[Federal Register Volume 68, Number 215 (Thursday, November 6, 2003)]
[Proposed Rules]
[Pages 62872-62907]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-27306]



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Part II





Securities and Exchange Commission





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17 CFR Part 240



Alternative Net Capital Requirements for Broker-Dealers That Are Part 
of Consolidated Supervised Entities; Proposed Rule

  Federal Register / Vol. 68, No. 215 / Thursday, November 6, 2003 / 
Proposed Rules  

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-48690; File No. S7-21-03]
RIN 3235-AI96


Alternative Net Capital Requirements for Broker-Dealers That Are 
Part of Consolidated Supervised Entities

AGENCY: Securities and Exchange Commission (``Commission'').

ACTION: Proposed rule.

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SUMMARY: We are proposing for comment rule amendments under the 
Securities Exchange Act of 1934 that would establish a voluntary 
alternative method for computing net capital charges for certain 
broker-dealers. If the broker-dealer is part of a holding company, that 
holding company must have a group-wide internal risk management control 
system and must consent to group-wide Commission supervision (the 
holding company and its affiliates are referred to in this proposal as 
a ``consolidated supervised entity,'' or ``CSE''). The proposed 
alternative method of computing certain market and credit risk net 
capital charges involves the use of internal mathematical models that 
the broker-dealer uses to measure risk. Commission supervision would 
include examination of unregulated holding companies, holding companies 
that are not primarily in the insured depository institutions business, 
and affiliates that are not functionally regulated. Among other things, 
the CSE would comply with stringent rules regarding its group-wide 
internal risk management control system and would make periodic reports 
to the Commission, which would include group-wide financial and risk 
management information and a capital computation consistent with the 
Basel Standards. We expect that this proposal, if adopted, would 
improve the Commission's oversight of broker-dealers.

DATES: Comments should be received on or before February 4, 2004.

ADDRESSES: To help us process and review your comments more 
efficiently, comments should be sent by hard copy or e-mail, but not by 
both methods. Comments sent by hard copy should be submitted in 
triplicate to Jonathan G. Katz, Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments 
also may be submitted electronically at the following electronic mail 
address: [email protected]. All comment letters should refer to 
File No. [S7-21-03] ; please include this file number in the subject 
line if you use electronic mail. We will make all comment letters 
available for public inspection and copying in our public reference 
room at the above address. We will post electronically submitted 
comment letters on the Commission's Web site (http://www.sec.gov).\1\
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    \1\ We do not edit personal identifying information, such as 
names or electronic-mail addresses, from electronic submissions. You 
should submit only information that you wish to make publicly 
available.

FOR FURTHER INFORMATION CONTACT: With respect to general questions, 
contact Catherine McGuire, Chief Counsel, Lourdes Gonzalez, Assistant 
Chief Counsel, or Linda Stamp Sundberg, Attorney Fellow, at (202) 942-
0073, Division of Market Regulation, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-1001.
    With respect to amendments to financial responsibility rules and 
books and records requirements, contact Michael A. Macchiaroli, 
Associate Director, at (202) 942-0132, Thomas K. McGowan, Assistant 
Director, at (202) 942-4886, Rose Russo Wells, Attorney, at (202) 942-
0143, Bonnie L. Gauch, Attorney, at (202) 942-0765, or David Lynch, 
Financial Economist, at (202) 942-0059, Division of Market Regulation, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-1001.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission is 
publishing for comment amendments to Rules 15c3-1, 15c3-4, 17a-5, 17a-
11, 17h-1T, and 17h-2T under the Securities Exchange Act of 1934 
(``Exchange Act'').

I. Introduction

    The Commission is proposing to amend Rule 15c3-1 \2\ (``net capital 
rule'') under the Exchange Act to establish a voluntary alternative 
method for computing net capital for certain broker-dealers. If the 
broker-dealer is part of a holding company, that holding company must 
have a group-wide internal risk management control system and must 
consent to group-wide Commission supervision (the holding company and 
its affiliates are referred to in this proposal as a ``consolidated 
supervised entity'' or ``CSE'').\3\ We have modeled the proposal on the 
Commission's rules pertaining to over-the-counter (``OTC'') derivative 
dealers.\4\ Under the proposal, a broker-dealer that maintains 
tentative net capital \5\ of at least $1 billion and net capital \6\ of 
at least $500 million \7\ could apply to the Commission for a 
conditional exemption from the application of the standard net capital 
rule calculation and, upon Commission approval, elect to calculate 
certain of its market and credit risk capital charges using the firm's 
own internal mathematical models for risk measurement, including 
internally developed value-at-risk (``VaR'') models and scenario 
analysis. The standard net capital rule calculation, however, would 
continue to apply to the broker-dealer's positions where the use of a 
VaR model or scenario analysis would not be appropriate.
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    \2\ 17 CFR 240.15c3-1.
    \3\ If a broker-dealer is the ultimate parent company of its 
affiliate group, it would be considered the holding company for 
purposes of this proposal. The holding company may not be a natural 
person. Nothing in this proposal is intended to create a preference 
for one organizational structure over another.
    \4\ See Exchange Act Release No. 40594, 63 FR 59362 (November 3, 
1998), effective January 1999 (adopting rules relating to OTC 
derivatives dealers).
    \5\ See proposed Rule 15c3-1(c)(15).
    \6\ See proposed Rule 15c3-1(a)(7).
    \7\ According to first quarter 2003 FOCUS reports, 28 broker-
dealers reported more than $1 billion in tentative net capital and 
more than $500 million in net capital.
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    Large broker-dealers typically are owned by holding companies that 
may also own many other entities. These affiliated entities may engage 
in both securities and non-securities activities worldwide. Broker-
dealer holding company structures vary, and may be quite complex. 
Depending upon the nature of these structures, broker-dealers may incur 
risks due to their affiliation with unregistered entities, including 
the increasingly common arrangement of using unregistered affiliates to 
trade in derivatives and other highly structured financial products.
    The principal purposes of the net capital rule are to protect 
customers and other market participants 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 net capital rule requires different minimum 
levels of capital based upon the nature of the firm's business and 
whether the broker-dealer handles customer funds or securities.
    A broker-dealer may incur many types of risk through its 
affiliates. For example, a broker-dealer's access to short-term funding 
may be affected by the insolvency of an affiliate. In addition, 
management at the holding company level may attempt to divert

