Business And Industry


SEC Mulls Expanded Role for Risk Modeling

Plotting a safe and profitable course through the financial markets is never easy for those who manage large securities portfolios for investment banks, broker–dealers and mutual fund companies. But the pervasive use of derivatives and other complex investment products in today’s capital markets means that money managers now may have more need than their predecessors for advanced computerized tools to accurately measure financial risk.

There’s more to do than design such yardsticks, however. Innovators may face a daunting challenge in trying to persuade regulators that such new tools also can determine reliably whether securities firms dealing in derivatives and the like are able to protect their customers’ assets adequately and to operate in a manner that fosters orderly operation of the markets. Whatever the outcome, it will affect not only those who participate in the markets but also the auditors who follow their activities.

To encourage productive changes in this area, the Securities Industry Association (SIA) asked the SEC in September to liberalize the rule governing liquidity requirements for its member securities firms and nonmember broker–dealers in securities. Section 15c3-1 (the “net capital rule”) under the Securities Exchange Act of 1934 employs a relatively straightforward approach to set minimum liquidity levels. It prohibits both SIA members and nonmembers from taking on debt greater than 15 times their liquid capital; its purpose is to ensure that securities firms have adequate capital to protect against liquidity crises that could threaten their solvency and that of anyone dealing with them (or perhaps even set off a destructive chain reaction in the financial markets). As of late November, an SEC spokesman had told the JofA the commission was still considering the SIA’s recommendations and “would respond in due course.” An SIA spokeswoman said the association remained optimistic about the SEC’s response to its request.

I n the September 24, 1999, memorandum to SEC Chairman Arthur Levitt, SIA President Marc E. Lackritz and General Counsel Stuart J. Kaswell called the net capital rule “fundamentally outdated,” and said it “in key respects actually discourages risk-reducing strategies” by encouraging uneconomic decisions that “increase risk exposures in order to reduce capital charges.” Pointing to technology’s effect on the markets, they argued for the use of “new regulatory tools that more effectively align capital requirements with economic risks.” They also proposed short- and long-term steps to address those deficiencies.

In the near term, the SIA requested permission to implement various proposals already under discussion with the SEC, including the capital treatment of credit-risk-mitigation strategies such as master netting agreements. The SIA also suggested reforms pertaining to the imposition of 100% capital charges, the treatment of asset-backed securities on the basis of duration rather than on stated maturity, the capital treatment of fixed-income options and related hedges, the capital treatment of broker–dealers’ use of derivatives and credit charges governed by the net capital rule.

For the long term, the SIA proposed that firms that can develop risk management models and demonstrate their capabilities, as well as the adequacy of their internal controls, should be allowed to “operate under an alternative capital rule that would give much greater recognition to the use of risk management models. This alternative would permit firms to operate under a capital regime that is strongly linked to prudent risk management.” Firms not interested in, or not ready for, this challenge, the SIA said, should be allowed to operate under a rule similar to the current one but with certain modifications that are spelled out in the SIA’s memo.

Despite the urgency of these issues, their complexity demands careful analysis—something the SEC may be ill-prepared to perform in the near future. Robert Flaum, a partner of the PricewaterhouseCoopers capital markets practice, spoke to the JofA about why this may be so. “The SEC, like all government agencies, has resource constraints. Another issue is the uncertainty surrounding the use of advanced technological tools for measuring risk.” He predicted the SEC would move cautiously until there was more evidence to consider and it could analyze the issues on a long-term basis.

Flaum also offered his view of what the SIA might be thinking. “Because capital charges under the current rule have been prohibitive, the SIA believes advanced tools would allow broker–dealers to put aside what they think is an appropriate level of capital.”

Although the SEC, according to Flaum, has great faith in the net capital rule, it also is considering alternative strategies to enable money managers to more accurately match capital reserves to economic risks. “The SEC has a very limited program in which broker–dealers that trade derivatives get to use risk-based models,” he said. “It’s called ‘broker–dealer lite.’”

“But,” Flaum noted, alluding to the SEC’s cautious stance toward such innovations, “this is relatively new territory for the SEC.” Flaum concluded that while the SEC recognizes some need for risk-based models, it may not move quickly to revamp a rule that its Division of Market Regulation believes has served the markets so well.

The text of the SIA letter to the SEC is available at www.sia.com/legal_regulatory/html/sec99-21memo.html .

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