[Federal Register Volume 62, Number 249 (Tuesday, December 30, 1997)]
[Proposed Rules]
[Pages 68011-68018]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-33400]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-39456; File No. S7-32-97]
RIN 3235-AH29


Net Capital Rule

AGENCY: Securities and Exchange Commission.

ACTION: Concept release; request for comments.

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SUMMARY: The Securities and Exchange Commission is continuing its study 
of its approach to determining net capital requirements for broker-
dealers. As part of its study, the Commission is considering the extent 
to which statistical models should be used in setting the capital 
requirements for a broker-dealer's proprietary positions. Accordingly, 
the Commission is posing a number of questions on this subject as well 
as soliciting views on other possible alternatives for establishing net 
capital requirements.

DATES: Comments must be received on or before March 30, 1998.

ADDRESSES: Interested persons should submit three copies of their 
written data, views, and opinions to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 20549. Comments also may be submitted electronically at the 
following E-mail address: <a href="/cdn-cgi/l/email-protection#5220273e377f313d3f3f373c2621122137317c353d24"><span class="__cf_email__" data-cfemail="2d5f584148004e4240404843595e6d5e484e034a425b">[email protected]</span></a>. Comment letters should 
refer to File No. S7-32-97; this file number should be included on the 
subject line if E-mail is used. All submissions will be available for 
public inspection and copying at the Commission's Public Reference 
Room, 450 Fifth Street, N.W., Washington, D.C. 20549. Electronically 
submitted comment letters will be posted on the Commission's Internet 
web site (http://www.sec.gov).


[[Page 68012]]


FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate 
Director, at 202/942-0132; Peter R. Geraghty, Assistant Director, at 
202/942-0177; Thomas K. McGowan, Special Counsel, at 202/942-4886; Marc 
J. Hertzberg, Attorney, at 202/942-0146; or Gary Gregson, Statistician, 
at 202/942-4156, Division of Market Regulation, Securities and Exchange 
Commission, 450 Fifth Street, N.W., Mail Stop 2-2, Washington, D.C. 
20549.

SUPPLEMENTARY INFORMATION:

I. Introduction

    As part of a comprehensive review of the net capital rule, Rule 
15c3-1 (17 CFR 240.15c3-1) (the ``net capital rule'' or the ``Rule''), 
the Securities and Exchange Commission (``Commission'') is publishing 
this release to solicit comment on how the net capital rule could be 
modified to incorporate modern risk management techniques as to a 
broker-dealer's proprietary positions and to reflect the continuing 
evolution of the securities markets. More specifically, the Commission 
seeks comment 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 to calculate net capital requirements.

A. The Current Net Capital Rule

    The Commission adopted the net capital rule in substantially its 
current form in 1975. The Rule requires every broker-dealer to maintain 
specified minimum levels of liquid assets, or net capital. The Rule 
requires broker-dealers to maintain sufficient liquid assets in order 
to enable those firms that fall below the minimum net capital 
requirements to liquidate in an orderly fashion. The Rule is designed 
to protect the customers of a broker-dealer from losses upon the 
broker-dealer's failure. The Rule requires different minimum levels of 
capital based upon the nature of the firm's business and whether a 
broker-dealer handles customer funds or securities.
    In calculating the capital requirement, the Rule requires a broker-
dealer to deduct from its net worth certain percentages, known as 
haircuts, of the value of the securities and commodities positions in 
the firm's portfolio. The applicable percentage haircut is designed to 
provide protection from the market risk, credit risk, and other risks 
inherent in particular positions. Discounting the value of a broker-
dealer's proprietary positions provides a capital cushion in case the 
portfolio value of the broker-dealer's positions decline.
    The Rule requires a broker-dealer to compute its haircuts by 
multiplying the market value of its securities positions by prescribed 
percentages. For example, a broker-dealer's haircut for equity 
securities is equal to 15 percent of the market value of the greater of 
the long or short equity position plus 15 percent of the market value 
of the lesser position, but only to the extent this position exceeds 25 
percent of the greater position. <SUP>1</SUP> In contrast to the 
uniform haircut for equity securities, the haircuts for several types 
of interest rate sensitive securities, such as government securities, 
are directly related to the time remaining until the particular 
security matures. The Rule uses a sliding scale of haircut percentages 
with these securities because changes in interest rates will usually 
have a greater impact on the price of securities with longer remaining 
maturities compared to those securities with shorter remaining 
maturities. For example, there is no haircut on government securities 
with less than three months remaining maturity, but there is a six 
percent haircut on government securities with 25 years or more 
remaining maturity.
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    \1\ For example, in the case where a firm has a long position of 
$100,000 in equity securities and a short position of $50,000 in 
equity securities, that firm's haircut for equity securities would 
be:
    1. Long Position: $100,000 x 15% = $15,000
    2. Short Position: $50,000--$25,000 (25% of long position) x 15% 
= $3,750
    3. Total haircut for equity securities: $15,000 + $3,750 = 
$18,750.
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    The Commission believes the Rule has worked well over the years. 
The Commission and the self-regulatory organizations (``SROs'') have 
generally been able to identify at early stages broker-dealers that are 
experiencing financial problems and to supervise self-liquidations of 
failing securities firms. This early regulatory intervention has helped 
to avoid customer losses and the need for formal proceedings under the 
Securities Investor Protection Act of 1970.