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capital from the broker-dealer, to the extent permitted by the net 
capital rule, to support an affiliate experiencing financial 
difficulty. While this shift of assets would not, in itself, place a 
firm in net capital violation, it could make it more likely that the 
firm would fail during volatile market conditions. Under the proposed 
rules, a broker-dealer's ability to calculate its net capital based on 
the alternative net capital rules would be conditioned on the 
Commission receiving additional information regarding the financial 
condition of the holding company and its affiliates, including a 
calculation of allowable capital at the holding company level.
    The significance of a Commission assessment of group-wide risk was 
highlighted by the failure of the Drexel Burnham Lambert Group 
(``Drexel'') and its impact on its then-solvent broker-dealer 
subsidiary.\8\ In that case, Drexel had over $1 billion in commercial 
paper and other unsecured short-term borrowings outstanding. As a 
result of significant losses and a decline in the rating of its 
commercial paper, Drexel found it more difficult to renew its short-
term borrowings. Drexel was then forced to look to its only liquid 
sources of capital--the excess net capital of its broker-dealer and an 
affiliated government securities dealer. Significant amounts of the 
broker-dealer's capital were transferred to other affiliates over 
several weeks.
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    \8\ See, e.g. Breeden, Richard C., ``Statement Before the 
Committee on Banking, Housing and Urban Affairs, United States 
Senate, Concerning the Bankruptcy of Drexel Burnham Lambert'' (March 
2, 1990) and Exchange Act Release No. 28347 (Aug. 15, 1990), 55 FR 
34027 (Aug. 21, 1990) (``Recent events have indicated that the 
existing early warning restrictions may not be sufficient to address 
the problems that have arisen in connection with the development by 
many broker-dealers of large, complex holding companies.'').
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    Exchange Act section 17(h) was enacted in part as a response to the 
failure of Drexel and authorizes the Commission to obtain information 
regarding certain activities of the holding company and non-regulated 
affiliates of a broker-dealer. Pursuant to the rules adopted under 
section 17(h), broker-dealers also submit consolidated and 
consolidating financial statements, organizational charts of the 
holding company, descriptions of material legal exposures, and risk 
management policies and procedures to the Commission.\9\
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    \9\ 17 CFR 240.17h-1T and 17 CFR 240.17h-2T (the ``risk 
assessment rules'').
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    In addition, member firms of the Derivatives Policy Group (``DPG'') 
voluntarily supply us with additional information regarding derivative 
financial instruments, off balance sheet obligations, and the 
concentration of credit risk. The DPG was formed in March 1995 by the 
industry and the Commission to provide a voluntary oversight framework 
for monitoring derivatives activities of broker-dealer affiliates.
    The proposed alternative net capital provisions would be 
conditioned on the broker-dealer and its holding company documenting a 
comprehensive risk management system for identifying, measuring, and 
managing risk, which would be subject to Commission review. Risks that 
are managed on a consolidated basis at the holding company level cannot 
be understood by reviewing risk management practices of only one 
regulated entity--the broker-dealer. To have a full understanding of 
how risks, including risks to the broker-dealer, are identified, 
quantified, and managed, regulators need to review how risk is managed 
across the organization, including how risk at the affiliate may affect 
other interrelated entities.
    Under this proposal, a broker-dealer could use its proprietary 
mathematical risk measurement models under prescribed circumstances to 
calculate its regulatory capital requirement. Because many broker-
dealers and their holding companies already manage risk on a group-wide 
basis using these models, the proposed supervisory structure also 
should be more closely aligned with the firms' group-wide financial and 
risk management. Broker-dealers wanting to take advantage of this 
alternative capital calculation would need to provide the Commission 
with access to group-wide information.
    In most instances, the Commission's supervision on a group-wide 
basis would consist of analyzing records and reports provided by the 
holding company (or ``CSE'') of the broker-dealer.\10\ Nevertheless, a 
CSE that is not an entity that has a principal regulator would permit 
the Commission to examine its books and records. A CSE also would 
permit the Commission to examine the books and records of any affiliate 
of the broker-dealer that does not have a principal regulator.\11\ As a 
condition to the broker-dealer's exemption from the standard net 
capital rule, for a holding company that has a principal regulator, the 
holding company would make available to the Commission such information 
concerning the operations of the holding company that is necessary for 
the Commission to evaluate the financial and operational risk within 
the affiliate group of the broker-dealer (including any risks that 
could affect the reputation of the holding company or broker-dealer) 
and to evaluate compliance with the conditions of eligibility for 
computing the broker-dealer capital charges in accordance with this 
proposal. The Commission would not examine any holding company that is 
primarily in the insured depository institutions business (excluding 
its insurance and commercial businesses) and that arranges to provide 
the records necessary to meet the Commission's supervisory purposes. 
The Commission also would not examine functionally regulated broker-
dealer affiliates. We request comment on the adequacy of the 
Commission's recordkeeping and examination requirements with respect to 
the holding company and whether, and to what extent, they should be 
modified. With respect to any recordkeeping or examination requirement 
that should be modified, please specifically list the records that a 
holding company provides to its holding company regulator that could 
substitute for records that would be required under this proposal.
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    \10\ In some instances, another financial regulator may require 
reports and calculations that are similar to those we propose here. 
We intend to make the proposal available to broker-dealers that have 
regulated holding companies. We do not intend to examine holding 
companies that are primarily in the insured depository institution 
business (excluding their insurance and commercial businesses) when 
the Commission determines that the information the holding company 
provides is sufficient to meet the Commission's supervisory purposes 
as set forth in this proposal. We request comment on how and to what 
extent the Commission's recordkeeping and examination requirements 
applicable to the holding company should be modified.
    \11\ The rules would define affiliates with a principal 
regulator as banks or savings associations, entities registered with 
the Commodity Futures Trading Commission (other than broker-
dealers), and licensed or registered insurance companies. Bank 
holding companies, savings and loan holding companies, and foreign 
banks also would be considered to have a principal regulator if: (1) 
The Commission determines that it has in place appropriate 
arrangements so that information provided to the Commission is 
sufficient; and (2) The holding companies or foreign banks are 
primarily in the insured depository business (excluding their 
insurance and commercial businesses).
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    We believe that broker-dealers that may choose to apply to use the 
alternative net capital proposal could be affiliated with holding 
companies that are primarily in the insured depository institutions 
business. We request comment on whether we should adopt a definition of 
``primarily in the insured depository institutions business,'' and, if 
so, what factors we should consider.
    As a condition of the broker-dealer using the alternative capital 
calculation, the broker-dealer's holding company would also be required 
to comply with stringent rules regarding its group-wide

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internal risk management control system. Those rules are designed to 
ensure the integrity of the risk measurement, monitoring, and 
management process, and to clarify accountability, at the appropriate 
organizational level, for defining the permitted scope of activity and 
level of risk. This would help to ensure that the control system would 
adequately address the risks posed by the CSE's business and the 
environment in which it is being conducted. It is important that the 
Commission be informed that these risks are adequately addressed 
because financial or operational problems at the holding company or 
affiliate of a broker-dealer could impair the financial and operational 
stability of the broker-dealer.
    Large broker-dealers have long expressed interest in having their 
supervisory risk assessment and regulatory capital requirements more 
closely aligned to the mathematical modeling methods they already use 
to manage their own business risk and capital. In response, the 
Commission considered reformulating its net capital rule to incorporate 
mathematical risk management techniques into the computation of 
regulatory capital charges.\12\ The proposed alternative capital 
calculation responds to the firms' requests while recognizing the 
complexities of modern financial services conglomerates.
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    \12\ In 1997, the Commission issued a concept release to solicit 
comment regarding whether to consider reformulating its net capital 
rule to incorporate mathematical risk management techniques into the 
computation of regulatory capital charges. See Securities Exchange 
Act Release No. 39456 (December 30, 1997), 62 FR 68011.
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    The proposal also responds to international developments. Firms 
that do business in the European Union (``EU'') have told us that they 
may need to demonstrate that they have consolidated supervision at the 
holding company level that is ``equivalent'' to EU consolidated 
supervision.\13\ We expect that the Commission supervision contemplated 
by this proposal would meet this standard. As a result, we believe this 
proposal would minimize duplicative regulatory burdens on firms that 
are active in the EU as well as in other jurisdictions that may have 
similar laws.
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    \13\ EU ``consolidated supervision'' would take the form of a 
series of quantitative and qualitative rules, imposed at the level 
of the holding company, regarding firms' internal controls, capital 
adequacy, intra-group transactions, and risk concentration. Without 
a demonstration of ``equivalent'' supervision, we understand that an 
affiliate institution located in the EU may either be subject to 
additional capital charges or be required to form a sub-holding 
company in the EU. See ``Directive 2002/87/EC of the European 
Parliament and of the Council of 16 December 2002.''
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    We note that the EU uses the international regulatory standards 
developed by the Basel Committee on Banking Supervision (``Basel 
Committee''), which aim to align economic capital calculations with 
regulatory capital requirements for large internationally active 
banking institutions (``Basel Standards'').\14\ Our proposal 
incorporates a capital computation for the CSE that is designed to be 
consistent with the Basel Standards. The Basel Standards have been used 
by many other financial regulators for many years as a method to assess 
capital adequacy at the holding company level. Requiring that the CSE 
calculate its allowable capital based on the Basel Standards would 
provide the Commission with a useful measure of the CSE's financial 
position and allow for greater comparability of the CSE's financial 
position to that of international securities firms and banking 
institutions.
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    \14\ The central bank governors of the Group of Ten countries 
(``G-10 countries'') established the Basel Committee in 1974 to 
provide a forum for ongoing cooperation among member countries on 
banking supervisory matters. Its basic consultative papers are: the 
Basel Capital Accord (1988), the Core Principles for Effective 
Banking Supervision (1997), and the Core Principles Methodology 
(1999). The Basel Standards establish a common measurement system, a 
framework for supervision, and a minimum standard for capital 
adequacy for international banks in the G-10 countries. In April 
2003, the Basel Committee released for public comment a document 
entitled ``The New Basel Capital Accord.'' Comments were accepted 
through July 31, 2003. On October 11, 2003, the Basel Committee 
announced that it had received over 200 comment letters and that 
there is continued broad support for the structure of the proposed 
New Basel Capital Accord and agreement on the need to adopt a more 
risk-sensitive capital framework. The Committee requested comment by 
December 31, 2003 on an amendment to its proposed treatment of 
expected and unexpected losses. The Basel Committee expects to issue 
a final revision of the proposed New Basel Capital Accord by the 
middle of 2004, with an effective date for implementation of 
December 31, 2006.
    The Basel Standards generally have been implemented for 
internationally active, large banking institutions by U.S. bank 
regulators. See Office of the Comptroller of the Currency, Federal 
Reserve System, Federal Deposit Insurance Corporation, ``Risk Based 
Capital Standards; Market Risk,'' 61 FR 47358 (Sept. 6, 1996). 
Currently, U.S. banking regulators have released an Advanced Notice 
of Proposed Rulemaking to seek comment on their preliminary views 
regarding the implementation of the proposed New Basel Capital 
Accord (68 FR 45900 (August 4, 2003)). Comments are due by November 
3, 2003.
    Proposed Appendix G is designed to be consistent with the Basel 
Standards.
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    Eliminating the need to maintain a separate system to calculate 
regulatory capital should reduce regulatory costs for broker-dealers 
that have developed mathematical risk measurement models as part of a 
risk management system for business purposes. We also expect it to 
lower the market and credit risk deductions from net capital for 
eligible broker-dealers. Despite this anticipated reduction in required 
net capital, we believe that the proposal's safeguards, including the 
proposed minimum tentative net capital and net capital levels, should 
reduce systemic risk and not impair investor protection.

