Transcript IOSCO Objectioves and Principles of Securities Regulation

Caribbean Group of Securities
Regulators 10th Annual Conference
and Workshop
Risk Based Capital Adequacy
Framework for Securities Regulators
Session 1
Richard Britton
Montego Bay, Jamaica
November 2013
Scope of the first session
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Broker dealer supervision
The anomalous position of the banks
The two models for risk based regulatory capital
Licensing by function
The modified Basel approach
Constraints on withdrawal of capital
Calculating the risk based capital requirement
Objectives of supervision
• To protect client assets from insolvency of the
intermediary or appropriation by the intermediary or its
employees
• Guard against defaults and sudden disruptions to the
market, either through sudden insolvency or settlement
failure
• To ensure that intermediaries are fair and diligent in
dealing with their clients.
Tools of supervision
• Licensing standards (limiting the market place to those
with sufficient resources and qualifications)
• Imposing prudential standards (protecting against sudden
financial failure)
• Requiring high standards of internal controls and risk
management (reducing the possibility of default or misappropriation of client assets)
• Imposing business conduct rules (ensuring suitability of
advice and proper handling of client accounts)
Advantages of Risk Based
Supervision
• Enables the construction of a licensee’s Risk Profile
• promotes transparency, provides early warning signals
• encourages managements to self-evaluate their position
at regular intervals
• regulatory and supervisory resources are deployed in a
more effective and efficient manner as risk-based
supervision takes into consideration the risk profile of the
individual financial institutions.
Risks in risk-based supervision
• Greater reliance on the supervisors’ exercise of judgment;
the quality of the supervisors needs to be higher
• Reliance on a market intermediary’s internal controls and
the work of other parties such as external auditors
• The possibility that the approach could potentially become
simply another set of procedures to be followed
• Inconsistency of treatment of different firms might not
properly reflect the risks
• Regulatory overload.
• Overlap/underlap between rule-based and risk-based
supervision of a firm.
The approach of risk-based
supervision
• Identify, classify and categorize the risks to which the
licensees are exposed
• Assess the licensee’s risk management capacity in the
overall assessment of the risk
• Determine the probability and weighting of the major risks
for each licensee
Bottom line:
Continuous appraisal and adjustment of the system is
essential. This is not a “fire and forget” framework.
Preconditions
IOSCO Principles set out the powers necessary for a
regulator to conduct effective risk based supervision:
10. The regulator should have comprehensive inspection,
investigation and surveillance powers
11. The regulator should have comprehensive enforcement
powers
12. The regulatory system should ensure an effective and
credible use of inspection, investigation, surveillance
and enforcement powers and implementation of an
effective compliance program
Inspection powers (P10)
• The regulator should have the power to require the provision of information in
the ordinary course of business, in response to an inquiry or as part of a
reporting cycle, or to carry out inspections of regulated market participants’
business operations whenever it believes it necessary to ensure compliance
with relevant standards. The suspicion of a breach of law should not be
necessary to enable the regulator to conduct inspections or require
information of regulated entities.
• The regulator should be able to require the provision of all information
reasonably needed to ensure compliance with relevant standards, including
books, documents, communications, and statements.
• Where regulatory enforcement responsibilities are delegated to an SRO or a
third party, these parties should be subject to disclosure and confidentiality
requirements that are as stringent as those applicable to the regulator.
• Conflicts of interest
• Capture by the industry
Enforcement powers (P11)
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The regulator or other competent authority should be provided with comprehensive
investigative and enforcement powers including the power: to seek orders or to take
action to enforce regulatory, administrative or investigative powers; to impose
effective sanctions, or to seek them; or to initiate or refer matters to the criminal
authorities.
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The regulator or other competent authority should be able to obtain data, information,
documents, books and records and statements or testimony from any person involved
in relevant conduct or who may have information relevant to a regulatory or
enforcement inquiry/investigation.
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Where enforcement or other corrective action requires the action of more than one
regulator or other competent authority, prompt cooperation, including information
sharing between them, should be possible for investigative and enforcement
purposes.
