charges with

actual market risk hedging practices employed by broker-dealers.

CFTC Is Exploring the

Regulatory Structure

Applicable to OTC Derivatives

As part of its comprehensive regulatory reform efforts to update its

oversight of both exchange and off-exchange markets, CFTC published a

concept release in May 1998, on issues relating to the OTC derivatives

market. The concept release requests comments on whether the regulatory

structure applicable to OTC derivatives under CFTC regulations should be

changed in light of the growth in the derivatives marketplace since CFTC’s

last major regulatory actions involving OTC derivatives in 1993.

CME and CBOT Adopted

Risk-Based Capital

Requirements for Their

Clearing Organizations

In 1995, two futures industry SROs, the Chicago Board of Trade (CBOT) and

the Chicago Mercantile Exchange (CME), informally proposed to CFTC to

base minimum capital requirements on “funds at risk” as opposed to the

current “funds required to be segregated.” In their view, the current CFTC

net capital requirements (CFTC Rule 1.17) do not fully reflect all of the risks

(e.g., foreign customers trading in foreign markets) faced by FCMs’ trading

activities and thus impose insufficient capital requirements on FCMs. Funds

at risk are generally defined as the initial margin requirements, which are

themselves risk-based, imposed by the various exchanges on all open

positions held at those exchanges; segregated funds are generally balances

that FCMs owe to customers.

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The CBOT and the CME risk-based capital proposals were positively received

by CFTC, which consulted with the SROs on the parameters of the risk

model. The SROs’ risk-based capital requirements for their clearing

organizations became effective on January 1, 1998. Under the newly

adopted risk-based capital requirements, all members of the two SROs are

required to maintain adjusted net capital in excess of the greater of (1) the

minimum dollar balances of the respective clearing organizations, or

(2) 10 percent of domestic and foreign domiciled customer and 4 percent

of noncustomer (excluding proprietary) risk maintenance

margin/performance bond requirements for all domestic and foreign

futures and options on futures contract, or (3) the CFTC/SEC minimum

regulatory capital requirements. CME and CBOT believe that these new

requirements will correlate FCMs’ capital requirements more closely to the

total risks they face in their business.

To aid in the adoption of an industrywide risk-based capital standard, CBOT

and CME plan to collect and analyze data over several years to determine

the effect of the new requirements on overall industry capital levels.

Life Insurance Regulators

Are Exploring Changes to

Their Risk-Based Capital

Requirements

NAIC has asked the American Academy of Actuaries13 to study the

possibility of increasing the level of quantification in the interest rate risk

component of the life insurance risk-based capital requirements. The

reason for changing the interest rate risk component is due to the

difficulty in managing interest rate risk for life insurance companies. This

difficulty increases as financial products become more complex, and

interest rate risk exists in both the assets and liabilities of life insurance

companies. The current risk-based capital formula addresses interest rate

risk only in the asset side.

Changes to the interest rate risk component of the risk-based capital

requirements are seen by life insurance regulators and companies as a

major change. Other changes that are being made to the risk-based capital

formula are considered to be minor modifications. For example, since the

initial formula was adopted, changes have been made to the mortgage loan

factors, and the treatment of insurers’ investments in certain mutual funds

have been given different treatment depending upon what the mutual

funds invest in. Regulators we spoke with expected further changes

similar to these to continue in the future.

13The American Academy of Actuaries is the public policy, communications, and professional

organization for all actuaries.

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New Approaches to

Capital Regulation

Are Also Being

Explored

In addition to initiatives that would make regulatory capital requirements

more sensitive to risks in firms’ activities, a number of other ideas are

being explored, primarily in banking, that would take different approaches

to simplifying capital regulation. Three of them would use various

incentives rather than detailed requirements to deter excessive risk-taking

by firms. The final idea in this section is motivated by a desire of some in

the industry to keep capital requirements from becoming extremely

complex and comes from the recognition that minimum regulatory capital

standards and banks’ own internal capital allocation models serve

different purposes.

The Precommitment

Approach Was Pilot Tested

In July 1995, the Federal Reserve Board requested public comment on the

so-called precommitment approach to market risk capital requirements,

which was introduced in a paper by two Federal Reserve officials.14 It was

developed in response to perceived difficulties with the internal models

approach to market risk capital. For example, banks’ internal models are

not designed to measure risk exposure over the time horizons of

regulatory concern and thus may not accurately translate to these

intervals. In addition, model-based capital calculations cannot account for

the fact that some banks will be in a position to reduce their exposure to

losses through investment in superior information systems or other

aspects of risk management.

Under the precommitment approach, the bank would specify an amount of

capital it believed was adequate to cover its risk exposure over a fixed

subsequent interval and would commit to manage its trading portfolio to

limit losses over the interval to this amount. If the bank’s losses exceeded

the precommitment amount, it would face penalties that could range from

public disclosure to additional capital requirements or monetary fines.

Under this approach, both the commitment and the bank’s risk

management system would be subject to review by regulatory authorities.

The penalties associated with a breach of the capital commitment are to

provide the incentive for banks to commit honestly and to manage risk to

stay within the commitment.

Some industry analysts considered such an approach to be a major

improvement in capital regulation. However, others believe the approach

raises a number of issues because of its departure from traditional capital

14A Precommitment Approach to Capital Requirements for Market Risk, Paul H. Kupiec and James M.

O’Brien, FEDS 95-36, Federal Reserve Board, July 1995.

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regulation—comparability, interaction with other supervisory policies,

enforceability, and the role of penalties.

Regarding comparability, on the surface it would seem that precommitted

amounts would be comparable across firms because the firms are all being

asked about the maximum amount they could lose over the same time

interval. However, the amounts are likely to differ because they would still

be based on subjective estimates of the quality of internal risk

management and differences in firms’ tolerances for risk. Comparability

might also be compromised because the cost of capital differs across

firms.

With regard to interaction with other supervisory policies, bank

supervisors are already required to focus on bank internal risk

measurement and management systems. Thus, it is not clear that the

adoption of the precommitment approach would eliminate supervisory

interest in the validation of such systems.

With regard to enforcement and the role of penalties, there is a concern

not only about the types of penalties that should be used, but also whether

it would be counterproductive to enforce them during stressful market

conditions. The paper notes that in choosing penalties, it will be important

to determine what the goal of penalties is—that is, the degree of incentive

they are to provide the bank. Some experts believe that to reliably achieve

regulatory objectives, the penalties would need to be bank specific and

that the appropriate penalty would depend on a bank’s cost of capital and

its individual investment opportunities. However, these factors are not

ascertainable by regulators. In addition, recent work by the original

designers of the precommitment approach acknowledges that the link

between after-the-fact penalties and regulatory capital objectives is

tenuous.15 In the view of a Federal Reserve official, the appropriate

penalty for achieving regulatory capital objectives for market risks is bank

specific and depends on characteristics that regulators cannot precisely

measure. Moreover, an approach that relies on after-the-fact penalties to

influence bank behavior implicitly assumes that the bank is

forward-looking and takes potential penalties into account when making

current capital allocation decisions. This might be a reasonable

assumption for healthy banks, but weak banks may not care about future

penalties that, in the extreme, might not be enforceable if the bank is

insolvent.

15Deposit Insurance, Bank Incentives, and the Design of Regulatory Policy, Paul H. Kupiec and James

M. O’Brien, Board of Governors of the Federal Reserve System, Dec. 1997.

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The New York Clearing House Association (Clearing House)16 conducted a

four-quarter test of the precommitment approach that began in

October 1996. The pilot was designed to assist the bank regulators and the

participating banks and bank holding companies in evaluating and

assessing the usefulness and viability of the approach for regulatory

capital purposes. In a comment letter to the Federal Reserve, the Clearing

House suggested that the U.S. bank regulators consider adoption of this

approach for two reasons: (1) it might constitute a way to effectively

establish a relationship between an institution’s calculation of value-at-risk

for management purposes and prudent capital requirements for regulatory

purposes, and (2) it would result in capital requirements for market risks

tailored to the particular circumstances of each institution.

There were 10 participants in the pilot—8 U.S. and 2 foreign banking

organizations.17 During the pilot, each participant precommitted the

amount of capital it needed to hold against its market risk for four 3-month

periods. The pilot was conducted on a consolidated basis in that

participants precommitted capital for the consolidated trading operation

of the holding company, including bank and Section 20 subsidiaries. After

the end of each period, participants reported their results to their primary

regulators and provided copies of the reports to the Clearing House. The

participants conducted the pilot under the assumption that the penalty

would be disclosure, not financial penalties.

In its report on the pilot’s results, the Clearing House said that the

participants believe (1) the precommitment approach is a viable

alternative to the internal models approach for establishing capital

adequacy of a trading business for regulatory purposes; and (2) when

properly structured and refined, steps should be taken to implement it as

an alternative to existing market risk capital standards. Further, the

participants believe this approach provides strong incentives for prudent

risk management and more efficient allocation of capital as compared to

other existing capital standards. The Clearing House believes the pilot

contributed to the development and depth of the participants’ thinking

about the purpose of capital and about the distinction between economic

capital maintained for the benefit of shareholders and minimum regulatory

capital.

16A clearing house is a voluntary association of depository institutions that facilitates the exchange of

payments transactions, such as checks, and the settlement of participants’ net debit or credit positions.

17The participants in the pilot were BankAmerica Corporation, Bankers Trust New York Corporation,

The Chase Manhattan Corporation, Citicorp, First Chicago NBD Corporation, First Union Corporation,

The Fuji Bank Limited, J.P. Morgan & Co., Inc., NationsBank Corporation, and Swiss Bank

Corporation.

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Pilot results showed that the participants’ precommitted capital amounts

were less than the market risk regulatory capital requirements. No

participant reported a negative change that exceeded its precommitted

capital amount. Finally, the participants believe the benefits of the

precommitment approach are likely to apply to other risks of trading

businesses, such as operational risk, as well. In their view, the approach

avoids many of the complications and inefficiencies that are generated

when capital requirements are set separately for each category of risk.

One high level regulatory official, reflecting the generally held regulatory

and industry views, said that the pilot demonstrated that the participants

have internal procedures for allocating capital for market and other risks

in their portfolios; but it did not, and realistically could not, demonstrate

that these internal allocations are sufficiently large to meet regulatory

objectives with respect to minimum capital. Even though none of the

participants reported losses in excess of their commitments during the

pilot, in reality, none of the participants incurred any cumulative loss over

any of the four quarters. Hence, no violations would have occurred if no

capital had been committed.

An Approach That

Emphasizes Supervision Is

Being Explored

Another alternative approach to the evolution of bank capital regulation

would be one that emphasizes supervision rather than minimum

standards. In a 1995 paper, a Federal Reserve official argued that the

distinct uses and characteristics of minimum regulatory capital

requirements and firm internal capital allocations make it inadvisable to

combine them into a single measure.18 In his view, they are so naturally

contradictory that a hybrid would be much less informative than two

individual measures. Moreover, he believes an attempt to bring the two

constructs closely in line could undermine the useful objectivity of

minimum capital and deprive firms of the flexibility they need to

determine optimum capital levels. Under this approach, the firm would be

accountable for determining its own appropriate level of capital while

abiding by sound practices developed in the context of the business. Firms

engaged in trading complex instruments would need to apply

sophisticated mathematical techniques; those that focus on, for example,

small business lending would have to apply different techniques (e.g.,

traditional credit analysis). The supervisor would monitor the

performance of the firm in the firm’s determination of its appropriate

capital level.

18“A Prolegomenon to Future Capital Requirements,” Arturo Estrella FRBNY Economic Policy Review,

July 1995.

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Like the precommitment approach discussed above, this approach also

relies on incentives. However, in contrast to the precommitment approach

in which penalties are to act as a deterrent to excessive risk taking, the

key to the success of this approach would be the supervisor. The

supervisor would monitor compliance with minimum requirements as

frequently as feasible and then supplement the effectiveness of minimum

requirements by ensuring that the firm makes its best efforts to determine

an optimum level of capital. In this way, the development and

determination of the optimum are best left to the firm, and supervisors

would work closely with the firm to ameliorate the situation if they find

capital levels declining toward the minimums. The Federal Reserve official

also believes this approach would be consistent with the prompt

corrective action rules. (See app. I for more information on prompt

corrective action.)

An Approach That

Emphasizes Disclosure Is

Also Being Explored

In their 1997 paper,19 two Federal Reserve officials noted that a number of

different approaches exist that would emphasize disclosure rather than

minimum standards. One of these approaches would operate along the

same lines as the approach emphasizing supervision discussed above. It

would develop a two-pronged capital structure that would separate

minimum standards, which would be set by the supervisor, from the

optimal capital held by the firm, which should be its own decision. The

first prong could be a minimum capital calculation in which the method

would be chosen to emphasize comparability across firms; the second

prong would be an internal capital calculation in which the bank would

have greater freedom to use its own methodology. The bank would

publicly disclose the results of both calculations. In the authors’ view, this

approach would seek to combine public disclosure and the discipline of

the marketplace to ensure that banks had appropriate incentives in the

development of these internal calculations.

Other Approaches to

Changing Bank Capital

Regulation Emphasize

Reducing the Complexity

of the Rules

A number of other approaches to capital regulation are being explored,

particularly in the banking area, that would also simplify capital

requirements. One possible approach discussed by the Federal Reserve

officials in their paper is,20 in their view, motivated by the desire of some

in the industry to keep the capital rules from becoming extremely complex

and by the recognition that minimum capital standards serve a different

purpose from banks’ own internal capital allocation models. This

19See footnote 6.

20See footnote 19.

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approach would develop a capital framework that would not require ever

more complex measures of portfolio risk. The hope in developing such a

framework is that a suitable proxy for true economic risk could be found.

This proxy would not be intended to be extremely precise, but it would

need to roughly capture the bulk of the firm’s exposures. According to the

Federal Reserve officials, the key issue for this alternative approach is

whether it is possible to achieve this goal. There are two interpretations

for this approach. In the first, the aim is for the simple measure of risk to

be roughly accurate in that, on average, it produces a measure of risk that

is equivalent to what an ideally precise measure would produce. In the

second, the goal would be a simple measure of risk that is good enough to

determine whether the firm has a dangerously low level of capital.

Another approach discussed by the Federal Reserve officials in their paper

is one that would base capital regulation on observed measures of

volatility, such as earnings volatility. This approach is also motivated by a

desire to develop a simple but comprehensive approach to bank capital

regulation that would not require the separate specification of each risk.

One possibility suggested in the paper would be for minimum capital to

equal some multiple of quarterly earnings volatility. Such an approach

would require almost no additional calculations by the bank and, in the

authors’ view, it would be objective and verifiable; however, they noted a

number of drawbacks to such an approach. First, it is not clear that

earnings volatility is itself a good proxy for economic risk. Second,

because it is a transformation of publicly available information, it does not

provide any additional information to the marketplace. Third, it would

potentially create incentives for bank behavior aimed at smoothing

reported income.

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Appendix I 

Bank Risk-Based Capital Standards

The current U.S. bank risk-based capital regulations implement the Basle

Accord on risk-based capital.1

 In implementing the Basle Accord each

national bank regulator was to make its own regulations at least as strict

as the Accord. In the United States, U.S. bank regulators applied it to all

banks, rather than just internationally active ones, which were targeted by

the Accord. Since 1990, banks and bank holding companies in the United

States have been subject to risk-based capital standards. This appendix

describes the risk-based capital standards for banks. The standards for

bank holding companies are similar.