II. Alternative Capital Computation for Eligible Broker-Dealers

    Exchange Act section 15(c)(3) gives the Commission broad authority 
to adopt rules and regulations regarding the financial responsibility 
of broker-dealers that we find are necessary or appropriate in the 
public interest or for the protection of investors.\15\ The Commission 
has promulgated various rules under this provision, including the net 
capital rule,\16\ the hypothecation rules,\17\ and the customer 
protection rule.\18\ Other rules, such as the Commission's books and 
records rules,\19\ reporting requirements,\20\ and the early warning 
rule,\21\ support our financial responsibility framework. The 
Commission receives additional information, including information about 
affiliates of broker-dealers, financial and risk information about 
holding companies and certain affiliates of broker-dealers, and certain 
off-balance sheet items of broker-dealers, their holding companies, and 
their affiliates through the risk assessment rules and meetings with 
and reports from members of the Derivatives Policy Group. Since its 
adoption, we believe that the net capital rule and these other

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supervisory tools generally have performed well by assisting the 
Commission and the self-regulatory organizations (``SROs'') in 
identifying at an early stage firms that are experiencing financial 
problems.
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    \15\ 15 U.S.C. 78o(c)(3).
    \16\ 17 CFR 240.15c3-1. In calculating its net capital, a 
broker-dealer is required to reduce the value of its proprietary 
positions to provide a capital cushion if the value of these 
positions should decline. The rule also places restrictions on the 
withdrawal of equity capital from a broker-dealer.
    \17\ 17 CFR 240.15c2-1 and 240.8c-1. The hypothecation rule 
restricts broker-dealers' handling and use of customer securities, 
including prohibiting commingling of customers' securities without 
their consent.
    \18\ 17 CFR 240.15c3-3. The customer protection rule requires 
broker-dealers to have possession or control of all fully paid and 
excess margin securities that they carry for their customers. In 
addition, the customer protection rule prohibits the broker-dealer's 
use of customer funds to finance the broker-dealer's proprietary 
business. The rule also requires broker-dealers that carry customer 
accounts to establish a special reserve bank account for the 
exclusive benefit of customers.
    \19\ 17 CFR 240.17a-3 and 240.17a-4.
    \20\ 17 CFR 240.17a-5.
    \21\ 17 CFR 240.17a-11. The early warning rule requires that if 
a broker-dealer's net capital falls below a certain specified level 
or if it discovers a material internal control inadequacy, the 
broker-dealer must file a notice with us and with the firm's 
designated examining authority.
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    This proposal would expand the use of mathematical model-based 
capital charge calculations, which the Commission has permitted for 
several years in the context of OTC derivatives dealers,\22\ to 
eligible broker-dealers that elect Commission supervision of their 
holding company and affiliates, subject to certain specified 
conditions.\23\
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    \22\ The Commission permits broker-dealers that limit their 
business to OTC derivatives trading and ancillary cash and portfolio 
management activities (``OTC derivatives dealers'') to calculate 
capital charges based on VaR models. Exchange Act Release No. 40594 
(November 3, 1998), 63 FR 59362. This voluntary registration allows 
an OTC derivatives dealer to use mathematical models to calculate 
its market and credit risk capital charges upon Commission approval 
of an application that is subject to an intensive Commission review 
of how the firm manages its market, credit, liquidity and funding, 
legal, and operational risks. Because the amounts at risk are 
calculated across the affiliate group of the OTC derivatives dealer, 
the Commission gains a group-wide perspective on how the firm is 
managed and how it handles large group-wide exposures.
    \23\ The affiliate group, i.e. the CSE, includes the broker-
dealer and all affiliates of the broker-dealer, including the 
holding company.
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    A broker-dealer's use of this alternative net capital treatment 
would be conditioned on the CSE complying with a series of 
requirements. The CSE would be required on a monthly and quarterly 
basis to compute group-wide capital and allowances for market, credit, 
and operational risk as if it were subject to the Basel Standards. The 
CSE also would be required to provide the Commission with certain 
financial, operational, and risk management information. The CSE would 
be required to implement and maintain a consolidated internal risk 
management control system and procedures to monitor and manage group-
wide risk, including market, credit, funding, operational, and legal 
risks.
    We are proposing what we believe are prudent parameters for 
measuring a broker-dealer's net capital charges and allowances for risk 
for its holding company, although in some cases these parameters may be 
more conservative than some firms may believe are necessary to account 
for risk. For example, the proposal contains the requirements that the 
VaR model used to calculate market risk for the broker-dealer and for 
the holding company be based on a ten business-day movement in rates 
and prices and that a 99% confidence level be used, and that the VaR 
measure be multiplied by a factor of at least three. These parameters 
are based on our experience and existing Commission rules and rules of 
other regulatory agencies where there are similar risk factors in the 
regulated entities. We ask for comment on all these parameters.
    Proposed paragraph (a)(7) of Rule 15c3-1 provides that the 
Commission may grant, in whole or in part, an application, or an 
amendment to an application, by a broker-dealer to use the voluntary 
alternative net capital computation. \24\ This proposed paragraph also 
provides that the broker-dealer must at all times maintain tentative 
net capital of not less than $1 billion and net capital of not less 
than $500 million.
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    \24\ The application and approval process for firms that elect 
this capital treatment would be similar to the one for firms using 
the alternative capital computation for OTC derivatives dealers. 
Among other things, the Commission would issue a firm-specific 
approval setting forth the terms of the alternative capital 
computation. We would expect to revise the approval when 
circumstances change. Changes that might necessitate revising the 
approval would include a change in the firm's internal risk 
management control systems or a change in the firm's eligibility to 
use models for certain categories of positions.
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    We expect that net capital charges will be reduced for broker-
dealers that use the proposed alternative net capital computation. The 
present haircut structure is designed so that firms will have a 
sufficient capital base to account for, in addition to market and 
credit risk, other types of risk, such as operational risk, leverage 
risk, and liquidity risk. Raising the minimum tentative net capital 
requirement to $1 billion and net capital requirement to $500 million 
is one way to ensure that firms that use the alternative capital 
computation maintain sufficient capital reserves to account for these 
other risks. In addition, based on our experience, firms must have this 
scale of operations in order to have developed internal risk management 
control systems necessary to support reliable VaR computations.
    We request comment on these required minimum levels of tentative 
net capital and net capital. Should they be raised or lowered?
    Proposed paragraph (c)(13) of Rule 15c3-1 defines ``entity that has 
a principal regulator'' as a person (other than a natural person) that 
is not a registered broker-dealer (other than a broker-dealer 
registered under Sec.  15(b)(11) of the Exchange Act) and that belongs 
to one of two categories. Under proposed paragraph (c)(13)(i), the 
person could be an insured depository institution, an entity registered 
with the Commodities Futures Trading Commission, or a licensed or 
regulated insurance company. Under proposed paragraph (c)(13)(ii), bank 
holding companies, savings and loan holding companies, and foreign 
banks that do business in the U.S. would also be considered to have a 
principal regulator if there are in place appropriate arrangements so 
that information provided to the Commission is sufficiently reliable 
for the purposes of proposed Appendix E and proposed Appendix G and if 
the entity is primarily in the insured depository institutions business 
(excluding its insurance and commercial businesses). We request comment 
on this definition of ``entity that has a principal regulator.''
    The proposed amendment to paragraph (c)(15) of Rule 15c3-1 defines 
``tentative net capital'' for a broker-dealer using the alternative net 
capital computation.