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Specifically with regard to capital, and capital deficiencies IOSCO also requires that
the regulator should have specific authority to impose restrictions on a securities firm’s
regulated business activities and more stringent capital monitoring and/or reporting
requirements if an intermediary’s capital deteriorates or when it falls below minimum
requirements.
Effectiveness and credibilty
(P12)
In order to have an effective and credible enforcement system, it is
not sufficient for a regulator simply to have the statutory powers set
forth in the Principles. The regulator should be able to:
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Detect suspected breaches of the law in an effective and timely manner.
Gather the relevant information necessary for investigating such potential
breaches.
Be able to use such information to take action where a breach of the law is
identified.
In addition, the regulator should require a compliance system to be in
place for regulated entities aimed at detecting and deterring
securities law violations, which includes:
• Inspections using instruments and techniques which are adequate, but which
may vary from jurisdiction to jurisdiction.
• Other monitoring or surveillance techniques.
Outcomes matter
FSB report : Intensity and Effectiveness of SIFI Supervision: Recommendations
for enhanced supervision - Recommendation: Supervisory authorities should
determine whether their frameworks or risk assessment focus enough on the risk
outcomes that result from the processes which are being evaluated.
IOSCO EMC report 2009: Approaches to Market Surveillance in Emerging
Markets - Conclusions:
There is a need for regulators to re-examine the current approaches to market
surveillance in emerging markets, and to review whether the existing approaches are
effective in detecting and deterring potential market abuse, given the context of the
current market environment and the sweeping changes occurring in financial markets
globally. This requires an examination of the fundamentals of the surveillance program,
and the existing instruments and systems in support of surveillance, including having the
appropriate tools, skills and capacity, and coordination and cooperation mechanisms
between relevant authorities to enhance the surveillance capabilities.
Globalisation of financial markets reinforces the need for surveillance approaches to
stay abreast with global changes in order to meet the challenges posed. Regulators
must be able to respond quickly to market crises that have systemic implications.
Further, regulators need to remain effective supervisors in a global marketplace where
no single regulator necessarily possesses all the requisite information to regulate the
market.
Application of these powers to a
Risk Based Capital Framework
IOSCO Principle 30: There should be initial and ongoing capital and
other prudential requirements for market intermediaries that reflect the
risks that the intermediaries undertake.
• The orderly wind down requirement
• Time for the regulator to intervene effectively
• Financial resources sufficient to meet the firms business
commitments and to withstand the risks to which its business is
subject
• Risks faced by securities firms are judged by reference to the
nature and amount of the business undertaken by the firm.
• Unlicensed and off balance sheet affiliates can be a source of risk
The (sometimes) anomalous
position of the banks
• When banks conduct securities business (including with
customers) on their own balance sheets whose capital
rules and internal control requirements apply?
– MoU with the Central Bank
– Joint inspections
• How do you measure and manage group risk?
• What if the bank branches are part of foreign banks?
– Is the branch fully integrated?
– Is information sharing with the home state regulator sufficient?
– Does the home state regulator take account of the business in
your jurisdiction?
The functions of regulatory
capital
Securities markets: Investors and other securities market
participants have two expectations of broker dealers; that they will
complete transactions entered into - on their own behalf and on
their clients’ behalf - on time and in full; and that fully paid for
securities and cash held in safekeeping (free credit balances) will
be returned on demand.
Banking: the clients and counterparties of a bank have similar
expectations concerning the fulfilment by the bank of the obligations
it has entered into – repayment of deposits when they fall due and
honouring loans; in this case however the nature of the business of
banking does not lend itself to the matching of expectations and the
business model in as straightforward a way.