B. Prior Relevant Actions

    Since 1993, the Commission has undertaken a number of initiatives 
to better understand how securities firms manage market and credit risk 
and to evaluate whether the firms' risk management techniques could be 
incorporated into the net capital rule. This section reviews four of 
the Commission's initiatives as well as recent rules addressing capital 
requirements for banks adopted by the Board of Governors of the Federal 
Reserve System, the Office of the Comptroller of the Currency, and the 
Federal Deposit Insurance Corporation (collectively, the ``U.S. Banking 
Agencies'').
1. 1993 Concept Release
    In May 1993, the Commission began a comprehensive review of the 
Rule by issuing a concept release soliciting comment on alternative 
methods for computing haircuts on derivative financial instruments 
(``Concept Release''). <SUP>2</SUP> Although the Concept Release's 
focus was on derivative instruments, the Commission intended to 
commence a dialogue with the securities industry regarding how the Rule 
could better reflect the market and credit risks inherent in a broker-
dealer's proprietary securities portfolio. At that time, the Commission 
envisioned a multi-step revision of the net capital rule that would 
substantially change how broker-dealers calculate the market and credit 
risk haircuts arising from their proprietary positions.
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    \2\ Securities Exchange Act Rel. No. 32256 (May 4, 1993), 58 FR 
27486 (May 10, 1993).
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2. Derivatives Policy Group
    The Derivatives Policy Group (``DPG''), consisting of the six U.S. 
firms <SUP>3</SUP> most active in the over-the-counter (``OTC'') 
derivatives market, was formed at the Commission's request to address 
the public policy issues arising from the activities of unregistered 
affiliates of registered broker-dealers and registered futures 
commission merchants. In March 1995, after discussions with the 
Commission, the DPG published its Framework for Voluntary Oversight 
(``Framework'') under which the members of the DPG agreed to report 
voluntarily to the Commission on their activities in the OTC 
derivatives market. <SUP>4</SUP> The Framework provides for the use of 
proprietary statistical models to measure capital at risk due to the 
firms' OTC derivatives activities; however, the Framework was not 
intended to be used as a method for calculating minimum capital 
standards for the DPG firms.
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    \3\ The six firms in the DPG are CS First Boston, Goldman Sachs, 
Morgan Stanley, Merrill Lynch, Salomon Brothers, and Lehman 
Brothers.
    \4\ Framework For Voluntary Oversight, A Framework For Voluntary 
Oversight Of The OTC Derivatives Activities Of Securities Firm 
Affiliates To Promote Confidence And Stability In Financial Markets, 
Derivatives Policy Group (March 1995).
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    For purposes of using models to measure capital at risk, the DPG 
defines risk of loss, or ``capital at risk,'' to be ``the maximum loss 
expected to be exceeded with a probability of one percent over a two-
week holding

[[Page 68013]]