A. Proposed Appendix E to Rule 15c3-1

    Proposed Appendix E to Exchange Act Rule 15c3-1 would include 
application requirements and the proposed new alternative method of 
calculating market and credit risk capital charges for the broker-
dealer as well as additional supervisory conditions the Commission 
could impose on the broker-dealer in appropriate circumstances, such as 
compliance failures. Many of these requirements are similar to the 
rules applicable to OTC derivatives dealers. The requirements are also 
based on our experience with the risk assessment rules and meetings 
with and reports from members of the DPG and other broker-dealers. Once 
a broker-dealer has submitted an application, the Commission will 
conduct an intensive review of how the firm manages its market, credit, 
liquidity and funding, legal, and operational risks to determine 
whether the broker-dealer has met the requirements of proposed Appendix 
E and is in compliance with other applicable rules and whether the 
holding company of the broker-dealer is in compliance with the terms of 
its undertaking.
1. Application
    Pursuant to paragraph (a) of proposed Appendix E, a broker-dealer 
may apply to the Commission for an exemption from the standard net 
capital rule to calculate certain market and credit risk capital 
charges in accordance with Appendix E.\25\ Paragraph (a) describes

[[Page 62876]]

the various documents and information which must be submitted as part 
of the application from the broker-dealer and from the holding company 
of the broker-dealer that will allow the Commission to determine 
whether an exemption from the net capital rule is necessary or 
appropriate in the public interest and consistent with the protection 
of investors.
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    \25\ From time to time, the broker-dealer will submit amendments 
to its application. For example, the broker-dealer will be required 
to submit an amendment to its application if it materially amends a 
VaR model that it uses to calculate a market or credit risk capital 
charge.
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    The documents and information that must be submitted as part of the 
application are similar to those we presently obtain under the OTC 
derivatives dealer rules, under the risk assessment rules, and 
voluntarily from the DPG firms and other broker-dealers. We have found 
that they are useful in gaining insight into the financial condition, 
internal risk management control system, and activities of the broker-
dealer and its holding company and affiliates and to understand and 
evaluate group-wide risk exposures. Adverse financial or operational 
conditions at the holding company or an affiliate of the broker-dealer 
may expose the broker-dealer to additional risk. For example, the 
failure of an affiliate may adversely affect the ability of the broker-
dealer to obtain short-term funding. Therefore, we would require 
receipt of these documents and information relating to the operational 
and financial condition of the broker-dealer, and its holding company 
and other affiliates, as a condition for the broker-dealer's use of 
proposed Appendix E to calculate certain of its capital charges. We 
request comment on all aspects of the application requirements.
a. Documents and Information To Be Submitted by the Broker-Dealer
    Paragraph (a)(1) of proposed Appendix E lists the documents and 
information to be submitted by the broker-dealer as part of its 
application to use the alternative capital computation. The documents 
and information would include:
    [sbull] An executive summary of the documents and information 
submitted to the Commission by the broker-dealer and a description of 
the holding company of the broker-dealer (which may not be a natural 
person);
    [sbull] A list of types of positions the broker-dealer holds in its 
proprietary account and a description of the method the broker-dealer 
would use to compute its capital charges on those positions;
    [sbull] A description of mathematical models used to price 
positions and to compute capital charges and how those models meet the 
quantitative and qualitative requirements of proposed Appendix E;
    [sbull] If the broker-dealer is applying to the Commission to use 
scenario analysis to calculate capital charges for certain positions, a 
list of the positions and a description of how the capital charges will 
be calculated; and
    [sbull] A description of the broker-dealer's internal risk 
management control system and how that system satisfies the 
requirements set forth in Rule 15c3-4.
b. Holding Company Undertaking
    As part of the application, and as a condition of the broker-
dealer's use of proposed Appendix E to calculate certain of its capital 
charges, the broker-dealer would also be required, by paragraph 
(a)(1)(viii) of proposed Appendix E, to file a written undertaking by 
the broker-dealer's holding company, signed by a duly authorized person 
at the holding company, in which the holding company would agree, among 
other things, to:
    [sbull] Comply with proposed Appendix G to Rule 15c3-1, discussed 
in further detail below, which generally would require that the holding 
company make certain capital calculations, make certain reports to the 
Commission, maintain and keep certain records, and notify the 
Commission upon the occurrence of certain events;
    [sbull] Comply with all applicable provisions of proposed Appendix 
E;
    [sbull] Comply with the provisions of Rule 15c3-4 with respect to a 
group-wide internal risk management control system for the CSE as if it 
were a broker-dealer that computes its capital charges in accordance 
with proposed Appendix E;
    [sbull] As part of the group-wide internal risk management control 
system, establish, document, and maintain procedures for the detection 
and prevention of money laundering and terrorist financing;
    [sbull] Permit the Commission to examine the books and records of 
any affiliate, including the holding company, if the affiliate is not 
an entity that has a principal regulator (as defined in proposed 
paragraph (c)(13) of Rule 15c3-1) for the purposes of these rules;
    [sbull] For certain entities that have principal regulators (those 
entities listed in proposed paragraph (c)(13)(ii) of Rule 15c3-1) for 
the purposes of these rules, make available to the Commission such 
information concerning the operations of the entity that the Commission 
determines is necessary to evaluate risks that may affect the financial 
or operational condition of the holding company;
    [sbull] If the disclosure to the Commission of any information 
required as a condition for the broker-dealer to use proposed Appendix 
E would be prohibited by law or otherwise, cooperate with the 
Commission as needed, including by describing any secrecy laws or other 
impediments that could restrict the ability of the broker-dealer or its 
affiliates from providing information to the Commission and by 
discussing the manner in which the broker-dealer and the holding 
company propose to provide the Commission with adequate assurances of 
access to information;
    [sbull] For any non-U.S. holding company, consent to the 
jurisdiction of the Commission and agree to maintain a U.S. registered 
agent;
    [sbull] Submit to the Commission all material changes to 
mathematical models used to calculate allowances for market and credit 
risk for Commission approval;
    [sbull] Submit to the Commission all material changes to the group-
wide internal risk management system; and
    [sbull] Acknowledge that the Commission may implement additional 
supervisory conditions, described in detail below, if the holding 
company fails to comply with any provision of its undertaking.
    The proposed terms of the undertaking are those that we have 
determined are necessary for us to understand the risks to the broker-
dealer that may result from activities of its affiliates and for us to 
have access to information concerning the CSE. For example, permitting 
the Commission to examine the books and records of non-functionally 
regulated affiliates of the broker-dealer will provide the Commission 
with an understanding of the group-wide risk exposures that may have a 
material effect on the financial or operational condition of the 
broker-dealer. The requirement to establish a group-wide internal risk 
management control system in accordance with the standards of Rule 
15c3-4 will help provide assurance that the control system that is 
implemented will adequately address the risks posed by the firm's 
business and the environment in which it is being conducted. We request 
comment on the documents that the broker-dealer must submit as part of 
its application to use proposed Appendix E to compute certain of its 
capital charges.
    As noted above, use of the alternative net capital treatment by a 
broker-dealer is conditioned on the broker-dealer's holding company 
undertaking to comply with the above requirements. We request comment 
on all aspects of the holding company undertaking.