Required capital Basel v US
SEC’s Net Capital Rule
• Basel focuses on the permanence of capital
– Graded according to permanence: Tiers 1,2,3
• SEC focuses on its liquidity
– Available to be turned into cash at short notice
• Both have the same client protection objective, to enable
investors/depositors to be paid back rapidly
• Basel also seeks to preserve the bank as a going concern if
possible
SEC “haircuts”
• Illiquid assets are discounted
• Liquid assets (marketable securities) are marked to
market and the profits or losses taken to capital
• The current value of securities held is then subject to
haircuts which cover market risk and (implicitly) credit risk,
and interest rate risk
– Eg SEC applies a 4% haircut on a 5 year US Treasury bond;
Basel applies a Market Risk factor of 3.75% (Credit Risk is 0%)
SEC: limits to leverage
The objective is to ensure that a broker-dealer has one
dollar of liquid capital for each dollar of client liabilities. In
order to prevent excessive leverage the SEC also
requires broker dealers to compute an aggregate
indebtedness ratio.This can either limit a broker dealer’s
aggregate indebtedness to all other persons to 15 times
its net capital or require a broker dealer to maintain a
minimum level of net capital equal to 2% of its ‘customer
debit items’. In practice an early warning notification
obligation arises when net capital falls below 5% of
customer debit items making this the effective minimum.
Basel: risk weighted assets
• Basel permitted a bank to hold risk weighted assets up to 12.5
times its adjusted capital (the 8% rule)
• To prevent excessive leverage banking regulators can apply a non
risk-based percentage to all assets (eg 6%)
– Initially focussed just on Credit Risk
– All assets weighted eg 0% for AAA government bonds to 100%
for low grade corporate bonds, mortgages etc
– In 1996 the Accord was extended to cover Market Risk in the
Trading Book and eventually to Interest Rate Risk in the
Banking Book
– Positions in the trading book are marked to market (at least
daily) and profits or losses taken directly to capital
Bottom line and options
• A bank cannot comply with regulatory capital rules as
traditionally enforced by securities regulators as most of a
bank’s assets are illiquid
• What is the solution?
– Mandatory subsidiarization or,
– Exclusion of banks from the securities regulator’s capital regime
or,
– Application by the securities regulator and the central bank of
the same risk based capital rules, appropriately modified where
necessary.
Elements of the licensing
process
• Include an initial capital requirement that addresses the risks to the
applicant (and its clients and counterparties) judged by reference to
the nature and amount of the business for which it is seeking a
license.
• Include a comprehensive assessment of the applicant and all those
in a position to control or materially influence the applicant that
addresses a demonstration of appropriate knowledge, business
conduct, resources, skills, ethical attitude (including a consideration
of past conduct)
• Include an assessment of the sufficiency of internal organization
and risk management and supervisory systems in place, including
relevant written policies and procedures, which also enable ongoing
monitoring as to whether the minimum standards are still met
Licensing by function
Risk based Initial Capital Requirements
(for illustration)
Securities Activity
Initial Capital
Additional Initial Capital
required for holding client
funds and/or securities
Advising on securities
Advising and discretionary
management
$15,000
$50, 000
Not permitted
$100,000
Dealing and arranging deals as
agent
$100,000
$180,000
Any or all of the above plus
dealing as principal
$300,000
$300,000
Assessment of risk management
and internal controls
Before granting a license the regulator must be
satisfied that:
• the firm is structured appropriately and has an adequate internal
structure and controls, given the types of business in which it
engages
• senior managers understand and accept that they bear primary
responsibility for ensuring the maintenance of appropriate
standards of conduct and adherence to proper procedures by the
whole firm
• senior managers understand and accept the firm’s policies on the
assumption and level of risk
• processes are in place that seek to ensure that the applicant will be
complying with all applicable laws and regulations and which seek
to reduce the risk of legal or regulatory sanctions, financial loss or
reputational damage.
Proprietary trading - Valuing
positions – IOSCO principles
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Comprehensive, documented policies and procedures should be established for the
valuation of positions in financial instruments held by the firm.
The policies should identify the methodologies that will be used for valuing each type of
positions in financial instruments held by the firm.
Positions in financial instruments held by the firm should be consistently valued according
to the policies and procedures.
The policies and procedures should be reviewed periodically to seek to ensure their
continued appropriateness.
The Board of the firm should seek to ensure that an appropriately high level of
independence is brought to bear in the application of the policies and procedures and
whenever they are reviewed.
The policies and procedures should seek to ensure that an appropriate level of
independent review is undertaken of each individual valuation and in particular of any
valuation that is influenced by the trader.