period.'' <SUP>5</SUP> The Framework covers several products, 
including: interest rate, currency, equity, and commodity swaps; OTC 
options (including caps, floors, and collars); and currency forwards 
(i.e., currency transactions of more than a two-day duration, except 
that firms may elect to include only currency transactions of 14 days 
or more of duration). The Framework provides that each firm's model 
must capture all material sources of market risk that might impact the 
value of the firm's positions, including nine specific material sources 
of risk, or core risk factors, based on interest rate shocks, changes 
in equity values, and changes in exchange rates.<SUP>6</SUP>
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    \5\ Id. at 28.
    \6\ Specifically, the core risk factors include: (1) Parallel 
yield curve shifts, (2) changes in steepness of yield curves, (3) 
parallel yield curve shifts combined with changes in steepness of 
yield curves, (4) changes in yield volatilities, (5) changes in the 
value of equity indices, (6) changes in equity index volatilities, 
(7) changes in the value of key currencies (relative to the U.S. 
dollar), (8) changes in foreign exchange rate volatilities, and (9) 
changes in swap spreads in at least the G-7 countries plus 
Switzerland.
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    Each DPG firm agreed to calculate capital at risk under two 
scenarios. Under the first scenario, each firm would independently 
determine the size of the shocks used to calculate its capital at risk. 
Under the second scenario, each firm would calculate its capital at 
risk due to certain Commission specified, hypothetical large shocks to 
the core risk factors. The purposes of preparing a second set of 
capital at risk data are to assist the Commission in comparing 
volatility among the firms' portfolios and to evaluate the usefulness 
of the firms' models in measuring market risk during times of unusual 
market stress.
    The Framework does not specify minimum correlations between 
securities that are to be used in the models. The Framework states that 
there are many generally accepted methods for estimating historical or 
market-implied volatilities and correlations and, instead of utilizing 
predetermined correlation factors, the Framework provides that hedging 
would be permitted where contracts and instruments within the category 
exhibit an ``appropriately high degree of positive price correlation.'' 
Thus, the degree to which firms would recognize positions as hedges was 
left to the individual discretion of each firm. The Framework notes, 
however, that estimates of volatility and correlation may not be 
accurate during times of market stress.
    The Framework also sets forth common audit and verification 
procedures of the technical and performance characteristics of the 
models. Under the Framework, the firms are responsible for making all 
computations necessary for purposes of assessing risk in relation to 
capital on a regular basis and to provide such computations on a 
current basis upon request. Under the Framework, the inventory pricing 
and modelling procedures of firms are to be reviewed at least annually 
by independent auditors or consultants. The independent auditors or 
consultants provide reports summarizing the results of their reviews, 
and the firms provide the audit reports to the Commission.
    Under the Framework, the DPG firms have enhanced reporting 
requirements regarding their exposure to credit risk. The information 
reported to the Commission falls primarily into two principal 
categories: credit concentration and portfolio credit quality. Credit 
concentration in the portfolio is reported by separately identifying 
the top 20 net exposures on a counterparty-by-counterparty basis. The 
credit quality of the portfolio is reported by aggregating for each 
counterparty the gross and net replacement value and net exposure of 
the firm. Credit information also is categorized by credit rating, 
industry, and geographic location.
    The Framework established risk management guidelines that provide a 
comprehensive framework for the DPG firms to implement their business 
judgments as to the appropriate scope and level of their OTC 
derivatives activities. The Framework provides that each firm's board 
of directors should adopt written guidelines addressing the scope of 
permitted activities, the acceptable levels of credit and market risk, 
and the structure and independence of the risk monitoring and risk 
management processes and related organizational checks and balances 
from the firm's trading operations. Senior management should also 
implement independent risk measuring and risk monitoring processes to 
manage risk within the guidelines established by the board of 
directors.
3. Theoretical Options Pricing Models
    In February 1997, the Commission completed an important step in its 
review of the net capital rule by amending the Rule to allow broker-
dealers to use theoretical option pricing models to determine capital 
charges for listed equity, index, and currency options, and related 
positions that hedge these options.<SUP>7</SUP> The amendment permits 
broker-dealers to use a model (other than a proprietary model) 
maintained and operated by a third-party source (``Third-Party 
Source'') and approved by a designated examining authority 
(``DEA'').<SUP>8</SUP> The Third-Party Source is required to collect 
certain information on a daily basis concerning different options 
series.<SUP>9</SUP> Using this information, the Third-Party Source 
measures the implied volatility for each option series and inputs to 
the model the resulting implied volatility for each option series. For 
each option series, the model calculates theoretical prices at 10 
equidistant valuation points using specified increases and decreases in 
the underlying instrument.
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    \7\ Securities Exchange Act Rel. No. 38248 (February 6, 1997), 
62 FR 6474 (February 12, 1997).
    \8\ Currently, the model maintained and operated by The Options 
Clearing Corporation (``OCC'') is the only approved model. OCC's 
model has been temporarily approved until September 1, 1999.
    \9\ Under the rule amendment, the Third-Party Source will 
collect the following information: (1) the dividend streams for the 
underlying securities, (2) interest rates (either the current call 
rate or the Eurodollar rate for the maturity date which approximates 
the expiration date of the option), (3) days to expiration, and (4) 
closing underlying security and option prices from various vendors.
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    After the model calculates the theoretical gain or loss valuations, 
the Third-Party Source provides the valuations to broker-dealers. 
Broker-dealers download this information into a spreadsheet from which 
the broker-dealer calculates the profit or loss for each of its 
proprietary and market-maker options positions. The greatest loss at 
any one valuation point is the haircut. This amendment to the Rule was 
a milestone because it was the first time the Commission allowed 
modelling techniques for regulatory capital purposes.
4. OTC Derivatives Dealers
    Simultaneously with this release, the Commission is proposing a new 
limited regulatory regime for OTC derivatives dealers.<SUP>10</SUP> 
Under this regime, OTC derivatives dealers could register with the 
Commission and be subject to specialized net capital requirements. The 
Commission is considering requiring OTC derivatives dealers registered 
under this framework to maintain tentative net capital of not less than 
$100 million and net capital of not less than $20 million. As part of 
this proposal, the Commission is contemplating giving OTC derivatives 
dealers the option of taking either the existing securities haircuts or 
haircuts based on statistical models. OTC derivatives dealers electing 
to use

[[Page 68014]]

models would have to calculate potential losses and specific capital 
charges for both market and credit risk. These OTC derivatives dealers 
also would have to maintain models that meet certain minimum 
qualitative and quantitative requirements that are substantially 
similar to the requirements set forth in the U.S. Banking Agencies' 
rules.
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    \10\ Securities Exchange Act Rel. No. 39454 (December 17, 1997).
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5. U.S. Banking Agencies
    In August 1996, the U.S. Banking Agencies adopted rules 
incorporating into their bank capital requirements risk-based capital 
standards for market risk that cover debt and equity positions in the 
trading accounts of certain banks and bank holding companies and 
foreign exchange and commodity positions wherever held by the 
institutions. The U.S. Banking Agencies' rules were designed to 
implement the Basle Committee on Banking Supervision's (``Basle 
Committee'') <SUP>11</SUP> agreement on a model based approach to cover 
market risk. These rules apply to any bank or bank holding company 
whose trading activity equals ten percent or more of its total assets, 
or whose trading activity equals $1 billion or more. The U.S. Banking 
Agencies' final rules became effective January 1, 1997 and compliance 
will be mandatory by January 1, 1998. Institutions that do not meet 
these minimum securities trading thresholds will not be subject to 
market risk capital requirements.
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    \11\ The Governors of the G-10 countries established the Basle 
Committee on Banking Supervision in 1974 to provide a forum for 
ongoing cooperation among member countries on banking supervisory 
matters.
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    The U.S. Banking Agencies' rule amendments require affected banks 
or bank holding companies to adjust their risk-based capital ratio to 
reflect market risk by taking into account the general market risk and 
specific risk of debt and equity positions in their trading 
accounts.<SUP>12</SUP> These institutions also must take into account 
the general market risk associated with their foreign exchange and 
commodity positions, wherever located. The capital charge for market 
risk must be calculated by using the institution's own internal model.
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    \12\ The Banking Agencies defined general market risk as changes 
in the market value of on-balance sheet assets and liabilities and 
off-balance sheet items resulting from broad market movements, such 
as changes in the general level of interest rates, equity prices, 
foreign exchange rates, and commodity prices. Specific risk is 
defined by the Banking Agencies as changes in the market value of 
individual positions due to factors other than broad market 
movements and includes such risks as the credit risk of an issuer.
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II. Alternatives to the Current Financial Responsibility Regime