[[Page 62877]]

Should we consider any other conditions? Are any of the proposed 
conditions problematic?
c. Documents and Information To Be Submitted by the Holding Company
    Under paragraph (a)(2) of proposed Appendix E, as a condition of 
the broker-dealer's use of the alternative capital treatment, the 
holding company of the broker-dealer must submit the following 
documents and information to the Commission as part of the application 
of the broker or dealer:
    [sbull] A narrative description of the business and organization of 
the holding company;
    [sbull] An organizational chart depicting the holding company and 
its subsidiaries and affiliates;
    [sbull] An alphabetical list of the affiliates of the broker-dealer 
(``affiliate group''), with an identification of the financial 
regulator, if any, with whom the affiliate is registered and a 
designation of those affiliates that are material to the holding 
company (``material affiliates'');
    [sbull] Consolidated and consolidating financial statements;
    [sbull] Certain sample capital calculations made according to 
proposed Appendix G to Rule 15c3-1;
    [sbull] A description of the categories of positions held by the 
holding company and affiliates;
    [sbull] A description of the methods the holding company intends to 
use for computing allowances for market risk, credit risk, and 
operational risk;
    [sbull] A description of any differences between the models used by 
the holding company and those used by the broker-dealer to compute 
capital charges on the same instrument or counterparty;
    [sbull] A description of the internal risk management control 
system used by the holding company to manage group-wide risk and how 
that system satisfies the requirements of Rule 15c3-4; and
    [sbull] Sample risk reports that the holding company provides to 
its senior management.
    Because each firm manages its internal risk differently, the 
Commission, during the application process, must assess each firm's 
business and internal risk management control systems to determine 
whether an exemption is appropriate. The documents and information we 
would require the holding company to file as a condition for the 
exemption would allow us to evaluate this risk. In certain 
circumstances, depending on the relationship or the geographic location 
of the holding company and its affiliates, the Commission may condition 
its approval on obtaining additional information or documents necessary 
to adequately assess the risks to the CSE and to the broker-dealer. 
Paragraph (a)(3) of proposed Appendix E provides that the application 
shall be supplemented by such other information or documents relating 
to the internal risk management control system, mathematical models, 
and financial position of the broker-dealer or the holding company that 
the Commission may request to complete its review of the application.
    Under paragraph (a)(4) of proposed Appendix E, the application 
would be considered filed when received at the Commission's principal 
office in Washington, DC. All information and documents submitted in 
connection with the application would be accorded confidential 
treatment under the proposal.
    We request comment on the documents and information we propose to 
require that the broker-dealer and holding company file as a condition 
for the exemption. For example, are there other documents or 
information we should require?
    As part of its group-wide internal risk management control system, 
the holding company would be required to establish, document, and 
maintain procedures for the detection and prevention of money 
laundering and terrorist financing. These procedures would include 
appropriate safeguards at the holding company level to prevent money 
laundering through affiliates.\26\
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    \26\ This parallels requirements in the proposed New Basel 
Capital Accord. See also Financial Action Task Force on Money 
Laundering (FATF) Recommendation 22 and see generally the FATF's 
Special Recommendations on Terrorist Financing. (The FATF's 
documents can be found at http://www.FATF-GAFI.org).
---------------------------------------------------------------------------

    Under paragraph (a)(6) of proposed Appendix E, the Commission would 
grant an application by a broker-dealer to use the alternative capital 
computation if it determines that the broker-dealer has met the 
requirements of Appendix E and is in compliance with other applicable 
Exchange Act rules and that the holding company is in compliance with 
the terms of its undertaking, which are conditions for the approval.
    Under paragraph (a)(7) of proposed Appendix E, a broker-dealer 
would be required to amend and resubmit its application to use Appendix 
E to the Commission if the broker-dealer or its holding company desires 
to make a material change to a mathematical model used to calculate 
market or credit risk or its internal risk management control system as 
described in the application. Because material changes to the 
mathematical models may have a significant impact on the firm's net 
capital or risk allowances and changes to the internal risk management 
control systems could result in changes to the amount of risk assumed 
by the broker-dealer or holding company, Commission review of those 
changes would be appropriate to determine if the exemption continues to 
be consistent with the Exchange Act. Under paragraph (a)(8) of proposed 
Appendix E, the broker-dealer would be required to notify the 
Commission of any material change to the corporate structure of the 
broker-dealer or the holding company as described in the application.
    Under paragraph (a)(9) of proposed Appendix E, as a condition of 
the exemption to compute its capital charges pursuant to Appendix E, a 
broker-dealer would agree to provide 45 days written notice to the 
Commission if it chose to end its reliance on the exemption. The 
broker-dealer would also agree that the Commission could determine that 
the notice would be effective after a shorter or longer period of time 
if the broker-dealer consents or if the Commission determines that the 
shorter or longer period is necessary or appropriate in the public 
interest and consistent with the protection of investors. We request 
comment on this notice provision. For example, is 45 days an 
appropriate notification period? Would a shorter or longer time period 
be preferable?
    Pursuant to paragraph (a)(10) of proposed Appendix E, the 
Commission may, by order, revoke the broker-dealer's exemption that 
allows it to use proposed Appendix E to calculate certain capital 
charges if the Commission finds that the exemption is no longer 
necessary or appropriate in the public interest or is no longer 
consistent with the protection of investors. A broker-dealer that is no 
longer permitted to calculate its regulatory capital requirements 
pursuant to Appendix E must compute its capital charges using the 
standard haircut method in the net capital rule. We request comment on 
the revocation provisions. Should paragraph (a)(10) of proposed 
Appendix E specify certain circumstances where revocation of the 
exemption would be appropriate?
2. Risk Management Control System
    Under paragraph (b) of proposed Appendix E, the broker-dealer would 
be required to establish, document, and maintain an internal risk 
management control system that meets the requirements of Sec.  
240.15c3-4 (with proposed amendments to apply the rule

[[Page 62878]]

to broker-dealers using Appendix E).\27\ Rule 15c3-4 is designed to 
ensure the integrity of the risk measurement, monitoring, and 
management process, and to clarify accountability, at the appropriate 
organizational level, for defining the permitted scope of activity and 
level of risk. We request comment on this proposed requirement.
---------------------------------------------------------------------------

    \27\ See infra, discussion of proposed amendments to Rule 15c3-
4.
---------------------------------------------------------------------------

3. Market Risk Capital Charge
    Under paragraph (c) of proposed Appendix E, the market risk capital 
charge on certain of the broker-dealer's positions would be computed 
either using VaR mathematical models, scenario analysis, or the 
standard haircut method of paragraph (c)(2)(vi) of Rule 15c3-1. The 
computation of the market risk capital charge under this proposal is 
based on the method for computing market risk under the OTC derivatives 
dealer rules. Generally, when a statistical model is used to determine 
market risk charges, the VaR amount determined by using the model must 
be multiplied by a multiplication factor to take into account the risk 
that the model does not measure the effects of unlikely but significant 
events.
a. Market Risk Capital Charge Calculation Using a VaR Model
    For positions for which a market risk capital charge may be 
computed using a VaR model,\28\ the market risk capital charge would be 
the VaR of the positions, which would be multiplied by the appropriate 
multiplication factor to provide an adequate measure of risk during 
periods of market stress.\29\
---------------------------------------------------------------------------

    \28\ These positions include those that have a ready market and 
for which there is adequate historical data to support a VaR model.
    \29\ Proposed Rule 15c3-1e(c)(1).
---------------------------------------------------------------------------