The policies and procedures should describe the process for handling and documenting
price overrides, including the review of price overrides by the independent person.
The Board of the firm should conduct initial and periodic due diligence on the
independence of the valuation process.
Investment Advisors
Investment Advisors
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A grey area to define and police, with some advisors subject to supervision to
some extent at least, and others who manage to organise their business so as to
be outside the perimeter of regulation. IOSCO is somewhat ambiguous on the
licensing requirements.
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n regulating the activities of investment advisers, the regulator may use the
approach to other licensees such as broker dealers or may use a disclosurebased regime designed to permit potential advisory clients to make an informed
choice of advisers. The regulator’s decision may be based on the precise nature
of the securities business performed by the investment adviser
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Investment advisers that deal on behalf of customers or that are permitted to
have custody of client assets should be licensed.
Proposal for a Risk Based
Capital Rule (the Basel model)
Constituents of Capital
– 3 tiers….
• Tier 1 (permanent reserves)
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Ordinary shares - issued and fully paid
Preference shares - perpetual non-cumulative issued and fully paid
Share premium - ordinary and preference shares
Retained earnings (accumulated deficit) - brought forward
Current year’s profit (loss)
Other eligible reserves as approved by the SCB
Less
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Goodwill
Accumulated losses for previous years
Start-up expenses
Other intangible assets
…..Constituents of Capital
– 3 tiers…..
• Tier 2
– Preference shares - perpetual cumulative issued and fully paid
– Preference shares – non perpetual (original term >5 years) issued and fully
paid
– Share premium on preference shares
– Subordinated debt with a maturity over 5 years
– General provisions for loss on assets up to a maximum of 1.25% of a
registrants Risk Weighted Assets
– Capital reserve
– Revaluation reserve (including real property)
…..Constituents of Capital
– 3 tiers
• Tier 3 (trading book capital) (@ national discretion)
– Subordinated debt with a maturity over 2 years;
– Minority Interests (in short term subordinated debt).
– Less adjustments to Tier 3 Capital - Excess Tier 3 capital (eligible Tier 3
capital is limited to 50% of Tier 1 capital)
Tier 3 capital may only be used to support market risk
(including foreign exchange risk) arising from trading book
activities. It is normal practice to treat all marketable
securities held by non-bank registrants as being held in the
trading book.
Components of Risk
Market Risk is the risk of loss arising from potential movements in
market prices of securities held by the broker dealer or in off-balance
sheet exposures such as holdings of derivatives contracts.
Operational Risk is the risk of loss resulting from inadequate or failed
internal processes, people and systems or from external events.
Credit Risk is the risk of loss due to a borrower failing to pay interest
on a loan or the principal at maturity.
Liquidity Risk is the risk that a broker dealer is unable to repay its
debts to counterparties and clients when contractually obliged to.
Leverage Risk is the risk that too little equity capital is supporting the
balance sheet thereby multiplying potential losses
Regulation and Management of
Risk – Key Terms
• Capital Adequacy Ratio (Trigger Ratio)
– All licensees are required to maintain a capital adequacy ratio as set by its regulator
– The capital adequacy ratio is calculated by dividing a licensee’s Eligible Capital by its
total Risk-Weighted Assets plus Operational Risk
– When the regulator judges it appropriate, it may impose a higher capital adequacy
ratio, for all licensees or for a single licensee
• Eligible Capital
– Initial Capital adjusted to ensure that the licensee is at all times in compliance with the
capital adequacy ratio as established by the regulator.
– Eligible capital must, at a minimum, never fall below a registrant’s initial capital as set
out in this rule.
• Target Ratio
– An early warning signal
– A breach of the target ratio may indicate that a licensee is in danger of becoming
under-capitalised.
Off-site Monitoring
• Compliance with the regulatory capital requirements
needs to be monitored on a regular basis.
– The frequency depends on the level of risk in the licensee’s business model Eg: monthly for a proprietary trader
• Reporting is only as effective as the quality of the data
you receive from the firms
– So the effectiveness of record keeping and internal controls is crucial.