Although U.S. bank risk-based capital guidelines2

 address a number of

types of risk, only credit and market risk are explicitly quantified.3

 The

quantified risk-based capital standard is defined in terms of a ratio of

qualifying capital divided by risk-weighted assets. In addition to the

quantified risk-based capital ratio for credit and market risks, bank

regulators are required by the Federal Deposit Insurance Corporation

Improvement Act of 1991 (FDICIA) to monitor other risks, such as interest

rate risk4

 and concentration risk.5

Calculating the

Risk-Based Capital

Ratio for Credit Risk

All banks are required to calculate their credit risk for assets, such as

loans and securities; and off-balance sheet items, such as derivatives or

letters of credit.6

 The credit risk calculation assigns all assets and

off-balance sheet items to one of four broad categories of relative riskiness

1

The official document referred to as the Basle Accord is entitled International Convergence of Capital

Measurement and Capital Standards, Committee on Banking Supervision (Basle, Switzerland:

July 1988).

2

Capital Adequacy Guidelines, Reg. H (12 C.F.R. pt. 208) App. A, Board of Governors of the Federal

Reserve System, as amended Dec. 31, 1993. OCC’s regulation is at 12 C.F.R. pt. 3.10 and 3.11 FDIC’s

regulation is at 12 C.F.R. pt. 325.

3

Credit risk is the potential for financial loss resulting from the failure of a borrower or counterparty to

perform on an obligation. Market risk is the potential for financial losses due to the increase or

decrease in the value or price of an asset resulting from broad movements in prices, such as interest

rates, commodity prices, stock prices, or the relative value of currencies (foreign exchange).

4

Interest rate risk is the risk of potential loss arising from changes in interest rates. It exists in

traditional banking activities, such as deposit-taking and loan provision, as well as in securities and

derivatives activities.

5

Concentration risk exists if a bank is heavily exposed to certain sectors or countries. It deals with the

risks of not diversifying the assets so that a problem in any one sector or country might financially

affect the bank.

6

An off-balance sheet item is a financial contract that can create credit losses for the bank but that is

not reported on the balance sheet under standard accounting practices. An example of such an

off-balance sheet position is a letter of credit or an unused line of credit that commits the bank to

making a loan in the future that would be on the balance sheet and thus create a credit risk.

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Bank Risk-Based Capital Standards

(0, 20, 50, or 100 percent) according to type of borrower/obligor and,

where relevant, the nature of any qualifying collateral or guarantee.

Off-balance sheet items are converted into credit equivalent amounts. The

assets and credit equivalent amount of off-balance sheet items in each

category are multiplied by their appropriate risk-weight and then summed

to obtain the total risk-weighted assets for the denominator of the credit

risk-based capital ratio. Capital, the numerator of the capital ratio, is

long-term funding sources for the bank that are specified in the

regulations. A bank is to maintain a total risk-based capital ratio (total

capital/risk-weighted assets) of at least 8 percent.

Measuring Risk-Weighted

Assets for Credit Risk

The credit risk regulation requires the use of two sets of multipliers. One

set of multipliers places each off-balance sheet item into one of four

categories and converts items in each category into asset equivalents.

These conversion factors are multiplied by the face or notional amount of

the off-balance sheet items to determine the “credit equivalent” amounts.

In addition, for derivatives, these credit equivalent amounts are the value

of the bank’s claims on the counterparties plus add-on factors to cover the

potential future value of the derivative contracts.7

 Then the other set of

multipliers applies the risk-weights to assets and off-balance sheet credit

equivalent amounts according to the type of borrower/obligor (and, where

relevant, the nature of any qualifying collateral or guarantee). The sum of

the risk-weighted assets in all categories is the credit risk-weighted assets

for the bank.

There are four conversion factors that convert off-balance sheet items into

their asset equivalents. The conversions are based on multiplying the

conversion factors by the face or notional amounts of the relevant

off-balance sheet position.

• The 100 percent credit conversion factor applies to direct credit

substitutes, such as guarantee-type letters of credit, risk participations in

bankers acceptances, and asset sales with recourse.

• The 50 percent credit conversion factor applies to items such as

performance bonds, revolving underwriting facilities, or unused

commitments with an original maturity exceeding 1 year.

• The 20 percent credit conversion factor applies to short-term,

self-liquidating, trade-related contingencies, including commercial letters

of credit.

7

Off-balance sheet derivatives include interest-rate, exchange-rate, equity-linked derivatives, and

commodity derivative contracts.

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Bank Risk-Based Capital Standards

• The 0 percent credit conversion factor applies to unused portions of

commitments with an original maturity of 1 year or less and unused

portions of commitments that can be cancelled at any time.

Credit equivalent amounts are also calculated for off-balance sheet

derivatives contracts. The credit equivalent amounts on such contracts are

the sum of the present positive value (if any) of the contracts plus

estimated potential future exposure.8

Under the capital regulations, the credit equivalent of the potential future

exposure of derivatives contracts is estimated by multiplying the notional

values of the contracts by specified percentages. The multipliers range

from 0 to 15 percent; cover 6 types of derivatives contracts (interest rate,

exchange rate, equity, gold, other precious metals, and other

commodities); and include maturity categories of 1 year or less, 1 to 5

years, and over 5 years.

Although the Basle Accord adopted five risk weight categories, U.S.

regulations allow only four risk categories.9

• Category 1 has a zero risk-weight and includes items such as cash, claims

on Organization for Economic Cooperation and Development (OECD)10

central governments and central banks, and claims on U.S. government

agencies.11 The zero weight reflects the lack of credit risk associated with

such positions.

8

Derivatives are financial products that enable risk to be shifted from one entity to another. The value

of the derivative is based on an underlying reference rate, index, or asset, such as stocks, bonds,

commodities, interest rates, foreign currency exchange rates, and various market indexes.

9

These risk-weights for the four categories assume all assets within each category have the same level

of credit risk. Thus, a loan to a highly rated corporation generally carries the same 100-percent

risk-weight as a start-up loan to a new company or a small business. According to the Federal Deposit

Insurance Corporation (FDIC), although this approach in the risk-based guidelines minimizes

government-mandated private sector credit allocation, applying the same risk-weights to all

commercial loans has been a source of concern to bankers and analysts in the government and the

private sector.

10When the Basle Accord was adopted, OECD included members of 24 developed countries.

Subsequently, other members have joined, and it currently has 29 members. Its goals are to achieve

high economic growth, contribute to sound economic expansion, and contribute to the expansion of

world trade.

11In July 1994, the Basle Committee amended the Capital Accord concerning the qualification for the

OECD risk-weighting. For purposes of risk-weighting, the OECD group comprises countries that are

full members of OECD (or that have concluded special lending arrangements with the International

Monetary Fund associated with the Fund’s General Arrangements to Borrow), but it excludes any

country within this group that has rescheduled its external sovereign debt in the previous 5 years.

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• Category 2 has a 20-percent risk-weight and includes items such as

long-term claims on banks in OECD countries, general obligations of OECD

governments below the national level, obligations of

government-sponsored enterprises, or cash items in the process of

collection.

• Category 3 has a risk-weight of 50 percent and includes items such as

certain loans secured by first liens on 1 to 4 family residential real estate

and obligations of local governments in OECD countries that depend on

revenue flows from projects financed by the debt.

• Category 4 has a risk-weight of 100 percent and represents the presumed

bulk of the assets of commercial banks. It includes, among other things,

commercial loans and claims on non-OECD central governments.

Defining Capital in the

Credit-Risk Capital Ratio

Before the capital ratio can be calculated, capital must be defined and

quantified. There are two qualifying capital components in the risk-based

credit risk computation—“core capital” (tier 1) and “supplementary

capital” (tier 2). Tier 1 includes common stockholders’ equity;

noncumulative perpetual preferred stock (including any related surplus);

and minority interests in consolidated subsidiaries, less deductions for

certain assets such as goodwill12 and core deposit intangibles. Tier 1 is

stockholder ownership value that cannot be removed if the bank faces

financial difficulties. Tier 2 includes the allowance for loan loss reserves,

up to a maximum of 1.25 percent of risk-weighted assets; other preferred

stock (subject to limitations); and various long-term debt instruments,

such as subordinated debt, that provide support to the firm if it is facing

financial difficulties because they cannot be readily liquidated by creditors

or bond holders prior to maturity. In addition, the regulations limit the

amount of tier 2 capital in total capital and the amount and type of

qualifying intangible assets13 that can be recognized for tier 1 capital

purposes.

The regulation outlines a number of deductions from the capital base.

Goodwill and other intangible assets are to be deducted from tier 1 capital

as prescribed in the rules. Other deductions from total capital include

12Goodwill means the intangible asset that represents the excess of the purchase price over the fair

market value of tangible and identifiable intangible assets acquired in purchases.

13Qualifying intangible assets include mortgage servicing assets and purchased credit card

relationships. Other intangible assets, such as goodwill, favorable leaseholds, and core deposit

intangibles, are deducted in their entirety in calculating tier 1 capital.

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• investments in unconsolidated banking and financial subsidiary companies

that are deemed to be capital of the subsidiary, and

• reciprocal bank holdings of investments in the capital of other banks and

financial institutions.

With capital and risk-weighted assets defined, the ratio calculation is the

sum of tier 1 and tier 2 capital divided by total risk-weighted assets. Table

I.1 summarizes the mechanics of converting on- and off-balance sheet

assets in each category into the risk-weighted assets and computing the

credit risk-based capital ratio. The minimum standard risk-based capital

ratio is 8 percent, of which core capital (tier 1) is to be at least 4 percent.14

Table I.1: The Calculation of the Credit

Risk-Based Capital Ratio Step Description

1 Convert all off-balance sheet items into credit equivalent

amounts using a conversion factor from the regulation.

The asset equivalent of each off-balance sheet item is the

notional or face amount of that item multiplied by a

conversion factor. The converted amount of each

off-balance sheet item is then placed into one of the four

risk categories.

2 Sum the balance sheet asset values and the credit

equivalent amount of off-balance sheet items in each risk

category.

3 Determine the risk-weighted assets in each risk category

by multiplying the balance sheet asset values and the

credit equivalent amount of off-balance sheet items in

each risk category by the appropriate risk-weight

percentage for that category found in the regulation.

4 Calculate risk-weighted assets as the sum of the

risk-weighted assets across the four risk categories.

5 Calculate the credit risk-based capital ratio:

tier 1 capital + tier 2 capital

risk-weighted assets

6 Compare the calculated ratio to the standards in the

regulation.

14In addition, banks must maintain a minimum leverage ratio of at least 3 percent tier 1 capital divided

by adjusted total assets. However, this minimum applies only to banks with the highest supervisory

ratings that are not anticipating or experiencing any significant growth. According to FDIC, most

banks are subject to a minimum leverage standard of not less than 4 percent.

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Calculating the

Risk-Based Capital

Ratio for Market Risk

The risk-based capital regulation requires a bank with a significant market

risk exposure to calculate a risk-based capital ratio that takes into account

market risk as well as credit risk. The market risk capital regulation

applies to positions in an institution’s trading account such as securities

and derivatives; and all foreign exchange and commodity positions,

wherever they are located in the bank. Market risk exposure is the gross

sum of trading assets and liabilities on the bank’s balance sheet. To be

considered a significant exposure, this gross exposure must exceed 10

percent of total assets or exceed $1 billion. Credit risk determinations are

also made, where necessary, for items included in the market risk

calculation. Over-the-counter derivatives and foreign exchange positions

outside of the trading account are items subject to both market and credit

risk charges.

This adjusted risk-based capital ratio requires banks to determine whether

positions are subject to market risk capital requirements, credit risk

capital requirements, or both. The denominator of the risk-based capital

ratio is the sum of credit risk-weighted assets for assets with credit risk

and market risk-equivalent assets. To determine market risk-equivalent

assets, the bank is required to use its own internal model to calculate its

daily value-at-risk (VAR).15 The numerator of the risk-based capital ratio

expands the definition of capital to include a tier 3, which is a special form

of subordinated debt as defined in the regulations. The market risk

regulation imposes qualitative requirements on the banks and specifies

quantitative parameters to be used with the banks’ internal models.

Measuring Market Risk and

Market Risk-Equivalent

Assets

Market risk consists of general market and specific risk components. To

determine the market risk-equivalent assets, the risk or capital charges

must be calculated for both components.

Market risk capital charges are based on general market and specific risks.

Examples of general market risk factors are interest rate movements and

other general price movements. Capital charges for general market risks

are to be based on internal models developed by each bank to calculate a

VAR estimate, i.e., potential loss that capital will need to absorb. The

internal VAR estimate for general market risks is to be based on statistical

analyses that determine the probability of a given loss, based on at least 1

year of historical data. This VAR estimate is to be calculated daily using a

15VAR models use statistical analyses to estimate the maximum amount that the value of all covered

positions (trading account, all foreign exchange, and commodities) could decline during a fixed

holding period within a stated confidence level. For example, a value-at-risk estimate might be the

dollar loss that could occur 1 out of every 100 days based on statistical analyses.

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Bank Risk-Based Capital Standards

99 percent one-tailed confidence interval with a price shock equivalent to

a 10-business day movement in rates and prices; i.e., 99 percent of the time

the calculated VAR would not be exceeded in a 10-day period.

Specific risk arises from factors relating to the characteristics of specific

issuers of instruments. Specific risk factors reflect both idiosyncratic price

movements of individual securities and “event risk” from incidents, such

as defaults or credit downgrades, which are unique to the issuer and not

related to market factors. If a bank’s internal model does not capture all

aspects of specific risk, an add-on to the capital charge is required for

specific risk. Specific risk estimates based on internal models are subject

to adjustments based on the precision of the model.

The total market risk capital charge is the sum of the capital charges for

general market and specific risk.16 The total market risk capital charge is

based on the larger of the previous day’s VAR estimate and the average of

the daily VAR estimates for the past 60 days times the multiplier. The

multiplier ranges from 3 up to a maximum of 4 depending on the results of

backtesting.17 Market risk-equivalent assets are the total market risk

capital charges multiplied by 12.5.18

Defining Capital in the

Market Risk Capital Ratio

The market risk capital ratio augments the definitions of qualifying capital

in the credit risk requirement by adding an additional capital component

(tier 3). Tier 3 capital is unsecured subordinated debt that is fully paid up,

has an original maturity of at least 2 years, and is redeemable before

maturity only with approval by the regulator. To be included in the

definition of tier 3 capital, the subordinated debt is to include a lock-in

clause precluding payment of either interest or principal (even at

maturity) if the payment would cause the issuing bank’s risk-based capital

ratio to fall or remain below the minimum requirement. Tier 3 capital

provides another capital cushion against losses due to market risk.

16In this discussion, de minimis risks are subsumed in the specific risk discussion. De minimis risks are

those risks that the regulator permits the bank to calculate in an alternative manner.

17Backtests provide information about the accuracy of an internal model by comparing a bank’s daily

VAR measures to its corresponding daily trading profits and losses.

18The multiplier (12.5) is related to the 8-percent minimum risk-based capital ratio in the regulation and

is used in order to generate a denominator for the capital requirement that is comparable to the

denominator used for credit risk. An 8-percent requirement means that asset values can be, at most,

12.5 times capital values because 8 x 12.5 = 100. If the multiplier were any larger, the 8 percent capital

requirement could not be met for market risk.

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Calculating the Market

Risk-Based Capital Ratio

Application of the market risk capital ratio requires the use of a two-part

test. The sum of tiers 1, 2, and 3 capital must equal at least 8 percent of

total adjusted risk-weighted assets. The tier 3 capital in this sum is only to

be allocated to cover market risk. In addition, the sum of tier 2 and tier 3

capital for market risk may not exceed 250 percent of tier 1 capital

allocated for market risk. The regulation includes other restrictions on the

use of tier 2 and 3 capital.

Table I.2 shows the mechanisms by which the risk-based capital ratio is

calculated for credit and market risk.

Table I.2: The Calculation of the

Risk-Based Capital Ratio for Market

and Credit Risk

Step Description

1 Determine whether positions are subject to market risk

capital requirements, credit risk capital requirements, or

both.

2 For the credit risk assets and off-balance sheet items,

calculate the credit risk-weighted assets as described in

table I.1.

3 Quantify general market risks using the bank’s VAR model

to estimate the volatility of the prices of market risk assets

and items using a VAR model. The estimated VAR is the

higher of the previous VAR or the average of the daily

VAR estimates for the past 60 days multiplied by a factor

between 3 and 4 depending on the accuracy of the VAR

model.