    In order for the Commission to monitor whether the broker-dealer's 
VaR models provide an adequate measure of the broker-dealer's risk 
exposures, an eligible broker-dealer would be required to obtain 
authorization from the Commission, either in its original application 
or by submitting an amendment to its application, before using a VaR 
model to calculate market risk capital charges on particular categories 
of exposures. The multiplication factor would be determined by 
reference to Table 1 of proposed Appendix E based on the results of 
quarterly backtests of the VaR model, which compare the losses 
predicted by the model to actual losses incurred in the broker-dealer's 
portfolio, except that the initial multiplication factor would be 
three. In considering an application or amendment, the Commission may 
adjust the multiplication factor or take other action, as appropriate, 
after evaluating the firm's adherence to robust internal risk 
management procedures, including a review of its VaR models.\30\
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    \30\ The Commission may take such actions, for example, in 
considering an application or amendment to an application of a 
broker-dealer to calculate certain market and credit risk capital 
charges in accordance with proposed Appendix E or during its routine 
oversight of the broker-dealer.
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    Paragraph (e) of proposed Appendix E would set forth the 
qualitative and quantitative requirements for VaR models used by the 
broker-dealer to calculate capital charges.\31\ These requirements are 
intended to make the capital charges based on the VaR measures a more 
accurate measure of losses that may occur during periods of market 
stress and are based on those in the OTC derivatives dealer rules and 
our experience in implementing those rules. The qualitative 
requirements, listed in paragraph (e)(1) of proposed Appendix E, would 
require that the VaR models used to calculate market and credit risk be 
the same models used to report market and credit risk to the firm's 
senior management and must be integrated into the internal risk 
management system of the firm; that the VaR model must be reviewed by 
the firm periodically and annually by a registered public accounting 
firm, as that term is defined in the Sarbanes-Oxley Act of 2002; \32\ 
and that for purposes of computing market risk, the multiplication 
factor must be determined based on quarterly backtesting of the VaR 
model used to calculate market risk and by reference to Table 1 of 
proposed Appendix E.
---------------------------------------------------------------------------

    \31\ Proposed Rule 15c3-1e(e)(1)-(2).
    \32\ ``Registered public accounting firm'' is defined in section 
2(a)(12) of the Sarbanes-Oxley Act of 2002 (Pub. L. 107-204) as ``a 
public accounting firm registered with the [Public Company 
Accounting Oversight] Board in accordance with this Act.'' We 
propose that a registered public accounting firm conduct the review 
of the VaR models, prepare supplemental reports concerning 
management controls and inventory pricing and modeling for the 
broker-dealer and its holding company, and prepare the holding 
company's annual audit report because such firms would be subject to 
Board rules, examination, and discipline.
---------------------------------------------------------------------------

    The quantitative requirements would set forth basic standards for 
each model including, (i) it must use a 99 percent, one-tailed 
confidence level and with price changes equivalent to a ten business-
day movement in rates and prices for purposes of determining market 
risk, (ii) it must use an effective historical observation period that 
must be at least one year in length and include periods of market 
stress, and (iii) it must take into account and incorporate all 
significant identifiable market risk factors applicable to the firm's 
positions.\33\
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    \33\ Proposed Rule 15c3-1e(e)(2).
---------------------------------------------------------------------------

    Under paragraph (c)(3) of proposed Appendix E, the Commission 
proposes to phase in the use of VaR models to calculate capital charges 
for three bands of positions over a period of at least 18 months 
beginning with positions with lower risk exposures and progressing to 
those with higher levels of risk. During the phase-in period, 
Commission approval of an application or amendment would be required 
before a broker-dealer could begin to use VaR models to calculate 
market risk capital charges at each of the succeeding levels of risk 
exposures. The phase-in of the application of mathematical models to 
calculate capital charges and the requirement that the previous stage 
VaR use must have been successful are intended to allow the Commission 
to determine whether an applicant has management controls that can 
adequately assess increasing risk levels and whether the models have 
flaws or other defects. A broker-dealer would request Commission 
approval by filing an amendment to its application.
    Upon Commission approval of its application to use proposed 
Appendix E to calculate certain of its capital charges, the broker-
dealer would be able to use VaR models to calculate market risk capital 
charges on the first level of eligible positions, which are generally 
securities with lower risk exposures: (1) U.S. government securities 
and derivatives on those securities; (2) investment grade corporate 
debt and derivatives on those securities; (3) highly rated foreign 
government securities and derivatives on those securities; (4) highly 
rated short-term asset-backed securities and derivatives on those 
securities; (5) highly rated municipal securities and derivatives on 
those securities; and (6) derivatives on major market foreign 
currencies.
    After at least nine months of successfully using VaR models to 
calculate market risk capital charges on the first level of eligible 
positions, a broker-dealer could amend its exemptive application to 
request Commission approval to use VaR models to calculate market risk 
capital charges on the second level of eligible positions, which 
include equities and derivatives on equities.
    After at least another nine months of successfully using VaR models 
to calculate market risk capital charges on the second level of 
eligible positions as well as continuing to successfully calculate 
market risk charges on the first level of eligible positions, a broker-

[[Page 62879]]

dealer could amend its exemptive application to request Commission 
approval to use VaR models to calculate market risk capital charges for 
other eligible positions, which would include positions for which there 
is a ready market and for which there is adequate historical data to 
support a VaR model.
    The Commission seeks comment on all aspects of the phase-in 
timetable, including the appropriateness of the positions selected for 
each level of eligibility and the 9-month time periods between 
successive levels. Should these time periods be shorter or longer? How 
should the Commission evaluate the success or adequacy of the models 
during these phase-in periods? Are there any other additional criteria 
or methods the Commission should consider using?
    The Commission seeks comment on all aspects of the proposed 
calculation of market risk capital charges. In particular, we request 
comment on the use of mathematical models for regulatory capital 
purposes, including the quantitative and qualitative requirements for 
VaR models, the multiplication factors used to calculate the capital 
charge for market risk, and the use of backtesting to determine the 
multiplication factor. For example, should the multiplication factors 
be higher or lower? How should the multiplication factors be 
determined? Are the backtesting procedures appropriate? Is the 99% one-
tailed confidence level appropriate? Is the requirement that the price 
changes be equivalent to a ten business-day movement in rates and 
prices appropriate? If not, what parameters would be appropriate?
    Because VaR models use historical price data to predict future 
price movements, under paragraph (c)(4) of proposed Appendix E, an 
eligible broker-dealer could not use VaR models to calculate capital 
charges on securities that do not have adequate historical data 
available to make the VaR models reliable. For example, a broker-dealer 
could not use VaR models to calculate capital charges on securities 
recently sold in an initial public offering or for securities without a 
ready market. In those cases, the broker-dealer could apply to use 
scenario analysis or would continue to use the standard haircut method 
to calculate the capital charges on those positions.
b. Market Risk Capital Charge Calculation Using Scenario Analysis
    Under paragraph (c)(5) of proposed Appendix E, for positions for 
which the Commission has approved the broker-dealer's use of scenario 
analysis \34\ to compute a market risk capital charge (for example, 
positions having no ready market) the market risk capital charge would 
be three times the greatest adverse price movement resulting from the 
scenario over any ten-day period on a daily basis. The broker-dealer 
would be required to take a minimum market risk capital charge of $25 
per 100-share equivalent equity contract for equity positions or \1/2\ 
of one percent of the face value of the contract for all other types of 
contracts, even if the scenario model indicates a lower amount. We 
believe that it is appropriate to build in minimum charges to help 
assure that the firm has adequate capital in view of risks that may not 
be captured by scenario analysis. We request comment on the proposed 
calculation of capital charges using scenario analysis. Specifically, 
is three the appropriate multiplier? Is $25 per 100-share equivalent 
equity contract the appropriate minimum charge for equity positions? Is 
\1/2\ of one percent of the face value of the contract the appropriate 
minimum for all other types of contracts? The Commission also could 
require a broker-dealer using scenario analysis to take additional 
capital charges for specific risk based on the liquidity or the 
perceived risks of the instruments. We request comment on the 
appropriate capital charge for specific risk.
---------------------------------------------------------------------------

    \34\ Scenario analysis is the identification of the potential 
impact on the profit or loss on a position of various extreme events 
that affect the pricing of the position in the portfolio.
---------------------------------------------------------------------------