    The Commission is soliciting comment on possible alternative 
methods for calculating credit and market risk capital requirements for 
broker-dealers. This release will help the Commission evaluate 
different ways the net capital rule could be modified to accommodate 
changes in the securities business since the current uniform net 
capital rule was adopted in 1975, with a particular emphasis on 
incorporating modern risk management techniques. In this regard, the 
Commission believes it can modernize the Rule by either amending the 
current haircut percentages or by allowing certain broker-dealers to 
use a model-based system to calculate appropriate capital charges for 
market risk. This section discusses each of the alternative structures 
and lists relevant questions.

A. Modify Current Haircut Approach

    As discussed above, the Rule requires a broker-dealer to deduct 
from its net worth certain fixed percentages, or haircuts, of the value 
of its securities positions. The present prescriptive haircut 
methodology has several advantages. It requires an amount of capital 
which will be sufficient as a provision against losses, even for 
unusual events. It is an objective, although conservative, measurement 
of risk in positions that can act as a tool to compare firms against 
one another. Moreover, the current methodology enables examiners to 
determine readily whether a firm is properly calculating haircuts. The 
examiner can review either the entire net capital calculation or just 
material portions of the firm's proprietary positions.
    However, there are some weaknesses associated with determining 
capital charges based on 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. Accordingly, 
the net capital rule recognizes only certain specified hedging 
activities, and the Rule does not account for historical correlations 
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.
    To eliminate weaknesses in the current haircut structure, the 
Commission could modernize the Rule by maintaining the current 
methodology but changing the haircut percentages and recognizing 
additional offsetting positions. For example, the proposing release 
issued simultaneously with this concept release proposes amendments to 
the Rule that would treat haircuts on certain interest rate products as 
being part of a single portfolio, similar to the standard approach in 
the Basle Committee's Capital Accord.<SUP>13</SUP> As proposed, the net 
capital rule would recognize hedges among government securities, 
investment grade nonconvertible debt securities (or corporate debt 
securities), pass-through mortgage backed securities, repurchase and 
reverse repurchase agreements, money market instruments, and futures 
and forward contracts on these debt instruments. As a next step, the 
Commission could revise the current haircut percentages and develop 
methodology to account for more correlations and hedges among other 
types of securities.
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    \13\ Securities Exchange Act Rel. No. 39455 (December 17, 1997).
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    The Commission solicits comment on the following topics. It is not 
necessary, however, that comments be limited to the specific issues 
raised in this release. Commenters are encouraged to submit statements 
with respect to any aspect of the current net capital rule that may be 
useful to the Commission.

    Question 1: Should the Commission retain the current haircut 
approach but revise the current percentages? If so, which haircut 
percentages should be modified? How should these percentages be 
modified? What should be the objective basis for modified haircut 
percentages? Please provide relevant data to support your response.
    Question 2: Do the current haircut percentages adequately 
account for the market risk, credit risk, and other risks inherent 
in a particular position?
    Question 3: Do the current haircut percentages enable firms to 
reserve sufficient capital for times of market stress, including one 
day movements and movements over a period of time? Please provide 
relevant data to support your response.
    Question 4: How can haircut percentages be further adjusted to 
account for correlations between and within asset classes? Please 
provide relevant data to support your response.
    Question 5: How can the current haircut approach be modified to 
improve the treatment for specific types of securities, including 
foreign securities, collateralized mortgage obligations (``CMOs''), 
and over-the-counter options on interest-rate securities? Please 
provide relevant data to support your response.

[[Page 68015]]

    Question 6: Should the Commission include security-specific 
models, other than the option pricing models, in the Rule? If so, 
what forms should these models take and what types of minimum 
requirements should apply to the use of such models?
    Question 7: If the Commission includes other security-specific 
models in the Rule, what types of securities should be covered by 
such models (i.e., CMOs, over-the-counter options, or treasury 
securities)?