4 Quantify specific risks using risk add-ons or estimates

based on the bank’s internal model, or some combination

of both.

5 Determine the total risk-weighted assets for market risk by

summing the measures of general market and specific

risks and multiply this sum by 12.5.

6 Calculate the total risk-weighted assets for market risk by

summing the credit risk-weighted and market

risk-equivalent assets.

7 Determine tier 3 capital and the total capital for the

numerator. The mix of the capital tiers in the numerator of

the combined credit and market risk-based capital ratio is

limited by the regulation.

8 Calculate the total risk capital ratio subject to the capital

restrictions in step 7.

(tier 1 + tier 2 + tier 3 capital)

(credit risk-based assets + market risk-equivalent assets)

9 Compare the calculated ratio to the standards in the

regulation.

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Bank Risk-Based Capital Standards

Internal Model

Specifications and

Requirements

The regulation requires the bank’s internal model to address all major

market risk categories19 using factors sufficient to measure market risks in

all covered positions.20 The regulation specifies certain requirements for

the bank’s internal model. In developing its internal model, the bank may

use any generally accepted measurement technique, such as

variance-covariance models, historical simulations, or Monte Carlo

simulations. However, the level of sophistication and accuracy of the

model must be commensurate with the nature and size of the bank’s

covered positions.

Quantitative Requirements

for General Market Risk

For regulatory capital purposes, the VAR measures must meet the following

quantitative requirements:

1. The VAR measure or maximum likely loss is to be calculated on a daily

basis with a 99 percent one-tailed confidence level with a price shock

equivalent to a 10-business day holding period. This 10-day shock can be

calculated directly or be based on the 1-day VAR figures.

2. The VAR calculation is to be based on historical data of at least 1 year.

3. The VAR calculation is to account for nonlinear price characteristics of

options positions and the sensitivity of the market value of the positions to

changes in the volatility of the underlying rates or prices. That is, the

calculation must take into account the fact that certain financial positions

imply minimal risk for certain market price movements and much larger

risks for other market price movements.

4. The VAR measures may incorporate quantified empirical correlations21

within and across risk categories, provided that the bank’s process for

measuring correlations is sound.

5. Beginning 1 year after adoption of the rules, backtesting will be required

and it is to be based on the most recent 250 days of trading. The testing is

to be done on a 1-day holding period and a 99 percent one-tailed

confidence level.

19The market risk model does not cover all market risks. For example, it does not cover interest rate

risk on mortgages that are not held in the trading book.

20Covered positions means all positions in a bank’s trading account and all foreign exchange and

commodity positions, whether or not in the trading account.

21Correlation is a measure of the degree of association between two variables. The empirical

correlation can be either positive, negative, or nonexistent.

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Quantitative Requirements

for Specific Risk

An institution whose internal model does not adequately measure specific

risk must continue to calculate standard specific risk capital charges or

add-ons to the VAR-based capital charge to determine market risk capital

requirements. An institution whose internal model adequately captures

specific risk may base its specific risk capital charge on the model’s

estimates.

Specific risk means the changes in the market value of specific positions

due to factors other than broad market movements, including

idiosyncratic variations as well as event and default risk. In order to

capture specific risk, the internal model is to explain the historic price

variation in the portfolio and be sensitive to changes in portfolio

concentrations—the extent to which one type of asset dominates the

portfolio—requiring additional capital for greater concentrations. The

internal model is required to be robust to adverse environments. The

model’s ability to capture specific risks is to be validated through

backtesting. Institutions with models that are not validated with

backtesting are to continue to use specific risk add-ons as defined in the

regulations.

Qualitative Restrictions in

Applying the Market

Risk-Based Capital

Regulation

The risk management system of any bank subject to the market risk

requirement is required to meet the following minimum qualitative

requirements. It is to have

• a risk control unit that reports directly to senior management and is

independent from business trading units,

• an internal risk management model that is integrated into daily

management processes,

• policies and procedures to identify and conduct appropriate stress tests

and backtests of the model,22

• independent annual reviews of its risk measurement and risk management

systems.

FDICIA Required

Revisions to U.S.

Risk-Based Capital

Standards

FDICIA was enacted to make fundamental changes in federal oversight of

depository institutions in response to the thrift and banking crisis of the

1980s, which resulted in large federal deposit insurance fund losses.

Section 305 of FDICIA required, among other things, that bank regulators

revise their risk-based capital standards to include concentration of credit

22Stress testing provides information about the impact of adverse market events on a bank’s covered

positions.

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Bank Risk-Based Capital Standards

risk, risks of nontraditional activities, and interest rate risk. Inadequate

management of these risks had created problems for the bank and thrift

deposit insurance funds.

In response, on December 13, 1994, bank regulators amended risk-based

capital standards for depository institutions to “ensure that those

standards take adequate account of concentration of credit risk and the

risks of nontraditional activities,” which include derivatives activities.

Regulators are to consider the risks from nontraditional activities and

management’s ability to monitor and control these risks when assessing

the adequacy of a bank’s capital. Similarly, institutions identified through

the examination process as having exposure to concentration of credit

risk or as not adequately managing their concentration of risk are required

to hold capital above the regulatory minimums. Because no generally

accepted approach exists for identifying and quantifying the magnitude of

risk associated with concentrations of credit, bank regulators determined

that including a formula-based calculation to quantify the related risk was

not feasible.

U.S. bank regulators addressed the interest rate risk portion of section 305

through a two-step process. Step one consisted of a final rule issued on

August 2, 1995, that amended the capital standards to specify that bank

regulators will include in their evaluations of a bank’s capital adequacy an

assessment of the exposure to declines in the economic value of the

bank’s capital due to changes in interest rates. The final rules specify that

examiners will also consider the adequacy of the bank’s internal interest

rate risk management. Step one also included a proposed joint policy

statement that was issued concurrently with the final rule. This joint policy

statement described how bank regulators would measure and assess a

bank’s exposure to interest rate risk.

Originally, bank regulators intended that step two would be the issuance

of a proposed rule based on the August 2, 1995, joint policy statement that

would have established an explicit minimum capital requirement for

interest rate risk. Subsequently, bank regulators elected not to pursue a

standardized measure and explicit capital charge for interest rate risk.

According to the bank regulators’ June 26, 1996, joint policy statement on

interest rate risk, the decision not to pursue an explicit measure reflects

concerns about the burden, accuracy, and complexity of developing a

standardized model and the realization that interest rate risk measurement

techniques continue to evolve. Nonetheless, bank regulators said they will

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continue to place significant emphasis on the level of a bank’s interest rate

risk exposure and the quality of its risk-management process when they

are evaluating its capital adequacy.

The regulators concluded that interest rate risks were too difficult for

many institutions to quantify, and concentration risk was too difficult to

quantify in a manner that could be used in a risk-based capital calculation.

Therefore, instead of developing a quantitative standard for each of these

risks, the regulators decided that both risks need to be carefully monitored

by examiners and that regulators could increase capital requirements for

any institution on a case-by-case basis.

FDICIA Uses Capital

Ratios to Determine

Bank Capital

Adequacy

FDICIA contains several provisions that were intended to collectively

improve supervision of federally insured depository institutions. FDICIA’s

Prompt Regulatory Action provisions created two new sections in the

Federal Deposit Insurance Act—sections 38 and 39—which mandate that

regulators establish a two-part regulatory framework to improve

safeguards for the deposit insurance fund. Section 38 creates a

capital-based framework for bank and thrift oversight that is based on the

placement of financial institutions into one of five capital categories. FDICIA

requires that banks meet both a risk-based and a leverage requirement.

Capital was made the centerpiece of the framework because it represents

funds invested by an institution’s owners, such as common and preferred

stock, that can be used to absorb unexpected losses before the institution

becomes insolvent. Thus, capital was seen as serving a vital role as a

buffer between bank losses and the deposit insurance system. Although

section 38 does not in any way limit regulators’ ability to take additional

supervisory action, it requires federal regulators to take specific actions

against banks and thrifts that have capital levels below minimum

standards. The specified regulatory actions are made increasingly severe

as an institution’s capital drops to lower levels.23 By focusing on capital,

which absorbs losses, and requiring regulators to take actions when

capital levels fall below predetermined thresholds, including requiring

closure if capital levels become too low, FDICIA was meant to curb failures

and deposit insurance losses if regulators had to close an institution.

23In November 1996, we reported that inherent limitations of section 38 requirements and the

regulatory implementation of section 39 raise questions about their effectiveness in ensuring that

regulators will act early and forcefully enough to prevent or minimize losses to the insurance funds.

See Bank and Thrift Regulation: Implementation of FDICIA’s Prompt Regulatory Action Provisions

(GAO/GGD-97-18, Nov. 21, 1996).

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Section 38 of FDICIA requires regulators to establish criteria for classifying

depository institutions into the following five capital categories:

well-capitalized, adequately capitalized, undercapitalized, significantly

undercapitalized, and critically undercapitalized. The section does not

place restrictions on institutions that meet or exceed the minimum capital

standards—that is, those that are well-capitalized or adequately

capitalized—other than prohibiting the institution from paying dividends

or management fees that would drop them into the undercapitalized

category.

The regulators jointly developed the implementing regulations for section

38 and based the criteria for four of the five capital categories on the

international risk-based capital calculation and the leverage capital ratio.

The fifth category—critically undercapitalized—is based on a tangible

equity-to-total assets ratio.

The four regulators specifically based the benchmarks for an adequately

capitalized institution on the Basle Committee’s risk-based capital

requirement, which stipulates that an internationally active bank must

have at least 8 percent total risk-based capital and 4 percent tier 1

risk-based capital. The benchmarks are also based on the U.S. leverage

capital standard, which generally requires U.S. banks to have tier 1 capital

equal to at least 4 percent of total assets. For the definition of a critically

undercapitalized institution, the regulators adopted section 38’s

requirement of a tangible equity ratio of 2 percent or less.

As shown in figure I.1, three capital ratios are used to determine if an

institution is well-capitalized, adequately capitalized, undercapitalized, or

significantly undercapitalized. A well-capitalized or adequately capitalized

institution must meet or exceed all three capital ratios for its capital

category. To be deemed undercapitalized or significantly undercapitalized,

an institution need fall below only one of the ratios listed for its capital

category. Although not shown in the figure, a fourth ratio—tangible

equity—is used to categorize an institution as critically undercapitalized.24

Any institution that has a 2 percent or less tangible equity ratio is

considered critically undercapitalized, regardless of its other capital ratios.

24The tangible equity ratio is the sum of common stock, surplus, and retained earnings, net of Treasury

stock and currency translation adjustments, with intangible assets subtracted from both the numerator

and denominator.

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Figure I.1: Summary of Four Section 38 Capital Categories and Ratio Requirements

must

meet or

exceed

Well capitalized

Adequately 

capitalized

10 percent or more

8 percent or more

6 percent or more

4 percent or more 4 percent or more

5 percent or more

can fall

below only

one

Undercapitalized

Significantly 

undercapitalized

less than 8 percent

less than 6 percent

less than 4 percent

less than 3 percent

less than 4 percent

less than 3 percent

Capital 

category

Total risk-based

capital ratio

Tier 1 risk-based

capital ratio

Leverage

capital ratio

and and

and and

or or

or or

a

b

Note: Only the tangible equity ratio is used to determine whether an institution is critically

undercapitalized. Institutions with a tangible equity ratio of 2 percent or less are considered to be

critically undercapitalized.

aThe leverage ratio can be as low as 3 percent if the institution has a regulator-assigned

composite rating of 1. Regulators are to assign a composite rating of 1 only to institutions

considered to be sound in almost every respect of operations, condition, and performance.

bAn institution cannot be considered to be well-capitalized if it is subject to a formal regulatory

enforcement action that requires the institution to meet and maintain a specific capital level.

Source: Interagency regulations issued on September 29, 1992 (57 Fed. Reg. 44866).

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Appendix II 

Key SEC Financial Responsibility Rules

The Securities and Exchange Commission’s (SEC)1 uniform net capital rule

(15c3-1) and customer protection rule (15c3-3) form the foundation of the

securities industry’s financial responsibility framework.2

 The net capital

rule focuses on liquidity and is designed to protect securities customers,

counterparties, and creditors by requiring that broker-dealers have

sufficient liquid resources on hand at all times to satisfy claims promptly.

Rule 15c3-3, or the customer protection rule, which complements rule

15c3-1, is designed to ensure that customer property (securities and funds)

in the custody of broker-dealers is adequately safeguarded. By law, both of

these rules apply to the activities of registered broker-dealers, but not to

unregistered affiliates.

The SEC Net Capital

Rule (Rule 15c3-1)

Background SEC amended the net capital rule (Rule 15c3-1) in 1975 to establish uniform

net capital standards for brokers and dealers3

 registered with SEC under

Section 15(b) of the Securities Exchange Act of 1934 (Exchange Act). With

few exceptions, all broker-dealers registered with SEC must comply with

this liquidity standard.4

 The primary purpose of this rule is to ensure that

1

SEC is the federal agency responsible for administering the Federal Securities Laws. One objective of

the Federal Securities Laws is to protect investors.

2

Other financial responsibility rules include the records maintenance and preservation rules (17a-3 and

17a-4); the financial reporting rule (17a-5); the early warning or “telegraphic” notice rule (17a-11); the

quarterly security counts rule (17a-13); the hypothecation rules (8c-1 and 15c2-1); the initial margin

requirements of the Board of Governors of the Federal Reserve System (12 C.F.R. Section 220.3(b));

and the maintenance margin rules of the self-regulatory organizations (e.g., New York Stock Exchange

rule 431).

Note: SEC and Commodity Futures Trading Commission (CFTC) officials stated that the futures

industry capital adequacy and customer assets protection requirements (CFTC Rules 1.17, and

1.20-1.30, respectively) generally mirror the requirements in SEC rules 15c3-1 and 15c3-3.

3

A broker is any person that engages in the business of effecting transactions in securities for the

account of others, but does not include a bank. A dealer is any person that engages in the business of

buying and selling securities for his own account, through a broker or otherwise, but does not include

a bank, or any person insofar as he buys or sells securities for his own account, either individually or

in some fiduciary capacity, but not as part of a regular business. Broker-dealers combine the functions

of brokers and dealers.

4

The sole market maker (a dealer that makes bids and offers at which he/she will trade) and sole

specialist (a member designated by an exchange to be the sole market maker for a particular stock) on

the options floor are exempted from the SEC net capital rule; and floor brokers on an exchange, under

certain circumstances are exempted from the rule. Also, SEC may exempt certain broker-dealers from

the rule upon a determination that it is “not necessary in the public interest or for the protection of

investors” to subject the particular broker-dealer to the rule. See Rule 15c3-1(b).

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Key SEC Financial Responsibility Rules

registered broker-dealers maintain at all times sufficient liquid assets5 to

(1) promptly satisfy their liabilities—the claims of customers, creditors,

and other broker-dealers; and (2) to provide a cushion of liquid assets in

excess of liabilities to cover potential market, credit, and other risks if

they should be required to liquidate. The rule achieves its purpose by

prescribing a liquidity test that requires a broker-dealer to maintain the

greater of a specified minimum dollar amount or specified percentage of

net capital in relation to either aggregate indebtedness (generally all

liabilities of the broker-dealer) or customer-related receivables (money

owed to the broker-dealer by customers) as computed by the reserve

requirements of Rule 15c3-3. The net capital rule thus enhances

investor/customer6

 confidence in the financial integrity of broker-dealers

and the securities market. The net capital rule applies only to the

registered broker-dealer and does not apply to the broker-dealer’s holding

company or unregulated subsidiaries or affiliates.7

Net Capital Computation To comply with SEC’s net capital rule, broker-dealers must perform two

computations: one computation determines the broker-dealer’s net capital

(liquid capital), and another computation determines the broker-dealer’s

appropriate minimum net capital requirement (base capital requirement).