    The Commission solicits comment on all aspects of the use of 
scenario analysis to determine capital charges including the proposed 
multipliers and minimum charges. We are also interested in receiving 
any comments on other methodologies that may be appropriate to more 
accurately measure risk and correlate that risk to capital charges.
c. Market Risk Capital Charge Calculation for Other Positions
    Under paragraph (c)(6) of proposed Appendix E, an eligible broker-
dealer that computes its market risk capital charges pursuant to 
proposed Appendix E to Rule 15c3-1 would continue to compute market 
risk capital charges using paragraph (c)(2)(vi) of Rule 15c3-1 (the 
``haircut method'') for positions for which the Commission has not 
approved its use of a VaR model or scenario analysis to compute those 
capital charges.
4. Credit Risk Capital Charge
    An eligible broker-dealer would be required to use paragraph (d) of 
proposed Appendix E to compute its credit risk capital charge on credit 
exposures arising from the broker-dealer's positions in derivatives 
instruments if the Commission authorized the broker-dealer to use VaR 
or scenario analysis to compute its market risk capital charge on those 
positions. The credit risk capital charge computed pursuant to proposed 
Appendix E would be similar to the credit risk capital charge 
calculated pursuant to Appendix F to Rule 15c3-1, which applies to 
electing OTC derivatives dealers. The credit risk capital charge would 
be the sum of counterparty exposure charges for each counterparty, 
concentration charges by counterparty, and a portfolio concentration 
charge across all counterparties. Each of these charges is designed to 
address different components of credit risk.
    First, for each counterparty, the broker-dealer would compute a 
counterparty exposure charge equal to the ``credit equivalent amount'' 
(defined below) of the broker-dealer's exposures to the counterparty, 
multiplied by 8%,\35\ and further multiplied by a credit risk weight 
for the counterparty (or, under paragraph (d)(1) of proposed Appendix 
E, the counterparty exposure charge is the net replacement value in the 
account of a counterparty if that counterparty is insolvent, in 
bankruptcy, or that has senior long-term debt in default). This method 
for computing credit risk capital charges is consistent with the 
computation of credit risk capital charges for OTC derivatives dealers 
under Appendix F to Rule 15c3-1.
---------------------------------------------------------------------------

    \35\ The 8% multiplier is consistent with the calculation of 
credit risk in the OTC derivatives dealers rules and with the Basel 
Standards and is designed to dampen leverage to assure that the firm 
maintains a safe level of capital.
---------------------------------------------------------------------------

    The credit equivalent amount to a counterparty would be defined in 
paragraph (d)(2) of proposed Appendix E as the sum of: (1) the broker-
dealer's maximum potential exposure to the counterparty multiplied by 
the appropriate multiplication factor; and (2) the broker-dealer's 
current exposure to the counterparty. The multiplication factor would 
generally be determined based on backtesting results of the VaR model 
used to calculate maximum potential exposure, except that the initial 
multiplication factor would be one. Current exposure would be defined 
in paragraph (d)(3) of proposed Appendix E as the replacement value of

[[Page 62880]]

the counterparty's positions with the broker-dealer, after applying 
specified netting agreements \36\ and taking into account the value of 
certain collateral \37\ received from the counterparty. Maximum 
potential exposure would be defined in paragraph (d)(4) of proposed 
Appendix E as the increase in the replacement value of the 
counterparty's positions with the broker-dealer, after applying the 
effect of specified netting agreements and taking into account the 
value of certain collateral received from the counterparty, that will 
not be exceeded with 99% confidence over a time horizon of one year. 
The broker-dealer would have to calculate maximum potential exposure 
using a VaR model meeting the applicable quantitative and qualitative 
requirements of proposed Appendix E.\38\ The Commission requests 
comment on the proposed calculations of current exposure and maximum 
potential exposure, including the use of VaR models to measure maximum 
potential exposure as well as the impact of netting agreements and 
collateral.
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    \36\ Only netting agreements that meet the requirements of 
paragraph (d)(5) of proposed Appendix E could be used to derive 
current exposure and maximum potential exposure. For example, the 
netting agreements would have to be legally enforceable in each 
relevant jurisdiction, including in insolvency proceedings. These 
proposed requirements are designed to allow a broker-dealer to 
reduce its credit risk capital charge only if the netting agreement 
reduces credit risk.
    \37\ Only collateral that meets the requirements of paragraph 
(d)(6) of proposed Appendix E could be used to derive current 
exposure and maximum potential exposure. For example, the collateral 
must have a ready market or consist of certain major market foreign 
currency or U.S. currency. These proposed requirements are designed 
to allow a broker-dealer to reduce its credit risk capital charge 
only if the collateral reduces credit risk.
    \38\ See proposed Rule 15c3-1e(e).
---------------------------------------------------------------------------

    The credit risk weight of the counterparty would be calculated 
under paragraph (d)(7) of proposed Appendix E using methods that are 
consistent with the computation of credit risk capital charges for OTC 
derivatives dealers under Appendix F to Rule 15c3-1. If a counterparty 
is rated by a nationally recognized statistical rating organization 
(``NRSRO''), the credit risk weight would range from 20% to 150% 
depending on the credit rating of the counterparty, which provides a 
measure of credit risk. If a counterparty is not rated by an NRSRO, the 
broker-dealer could apply to the Commission, either in its original 
application or by amending its application, for permission to determine 
a credit rating for the counterparty using internal calculations and to 
use the internal credit rating in lieu of a rating by an NRSRO for 
purposes of determining the credit risk weight of the counterparty. We 
request comment on whether the broker-dealer should also be able to 
apply to the Commission for permission to determine the credit risk 
weight of a counterparty using internal calculations. For exposures 
covered by guarantees, where the guarantee is an unconditional and 
irrevocable guarantee of the due and punctual payment and performance 
of the obligation and the broker-dealer can demand immediate payment 
from the guarantor after any payment is missed without having to make 
collection efforts, a broker-dealer would be able to substitute the 
average of the credit risk weights of the guarantor and the 
counterparty for the credit risk weight of the counterparty.
    Concentration charges are appropriate when a lack of 
diversification exposes the broker-dealer to additional risk. When 
evaluating the debt holdings of an entity, a lack of diversification 
would be evidenced by either a relatively (relative to the amount of 
the broker-dealer's tentative net capital) large exposure to a single 
party (the credit rating of that counterparty would, of course, affect 
the amount of additional risk) or a relatively large amount of 
unsecured debt holdings.
    The second part of the credit risk capital charge, as provided in 
paragraph (d)(8) of proposed Appendix E, would take into account the 
additional risk of a relatively large exposure to a single party and 
would consist of concentration charges by counterparty that would 
generally apply when the current exposure of the broker-dealer to a 
single counterparty exceeds 5% of the tentative net capital of the 
broker-dealer. The amount of the concentration charge would be larger 
for counterparties with lower credit ratings and would range from 5% to 
50% of the amount of the current exposure of the broker-dealer to the 
counterparty in excess of 5% of the broker-dealer's tentative net 
capital. The 5% is based on the OTC derivatives dealers rules and 
Commission experience.
    The third part of the credit risk capital charge, as provided in 
paragraph (d)(9) of proposed Appendix E, would recognize the additional 
risk of holding a relatively large amount of unsecured debt and would 
consist of a portfolio concentration charge across all counterparties 
that would be the amount, if any, that the broker-dealer's aggregate 
current exposure across all counterparties for unsecured exposures 
exceeds 15% of the broker-dealer's tentative net capital.
    The Commission requests comment on all aspects of the credit risk 
capital charge; in particular, the determination of credit risk weights 
for counterparties. The Commission requests comment on whether an 
additional method of calculating credit risk weights, based on internal 
estimates of annual probabilities of default, should be included in 
proposed Appendix E. If such a method should be used, the Commission 
requests comment on whether the following table appropriately matches 
credit risk weights to annual probabilities of default:
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    \39\ These credit risk weights are based on the formulas 
provided in the Advanced Internal Ratings-Based approach to credit 
risk proposed by the Basel Committee. The New Basel Capital Accord, 
April 2003. The credit risk weights were derived using a loss given 
default (the percentage of the amount owed by the counterparty the 
firm expects to lose if the counterparty defaults) of 75%. We 
believe that 75% is a conservative number for use in determining 
credit risk weights. We request comment on whether 75% is 
appropriate, or whether it should be increased or decreased.