B. Model Based Approach

1. Generally
    A number of broker-dealers, primarily those with large proprietary 
securities portfolios, have indicated to the Commission that they may 
be willing to incur the expenses associated with developing and using 
statistical models to calculate haircuts on their securities 
portfolios. Under a model based net capital rule, in lieu of taking 
fixed percentage haircuts, a broker-dealer would use either an external 
or internal model as the basis for a market risk charge and take a 
separate charge, or charges, for other types of risk, such as credit 
risk and liquidity risk.
    The Commission could allow firms to calculate market risk capital 
charges according to external models for specific types of securities 
that are similar to the options pricing models allowed under Appendix A 
to the Rule. The benefit of an external model is that all firms would 
be utilizing the same model. However, the Commission could have 
difficulty finding a third party (comparable to the Options Clearing 
Corporation for listed options) that would have access to all the data 
necessary to facilitate external security-specific models for 
securities other than options.
    With respect to internal models, the Commission would need to 
prescribe certain minimum quantitative and qualitative standards that a 
firm's model would have to meet prior to that firm using its internal 
model for regulatory capital purposes. Currently, several large firms 
use value at risk (``VAR'') models as part of their risk management 
system. These firms typically utilize VAR modelling to analyze, 
control, and report the level of market risk from their trading 
activities. Generally, VAR is an estimate of the maximum potential loss 
expected over a fixed time period at a certain probability level. For 
example, a firm may use a VAR model with a ten-day holding period and a 
99 percentile criteria to calculate that its $100 million portfolio has 
a potential loss of $150,000. In other words, the firm's VAR model has 
forecasted that with this portfolio the firm may lose more than 
$150,000 during a ten-day period only once every 100 ten-day periods.
    In practice, VAR models aggregate several components of price risk 
into a single quantitative measure of the potential for loss. In 
addition, VAR is based on a number of underlying mathematical 
assumptions and firm specific inputs. For example, VAR models typically 
assume normality and that future return distributions and correlations 
can be predicted by past returns.<SUP>14</SUP>
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    \14\ The Commission recognizes that there is a wide variety of 
secondary source information discussing both the positive and 
negative aspects of VAR. See Philippe Jorion, Value at Risk: The New 
Benchmark for Controlling Market Risk (1996) (explaining how to use 
VAR to manage market risk); JP Morgan, RiskMetrics--Technical 
Document (1994) (providing a detailed description of RiskMetrics, 
which is JP Morgan's proprietary statistical model for quantifying 
market risk in fixed income and equity portfolios); Tanya Styblo 
Beder, VAR: Seductive but Dangerous, Financial Analysts Journal, 
September-October 1995, at 12 (giving an extensive analysis of the 
different results from applying three common VAR methods to three 
model portfolios); Darrell Duffie and Jun Pan, An Overview of Value 
at Risk, The Journal of Derivatives, Spring 1997, at 7 (giving a 
broad overview of VAR models); Darryll Hendricks, Evaluation of 
Value-at-Risk Models Using Historical Data, Federal Reserve Bank of 
New York Economic Policy Review, April 1996, at 39 (examining twelve 
approaches to value-at-risk modelling on portfolios that do not 
include options or other securities with non-linear pricing); and 
Robert Litterman, Hot Spots and Hedges, Goldman Sachs Risk 
Management Series (1996) (giving a detailed analysis on portfolio 
risk management, including how to identify the primary sources of 
risk and how to reduce these risks).
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    Given the increased use and acceptance of VAR as a risk management 
tool, the Commission believes that it warrants consideration as a 
method of computing net capital requirements for broker-dealers. 
However, while VAR can be used to manage market risk, broker-dealers 
that rely solely on VAR for risk management may not have a 
comprehensive risk management program. VAR models, unlike haircuts, do 
not typically account for those risks other than market risk, such as 
credit risk, liquidity risk, and operational risk. Broker-dealers that 
utilize VAR models should therefore use additional techniques to manage 
those risks.
    Further, while VAR may be useful in helping broker-dealers project 
possible daily trading losses under ``normal'' market conditions, VAR 
may not help firms measure the losses that fall outside of normal 
conditions during times of market stress. For example, VAR models may 
not capture possible steep market declines because these models 
typically measure exposure at the first percentile (or the fifth 
percentile) and steep market declines are, by definition, below the 
first percentile. In addition, the most common VAR approaches may pose 
a problem for those portfolios that utilize options or other products 
with non-linear payoffs.<SUP>15</SUP>
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    \15\ See Autoro Estrella et al., Options Positions: Risk 
Measurement and Capital Requirements, Federal Reserve Bank of New 
York Research Paper number 9415, September 1994 (evaluating 
different methods of measuring the market risk of options and 
analyzing the capital treatment of the market and credit risk of 
options).
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    The purpose of the Commission's net capital rule is to protect 
markets from broker-dealer failures and to enable those firms that fall 
below the minimum net capital requirements to liquidate in an orderly 
fashion without the need for a formal proceeding or financial 
assistance from the Securities Investor Protection Corporation. The 
Commission believes that market risk charges must adequately protect a 
broker-dealer during severe market stress, whether that stress occurs 
on only one day or over a period of several days, such as the drop in 
equity prices during the October 1987 market break or the Mexican debt 
crisis in 1994. Because VAR models do not typically reserve capital for 
severe market declines, it may be necessary to impose additional 
safeguards to account for possible losses or decreases in liquidity 
during times of stress. This may include the use of a multiplier or the 
use of stress tests that firms could apply to their portfolios. A 
multiplier could be used to account for the other risks in a firm's 
portfolio that are not captured by VAR models, such as operational, 
settlement, or legal risk. On the other hand, stress testing could 
provide a more complete picture of the portfolio's sensitivity to 
changing market conditions and a more accurate representation of 
capital needs than a simple multiplier.
    The primary advantage of incorporating models into the net capital 
rule is that a firm would be able to recognize, to a greater extent, 
the correlations and hedges in its securities portfolio and have a 
comparatively smaller capital charge for market risk. Accordingly, if 
the Rule is amended to permit models to be used to calculate market 
risk in lieu of taking the haircuts currently imposed by the rule, the 
Commission solicits comment on how the Rule may be modified to include 
separate capital requirements to cover sources of risk other than 
market risk. Other issues associated with incorporating models into the 
Rule are the need for management controls necessary to ensure that the 
firm is collecting accurate and comprehensive information on its 
proprietary positions