Net capital is defined as U.S. Generally Accepted Accounting Principles

(GAAP) equity plus qualified subordinated liabilities8

 and credits less

nonallowable assets,9

 certain operational charges (e.g., fail-to-deliver),10

5

Liquid assets are assets that can be converted easily into cash with relatively little loss of value.

Broker-dealers must have at all times at least $1 of liquid assets for each $1 of liabilities (except for

subordinated liabilities that are treated as part of the broker-dealer’s capital) in addition to the

minimum requirements of the net capital rule in case they fail the net capital test or voluntarily cease

operations. Once liquidation is decided upon, a broker-dealer’s operations are generally liquidated in

an orderly manner within a short time frame without the use of a formal bankruptcy proceeding.

6

Generally, a customer is defined as any person from whom or on whose behalf a broker or dealer has

received or acquired or holds funds or securities for the account of such person.

7

An exception to this principle is where the registered broker-dealer guarantees or assumes

responsibility for the liabilities of the related unregistered entity. In such a situation, the broker-dealer

is required to consolidate into a single computation the assets and liabilities of both itself and the

guaranteed entity. See Rule 15c3-1(a) and Appendix C to the rule.

8

To be counted as capital in the net capital computation, the subordinated liabilities, among other

things: (1) must have an initial term of 1 year or more; (2) must be subordinated to the claims of all

present and future creditors, including customers; (3) may not be repaid if the repayment would

reduce regulatory net capital below certain required amounts; and (4) must be approved for inclusion

as net capital by the broker-dealer’s self-regulatory organization (SRO).

9

Nonallowable assets are considered illiquid assets (assets that cannot be immediately or quickly

converted into cash) by the net capital rule. Such assets decrease a broker-dealer’s net capital, because

they are deducted from GAAP equity in the net capital computation.

10A fail-to-deliver is a situation in which the selling broker-dealer does not receive securities from the

client in time to make delivery with the buying broker-dealer.

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and prescribed percentages of the market value (otherwise known as

haircuts)11 of securities and commodities that constitute the

broker-dealer’s trading and investment positions. See figure II.1 below.

Figure II.1: SEC Net Capital Formulation

GAAP equity plus 

allowable subordinated debt 

 and credits 

Total capital

illiquid assets

most unsecured receivables

operational charges

proprietary positions haircuts

Deductions

Liquid capital available to meet

requirements.

Net capital

Liquid capital available to meet

requirements.

Net capital

Greater of $250,000 or 6-2/3 

percent of aggregate indebtedness 

(basic method); or greater of 

$250,000 or 2 percent of 

customer-related receivables or 

4 percent of customer aggregated 

funds if the broker dealer is also 

registered as an FCM under CEA 

(alternative method)

Requirement

Excess capital

Net capital above requirement.

Source: GAO analysis of SEC’s net capital rule.

The process of computing a broker-dealer’s regulatory net capital is really

a process of separating its liquid and illiquid assets. In computing net

capital, under either the basic or alternative method (discussed below),

11The haircut is based on the risk characteristics (i.e., market risk, price volatility, and liquidity) of a

particular security. For example, securities perceived as risky typically receive a large haircut (e.g.,

100 percent for nonmarketable securities); those perceived as less risky generally receive a small

haircut (e.g., 0 percent for short-term government securities). This means that for a 100-percent

haircut the broker-dealer must finance 100 percent of the security’s value with firm capital. Reduced

haircuts are allowed when risk is reduced through utilization of hedging strategies. Hedging is a

strategy designed to protect a position in securities or commodities against price movements by taking

an offsetting investment position. A haircut serves as a safety margin for market fluctuations and

delays encountered in liquidating securities and commodities positions. See pages 140-145 for greater

detail on haircuts.

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the broker-dealer must first determine its equity in accordance with GAAP.

GAAP liabilities deducted from GAAP assets result in GAAP equity. GAAP

requires that the broker-dealer mark to market all securities and

commodities positions daily, thereby reflecting unrealized gains (which

add to equity) and losses (which subtract from equity)—the current

market value—and making it difficult to forbear market losses beyond a

day.

Once GAAP equity is computed, a number of adjustments are made to

reflect the estimated value of the broker-dealer if it was liquidated in a

hurry. Liabilities that are properly subordinated to the claims of creditors,

including customers, are then added back to GAAP equity as well as certain

deferred income tax liabilities and accrued liabilities. Assets considered

not readily convertible into cash are deducted from GAAP equity. This

includes intangible assets (goodwill); fixed assets (furniture, fixtures, and

buildings); prepaid items (rent and insurance); and the value of exchange

memberships. The broker-dealer also deducts most unsecured receivables,

including unsecured customer debits and bridge loans; and charges for

delays in processing securities transactions beyond the normal settlement

date. These collective additions and subtractions to GAAP equity result in

an amount called tentative net capital. Tentative net capital is then

reduced by certain percentage deductions, called haircuts, of the current

market value of a broker-dealer’s securities and commodities positions

and an undue concentration charge, which reflects the risk of a large,

concentrated holding in one security, to arrive at the broker-dealer’s net

capital. Then, the net capital base requirement (required net capital

amount) is subtracted from the net capital amount to determine the

amount of excess net capital held by the broker-dealer.

Methods Available for

Broker-Dealers to

Compute Required Net

Capital

A broker-dealer may compute its net capital requirement by one of two

methods. The first method, called the basic or aggregate indebtedness

method, requires that the net capital of a broker-dealer conducting a

general securities business (i.e., a firm that clears securities transactions

and carries customer accounts) be equal to the greater of $250,000 or

6-2/3 percent of its aggregate indebtedness. The 6-2/3 percent requirement

says a broker-dealer must have at least $1 of net capital for every $15 of its

indebtedness (i.e., a leverage constraint). In the broker-dealer’s first year

of operation, its net capital must exceed 12.5 percent of its aggregate

indebtedness. Most of the smaller broker-dealers typically use the basic

method to compute their net capital requirements because of the nature of

their business. Typically, smaller broker-dealers either do not hold

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customer or broker-dealer accounts and therefore need less than the

$250,000 required for broker-dealers that carry customer accounts; or they

want to be subject to the less stringent requirements of Rule 15c3-3.

Under the second method, the so-called alternative method, the

broker-dealer is required to have net capital equal to the greater of

$250,000 or 2 percent of its customer-related receivables from the reserve

calculation of Rule 15c3-3 or, if registered as a futures commission

merchant (FCM),12 4 percent of the customer funds required to be

segregated pursuant to the Commodity Exchange Act (CEA) and the

regulations thereunder (less the market value of commodity options

purchased by option customers on or subject to the rules of a contract

market, each such deduction not to exceed the amount of funds in the

customer’s account). When a firm is registered both as a securities

broker-dealer with SEC and an FCM with CFTC,

13 known as being

“dually-registered,” it must comply with both agencies’ regulations.

However, a dually-registered firm is required to meet only the capital

standard that would cause it to hold the most capital. SEC offers this

method to broker-dealers as a voluntary alternative (with self-regulatory

organization approval) to the basic net capital requirement. This method is

based on the broker-dealers’ responsibilities to customers rather than

aggregate indebtedness. Reversion to the basic method by the

broker-dealer requires SEC’s approval. This option (most commonly used

by large broker-dealers because it can result in a lower net capital

requirement than under the basic method), in conjunction with Rule

15c3-3 (discussed below), is designed to ensure that sufficient liquid

capital exists to return all property (assets—funds and securities) to

customers, repay all creditors, and have a sufficient amount of capital

remaining to pay the administrative costs of a liquidation if the

broker-dealer fails. The broker-dealer’s ability to return customer property

is addressed by Rule 15c3-3. The repayment of creditors and the payment

of the broker-dealer’s liquidation expenses is addressed by the 2 percent of

customer-related receivables net capital requirement and the deductions

from net worth for illiquid assets and risk in securities and commodities

positions. See pages 148-151 for an example of a hypothetical simplified

net capital computation under the alternative method.

12An FCM is an individual, association, partnership, corporation, or trust that solicits or accepts orders

for the purchase or sale of any commodity for future delivery on or subject to the rules of any contract

market and that accepts payment from or extends credit to those whose orders are accepted.

13CFTC is the federal agency responsible for administering the CEA and overseeing the futures and

commodity options industry to protect the public from fraud and manipulation in the marketplace.

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There are some differences between the two methods of computation. For

example:

• The alternative method ties required net capital to customer-related assets

(receivables) rather than all liabilities like the basic method.

• The alternative method requires a broker-dealer to provide a bad debt

reserve of 3 percent of its customer-related receivables versus 1 percent

under the basic method.

• Under the alternative method, stock record differences and suspense

account items (prospective losses due to recordkeeping problems) must

be included in the calculation of net capital after 7 business days versus

the 30 calendar days required under the basic method.

However, both methods limit a broker-dealer’s ability to increase its

customer commitments only to the extent that net capital supports such

an increase.

Also, the type of securities business a broker-dealer conducts determines

its minimum net capital requirements. For example, for broker-dealers

engaging in all facets of a securities business (involves clearing securities

transactions and holding customer and broker-dealer accounts),14 the

minimum dollar net capital requirement is $250,000; for broker-dealers

that generally do not carry customer or broker-dealer accounts

(introducing brokers), the minimum dollar amount is $5,000. See pages

152-153 for more detail on the SEC minimum net capital requirements for

specialized types of business.

Early Warning Capital

Levels

In addition to the minimum base net capital requirements, SEC and SROs

(such as the National Association of Securities Dealers and the national

exchanges)15 have established “early warning” levels16 of capital that

exceed the broker-dealer’s minimum capital requirement. This advance

warning alerts SEC and the SROs to the fact that a broker-dealer is

experiencing financial difficulty (i.e., broker-dealer’s net capital is

14A more detailed description is a broker-dealer who buys and sells stocks, bonds, options, or

municipal securities, and/or engages in firm commitment underwritings as underwriter or selling group

member.

15Securities SROs set rules (with oversight by SEC) for fair conduct, license or approve firms engaged

in market making activities, and supervise the activities of market participants.

16This early warning system also includes other criteria for notification to SEC and the designated SRO

by broker-dealers: when the broker-dealer fails to keep books or records current, when the

broker-dealer’s independent accountant notifies it of a material inadequacy in financial statements, or

upon occurrence of other specified events. See Rule 17a-11.

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dropping toward its minimum requirement) and allows time for initiation

of corrective action. Broker-dealers that violate the early warning levels

must immediately notify SEC and their designated SRO17 and are thereby

subject to closer regulatory scrutiny by SEC and the SRO.

18 SROs may also

impose additional operating restrictions or warning requirements on their

members, which can be more stringent than SEC’s. For example, the New

York Stock Exchange’s rule 326 restricts the business activities of member

broker-dealers that are approaching financial or operational difficulties.

When a broker-dealer’s net capital drops below its minimum net capital

requirements, SEC requires the broker-dealer to cease operations

immediately and get additional capital to come into capital compliance or

liquidate its operations.

The early warning notice levels are as follows:

• Under the basic method, the broker-dealer’s ratio of aggregate

indebtedness to net capital is greater than 1,200 percent.

• Under the alternative method, the broker-dealer’s net capital is less than

5 percent of customer-related receivables or, if an FCM, net capital is less

than 6 percent of CEA customer segregated funds.

• The broker-dealer’s net capital is less than 120 percent of its required

minimum dollar net capital.

Market participants indicated that prudent broker-dealers maintain capital

levels far in excess of their required minimum net capital amount. They

told us that the largest broker-dealers typically hold $1 billion or more in

excess of their required capital levels because, among other reasons, their

counterparties require it for conducting business with them.

Financial Reporting

Requirements

SEC has delegated to the SROs primary responsibility for enforcing

broker-dealer compliance with the net capital and customer protection

17If a broker-dealer is a member of more than one SRO, one of them will be designated as the SRO

responsible for overseeing the broker-dealer’s activities and its compliance with the financial

responsibility rules.

18A broker-dealer is prohibited from withdrawing equity capital if such withdrawal would cause the

broker-dealer’s aggregate indebtedness to net capital to exceed 10 times its net capital; its net capital

to fall below 120 percent of its minimum dollar requirement; its net capital to fall to less than 5 percent

of customer-related receivables under the alternative method; or, if an FCM, less than 7 percent of

CEA-segregated funds; or subordinated debt to exceed 70 percent of total capital, or net capital to be

less than 25 percent of haircuts used in calculating net capital. This limitation includes withdrawals in

the form of redemption or repurchase of stock, dividends, or other distributions as well as unsecured

loans or advances to stockholders, partners, sole proprietors, employees, or affiliates (i.e., related

persons). Under certain conditions, a broker-dealer is required to notify (written form) SEC and the

designated SRO when capital is transferred out of the broker-dealer to related persons. For example,

the broker-dealer is required to notify SEC and the designated SRO 2 business days before any

withdrawals of equity capital greater than 30 percent of the broker-dealer’s excess net capital.

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rules. SEC and the SROs have established a uniform system of reporting by

broker-dealers and inspection schedules and procedures to routinely

monitor broker-dealers’ compliance with such rules. Registered

broker-dealers, depending on their type of business, are required to file

either monthly or quarterly reports with their designated SROs. FOCUS (an

acronym for Financial and Operational Combined Uniform Single Report

(SEC Form X-17A-5)), the report broker-dealers are required to file,

contains confidential key financial and operational information of a

broker-dealer’s operations. If a broker-dealer has financial or operational

difficulties, SEC or the SRO may require it to accelerate its reports filing at

any time as specified in Rule 17a-5(a)(2)(iv). FOCUS is an integral part of

the SRO’s early warning system and provides the SRO with a substantial

amount of information to detect existing or potential financial and

operational problems. Additionally, Rule 17a-5 requires broker-dealers to

file annual audited financial statements supplemented by an accountant’s

report setting forth any material inadequacies.

The SEC Customer

Protection Rule

Restricts

Broker-Dealer Use of

Customer Securities

and Funds

SEC Rule 15c3-3, adopted in 1972, provides regulatory safeguards regarding

the custody and use of customer securities and free credit balances

(funds)19 held by broker-dealers. The rule, with limited exceptions,20

requires compliance by all registered broker-dealers. The purpose of Rule

15c3-3 is to protect customer funds and securities held by the

broker-dealer.

Rule 15c3-3 has two parts. The first part requires broker-dealers to

promptly obtain and maintain the physical possession or control of all

fully paid and excess margin customer securities.21 The second part

19Free credit balances are a broker-dealer’s liabilities to customers and are subject to immediate cash

payment to customers on demand, whether resulting from sales of securities, dividends, interest,

deposits, or otherwise. However, they exclude funds in commodity accounts that are segregated in

accordance with the CEA or in a similar manner.

20Certain types of broker-dealers are exempted from the requirements of the customer protection rule.

See Rule 15c3-3(k)(2) for more detail.

21Fully paid securities are securities that are purchased in transactions for which the customer has

made full payment. Margin securities in a customer account are those securities with a market value

equal to or less than 140 percent of the customer’s debit balance (the amount the customer owes the

broker-dealer for the purchase of the securities). Excess margin securities in a customer account are

those securities with a market value greater than 140 percent of the customer’s debit balance. An

example of excess margin securities: A customer buys $80,000 worth of securities on 50 percent

margin. The broker-dealer loans the customer $40,000 (debit balance). The amount of the customer

margin securities that can be pledged as collateral for a bank loan is $56,000 (140 percent x $40,000

debit = $56,000 available as collateral). Because only $56,000 of the $80,000 of customer securities can

be pledged to the bank, the remaining $24,000 of securities are excess margin securities that must be

segregated and held in safekeeping by the broker-dealer.

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requires broker-dealers to segregate all customer cash or money obtained

from the use of customer property that has not been used to finance

transactions of other customers.