– As is the judgement you as the regulator make about the operational
effectiveness of those controls
– Mis-marking of proprietary positions (either deliberately or negligently) has
led to the collapse of many broker dealers over the years
– Rule mandating notification of an actual or potential shortfall in minimum
Eligible Capital is essential. For example:
• Capital falls below 120% of Eligible Capital
• Capital has dropped 50% since the last filing
Expenditure based requirement
• Simple, low risk firms
– Investment advisors and (possibly) some agency only brokers
• Objective
– Secure an orderly wind down
– Minimise risk of employees/owners stealing from clients
• Rule
– Capital must at all times exceed (for example) 3 months
adjusted annual expenditure
Professional Indemnity
Insurance (PII) – simple firms…..
• The policy must incorporate terms which are appropriate and must
make provision for:
– Cover in respect of any claim for loss or damage for which the licensee may
be liable as a result of an action or omission by
• The licensee
• Any person acting on behalf of the licensee including employees,
appointed representatives and other agents
• Appropriate limits of indemnity per year which are, at a minimum,
the following:
– If the licensee has relevant income up to $3 million:
• $500,000 for a single claim against the firm, and $700,000 in the
aggregate
– If the licensee has relevant income of more than $3 million:
• $1 million for a single claim against the firm, and $1,500,000 in the
aggregate
…..PII - Unacceptable policy
terms….
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Conditions or exclusions which unreasonably limit the cover provided, whether by
exclusion of cover, by policy excesses or otherwise.
A policy must not treat legal defence costs cover as part of the limits of indemnity
if this reduces the cover available for any individual substantive claim.
Exclude liability which is identified or crystallized as a result of action against the
firm by its regulator.
It would not be acceptable for the policy to provide for payment by a licensee of
an excess on any claim of more than $5,000 unless the licensee has readily
realizable initial capital/own funds sufficient to make reasonable provision against
its potential liabilities .
A firm must not take out insurance unless the insurance company is authorized to
transact such insurance business in the jurisdiction.
PII – Notification requirements
A licensee must notify the regulator if:
– The necessary insurance cannot be obtained within 28 days of
the inception or renewal date
– It is cancelled
– The amount of aggregate cover is exhausted
– The licensee commences a relevant business activity for which
it has not obtained cover.
Fund managers
Generally only subject to
• expenditure based requirement
• plus incremental amount based on funds under
management
• an obligation to obtain PII
See for example the EU’s Alternative Investment
Fund Managers Directive
More complex firms
Market Risk (Position Risk
Requirement)
Protects a broker dealer from the risk of losses in on- and off-balance
sheet positions arising from potential movements in market prices.
Specific Market Risk
• Protects against an adverse movement in the price of an individual
security owing to factors related to the individual issuer.
– It is not an explicit credit risk charge but the factors are credit rating specific
General Market Risk (for bonds)
• Captures the risk of loss arising from changes in market interest
rates.
– The capital charge increases with the tenor of the security
– Low coupon bonds have a higher charge than high coupon bonds
Specific Risk Factors
Type and rating of issuer
Risk Percentage
An issue of, or fully guaranteed by, or fully collateralised by,
a Zone 1 central government or central bank.
An issue of, or fully guaranteed by, or fully collateralised by,
a Zone 2 central government or central bank, where the
Security is denominated
in the local currency of the Issuer.
0.00%
An issue of, or fully guaranteed by, or fully collateralised by,
an international development bank or a Zone 1 deposit
taker.
Where the residual term to final maturity is
6 months or less: 0.25%.
A debt item (including money market obligations) rated as
Investment Grade
Where the residual term to final maturity is
between 6 and 24 months: 1.0%.
Where the residual term to final maturity
exceeds 24 months: 1.60%.