[[Page 68016]]

and the effectiveness of those controls to monitor the risk assumed by 
the firm.
2. Two Tiered Approach
    One way that the Commission could incorporate models into the net 
capital rule would be to have different net capital requirements based 
on certain standards (``Two Tiered Approach''). Under the Two Tiered 
Approach, broker-dealers meeting certain minimum threshold levels would 
be required to use models to determine capital compliance. For example, 
broker-dealers with net capital exceeding a certain amount and 
currently using models for in-house risk management purposes could use 
models to determine their market risk capital charge under prescribed 
circumstances. Firms with less than the prescribed level of net capital 
and those firms with net capital greater than the prescribed level but 
not using models for risk management could be required to continue to 
follow the current Rule's haircut methodology. These haircut 
percentages could either be the same as the current percentages or 
modified versions.
    A Two Tiered Approach potentially has two primary benefits. First, 
the Commission could structure a Two Tiered Approach to limit the use 
of models to those firms that currently use sophisticated models such 
as VAR, thereby not requiring other firms to incur the cost of 
implementing such models. Second, the Commission could design a Two 
Tiered Approach that establishes appropriate limits on which firms can 
utilize models to determine capital compliance.
    A potential weakness of a Two Tiered Approach is that it could 
inhibit competition between large and small firms because models may 
give large firms more flexibility in determining their net capital 
requirements. However, this advantage could be small if smaller firms 
did not have to incur the start-up and maintenance costs associated 
with models and the risk management infrastructure to support their 
use. Additionally, a Two Tiered Approach could still allow firms with 
simple portfolios to easily calculate the applicable haircuts on their 
portfolios.
3. Base Approach With Pre-Commitment Feature
    Another option for incorporating models into the Rule could be to 
combine the current haircut methodology using fixed percentage haircuts 
with a model-based approach (the ``Base Approach''). The Base Approach 
could combine the strengths of both haircuts and models and at the same 
time possibly address the weaknesses of each. The Base Approach would 
include three primary components. First, broker-dealers could be 
required to maintain a certain minimum base level of net capital for 
each of their business activities, similar to the minimum requirements 
under the current rule. For example, higher capital levels could apply 
to broker-dealers that hold customer funds and securities as opposed to 
those firms that only introduce customer accounts to clearing firms. 
Second, broker-dealers could take a fixed percentage haircut for each 
security in their portfolio. This haircut would be similar to the 
haircut requirements under the current net capital rule; however, the 
size of the haircut would be lower due to the additional charge for 
market risk obtained from the third component.
    The third component of the Base Approach could consist of a capital 
charge based on the firm's model and include a pre-commitment feature 
that could require a broker-dealer to take capital charges based on the 
realized performance of its models (``pre-commitment feature''). The 
pre-commitment feature could have two steps. First, at the start of a 
pre-determined time period (i.e., one month or one quarter), a broker-
dealer could be required to represent that its losses, as computed by 
its model, would be within certain parameters over the fixed time 
period. Second, at the conclusion of each fixed time period, the firm's 
minimum net capital level could increase by an amount equal to the 
difference between the actual portfolio gains and losses and those 
projected based on its model. These additional capital contributions 
would be required because differences between the actual results and 
those projected by the model could indicate that the firm's models may 
not be accurately assessing the risk of the firm's portfolio.
    By incorporating haircuts and models into the Base Approach, the 
inherent strengths and weaknesses of each could potentially offset each 
other. Additionally, the Base Approach may be a viable capital standard 
for firms with diverse portfolios and those that use more sophisticated 
methods of risk management. The pre-commitment feature would create 
additional incentives for broker-dealers to manage risk effectively. On 
the other hand, a Base Approach may be too complicated for firms to 
apply. In balance, however, the Base Approach could potentially provide 
firms with flexibility in developing models and control systems, 
encourage the development of accurate forecasts, and still ensure that 
firms reserve sufficient amounts of net capital.
4. Comments on the Potential Use of Models
    The Commission solicits comment on the following specific topics, 
including the appropriateness of using proprietary models generally and 
the recent initiatives of both the DPG and the U.S. Banking Agencies.
    a. Models as a means to determine broker-dealer regulatory capital.

    Question 8: Should the Commission permit the use of models to 
calculate regulatory capital for registered broker-dealers? If yes, 
please explain whether the Commission should allow firms to utilize 
internal models or whether the Commission should establish an 
external model approach similar to the treatment of options under 
Appendix A to the Rule.
    Question 9: If the Commission permits the use of internal 
models, should the models conform to certain objective criteria, or 
should they be subjective? When could the assumptions upon which 
models rest be challenged? Should internal or external auditors 
periodically review and approve the models and their applications? 
If so, how much should regulators rely on auditors' application of 
models? Could the self-regulatory organizations adequately surveil 
and examine for net capital compliance utilizing models?
    Question 10: Should the Commission impose limits on the types of 
firms that can use models? Should there be certain additional 
minimum criteria a firm must satisfy in order to use a proprietary 
model? Should firms that meet the minimum criteria for using models 
have the option of using an alternate standard approach (i.e., not 
using models) to calculate regulatory capital? If so, what should 
that approach be?
    Question 11: Is VAR an appropriate method of using models as the 
basis for calculating capital requirements for broker-dealers? The 
Commission understands there are several approaches to calculating 
VAR that are currently used by firms (e.g., Monte Carlo, variance/
covariance, and historical simulation approaches). Given the various 
methods, the Commission seeks comment on whether minimum criteria 
should be established for models used for regulatory capital 
purposes. If not, how can the Commission provide for the ability to 
compare levels of risks among firms or understand the significance 
of levels of risk reported by firms when determining their net 
capital requirements?
    Question 12: The Commission believes that any approach that uses 
models for setting regulatory capital requirements should result in 
broadly consistent results for firms with similar portfolios. Can 
consistent results for similar portfolios be obtained without the 
Commission requiring firms to use a standard model? How else can 
consistency of capital standards among firms with similar portfolios 
be achieved?
    Question 13: Some firms use different types of statistical 
models to measure risk