Part 1: Physical Possession

or Control of Customer

Securities

SEC’s requirement that broker-dealers maintain possession or control of all

customer fully paid and excess margin securities substantially limits

broker-dealers’ abilities to use customer securities. Rule 15c3-3 requires

broker-dealers to determine, each business day, the number of customer

fully paid and excess margin securities in their possession or control and

the number of fully paid and excess margin securities that are not in the

broker-dealer’s possession or control. Should a broker-dealer determine

that fewer securities are in its possession or control than is required (a

deficit position in security), Rule 15c3-3 requires the broker-dealer to

initiate action and specifies time frames by which these securities must be

placed in the broker-dealer’s possession or control. For example, for

securities that are subject to a bank loan,22 the broker-dealer must issue a

recall instruction within 1 business day of a deficit position determination,

and the securities must be returned to the broker-dealer’s possession or

control within 2 business days of the recall instruction. Once a

broker-dealer obtains possession or control of customer fully paid or

excess margin securities, the broker-dealer must thereafter maintain

possession or control of those securities.

Rule 15c3-3 also specifies where a security must be located to be

considered “in possession or control” of the broker-dealer. “Possession” of

securities means the securities are physically located at the broker-dealer.

“Control” of securities means the securities are located at one of the

approved “control” locations discussed below. “Control” locations include

a clearing corporation or depository, free of any lien; a Special Omnibus

Account in compliance with Federal Reserve System Regulation T23 with

instructions for segregation; a bona fide item of transfer of up to 40

calendar days (longer with written permission from the transfer agent);

foreign banks or depositories approved by SEC; a bank (as defined by the

Exchange Act) supervised by a federal banking authority, provided the

22Securities that have been pledged to a bank as collateral are an example of securities that are subject

to a bank loan.

23Federal Reserve System Regulation T (12 C.F.R. 220) regulates the extension of credit by and to

broker-dealers. For the purposes of SEC Rule 15c3-3, it deals primarily with broker-dealer margin

accounts. In securities industry parlance, margin is credit extended by a broker-dealer to a purchaser

of a security to fund part of the purchase price. Interest is charged on the balance amount, and

ownership of the stock certificate passes immediately to the purchaser. Regulation T currently allows

a purchaser of securities to borrow up to 50 percent of a security’s purchase price.

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securities are being held free of any lien; in transit between offices of the

broker-dealer (for no more than 5 business days) or held by a

majority-owned corporate subsidiary of the broker-dealer if the

broker-dealer assumes or guarantees all of the subsidiary’s obligations or

liabilities; or in any other location designated by SEC (e.g., a mutual fund or

its agent in the case of a registered open-ended investment company).

Part 2: Segregation of

Customer Funds and the

Reserve Formula

The second requirement of Rule 15c3-3 dictates how broker-dealers may

use customer cash credit balances and cash obtained from the permitted

uses of customer securities,24 including from the pledging of customer

margin securities. Essentially, the customer protection rule restricts the

use of customer cash or margin securities to activities directly related to

financing customer securities purchases. That is, the broker-dealer may

not use customer property as a source of working capital for its

operations.

The rule requires a broker-dealer to periodically (weekly for most

broker-dealers)25 compute the amount of funds obtained from customers

or through the use of customer securities (credits) and compare it to the

total amount it has extended to finance customer transactions (debits). If

credits exceed debits, the broker-dealer is required to have on deposit in

an account for the exclusive benefit of customers26 at least an equal

amount of cash or cash-equivalent securities (e.g., U.S. treasuries).

Consequently, the rule serves to protect any required deposit in a secured

location from creditors of the broker-dealer in an insolvency. For most

broker-dealers, the calculation must be made as of the close of business

every Friday, and any required deposit must be made by the following

24Permissible uses of customer funds by broker-dealers include, among others: financing customers’

margin accounts (i.e., an account in which a customer uses credit from a broker-dealer to take security

positions); borrowing of securities to effect customers’ short sales (i.e., securities sold but not owned

at time of sale by broker-dealer); and delivery on customers’ fail-to-deliver (i.e., selling broker-dealer

does not receive securities from client in time to make delivery to buying broker-dealer).

25A broker-dealer with customer credits (funds) of less than $1 million and aggregate indebtedness of

less than 800 percent of net capital can compute the reserve requirement on a monthly basis as of the

month’s close of business. The broker-dealer is required to make a deposit of 105 percent of the excess

credits on the second business day following the computation date. See Rule 15c3-3(e)(3).

26Rule 15c3-3(e)(1) requires that a broker-dealer maintain a bank account that is separate from any

other account of the broker-dealer and specified as a “Special Reserve Bank Account for the Exclusive

Benefit of Customers” (reserve account). The broker-dealer must also obtain written notification from

the bank that all cash or qualified securities within the reserve account are being held for the exclusive

benefit of customers; are being kept separate from any other accounts maintained by the broker-dealer

with the bank; cannot be used directly or indirectly as security for any loan to the broker-dealer by the

bank; and shall be subject to no right, charge, security interest, lien, or claim of any kind in favor of the

bank or any person claiming through the bank.

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Tuesday morning. If the required deposit is not made by the broker-dealer,

the broker-dealer must immediately notify its SRO and SEC by telegram and

promptly confirm such notice in writing. Such notice must be given even if

a broker-dealer is presently in compliance with the reserve portion of the

rule but discovers that it was previously out of compliance due to a

computational error or otherwise. If a broker-dealer fails to make a

deposit to the special reserve account when required to do so, it is a

criminal violation, and the broker-dealer must cease doing business. If the

debits exceed the credits, no deposit is required.

U.S. Securities

Haircuts

The haircuts described below are from SEC Rule 15c3-1(c)(2)(vi)(A)-(M).

Securities Haircuts The percentage amount of the haircut varies depending on the type of

security, the maturity date, the quality, and the marketability. Generally,

the haircut is deducted from the market value of the greater of the long or

short position in each security; however, in some cases haircuts apply to

the lesser position as well. The haircuts are designed to discount the firm’s

own positions to account for adverse market movements and other risks

faced by the firms, including liquidity and operational risks.

U.S. and Canadian

Government and Agency

Debt Securities

This refers to securities issued (or guaranteed as to principal and interest)

by the U.S. or Canadian government or agency. A haircut is applied to

aggregate net long or short positions in 4 main categories (and 12

subcategories) of maturity dates ranging from less than 3 months to 25

years or more. The haircuts range from 0 percent for the short-term

securities (0-3 months) to 6 percent for securities with later maturities.

For the most part, government securities haircuts are also applied to

quasi-agency debt securities, such as those issued by the Export-Import

Bank, Tennessee Valley Authority, and the Government National Mortgage

Association (Ginnie Mae).

Municipal Debt Securities These are securities that are direct obligations of, or guaranteed as to

principal and interest by, a state or any political subdivision thereof as

well as agencies and other state and local instrumentalities. Haircut

percentages are applied to the market value of the greater of the long or

short position according to maturity date. For municipal securities issued

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with stated maturities of 2 years or less, haircuts range from 0 percent for

securities maturing under 30 days to 1 percent for those maturing in 456

days but less than 732 days.

For longer term securities with stated maturities of 2 years or longer,

haircuts range from 3 percent to 7 percent.

Certain Municipal Bond

Trusts and Liquid Asset

Funds

These funds are redeemable securities issued by investment companies

whose assets consist of cash, securities, or money market instruments.

The haircut ranges from 2 percent to 9 percent based upon the types of

assets held by the fund.

Commercial Paper,

Bankers Acceptances, and

Certificates of Deposit

The percentage deductions for highly rated corporate short-term debt

instruments (money market instruments) that (1) have a fixed rate of

interest or (2) are sold at a discount and that have maturity dates not

exceeding 9 months range from 0 percent to 0.5 percent in five maturity

categories ranging from less than 30 days to less than 1 year.

Bankers acceptances and certificates of deposit guaranteed by a bank and

with maturity dates over 1 year have the same haircuts as U.S. government

securities.

Nonconvertible Debt

Securities

These securities are corporate bonds that cannot be exchanged for a

specified amount of another security, (e.g., equity securities), at a stated

price. Highly rated bonds are assigned haircuts ranging from 2 percent to

9 percent for maturity dates ranging from less than 1 year to over 25 years.

Certain positions in nonconvertible securities can be excluded from the

foregoing haircuts if hedged with U.S. government securities.

Also included in this category are foreign debt securities for which a ready

market exists. For purposes of foreign securities, a ready market is

deemed to exist if such securities (1) are issued as a general obligation of a

sovereign government; (2) have a fixed maturity date; (3) are not traded

flat or in default as to principal or interest; and (4) are highly rated

(implicitly or explicitly) by at least two nationally recognized statistical

rating organizations, such as Standard & Poor’s and Moody’s Investors

Service.

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For positions hedged with U.S. government securities, haircuts on the

hedged positions range from 1.5 percent for maturities of less than 5 years

to 3 percent for maturities of 15 years or more. For positions hedged with

nonconvertible debt, haircuts on the hedged positions range from

1.75 percent for a maturity of less than 5 years to 3.5 percent for a maturity

of 15 years or more. In either case, no haircut is taken on the hedging

position (i.e., the U.S. government securities or the nonconvertible debt).

Convertible Debt

Securities

The treatment of debt securities that can be converted into equities and

have fixed rates of interest and maturity dates is based on the securities’

market value. If the market value is 100 percent or more of the principal

amount, the haircut is the same as that applied to “all other securities,” or

15 percent of the market value of the greater of the long or short positions,

plus 15 percent of the market value of the lesser position, but only to the

extent that this lesser position exceeds 25 percent of the greater position.

If the market value is less than the principal amount, the haircut is the

same as for nonconvertible debt securities.

Preferred Stock This stock is cumulative, nonconvertible, highly rated, and ranked prior to

all other classes of stock. The stock is not in arrears as to dividends and

carries a haircut of 10 percent of the market value of the greater of the

long or short position.

Open Contractual

Commitments

These commitments are haircut at 30 percent of the market value of the

greater of the net long or net short position (minus unrealized profits),

unless the class and issue of securities are listed on a national securities

exchange or are designated as NASDAQ National Market System

Securities. If the securities are listed or designated, the haircut is then

15 percent (unless the security is an initial public offering whereupon the

percentage deduction reverts to 30 percent).

All Other Securities These securities include corporate equities and certain foreign securities

(other than preferred stock discussed above). They are assigned haircuts

of 15 percent of the market value of the greater of the long or short

positions, plus 15 percent of the market value of the lesser position, but

only to the extent that this lesser position exceeds 25 percent of the

greater position (i.e., the first 25 percent of the lesser position incurs no

haircut).

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Securities With a Limited

Market

In cases where there are only one or two independent market makers

submitting regular quotations in an interdealer quotation system for the

securities, the haircut is 40 percent on both the long and short positions. In

cases where there are three or more independent market makers

submitting regular quotations, the haircut is the same as for the “all other

securities” category above.

Undue Concentration This refers to a situation where a broker-dealer has a securities position

for which the market value is more than 10 percent of the broker-dealer’s

net capital before haircuts (i.e., “tentative net capital”). For the charge to

apply to equities, the market value of the position must exceed the greater

of $10,000 or the market value of 500 shares. For debt securities, the

provision applies to positions valued over $25,000. The haircut is an extra

percentage of the usual haircut applied, and it is applied only to the excess

portion of the total position (over 10 percent). The additional haircut for

concentrated positions in equity securities is 15 percent. For other

securities, it is 50 percent of the normal haircut on the concentrated

securities.

Nonmarketable Securities These are securities for which there is no ready market, and they carry a

100-percent haircut. Such securities have no independent market makers,

have no quotations, and are not accepted as collateral for bank loans.

U.S. Options and

Commodities Haircuts

The net capital rule also includes deductions for hedged positions,

including futures and options contracts. Options to buy and sell securities

and commodities are subject to haircuts because their market values

change. See Appendix A to Rule 15c3-1 for options contracts and

Appendix B to Rule 15c3-1 for relevant haircuts for futures contracts. CFTC

generally has jurisdiction over the regulation of futures and options

markets, including their relevant haircuts. Since securities broker-dealers

hold futures and options positions in their portfolios, SEC incorporates

CFTC’s haircuts for commodities futures and options into its net capital

rule. CFTC also incorporates SEC’s securities haircuts into its net capital rule

(Rule 1.17).

Appendix A to SEC Rule

15c3-1 (Options Haircuts)

Appendix A to SEC Rule 15c3-1 prescribes haircut methodologies for listed

and unlisted options.

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Appendix II 

Key SEC Financial Responsibility Rules

Risk-Based Haircut

Methodology for Listed Options

Recently, to better reflect the market risk in broker-dealers’ options

positions and to simplify the net capital rule’s treatment of options for

capital purposes, SEC adopted a risk-based methodology using theoretical

option pricing models to calculate required capital charges (haircuts) for

listed options and related hedged positions. A simple, strategy-based

methodology, similar to the old haircut methodology, remains for those

firms that do not transact enough options business to warrant the expense

of using option pricing models. This is the first time SEC has approved the

use of modeling techniques for computing regulatory capital charges. The

effective date of the new rule was September 1, 1997.

Third-party source models (and vendors) approved by a designated

examining authority (i.e., self-regulatory organization) are used to perform

the actual theoretical gain and loss calculations on the individual

portfolios of the broker-dealers. Such approved vendors provide, for a fee,

a service by which the broker-dealers may download the results generated

by the option pricing models to allow broker-dealers to then compute the

required haircut for their individual portfolios. The greatest loss at any one

valuation point would be the haircut. At this time, the only approved

vendor/model is the Options Clearing Corporation’s Theoretical

Intermarket Margining System (TIMS).

Underlying Price Movement

Assumptions

Specified underlying price movement assumptions designed to provide for

the maintenance of capital sufficient to withstand potential adverse

market moves are included. The underlying price movement assumptions

were established to be consistent with the volatility assumptions currently

incorporated into the net capital rule.27 Specifically, the models calculate

the theoretical gains and losses for a portfolio containing proprietary or

market maker options positions at 10 equidistant valuation points using

specified increases and decreases in the price of the underlying

instrument. The greatest loss at any valuation point becomes the haircut

for the entire portfolio.

27The option pricing model, for each option series, would calculate theoretical prices at 10 equidistant

valuation points within a range consisting of an increase or decrease of the following percentages of

the daily market price of the underlying instrument: (i) +(-)15 percent for equity securities with a ready

market, narrow-based indexes (as defined), and non-high-capitalization diversified indexes (as

defined); (ii) +(-)6 percent for major market currencies (e.g., European Currency Unit, Japanese Yen,

and Deutsche Mark); (iii) +(-)10 percent for high-capitalization diversified indexes (as defined); and

(iv) +(-)20 percent for currencies other than major market currencies. For nonclearing specialists and

market makers, there is a reduction in the underlying price movements: +(-)4-1/2 percent for major

market currencies positions, +(-)10 percent for non-high-capitalization diversified indexes, and

+6(–8) percent for high-capitalization diversified indexes. The maximum loss at any one valuation

point would be the haircut for the portfolio. An option series includes option contracts of the

same type (a call or a put) and exercise style covering the same underlying instrument with the same

exercise price, expiration date, and number of underlying units.

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Permissible Offsets A percentage of a position’s gain at any one valuation point is allowed to

offset another position’s loss at the same valuation point.28 For example,

options covering the same underlying instrument are afforded a

100-percent offset. Other offsets are permitted between qualified stock

baskets and index options, futures, or futures options on the same

underlying index. Broker-dealers are permitted to offset 95 percent of

gains with losses (i.e., a 5 percent capital charge).

Minimum Charge In addition, broker-dealers must take certain minimum deductions to

address decay and liquidity risk if the option pricing model calculated an

insignificant or no capital charge for a portfolio. This minimum charge is

generally one-quarter of a point, or $25 per option contract, unless the

basic equity option contract covers more than 100 shares. In this case, the

charge is proportionately increased.