Sovereign or other debt rated BB+ to B-
8%
Sovereign or other debt rated below B-
12%
General Market Risk Factors
Maturity high coupon
Maturity low coupon
Factor
Coupon of 3% or higher
Coupon of less than 3%
0 – 1 month
0 - 1 month
0.00%
1 – 3 months
1 – 3 months
0.20%
3 – 6 months
3 – 6 months
0.40%
6 – 12 months
6 – 12 months
0.70%
1 – 2 years
1 – 1.9 years
1.25%
2 – 3 years
1.9 – 2.8 years
1.75%
3 – 4 years
2.8 – 3.6 years
2.25%
4 – 5 years
3.6 – 4.3 years
2.75%
5 – 7 years
4.3 – 5.7 years
3.25%
7 – 10 years
5.7 – 7.3 years
3.75%
10 – 15 years
7.3 – 9.3 years
4.50%
15 – 20 years
9.3 – 10.6 years
5.25%
20+ years
10.6 – 12 years
6.00%
12 – 20 years
8.00%
20+ years
12.50%
Equity Market Risk
• Specific Risk; the sum of all long and all short positions
• General Market Risk: the net position in each equity
market (market by market)
• Specific Risk factor: 8%, unless the portfolio is both liquid
and well-diversified, in which case the charge is 4%.
• General Market Risk factor: 8%
Other sources of market risk….
• Foreign exchange risk
– The capital requirement is 10% of the total of all
positions.
• Commodity risk
– 5% of the net position in each commodity
• Options and warrants
– Complex subject
• In or out of the money
• Many different types of option
Credit Risk Requirement (CRR)
A CRR is intended to protect against the risk of loss due to a
borrower failing to pay interest on a loan or the principal at
maturity. In securities markets this can arise from the issuer
of securities held by the broker dealer failing to meet its
contractual obligations or from the failure of a counterparty
such as another broker or a client to whom the broker dealer
has extended credit.
Calculation of the Credit Risk
Requirement (CRR)……..
Zero Weighting
• Cash;
• Debt securities issued by the national government and the national
Central Bank denominated in the national currency and funded in
that currency;
• Debt securities issued by Zone A central governments and central
banks;
• Debt securities carrying explicit guarantees of Zone A central
governments and central banks
…. Calculation of the Credit Risk
Requirement (CRR)……..
20% Weighting
• Cash items in process of collection including client debit balances
• Debt securities issued by the national government denominated in
currencies other than the national currency,
• Debt securities issued by Zone A public sector corporations, as well
as claims on local authorities or other government organizations
and loans guaranteed by such entities;
• Debt securities issued by multilateral development banks and
claims guaranteed by, or collateralized by securities issued by such
banks;
• Debt securities issued by banks incorporated in Zone A countries or
guaranteed by Zone A incorporated banks;
• Debt securities issued or guaranteed by banks incorporated in
countries outside Zone A with a residual maturity of up to one year
…. Calculation of the Credit Risk
Requirement (CRR)
100% Weighting
• All other securities issued by private sector companies including
corporate bonds and shares;
• Debt securities issued by banks incorporated outside Zone A with a
residual maturity of over one year;
• Debt securities issued by Central Governments outside Zone A
(unless denominated in the national currency and funded in that
currency;
• Debt securities issued by commercial companies owned by the
public sector;
• All other assets.
Sovereign debt ratings – post
financial crisis
Does zero rating of domestic government debt and
all Zone A central government debt properly take
account of the credit risk?
• Russian domestic debt in 1998
• Greek debt in 2012
Operational Risk (OR)
The risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events.
• Eg: Natural disasters such as hurricanes or corrupt employees
stealing client securities or monies. OR includes legal risk but
excludes strategic and reputational risk.
Defined as a percentage of Average Gross Income over the last
three years.
Supported by a set of 10 Principles: Basel Principles for an
Effective Risk Management Environment
OR Principles - Role of
Supervisors
• Principle 8:The regulator should require that all licenseess,
regardless of size, have an effective framework in place to
identify, assess, monitor and control/mitigate material
operational risks as part of an overall approach to risk
management.
• Principle 9:The regulator should conduct, directly or
indirectly, regular independent evaluation of a licensees’s
policies, procedures and practices related to operational
risks. The regulator should ensure that there are
appropriate mechanisms in place which allows it to remain
apprised of developments at licensees.
Bringing the elements together
• Market Risk = capital required to cover market risk X 10
• Credit Risk = assets weighted according to their risk
• Operational Risk = capital required to cover operational
risk X 10
Regulatory capital requirement:
• Regulatory Capital (Tiers 1,2 and 3) > 10% of Market Risk
+ Credit Risk + Operational Risk
A simple example…..