[[Page 68017]]

from different types of businesses, such as fixed income securities 
and foreign equities. Should the Commission permit firms to use more 
than one model to calculate regulatory capital? If yes, would the 
inefficiencies in each model get accentuated or mitigated when the 
results of the different models are aggregated?
    Question 14: Should the Commission allow the use of models 
gradually (i.e., first allow models for debt securities, then allow 
models for equity securities and other securities)?
    Question 15: What will be the costs of implementing models? How 
do the costs of implementing models compare to the current costs of 
computing net capital? At what level would it be economical for 
firms to try to use models? How do the start-up costs of 
implementing models compare to the ongoing costs of managing models 
incurred by firms that currently use models? How does the 
availability (or anticipated future development) of software 
packages and databases impact cost estimates? Will the costs of 
implementing models be a barrier to firms not currently using 
models? Please provide relevant data to support your response.
    Question 16: Will firms not currently using models be at a 
competitive disadvantage to those firms that currently use models? 
Please provide relevant data to support your response.
    Question 17: If the Commission permits the use of models, what 
additional reporting or recordkeeping requirements would the 
Commission need to impose on broker-dealers using models? Should 
firms using models have to file additional reports with the 
Commission or their DEA? Should the Commission amend its books and 
records rules to require firms using models to maintain certain 
books and records that they are currently not required to maintain? 
How can the Commission ensure that it has access to information 
regarding a firm's models that is not maintained by the broker-
dealer (i.e., information maintained at an unregistered entity)? 
What measure could the Commission require to ensure broker-dealers 
would not be able to modify the model (or data inputs) to avoid 
falling out of net capital compliance? Should the Commission require 
models to be stored with third-parties subject to escrow 
arrangements?
    Question 18: If the Commission permits the use of models, should 
firms using models be subject to modified forms of Commission and 
DEA inspections? Should the models themselves be subject to review 
and approval by the Commission or DEA?

    b. Abnormal Market Conditions.

    Question 19: Because the purpose of VAR is to provide an 
estimate of losses over a short period under normal conditions, is 
it possible for VAR models to ensure an adequate capital cushion 
during unusual market stress or structural shifts in the economy 
given the nature, size, and liquidity of a broker-dealer's 
portfolio? Given the complexity of models, could an accurate and 
rapid assessment be made of a firm's true financial condition? 
Please provide relevant data to support your response.
    Question 20: Would models be more effective during times of 
severe market fluctuations if stress testing were required? Should 
the Commission specify what stress tests should be used by the 
firms? Please provide relevant data to support your response.
    Question 21: If stress testing were required, should a firm be 
required to use the same parameters when conducting stress testing 
on each of its business units (i.e., apply the same levels and 
stress the same movements in the relevant securities, markets, and 
indexes)?
    Question 22: If stress testing were required, should a firm be 
required to test its models based on a predetermined number of 
volatile days of market movements (i.e., models would have to be 
stress tested based on the 100 most volatile days of market 
movements during the last ten years)?
    Question 23: Should the results of stress testing impact the 
calculation of a firm's capital requirements (i.e., through the use 
of some type of multiplication factor)? Please provide relevant data 
to support your response.
    Question 24: Does the use of a minimum multiplier, as endorsed 
in the Basle Standard and by the U.S. Banking Agencies, adequately 
address risks arising from severe market movements? Please provide 
relevant data to support your response.
    Question 25: Should back-testing (i.e., ex post comparisons 
between model results and actual performance) be required and, if 
so, to what extent? Should back-testing results be used to determine 
a multiplier for minimum capital amounts? Could back-testing results 
be used to raise minimum capital levels for the firms?

    c. Qualitative and Quantitative Criteria for Models.

    Question 26: Will setting minimum qualitative and quantitative 
criteria prevent a firm from adjusting its model to encompass 
changing market conditions, the firm's structure, or the firm's 
business lines?
    Question 27: Two important components of models are the length 
of time over which market risk is to be measured and the confidence 
level at which market risk is measured. The definition of ``capital 
at risk'' as used in the DPG Framework is the maximum loss expected 
to be exceeded with a probability of one percent over a two-week 
period. Is this definition appropriate for regulatory capital 
purposes?
    Question 28: What should be the minimum criteria for models, 
including pricing accuracy, correlations, netting factors, and 
observation periods? Please provide relevant data to support your 
response.
    Question 29: Are the minimum standards for the use of models, 
the separate calculation of capital at risk due to shocks to the 
core risk factors, and the audit requirements used in the DPG 
Framework appropriate? Please provide relevant data to support your 
response.
    Question 30: VAR models typically assume normality and that 
future return distributions and correlations will behave similar to 
the way they behaved in the past. For these reasons, the Commission 
needs to ensure that VAR models can withstand steep market declines. 
Other than by specifying minimum qualitative and quantitative 
criteria, how can regulators assure themselves that the proprietary 
models used by the firms are adequate for capital purposes?
    Question 31: Should the Commission require that broker-dealers 
utilizing models manage these models from a risk management division 
that is separate from the firm's business divisions?
    Question 32: Should the Commission require that broker-dealers 
utilizing models use the same model for both computing net capital 
and internal risk management purposes?
    Question 33: Currently, firms utilize a wide variety of risk 
management techniques. Should the Commission mandate specific 
minimum risk management standards for firms that wish to use models?
    Question 34: Should the Commission require that firms using 
models manage risk on either a firm-wide, legal entity, or business 
basis?

    d. Additional Risks.