SEC rules also require a deduction of 7.5 percent of the market value for

each qualified stock basket of non-high-capitalization diversified indexes.

The rules also require 5 percent of the market value for each qualified

stock basket of high-capitalization diversified and narrow indexes used to

hedge options or futures positions that are subject to the minimum charge.

Alternative Strategy-Based

Haircut Methodology for Listed

and Unlisted Options

SEC also permits firms with limited options business to use an alternative

strategy-based haircut methodology that generally follows the haircut

approach in the previous version of Appendix A to the net capital rule. See

Table II.1. This rule was designed for firms whose options business would

not make it cost effective to use an option pricing model. A similar

strategy-based methodology is also employed for broker-dealers that

engage in buying and writing unlisted over-the-counter options. See Table

II.2.

28A valuation point refers to the repricing of an option in relation to assumed changes in the value of

the underlying instrument.

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Table II.1: Alternative Strategy-Based Haircut Methodology for Listed Options

Type of optiona/definitionb

Adjustments to net worth:

listed options only Haircuts on listed options

Uncovered short: Short put or call with no

related stock or option position.

Add market value of option.

Add time valuec of short option position.

Appropriate percentage of the current

market value of the securities underlying

the option security less the

out-of-the-money amount, but reduction

cannot serve to increase net capital.

Minimum haircut is the greater of $250 per

100 share option contract or 50 percent of

aforementioned percentage.

Long options (calls or puts): No offsetting

securities or options position.

None 50 percent of the current market value of

the option.

Hedged call: Long call option vs. short

underlying stock.

Deduct time value on long call. Take applicable haircut on the short stock

position not to exceed the out-of-the-money

amount on the call option. Minimum haircut

of $25 for each 100 share option contract,

but minimum charge need not exceed

intrinsic valued of the option.

Hedged put: Long put option vs. long

underlying stock.

Deduct time value on long put. Take applicable haircut on the long stock

position not to exceed the out-of-the-money

amount on the call option. Minimum haircut

of $25 for each 100 share option contract,

but minimum charge need not exceed

intrinsic value of the option.

Hedged call: Short call option vs. long

underlying stock.

Add time value of short option. Take applicable haircut on the long stock

position reduced by the call’s intrinsic

value. The minimum charge here is $25 per

each 100 share option contract.

Spread: Long put options vs. short put

options and long call options vs. short call

options.

Add net short market value or deduct net

long market value of options.

Call spread: excess of exercise valuee of

long call over short call. If exercise value of

long call is less than or equal to the

exercise value of the short call, no haircut

is required. 

Put spread: excess of exercise value of

short put over long put. If exercise value of

long put is greater than or equal to exercise

value of short put, no haircut is required.

(Table notes on next page)

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aA listed option is any option traded on a registered national securities exchange or automated

facility of a registered national securities association.

bUncovered means an option that is written without any corresponding security or option position

as protection in seller’s account. A call is an option giving its holder (buyer) the right to demand

the purchase of a certain number of shares of stock at a fixed price any time within a specified

period. A put is an option giving its holder (seller) the right to demand acceptance of delivery of a

certain number of shares of stock at a fixed price any time within a specified period. Short means

the investor sells the option. Long means the investor buys the option. Hedge means any

combination of long and/or short positions taken in securities, options, or commodities in which

one position tends to reduce the risk of the other. A spread is the simultaneous purchase and sale

of the same class of options at different prices.

cTime value is the amount by which the current market value of an option exceeds its intrinsic

value.

dIntrinsic value (or “in-the-money amount”) is the amount by which the exercise value, if a call

option, is less than the current market value of the instrument underlying the call; and if a put

option, the amount by which the exercise value of the option is greater than the current market

value of the instrument underlying the put. “Out-of-the-money” is the amount by which the

exercise value, if a call, is greater than the current market value of the underlying instrument; and,

if a put, the amount by which the exercise value is less than the current market value of the

underlying instrument.

eExercise value is the price at which an option can be exercised.

Source: The SEC Division of Market Regulation, Appendix A to SEC Rule 15c3-1, and SEC

Release No. 34-38248.

Table II.2: Alternative Strategy-Based

Haircut Methodology for Unlisted

Options

Type of optiona Haircuts on unlisted options

Uncovered calls and puts 15 percent, if equities, (or appropriate other percentage)

of the current market value of the underlying security less

any out-of-the-money amount. Minimum haircut of $250

per 100 share option contract.

Covered calls and puts 15 percent, if equities, (or appropriate other percentage)

of the current market value of the underlying security less

any in-the-money amount. Net capital cannot be

increased because of haircut.

Conversion accountsb 5 percent, if equities, (or 1/2 the appropriate other

percentage for other securities as set forth in the rule) of

the current market value of the underlying security.

Long options 15 percent, if equities, (or appropriate other percentage

for other securities as set forth in the rule) of the current

market value of the underlying security. Limited to

allowable asset value of the option.

aAn unlisted option is any option that is not traded on a registered national securities exchange or

automated facility of a registered national securities association.

bA conversion is a call option created from a put option when a long position in the underlying

equity is taken.

Source: The SEC Division of Market Regulation, Appendix A to SEC Rule 15c3-1 under the

Exchange Act, and SEC Release No. 34-38248.

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Key SEC Financial Responsibility Rules

Appendix B to SEC Rule

15c3-1 (Commodities and

Commodities Futures

Haircuts)

As for securities, the net capital rule imposes a series of deductions from

the market values of commodities. The amount of the deductions varies

depending on whether the commodities are part of a hedged or spread

position; whether the commodities stand alone as a long or short position;

and what types of commodities accounts (inventory accounts, customer

accounts) are at issue. These haircuts generally conform with similar

provisions in CFTC’s net capital rule and are dependent on the margin

requirements set by the commodities boards of trade and clearing

organizations. See Table II.3.

Table II.3: Commodities and

Commodities Futures Haircuts Commodities transaction: Haircut:

1. Inventory registered as deliverable and

covered by a futures or option

No charge

2. Covered inventory 5 percent charge of market value

3. Uncovered inventory 20 percent charge of market value

4. Covered commitments and forwards 10 percent charge of market value

5. Uncovered commitments and forwards 20 percent charge of market value

6. Futures and short and long options Applicable margin requirementa

150 percent of applicable maintenance

requirementb

200 percent of applicable maintenance

requirementc

aIf broker-dealer is a clearing member of a contract market with respect to applicable

transactions.

bIf broker-dealer is a member of an SRO.

cAll other broker-dealers.

Source: The SEC Division of Market Regulation and Appendix B to Rule 15c3-1.

Hypothetical Example of a

Broker-Dealer’s Net Capital

Calculation Under the

Alternative Method

Tables II.4 and II.5 and II.6 provide information for calculating net capital.

Table II.4, a trial balance, provides a starting point for our simplified

hypothetical example of a broker-dealer’s net capital calculation under

SEC’s alternative method. A trial balance is a list of all open accounts in the

general ledger and their balances. A general ledger is a collection of all

assets, liabilities, capital, revenue, and expense accounts. Accounts are the

means by which differing effects on business elements (e.g., revenues) are

categorized and collected. In table II.5, we converted the trial balance into

a balance sheet of assets, liabilities, and capital. In table II.6, we compute

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Key SEC Financial Responsibility Rules

the broker-dealer’s net capital, including haircuts, using information

contained in table II.5. The result of the computation shows that the

broker-dealer is in capital compliance and has $352.6 million in excess net

capital.

Table II.4: Broker-Dealer’s Trial

Balance as of December 31, 1997 Account title Debits Credits

Cash in banks $400,000,000

Customer debitsa 40,000,000

Customer credits $115,000,000

Dividends payable 8,000,000

Syndicate payable 30,000,000

Furniture and fixtures (net) 12,000,000

Advances and loansb 20,000,000

Good faith depositsc 13,000,000

Subordinated loansd 40,000,000

Loans payable 30,000,000

Accrued expenses payable 7,000,000

Commission income 40,000,000

Trading accounte 130,000,000

Investment accounte 100,000,000

Real estate 50,000,000

Mortgage payablef 35,000,000

Interest receivablesg 5,000,000

Capital account 465,000,000

Total $770,000,000 $770,000,000

Notes to financial statements:

aCustomer debits are in cash account and are outstanding for less than 7 days.

bAdvances and loans to employees are unsecured.

cGood faith deposits with utility companies.

dSubordinated loan from firm’s president, not approved by American Stock Exchange.

eAll securities are listed on the American Stock Exchange and are of long equity positions. As of

12/31/97, the market value of the Investment account is $99,000,000; and the market value of the

Trading account is $105,000,000.

f

Mortgage payable is for business condo.

gInterest receivable less than 30 calendar days from payable date.

Source: GAO.

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Key SEC Financial Responsibility Rules

Table II.5 Broker-Dealer’s Balance

Sheet as of December 31, 1997 Assets

Allowable assets

Cash $400,000,000

Customer debits 40,000,000

Trading account 105,000,000

Investment account 99,000,000

Interest receivables 5,000,000

Total allowable assets $649,000,000

Non-allowable assets

Real estate $ 50,000,000

Furniture & fixtures (net) 12,000,000

Advances & loans 20,000,000

Good faith deposits 13,000,000

Total non-allowable assets $ 95,000,000

Total assets $744,000,000

Liabilities

Aggregate indebtedness

Customer credits $115,000,000

Dividends payable 8,000,000

Accrued expenses payable 7,000,000

Loan payable 30,000,000

Mortgage payable 35,000,000

Syndicate payable 30,000,000

Total aggregate indebtedness $225,000,000

Other liabilities

Subordinated loan $ 40,000,000

Total liabilities $265,000,000

Owners’ equity

Capital account $465,000,000

Commission income 40,000,000

Mark to market (investment) (1,000,000)

Mark to market (trading) (25,000,000)

Total capital $479,000,000

Total liabilities and capital $744,000,000

Source: GAO.

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Table II.6: Broker-Dealer’s Net Capital

Computation as of December 31, 1997 Accounting steps: Description Computation

minus

equals

minus

equals

minus

equals

minus

equals

Total assets

Total liabilities

Net worth

Deductions:

Non-allowable assets

Net capital before haircuts

Total haircut chargesa

Net capital

Required minimum net capital

Excess net capital

$744,000,000

 265,000,000

$479,000,000

 95,000,000

$384,000,000 

 30,600,000

$353,400,000

 776,000

$352,624,000

aHaircut computation:

The haircut for equity securities is equal to 15 percent of the market value of the greater of the

long or short positions, plus 15 percent of the lesser positions, but only to the extent that these

positions exceed 25 percent of the market value of the greater position.

15% of trading account: 15% x $105,000,000 = $15,750,000

15% of investment account: 15% x $99,000,000 = $14,850,000

Total haircuts $30,600,000

Computation of Alternative Net Capital Compliance:

Base requirement: broker-dealer’s net capital must be the greater of $250,000 or 2 percent of

aggregate customer debits (i.e., customer-related receivables) as computed per Rule 15c3-3’s

reserve formula.

Aggregate customer debits equal (customer debits - (customer debits x 3%)). In our example,

aggregate customer debits equal $38,800,000 ($40,000,000 -($40,000,000 x 3%)). The 3 percent

is analogous to the broker-dealer’s loss reserve for the loans made to customers. Our base

requirement is $776,000 (2% x $38,800,000).

Because the $776,000 is more than the $250,000 minimum dollar requirement, the broker-dealer

must hold at least a minimum of $776,000 in net capital. The broker-dealer is in compliance with

this requirement because it has $353,400,000 in net capital.

Another requirement is that the broker-dealer’s subordinated debt to total debt-equity ratio may

generally not exceed 70 percent for 90 days. The ratio is calculated by dividing a broker-dealer’s

total net worth into its subordinated debt ($40,000,000/$479,000,000). With a ratio of only

8.35 percent, the broker-dealer meets this requirement.

Source: GAO.

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Table II.7: SEC Minimum Net Capital Requirements for Brokers and Dealers

Type of broker or dealer Minimum requirement

Brokers or dealers that carry accounts

1. Firms that carry customer accounts or broker or dealer accounts

and receive or hold funds or securities for those persons (known as

general securities brokers or dealers).

i. Basic or aggregate indebtedness (AI) method Greater of $250,000 or 6-2/3% of AI

ii. Alternative method Greater of $250,000 or 2% of Rule 15c3-3 Reserve Formula

debits

2. Firms that carry customer accounts, receive but do not hold

customer funds or securities, and operate under the paragraph

(k)(2)(i) exemption of Rule 15c3-3.

Greater of $100,000 or 6-2/3% of AI

Introducing brokers*

1. Firms that introduce accounts on a fully disclosed basis to

another broker or dealer and do not receive funds or securities.

Greater of $5,000 or 6-2/3% of AI

2. Firms that introduce accounts on a fully disclosed basis to

another broker or dealer and receive, but do not hold, customer or

other broker-dealer securities and do not receive funds.

Greater of $50,000 or 6-2/3% of AI

Dealers*

1. Brokers or dealers that trade solely for their own accounts,

endorse or write options, or effect more than 10 transactions for

their investment account in any 1 calendar year.

Greater of $100,000 or 6-2/3% of AI

Mutual fund brokers or dealers*

1. Brokers or dealers transacting a business in redeemable shares

of registered investment companies and certain other share

accounts.

i. Wire orders (or telephone calls) Greater of $25,000 or 6-2/3% of AI

ii. Application (or subscription) method and do not otherwise

receive or hold funds or securities

Greater of $5,000 or 6-2/3% of AI

Market makers*

1. Brokers or dealers engaged in activities as a market maker Greater of $100,000 or 6-2/3% of AI or $2,500 per security for

securities with a market value greater than $5 per share, and

$1,000 per security for securities with a market value of $5 or

less with a maximum requirement of $1 million

Other brokers or dealers*

1. Firms that deal only in Direct Participation Programs (i.e., real

estate syndications).

Greater of $5,000 or 6-2/3% of AI

2. Firms that do not take customer orders, hold customer funds or

securities or execute customer trades, because of the nature of

their activities (e.g., mergers and acquisitions).

Greater of $5,000 or 6-2/3% of AI

Futures commission merchants

1. Brokers or dealers registered with CFTC. Greater of $250,000 or 4% of customer funds required to be

segregated pursuant to the CEA and regulations thereunder

(continued)

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Key SEC Financial Responsibility Rules

Type of broker or dealer Minimum requirement

ALTERNATIVE METHODa

1. Any firm may elect this method; however, the firm will be subject

to the $250,000 minimum net capital requirement.

Greater of $250,000 or 2% of Rule 15c3-3 Reserve Formula

debits

aA broker or dealer electing this method to calculate its net capital levels must notify its examining

authority in writing and may not thereafter revert to the Aggregate Indebtedness Method (unless

approved by SEC.)

* The minimum capital requirements opposite the type of broker-dealers are under the Basic (or

Aggregate Indebtedness) Method.

Source: The SEC Division of Market Regulation and Rule 15c3-1 under the Securities Exchange

Act of 1934.

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Appendix III 

Regulatory Actions and Other Provisions of

the Life Risk-Based Capital Model Act

Nearly all life insurers are required to calculate both their total capital and

their required risk-based capital and file a risk-based capital report.1

 In the

view of the National Association of Insurance Commissioners (NAIC),

however, the true impact of the risk-based capital system occurs when the

Risk-Based Capital for Insurers Model Act (the act), developed by NAIC, is

adopted by the states. When adopted, as it has been in 50 of 51 insurance

jurisdictions, this act gives the state’s chief insurance regulator the

authority to act on the results generated by the risk-based capital formula.2

When the act is adopted by a state, all insurers in that state become

subject to its provisions. For example, the act requires each insurer to file

a report with NAIC; the commissioner of the insurer’s domiciliary state; and

the commissioner of any state in which the insurer is licensed, if that

state’s insurance commissioner requests it in writing. In their annual

regulatory financial reports, insurers are also required to report their

Authorized Control Level Risk-Based Capital (ACLRBC), which is the total

risk-based capital an insurer needs to hold to avoid being taken into

conservatorship.3

The general approach NAIC has taken has been to estimate the expected

loss an insurer would suffer in the face of a catastrophic financial event.