EverUp Securities - licensed broker dealer
• Average annual gross income $200,000
• Securities holdings
– $10 mln par value, domestic currency government bonds, maturing in 8
years, coupon 4%, rated A+
– $5 mln par value, foreign currency government bonds, maturing in 5 years,
coupon 6 %, rated A+
– 1 mln shares in the local telecoms company, market value $5 per share, total
value $5 mln, no dividends are paid
• Client debit balances
– Client debit balances (margin loans)
$10 mln
….a simple example….
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Calculation of the PRR
Domestic currency bonds: Specific risk factor 1.6% = $160,000
General risk factor 3.75% = $375,000
Foreign currency bonds:
Specific risk factor 1.6% = $80,000
General risk factor 3.25% = $162,500
Shares
Specific risk factor 8% = $400,000
General risk factor 8%
= $400,000
Total PRR $1,577,500
PRR expressed as CRR equivalent (PRR X 10) = $15,775,000
….a simple example
• Calculation of the CRR
– Client debit balances: $10 mln @ 20% = $2 mln
– Total CRR $2.000.000
• Total Risk Weighted Assets (TRWA) ($2 mln + $15,775.000) =
$17,775,000
• Operational Risk charge (Basic indicator approach)
• OR charge (200,000 X 18%) = $36,000
• OR expressed as CRR equivalent (OR X 10) = $360,000
• TRWA + OR =
$18,135.000
• Required Capital (TRWA X 10%) = $1,813,500
Risk exists in other guises
Liquidity Risk
Excessive Leverage
Large Exposures
Affiliate (Group) Risk
Hazardous Withdrawal of Capital
Liquidity Risk
• The risk that a broker dealer is unable to repay its debts
to counterparties and clients when contractually obliged
to. Closely aligned with solvency risk.
• Arises when a broker dealer owns large securities
positions (equity, bonds) financed by short term
borrowings (eg repurchase agreements)
• How can this risk be quantified and managed?
– Qualitative and quantitative tools
Liquidity Risk Management
Monitoring Processes
• Maturity gap analysis
• Cash flow forecasting
• Rollover rates
• Scenario planning
• Stress testing
Financial Ratio analysis
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Liquid assets to total assets
Volatile liabilities to total assets
Liquid assets to volatile liabilities
Net liquid assets to total assets
Unpledged eligible collateral to total assets
A quantitative (enforceable)
metric
• Liquidity coverage ratio (LCR)
– High Quality Liquid Assets ÷ Total Net Cash Outflow
over a 30 Day Stressed Period ≥ 100%
• Issues
– What is a reasonable estimate of stressed outflows?
– Do the government and money markets have sufficient
short term paper (T-bills, CDs etc) to enable
compliance?
– What can a securities regulator do to calm a panic
situation?
Leverage Ratio
• Excessive leverage at the core of the financial
crisis
– A leverage ratio is not risk based
– Avoids judgements of risk in different assets
– Avoids faulty internal modelling by banks and broker
dealers
• A simple leverage ratio rule requires that a broker
dealer maintains a ratio of book capital to total
assets of at least (for example) 8% or 12.5 times
– US SEC limit of 15 times for registered broker dealers
– Unregulated Lehman Bros Holdings was leveraged at
40 times
Other sources of risk…..
• Large exposure risk
– Securities underwriting
– A simple a large exposure rule has two elements
• Any exposure to a single counterpart of 10% or more of a
firms regulatory capital must be notified to the regulator
• An exposure of 25% or more is prohibited
– Generally holdings of debt of the national government
are exempt
…..other sources of risk
• Affiliate (Group) Risk
– Generally relies on accurate group data
– Information exchange with other regulators
• Withdrawal of capital
– Need for constraints
– Notification of intent to withdraw
– Regulators permission must be obtained
• Eg if the withdrawal will result in capital less then 120% of
the regulatory minimum
– Power to impose temporary restrictions
End of first session
Thanks for your attention
Enjoy the coffee