    Question 35: Usually, VAR models do not handle options products 
well because the returns on an options portfolio are not typically 
normally distributed. How should the non-linear nature of options be 
adequately addressed? For firms with substantial options positions, 
is a standard approach (similar to the Commission's amendments to 
Appendix A of the net capital rule) more appropriate? Is the 
approach set forth in the Commission's recent amendments to Appendix 
A a viable alternative?
    Question 36: Models typically measure losses by assuming that 
assets can be sold at current market prices. However, if a firm has 
a portfolio which includes illiquid assets, highly customized 
structured products (including, for example, some CMOs), or aged 
items, the Commission is particularly concerned that models may 
underestimate the true losses since these assets may have to be sold 
at a discount. Given the importance of liquidity risk, the 
Commission solicits specific comment with respect to how this risk 
should be addressed if models are permitted for regulatory purposes.
    Question 37: Is it possible to include a credit risk analysis in 
a model based methodology? Please provide relevant data to support 
your response.
    Question 38: As mentioned above, models may not properly account 
for additional risks, including credit risk, liquidity risk, 
operational risk, settlement risk, and legal risk. How should these 
additional risks be treated? Can the Rule be modified to include 
separate capital requirements to cover these sources of risk? Please 
provide relevant data to support your response.
    Question 39: Is there an alternative to using a multiplier to 
account for operational risk, legal risk, and other risks that are 
difficult to quantify? Is the use of insurance to cover these risks 
a viable option? Please provide relevant data to support your 
response.
    Question 40: In order for a firm to calculate VAR effectively, 
data must be aggregated from all its departments worldwide. Also, 
there is often incompatibility of trading and back-office accounting 
computer systems that operate from different regions of the world.

[[Page 68018]]

How can this problem of integration be adequately addressed?

    e. OTC Derivatives Dealer.

    Question 41: Should the Commission amend the Rule so that all 
broker-dealers are eligible to use the methodology for calculating 
market and credit risk as in proposed Appendix F to the Rule?
    Question 42: What minimum capital requirements should the 
Commission require a broker-dealer to meet to be eligible to use 
proposed Appendix F? Should the criteria be based on tentative net 
capital, net capital, or both? Are the $100 million tentative net 
capital and $20 million net capital requirements appropriate?
    Question 43: Assuming that the Commission were to allow all 
broker-dealers to utilize Proposed Appendix F, what sections in 
Proposed Appendix F need to be modified for all broker-dealers? Are 
the market risk and credit risk sections in Proposed Appendix F 
appropriate for all broker-dealers? Are the qualitative and 
quantitative requirements for VAR models in Proposed Appendix F 
appropriate to VAR models used by non-OTC derivatives dealers?

    f. Two Tiered Approach.

    Question 44: Is a Two Tiered Approach a viable alternative to 
the current net capital rule? If so, what standards should the 
Commission utilize to determine which broker-dealers are required to 
utilize statistical models? Should the tier limits be based on 
capital, amount of customer business, level of proprietary trading, 
or some other factor(s)? Should these minimum net capital amounts be 
fixed dollar amounts or be based on financial ratios such as 
aggregate indebtedness or aggregate debit items as in the current 
rule? Please provide relevant data to support your response.
    Question 45: Should the current haircut percentages be 
maintained? If not, what modifications should be made to the current 
haircut percentages? Please provide relevant data to support your 
response.
    Question 46: What will be the impact on competition among firms 
in different tiers? In this regard, the Commission seeks comment on 
the effects of creating a two-tiered system from broker-dealers that 
do not currently use models in their risk management system and from 
broker-dealers that currently use models for risk management 
purposes but either lack sufficient capital or sufficiently diverse 
securities portfolios to use models for net capital purposes.

    g. Base Approach with Pre-Commitment Feature.

    Question 47: Is the Base Approach a viable alternative to the 
current net capital rule?
    Question 48: Should the Base Approach only apply to firms that 
meet certain standards? If so, what are the appropriate standards?
    Question 49: What minimum capital requirements should the 
Commission establish for certain broker-dealer activities? Should 
these minimum net capital amounts be fixed dollar amounts or based 
on financial ratios such as aggregate indebtedness or aggregate 
debit items as in the current rule? Should the current minimum 
levels be retained?
    Question 50: What modifications should the Commission make to 
the current haircut percentages? Please provide relevant data to 
support your response.
    Question 51: What should be the parameters for the pre-
commitment feature? Should firms be penalized for differences 
between actual results and the results as projected by VAR models? 
If so, what criteria should be used to determine the additional 
capital requirements for these differences?

III. Summary of Requests for Comment

    Following receipt and review of comments, the Commission will 
determine whether rulemaking or other action is appropriate. Commenters 
are invited to discuss the broad range of concepts and approaches 
described in this release concerning the Commission's regulation of 
broker-dealers' net capital requirements. In addition to responding to 
the specific questions presented in this release, the Commission 
encourages commenters to provide any information to supplement the 
information and assumptions contained herein regarding the current net 
capital rule, VAR models, and the other suggested alternatives. The 
Commission also invites commenters to provide views and data as to the 
costs and benefits associated with the possible changes discussed above 
in comparison to the costs and benefits of the current net capital 
rule. In order for the Commission to assess the impact of changes to 
the Rule, comment is solicited, without limitation, from investors, 
broker-dealers, SROs, and other persons involved in the securities 
markets.

    Dated: December 17, 1997.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-33400 Filed 12-29-97; 8:45 am]
BILLING CODE 8010-01-P


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