The size of that expected loss represents the risk-based capital required to

deal with it. Each insurer determines the amount of risk-based capital that

it is required to set aside by multiplying its holdings of each category of

assets and/or liabilities by a factor. The factors are estimates of the

potential for a catastrophic loss to the insurer, or, in other words, an

estimate of the risk attached to that particular category of assets or

liabilities. In addition to risk-based capital, insurers are required to set

aside an Asset Valuation Reserve (AVR). The AVR is a prospective reserve

that is related to the likelihood that an asset will lose value, and its

calculation and value are closely related to the insurer’s risk-based capital.

Conceptually, the risks facing insurers are divided into four risk categories

(asset, insurance, interest rate, and all other business risks). These are

designated as C-0 through C-4 (asset risk is divided into two parts). After

the calculation of risk-based capital for each of the risk categories, the

total is adjusted for covariance. The covariance adjustment is meant to

1

All states have adopted a law requiring most insurers in their states to file an annual NAIC form

containing information on their assets, liabilities, and capital, including risk-based capital.

2

New York has adopted a similar law that applies to life insurers.

3

The material in this appendix has been largely taken from the 1997 NAIC Life Risk-Based Capital

Report Including Overview and Instructions for Companies.

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Appendix III 

Regulatory Actions and Other Provisions of

the Life Risk-Based Capital Model Act

take into account that problems in all four risk categories are not likely to

occur at the same time.

In order to calculate risk-based capital without requiring life insurers to

collect additional data on the assets and liabilities reported by life insurers

on their regulatory reporting forms, the NAIC risk-based capital formula

divided assets and liabilities already reported among the risk categories

C-0 through C-4. Table III.1 summarizes the specific items that are

assigned to each risk category.

Table III.1: Summary of the

Components of the Life Insurance

Risk-Based Capital Formula and Their

Relationship to Risk Categories C-0

Through C-4

Risk Factors Items included

C-0

Asset risk - affiliated amounts

• Affiliated U.S. Property and Casualty Insurers

• Affiliated U.S. Life Insurers

• Affiliated Alien Life Insurers

• Investment Subsidiaries

• Investments in Upstream Affiliates (Parents)

• Off-balance Sheet Items

C-1

Asset risk - All Other

• Bonds

• Mortgages 

• Preferred Stock and Common Stock

• Separate Accounts

• Real Estate 

• Other Long-term Assets

• Concentration Factor

• Miscellaneous

• Reinsurance

C-2

Insurance Risk

• Individual and Industrial Life Insurance

• Group and Credit Life Insurance

• Health Insurance Claim Reserves

• Premium Stabilization Reserve Credit

C-3

Interest Rate Risk

• Low-Risk Category

• Medium-Risk Category

• High-Risk Category

C-4

Business Risk

• Based on guaranty fund assessments

Source: 1997 NAIC Life Risk-Based Capital Report Including Overview and Instructions for

Companies.

C-0: Asset Risk From

Affiliated Investments

The insurance subsidiaries risk (C-0) is essentially the risk-based capital

requirement of the downstream insurance subsidiaries owned by an

insurer. The risk-based capital requirement is the best estimate of the

overall risk of an insurance company, so NAIC believes it is appropriate to

require the parent to hold an equivalent amount of risk-based capital to

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Regulatory Actions and Other Provisions of

the Life Risk-Based Capital Model Act

protect against financial downturns of the affiliate. The C-0 component is

assumed to be wholly correlated with the parent’s total risk-based capital

on the assumption that financial problems in the parent will have a

contagion effect in the subsidiaries, and vice versa.

The risk-based capital for affiliated investments of U.S. life insurance

companies, property and casualty insurance companies, and investment

subsidiaries is calculated on a “see through” basis (multiplied by the

percent of ownership). This requires “looking through” all holding and

subsidiary companies to the lowest level of ownership for each affiliated

stock investment. The advantage of this approach is that where there is a

choice of whether to have ownership of an asset in either the parent or the

subsidiary, risk-based capital results are unlikely to affect that decision.

Some insurance affiliates are themselves subject to risk-based capital

requirements. Others are not. The risk-based capital requirement of the

reporting life insurer for those insurance subsidiaries that are subject to a

risk-based capital requirement is based on the Total Risk-Based Capital

After Covariance of the subsidiary, prorated for the percent of ownership

of that subsidiary. For affiliates that are not subject to insurance

risk-based capital requirements, the risk factors vary from 30 to

100 percent, prorated by the percentage of the reporting company’s

holdings.

Off-balance sheet items are included in C-0, even though they may or may

not have any affiliate relationship with the life insurer. The potential for

risk exists in off-balance sheet items. For items other than derivative

instruments, a factor of 1 percent was chosen on a judgment basis. The

1-percent factor will differentiate between the companies that have small

and large exposures to this risk. Since there is no firm actuarial basis for

assigning the 1-percent factor to these risks, off-balance sheet items are

included in the sensitivity analysis (described later) using a factor of

3 percent; and leases are added as an additional off-balance sheet item.

C-1: Asset Risks for

All Nonaffiliated

Assets

Life insurance companies hold several types of assets. The major

categories are bonds, stocks, mortgages, and real estate. They also hold

other assets that do not fit neatly into these categories.

Bonds The bond holdings of insurers are split into seven different risk

classifications or categories based on bond quality. Class 1 bonds are

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those of the highest quality, while Class 6 bonds are those bonds that are

in or near default. The seventh bond classification is for U.S. government

securities.

Each bond classification has a different risk factor by which bond holdings

in that category are multiplied. The risk-based capital requirement for a

U.S. government security is zero because there is no default risk for those

bonds. The risk factors for other bonds range from 0.003 ($3 per $1000 of

value) for Class 1 bonds to 0.300 ($300 per $1000 of value) for high risk

bonds in Class 6. As the risk gets higher, the risk-based capital requirement

increases. In addition, there are other statutory limitations on the amount

of junk bonds that insurers are permitted to carry on their books.

There is also an adjustment, called the bond size factor, that increases the

nominal risk factors for insurers that have less diversification in their bond

portfolio, after excluding U.S. government issues and certain U.S. agency

issues. For insurers with relatively few different issuers (that is, little

diversification), the bond size factor increases the risk-based capital factor

by 2.5 times. Only a handful of insurers with at least 1,300 issuers in their

bond portfolio can use the nominal factors.

Mortgages The risk-based capital formula treatment of mortgages differs by the type

of mortgage and the mortgage status. Mortgages are generally broken

down into three main categories—farm, residential, and commercial.

These categories are also further subdivided as to whether the mortgage is

insured/guaranteed or not. The risk-based capital factors also differ for

current mortgages, those 90 days overdue, and those in the process of

foreclosure. There is also a company-specific experience adjustment to the

risk-based capital factors for farm and commercial mortgages, based on

the experience of the insurer relative to the industry as a whole.

Beginning in 1997, the risk-based capital calculation for troubled

mortgages is made on a mortgage-by-mortgage basis in order to recognize

the extent to which the statement value of each of those troubled

mortgages has already been marked to market or otherwise written down.

Unaffiliated Preferred and

Common Stocks

In contrast to banks, insurance companies are permitted to hold stocks as

investments.

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Unaffiliated Preferred Stock Experience data to develop preferred stock factors are not readily

available; however, it is believed that preferred stocks are somewhat more

likely to default than bonds, and the loss or default would be somewhat

higher than that experienced on bonds. Formula factors are equal to bond

factors plus 2 percent (but not more than 30 percent). This is consistent

with the approach adopted for preferred stock factors for AVR purposes.

Unaffiliated Common Stock The factor for unaffiliated common stock is based on studies conducted at

two large life insurance companies. Both of these studies indicated that a

30-percent factor is needed to provide capital to cover approximately

95 percent of the greatest losses in common stock value over a 2-year

period. This factor assumes capital losses are unrealized and not subject to

favorable tax treatment at the time loss in market value occurs. Two other

classes of common stock receive a different treatment. Nongovernment

money market mutual funds are more like cash than common stock;

therefore, the factor used is 0.3 percent, the same factor used for cash.

Federal Home Loan Bank stock has characteristics more like a fixed

income instrument rather than common stock. A 2.3-percent factor was

chosen.

Separate Accounts Separate accounts are investment pools held separately from all other

assets of the insurer. The primary purpose of separate accounts is to allow

the insurer to make investments exempt from the usual investment

restrictions imposed by state law. Separate accounts are authorized by

states to permit insurers to offer customers investment strategies that

would not otherwise conform to insurance regulations. Because of the

nature of separate accounts, losses cannot exceed the funds held in the

separate account and thus are insulated from the general accounts of the

insurer. The customer, rather than the insurer, is responsible for all

investment gains and losses. Separate accounts are maintained primarily

for pension funds and variable life and annuity products. Although

separate accounts represent a large segment of the aggregate assets and

liabilities of the life insurance industry, they have considerably less of a

risk-based capital requirement than other investment assets used to fund

general account obligations.

Real Estate Life insurance risk-based capital makes a distinction between

company-occupied real estate, real estate acquired by foreclosure, and

investment real estate. Furthermore, real estate may be owned directly, in

which case it is reported as “real estate,” or it may be owned through a

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partnership. Partnerships and joint ventures are referred to as “Schedule

BA” assets and are discussed separately. Like mortgage risk, the real

estate risk for real estate directly owned is calculated separately for each

property. There is a charge for the statement value of the property as well

as a charge for the amount of encumbrances.

Companies that have developed their own risk-based capital factors have

used factors ranging from 5 percent to 20 percent. One study indicated real

estate volatility is about 60 percent of common stock, suggesting a factor

in the range of 18 percent. Assuming some tax effect for losses, a factor of

10 percent was chosen. Foreclosed real estate would carry a somewhat

higher risk at 15 percent. The foreclosed real estate factor is lower than

the factor for mortgages in foreclosure (20 percent) because mortgages in

foreclosure have already been written down when they are moved to the

foreclosed real estate category. Because a surplus reduction has already

been taken, the factor is lower.

Other Long-Term Assets Schedule BA on the life insurers’ regulatory financial report (known as the

Annual Statement) includes those long-term assets that, because of their

peculiar nature, are not included elsewhere on the report. These include

assets owned by the insurer through partnership arrangements as well as

other unusual assets. In recognition of the diverse nature of Schedule BA

assets, the risk-based capital is calculated by assigning different risk

factors according to the different type of assets. Assets with underlying

characteristics of bonds and preferred stocks rated by the NAIC Securities

Valuation Office have different factors according to the Office’s assigned

classification. Unrated fixed-income securities are treated the same as

Other Schedule BA Assets and assessed a 30-percent charge. Rated surplus

and capital notes have the same factors applied as Schedule BA assets

with the characteristics of preferred stock. Schedule BA real estate also

has a 15-percent factor because of the additional risks inherent in owning

real estate through a partnership. The factors used for Schedule BA

mortgages are the same as for commercial mortgages. Where it is not

possible to determine the risk-based capital classification of an asset

reported on Schedule BA, a 30-percent factor is applied.

Asset Concentration

Factor

The purpose of the concentration factor is to reflect the additional risk of

high concentrations in single exposures (represented by an individual

issuer of a security or a holder of a mortgage, etc.). The concentration

factor doubles the risk-based capital factor (with a maximum of

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30 percent) of the 10 largest asset exposures, excluding various low-risk

categories or categories that already have a 30-percent factor. Because the

risk-based capital of the assets included in the concentration factor has

already been counted once in the basic formula, this factor itself serves

only to add in the additional risk-based capital required. The calculation is

completed on a consolidated basis; however, the concentration factor is

reduced by amounts already included in the concentration factors of

subsidiaries to avoid double counting.

Miscellaneous Assets:

Cash, Short-Term

Investments, and

Derivatives

The factor for cash is 0.3 percent. It is recognized that there is a small risk

related to possible insolvency of the bank where cash deposits are held.

The 0.3 percent, equivalent to a class 1 bond, reflects the short-term nature

of this risk.

The short-term investments to be included here are those that are not

reflected elsewhere in the formula. Commercial paper, negotiable

certificates of deposit, repurchase agreements, collateralized mortgage

obligations, mortgage participation certificates, interest only and principal

only certificates, and equipment trust certificates, should be included in

appropriate bond classifications (class 1 through class 6) and should be

excluded from short-term investments. The 0.3-percent factor is equal to

the factor for cash.

For derivative instruments, the statement value exposure net of collateral

(the balance sheet exposure) is included under miscellaneous C-1 risks.

Because collars, swaps, forwards, and futures can have statement values

that are positive, zero, or negative, the potential exposure to default by the

counterparty for these instruments cannot be measured by the statement

values and must be calculated. The factors applied to the derivative’s

off-balance sheet exposure are the same as those applied to bonds and

reflect the insurer’s exposure to loss upon default of the counterparty.

Reinsurance Insurance companies often lay off part of their risk by purchasing

reinsurance. There is a risk associated with recoverability of amounts

from reinsurers. The risk is deemed comparable to that represented by

bonds rated as risk classes 1 and 2 and is assigned a factor of 0.5 percent.

Some types of reinsurance such as reinsurance with nonauthorized

companies, reinsurance among affiliated companies, reinsurance with

funds withheld, and reinsurance involving policy loans, are subject to a

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separate surplus charge. To avoid an overstatement of risk-based capital,

the formula gives a 0.5-percent credit for these types of reinsurance.

C-2: Insurance Risk Life insurance and health insurance are often underwritten and sold by the

same companies. Each carries its own unique set of risks.

Life Insurance Life insurers establish reserves to cover expected claims costs from their

outstanding insurance-in-force. The life insurance risk-based capital

factors chosen represent the surplus needed to provide for excess claims

over expected claims, both from random fluctuations and from inaccurate

pricing, for future levels of claims. For a large number of trials, each

insured either lives or dies according to a “roll of the dice” reflecting the

probability of death. The present value of the claims generated by this

process, less expected claims, will be the amount of surplus needed under

that trial. The factors chosen under the formula produce a level of surplus

at least as much as needed in 95 percent of the trials.

The model was developed for portfolios of 10,000, 100,000, and 1 million

lives; and it was found that the surplus needs decreased with larger

portfolios, consistent with the law of large numbers.

One set of factors is applied to individual and industrial insurance-in-force

and another set for group and credit insurance.

Table III.2: Risk Factors for Life

Insurance in Force

Amount of insurance-in-force (in dollars)

Factors for

individual and

industrial

insurance

Factors for

group and

credit

insurance

First 500 million 0.150% 0.12%

Next 4,500 million 0.100% 0.10%

Next 20,000 million 0.075% 0.06%

Over 25,000 million 0.060% 0.05%

Source: GAO analysis of 1997 NAIC Life Risk-Based Capital Report Including Overview and

Instructions for Companies.

Premium Stabilization

Reserves

Premium stabilization reserves are funds held by the company in order to

stabilize the premium a group policyholder must pay from year to year.

Usually experience rating refunds are accumulated in such a reserve so

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that they can be drawn upon in the event of poor future experience. This

reduces the insurer’s risk. For group life and health insurance, 50 percent

of premium stabilization reserves held in the Annual Statement as a

liability (not as appropriated surplus) are permitted as an offset up to the

amount of risk-based capital.

Health Insurance Risk-based capital factors for health insurance are applied to medical and

disability income premiums and claim reserves with an offset for health

premium stabilization reserves.

C-3: Interest Rate Risk Interest rate risk is the risk of losses due to changes in interest rate levels.

The factors chosen represent the surplus necessary to provide for a lack of

synchronization of asset and liability cash flows.

The impact of interest rate changes will be greatest on those products for

which the guarantees are most in favor of the policyholder and for which

the policyholder is most likely to be responsive to changes in interest

rates. Therefore, the risk varies by withdrawal provision. The risk-based

capital calculation defines three risk categories: low, medium, and high.

Factors for each risk category were developed based on the assumption of

well-matched asset and liability durations. A loading of 50 percent was

then added on to represent the extra risk of less well-matched portfolios.

Companies with well-matched books may be eligible for a reduction in

their risk-based capital required for interest rate risk.

C-4: Business Risk General business risk is based on premium income and annuity

considerations. No good proxies for business risk exist in the information

usually reported by life insurers. As a result, the formula factors were

based on a company’s reported guaranty fund assessments. Guaranty

funds are the mechanism set up in the insurance industry to indemnify

policyholders in the event of an insurance company failure. In all states

except New York, the funds are post-assessment; that is, the remaining

insurance companies are assessed by the guaranty fund after a company

has failed. The assessments reflect each company’s share of the cost of

failures.

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Determining Whether

a Life Insurer Has

Adequate Risk-Based

Capital

Regulatory capital adequacy is determined by calculating a value called

the Authorized Control Level Risk-Based Capital (ACLRBC). This value is

then compared with the insurer’s Total Adjusted Capital (TAC) by

computing the ratio (that is, ACLRBC divided by TAC). The value of this ratio

determines the regulatory actions to be taken by regulators that are in

states that have adopted the Risk-Based Capital for Insurers Model Act.

Calculating the Authorized

Control Level Risk-Based

Capital

The purpose of the life insurance risk-based capital formula is to estimate

the risk-based capital levels required to manage losses that can result from

a series of catastrophic financial events. These are the C-0 through C-4

calculations described above. However, chances are remote that all such

losses will occur simultaneously. The covariance adjustment states that

the combined effect of the C-1, C-2, and C-3 risks are not equal to their

sum but are equal to the square root calculation described below. It is

statistically assumed that the C-1 risk and C-3 risk are correlated, and the

C-2 risk is independent of both. This assumption provides what is

considered by NAIC to be a reasonable approximation of the capital

requirements needed at any particular level of risks.

ACLRBC is 50 percent of the sum of the C-0 plus the C-4 risk-based capital

and the square root of the sum of the C-1 and C-3 risk-based capital

squared and the C-2 risk-based capital squared.

Total Adjusted Capital In order to calculate their TAC capital for risk-based capital purposes,

insurers are allowed to make several adjustments to their reported total

capital. These include adding to total capital their AVR, part of the

provision for future dividends, and an adjustment to avoid double counting

for some subsidiary amounts.

Risk-Based Capital Level of

Action

Under the Life Risk-Based Capital Model Act, a comparison of the ACLRBC

with the level of TAC determines the level of regulatory attention, if any,

applicable to the company.

Under the act, the following levels of risk-based capital require specific

regulatory actions as detailed in Table III.3:

• No Action

• Company Action Level

• Regulatory Action Level

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• Authorized Control Level

• Mandatory Control Level

Table III.3: Regulatory Actions

Triggered by Different Total Adjusted

Capital Levels Under the Risk-Based

Capital for Insurers Model Act

Action level or indicator Total adjusted capital level

No Actiona 2 times ACLRBC or more

Company Action Levelb 1.5 to 2 times ACLRBC

Regulatory Action Levelc 1 to 1.5 times ACLRBC

Authorized Control Leveld 0.7 to 1 times ACLRBC

Mandatory Control Levele 0.7 times ACLRBC or less

aThe No Action level means, basically, that the insurer has passed the risk-based capital test and

can go on about its business.

bIn a Company Action Level event, the company is required to prepare a detailed business plan,

including a discussion of corrective action to eliminate the event. The plan is to be submitted to

the insurance commissioner of the state of domicile for approval. If the commissioner approves

the plan, the state insurance department is to monitor the company’s progress until its TAC

exceeds its Company Action Level. If the company cannot or will not prepare a recovery plan that

is satisfactory to the commissioner, or the company fails to adhere to its plan, under some

circumstances it will drop into the Regulatory Action Level.

cAt the Regulatory Action Level, the commissioner of the state of domicile is to (1) require the

company to submit a plan for corrective action or, if applicable, a revised plan; (2) perform such

examinations as are deemed necessary; and (3) issue a corrective order.

dAt ACLRBC, the commissioner of the state of domicile is authorized to take all regulatory action

considered necessary to protect the best interest of the policyholders and creditors of the insurer.

eIn a Mandatory Control Level event, the commissioner of the state of domicile is authorized to

take the necessary steps to place the company under regulatory control (i.e., rehabilitation or

liquidation). The commissioner may delay action up to 90 days if there is a reasonable

expectation that the Mandatory Control Level event may be eliminated.

Source: GAO analysis of 1997 NAIC Life Risk-Based Capital Report Including Overview and

Instructions for Companies.

Trend Test Companies whose TAC is between 2.0 and 2.5 times the ACLRBC are subject

to a trend test. The trend test calculates the greater of the decrease in the

margin between the current year and the prior year and the average of the

past 3 years. It assumes that the decrease could occur again in the coming

year. Any company with a trend below 1.9 times ACLRBC would trigger

Company Action Level risk-based capital regulatory action.

Sensitivity Tests The sensitivity tests provide a “what if” scenario to the calculation of

risk-based capital by recalculating ACLRBC or TAC using a specified

alternative for a particular factor in the formula.

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The amounts reported in the sensitivity tests are an actual recalculation of

ACLRBC and TAC. If a company does not have any of the assets or liabilities

specified by the sensitivity tests, including affiliates, noncontrolled assets,

guarantees for affiliates, contingent liabilities, long-term leases, and

interest swaps, the amounts reported after the tests are the same ACLRBC

and TAC as originally calculated.

Other Provisions of

the Model Act

The Model Act extends confidentiality to any information contained in a

company’s risk-based capital report, except that information the company

publishes in a publicly available annual statement. The act also prohibits

any person or organization engaged in the insurance business from

publishing a company’s risk-based capital figures. However, a company

may publish its correct level if a materially misleading level has been

published by others. According to NAIC, the purpose of this provision is to

prevent insurers or their agents and brokers from using risk-based capital

levels for marketing purposes. In NAIC’s view, risk-based capital levels

were not designed for marketing purposes, and their publication could be

misleading to consumers.4

 Moreover, NAIC states that (1) risk-based capital

levels determined under its formula are still minimum capital levels,

(2) the ratio indicates whether or not a company is subject to regulatory

action because it fell below the minimum standard, and (3) any attempt to

rank companies by their levels indicates a lack of understanding of the

risk-based capital system.

4

A number of state insurance department representatives and insurance company officials told us that

risk-based capital figures have been used as a “beauty contest” for marketing and competition

purposes.

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Risk-Adjusted Return on Capital

To maximize value for stockholders, firms try to maximize returns for a

given risk or minimize risk for a given return. To evaluate whether they are

maximizing stockholder value, firms develop ratios of returns to risks.

These ratios permit them to simultaneously consider how changes in risks

and returns are related. In general, if the ratio of return to risk is

increasing, stockholder value has increased. The general risk management

principles discussed in chapter 3 require firms to develop measures of

risk-adjusted returns, whenever possible. In the large firms that we

interviewed, measures of risk-adjusted returns have been developed most

commonly for market and credit risks.

Among the firms we visited, this tracking, measuring, and managing is

often done via Risk-Adjusted Return on Capital (RAROC), a term first used

by Bankers Trust. RAROC permits a firm to evaluate the return, risk, and

capital trade-off. Each line of business or instrument in a fully developed

RAROC system can be evaluated to determine if its returns are high enough

to warrant the risks undertaken and if the capital allocated to cover the

risks is adequate.

In RAROC, risk is measured as a variability in returns and is based on

probability or frequency distributions of returns observed in historical

data. By putting all risks in terms of loss distributions and allocating

capital according to profit variability, risk is aggregated and priced all in

one exercise. That is, the trade-off between risk and return can be done for

the whole firm at once across all risks. The RAROC approach is based on

economic theory and is consistent with statistical models, such as VAR,

Monte Carlo, and the portfolio model approach to credit risk.

According to our interviews and our review of relevant literature, RAROC or

equivalent processes are in use or are under development in large banks,

securities firms, and life insurance companies. RAROC is used to help firm

management determine the capital required to protect the firm against

most, but not all, potential losses. Firm representatives stressed to us that

in practice, they used RAROC along with judgment for their decisions on

firmwide capital needs.

In conjunction with the determination of the amount of capital needed to

protect the firm, RAROC generates a determination of returns from each

investment for the firm. The firm’s return depends on the returns from

each particular investment and how the investment’s return correlates

with returns from other investments or products. That is, a RAROC system

takes into account the consequences of diversifying a firm’s investments

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Risk-Adjusted Return on Capital

so that losses and gains on a diversified portfolio of investments can

cancel each other out. RAROC also takes into account how hedges affect

returns and risks.

The basic steps in a RAROC system are:

1. The firm analyzes each activity and product in the firm and determines

the basic risk categories embedded in the investment or product. This

unbundling of risks in each product permits the firm to analyze the level of

risks in each risk category on a firmwide basis.

2. The firm quantifies firmwide the amount of risk and return in each basic

risk category and for each product. The firm measures each risk category

and product using standardized measures of return; and, when possible,

the returns on risk measures are based on widely traded instruments with

readily available market prices. When such prices are not available, firms

can use internal models. The measurement is based on weekly or daily

measures of returns and risks. This time period is consistent with

day-to-day use of VAR modeling—setting limits and allocating capital to

current risks in the trading book.

3. On the basis of the risk measures determined in step two, the firm

determines the risk levels for all risk categories consistent with its

planning horizon. (For the assets that are commonly traded, the planning

period may be less than 1 year.)

4. The firm computes the amount of capital required for each risk category

to reduce the probability of a loss to the agreed upon capital limit. For

example, the amount of capital required might be the amount needed to

protect a bank against losses 99 percent of the time over the next year.

Given that capital is to be set aside to cover risks at a 1 percent confidence

interval, the ratio of returns to such risks can be used as a measure of

relative profitability, hence the name risk-adjusted return on capital.

RAROC has several uses in addition to the basic use of determining the

amount of capital to set aside to cover risk. It can also be used to

• evaluate the extent to which a firm has diversified its risks so that losses

on one product are not positively correlated over time with losses on

another product;

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Risk-Adjusted Return on Capital

• determine, on a risk-adjusted basis, the performance of different products

or lines of business;

• allocate resources in order to earn a satisfactory return for shareholders;

• evaluate the accuracy of product pricing in order to affect risks, return,

and capital; and

• help determine employee compensation and rewards on the basis of the

risk-adjusted returns generated.

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Financial Firms Inteviewed by GAO

Bank Holding Companies BankAmerica Corporation1

Bankers Trust New York Corporation

Canadian Imperial Bank of Commerce

The Chase Manhattan Corporation

Citicorp2

First Chicago NBD Corporation3

Securities/Futures Firms ED&F Man International, Inc.

Goldman, Sachs & Co.

Lehman Brothers, Inc.

Merrill Lynch & Co., Inc.

Morgan Stanley & Co., Inc.4

Salomon Brothers, Inc.5

Insurance Companies Hartford Life Insurance Companies

Lincoln-National Corporation

The Prudential Insurance Company of America

Swiss Re Financial Products Corporation

1

In 1998, BankAmerica Corp. and NationsBank Corp. announced plans to merge and to create a new

holding company called BankAmerica Corp.

2

In 1998, Citicorp and Travelers Group, Inc. announced their intention to merge and form a new entity

called Citigroup.

3

In 1998, Bank One Corp. and First Chicago NBD Corp. announced their intention to merge. The new

entity is to be called Bank One Corp.

4

In 1997, Morgan Stanley Group, Inc. merged with Dean Witter Discover & Co. to form Morgan Stanley,

Dean Witter, Discover & Co. Morgan Stanley & Co., Inc. and Dean Witter Reynolds, Inc. remain as

separately registered broker-dealers.

5

In 1997, Travelers Group, Inc. bought Salomon Inc. and merged it with Smith Barney Holdings, Inc. to

create a new company called Salomon Smith Barney Holdings, Inc. Salomon Brothers, Inc. and Smith

Barney, Inc. remain as separately registered broker-dealers.

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Appendix VI 

Comments From the Office of the

Comptroller of the Currency

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

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Comments From the Office of the

Comptroller of the Currency

See comment 1.

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Comments From the Office of the

Comptroller of the Currency

Page 172 GAO/GGD-98-153 Risk-Based Capital
Appendix VI 

Comments From the Office of the

Comptroller of the Currency

The following are GAO’s comments on the Office of the Comptroller of the

Currency’s letter dated June 16, 1998.

GAO Comments 1. OCC commented that the report fails to recognize how capital regulations

change bank behavior and also how they influence overall economic

activity. In OCC’s view, to ignore these issues is to assume either that

capital regulations have no impact, or that the impact is invariant to

changes in capital regulations. Our purpose in presenting issues in capital

regulation was to discuss the potential effects of capital regulation on

behavior. It was not our purpose, however, to analyze in detail the extent

or interaction of those effects.

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Comments From the Federal Reserve Board

Page 174 GAO/GGD-98-153 Risk-Based Capital
Appendix VIII 

Comments From the Federal Deposit

Insurance Corporation

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

Now on p. 42.

See comment 1.

Now on p. 94.

Now on p. 97.

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Comments From the Federal Deposit

Insurance Corporation

Now on p. 103.

See comment 2.

Now on p. 32.

Now on p. 96.

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Comments From the Federal Deposit

Insurance Corporation

The following are GAO’s comments on the Federal Deposit Insurance

Corporation’s letter dated June 17, 1998.

GAO Comments 1. FDIC commented that the report’s focus on economic risk means that it

underemphasizes FDIC’s concern with bank failures. Our intent in chapters

2 and 3 was to describe the difference in the purpose of regulatory capital

as seen by financial regulators and economic capital as seen by financial

firms. We did not intend to underemphasize FDIC’s concern with bank

failures but, rather, place FDIC’s concern in the context of both other

regulators and firms themselves. In chapter 4, we explicitly point out that

regulators have different views from firms and this, in part, reflects

concerns about protecting the bank insurance fund.

2. FDIC commented that the report notes that capital requirements are only

one method of controlling risk, but that it does not analyze the interaction

between the regulatory tools meant to mitigate risk. Our purpose in

discussing the other regulatory tools was to place capital requirements in

their context within the bank regulatory system. Our purpose was not to

evaluate capital requirements and their interaction with other regulatory

tools.

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Comments From the Securities and

Exchange Commission

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Comments From the Securities and

Exchange Commission

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Comments From the Securities and

Exchange Commission

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Comments From the Securities and

Exchange Commission

Page 181 GAO/GGD-98-153 Risk-Based Capital
Appendix IX 

Comments From the Securities and

Exchange Commission

Page 182 GAO/GGD-98-153 Risk-Based Capital
Appendix IX 

Comments From the Securities and

Exchange Commission

Page 183 GAO/GGD-98-153 Risk-Based Capital
Appendix X 

Comments From the Commodity Futures

Trading Commission

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

See comment 1

Page 184 GAO/GGD-98-153 Risk-Based Capital
Appendix X 

Comments From the Commodity Futures

Trading Commission

The following are GAO’s comments on the Commodity Futures Trading

Commission’s letter dated June 24, 1998.

GAO Comments 1. CFTC commented that the report correctly recognized its concern with

protecting both customers and the markets in one place, but that this dual

concern was not reflected elsewhere in the report. We have made this

correction throughout the report.

Page 185 GAO/GGD-98-153 Risk-Based Capital
Appendix XI 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Lawrence D. Cluff, Assistant Director

Barbara I. Keller, Project Manager

Mitchell B. Rachlis, Senior Economist

Joe E. Hunter, Senior Evaluator

John H. Treanor, Banking Advisor

Desiree W. Whipple, Communications Analyst

(233513) Page 186 GAO/GGD-98-153 Risk-Based Capital
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