    Credit Risk Weight of Counterparty Based on Annual Probability of
                              Default \39\
------------------------------------------------------------------------
                                                           Credit risk
             Annual probability of default                 weight  (in
                                                             percent)
------------------------------------------------------------------------
Less than .003%........................................                2
0.05%..................................................               17
0.11%..................................................               30
3.80%..................................................              200
5.30% or higher........................................              230
Event of default has occurred..........................             1250
------------------------------------------------------------------------

    The Commission believes that calculating a credit risk capital 
charge on exposures arising from transactions in derivatives 
instruments using a qualifying VaR model to calculate maximum potential 
exposure is a more precise method than using a ``notional add-on'' to 
approximate maximum potential exposure. In addition, Commission reviews 
of risk management systems of large U.S. broker-dealers indicate that 
these broker-dealers use maximum potential exposure to measure and 
manage the credit risk of their portfolios. These broker-dealers would 
therefore incur small, if any, additional costs to calculate maximum 
potential exposure as opposed to ``notional add-ons.''
    The Commission requests comment on all aspects of this approach to 
the calculation of credit risk capital charges on derivatives 
instruments, including the two concentration charges that are 
applicable both to individual counterparties and across all 
counterparties. The Commission also requests comment on the appropriate 
treatment of credit derivatives in this

[[Page 62881]]

context. Credit derivatives can enter into the calculation of credit 
risk in two ways. The first would be to substitute the credit risk 
weight of the writer of the credit derivative for the credit risk 
weight of the counterparty. This is the treatment included in proposed 
Appendix E. The second would be to adjust the current exposure and the 
maximum potential exposure by the value of the credit derivative. We 
request comment on these methods of including credit derivatives in the 
calculation of credit risk capital charges. We also request comment on 
whether any special treatment should be accorded guaranteed obligations 
or other obligations that may have double default effects.
5. Additional Regulatory Conditions for Noncompliance With Appendices E 
and G, Model Failures, or Control Failures
    Paragraph (f) of proposed Appendix E provides that as a condition 
for the broker-dealer to be permitted to use proposed Appendix E to 
calculate certain of its capital charges, the Commission may impose 
additional regulatory conditions on the broker-dealer or may condition 
further use of the exemption on the holding company of the broker-
dealer filing more frequent reports, modifying its internal risk 
management control procedures or on imposing such other appropriate 
additional regulatory conditions that the Commission finds are 
necessary or appropriate in the public interest and consistent with the 
protection of investors. The Commission may impose these additional 
regulatory conditions if: the broker-dealer or the CSE fails to comply 
with reporting requirements under the proposal; if there is a material 
deficiency in the internal risk management control system or certain 
mathematical models of the broker-dealer or the CSE; if the CSE fails 
to comply with its undertakings; if the broker-dealer or the CSE 
notifies the Commission of the occurrence of certain events; if there 
is a material change in a mathematical model, internal risk management 
control system, or corporate structure as described in the application; 
or if the Commission finds that imposing an additional regulatory 
condition is necessary or appropriate in the public interest, and is 
consistent with the protection of investors. The events that require 
notification are specified in paragraph (e) of proposed Appendix G (for 
the CSE) and in the proposed amendments to Rule 17a-11 (for the broker-
dealer), which are described in detail below. The proposed additional 
regulatory conditions include requiring the broker-dealer to restrict 
its business, to provide a plan for increasing its net capital or 
tentative net capital, or to calculate its capital charges using the 
haircut method of Rule
15c3-1.
    This provision is intended to identify situations where the broker-
dealer may be exposed to increased levels of risk. We could respond to 
that increased risk level by, for example, requiring increased capital 
charges or requiring that we be provided more information concerning 
the operational or financial condition of the broker-dealer, its 
holding company, and its affiliates.
    We seek comment on the additional conditions that would be 
available to the Commission under paragraph (f) of Appendix E. Are the 
events pursuant to which the Commission may impose additional 
conditions appropriate? Should any other events be added to this list? 
Should we specify in the rule other conditions that could be imposed if 
the broker-dealer or CSE did not comply with applicable requirements? 
What should these conditions be?

B. Proposed Appendix G to Rule 15c3-1

    As a condition of Commission approval, the holding company of a 
broker-dealer applying for authorization to compute certain of its 
capital charges in accordance with proposed Appendix E would undertake 
to comply with the requirements listed in proposed Appendix G to Rule 
15c3-1, in addition to those listed in paragraph (a)(1)(viii) of 
proposed Appendix E. Under Appendix G, the CSE would be required to 
compute allowable capital and allowances for market, credit, and 
operational risk on a consolidated basis for the CSE; provide the 
Commission with certain monthly, quarterly, and annual reports; 
maintain certain books and records relating to the CSE's consolidated 
financial reports and internal risk management controls; and notify the 
Commission upon the occurrence of certain events. These conditions are 
designed to help the Commission assess the financial and operational 
health of the holding company and the potential impact on the risk 
exposure of the broker-dealer.
    We are proposing what we believe are prudent parameters for 
measuring allowable capital and risk allowances for the CSE and that 
are consistent with the Basel Standards, which are used by many other 
financial regulators as a method to assess capital adequacy at the 
holding company level. For example, the proposal contains requirements 
placing limits on the amount of subordinated debt that may be included 
in allowable capital, that the VaR model used to calculate the 
allowance for market risk be based on a ten business-day movement in 
rates and prices, and that the VaR measure be multiplied by a factor of 
at least three. Requiring that a CSE calculate its allowable capital 
based on the Basel Standards would provide the Commission with a useful 
measure of the CSE's financial position and allow for greater 
comparability of an CSE's financial condition to that of other 
international securities firms and banking institutions.
1. Calculation of Allowable Capital and Allowances for Market, Credit, 
and Operational Risk by the CSE
    Pursuant to proposed paragraph (a) of Appendix G, the CSE would be 
required to calculate allowable capital and allowances for market, 
credit, and operational risk on a consolidated basis for the affiliate 
group on a monthly basis, which is designed to be consistent with the 
Basel Standards, which will allow for greater comparability of CSEs to 
international securities firms and banking institutions. This 
requirement is necessary to monitor the financial condition of the 
affiliate group, which may impact the financial stability of the 
broker-dealer. A CSE that makes a capital calculation consistent with 
the Basel Standards that it is required to submit to another regulator 
can request in the original exemption application or in an amendment to 
substitute that calculation for the calculations required by paragraph 
(a) of proposed Appendix G. If the Commission finds that the 
calculation gives the Commission sufficient information about the 
financial health of the holding company, it will approve that request.
e. Group-Wide Allowable Capital Calculation
    Under proposed paragraph (a)(1) of Appendix G, the CSE would 
calculate ``allowable capital'' on a consolidated basis for the 
affiliate group. Consistent with the Basel Standards, allowable capital 
would include common shareholders' equity (less goodwill, deferred tax 
assets, and certain other intangible assets), certain cumulative and 
non-cumulative preferred stock,\40\ and certain properly subordinated 
debt. As set forth in detail in the rule, the cumulative and non-
cumulative preferred stock and the subordinated

[[Page 62882]]

debt are subject to additional limitations based on comparisons of the 
individual components of allowable capital.
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    \40\ To qualify, the cumulative and noncumulative preferred 
stock could not have a maturity date, could not be redeemed at the 
option of the holder, and could not contain any other provisions 
that would require future redemption of the issue. In addition, the 
issuer would have to be able to defer or eliminate dividends. 
Preferred stock meeting these conditions would have characteristics 
consistent with capital, as opposed to debt.
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    We request comment on whether goodwill should be included in 
allowable capital or whether it is appropriate to include goodwill 
subject to a phase-out. If so, we request comment on how the phase-out 
should be structured and how long the phase-out should last.
    An entity's debt is not ordinarily regarded as capital. Because 
subordinated debt can provide a long-term source of working capital to 
the entity and may have many of the characteristics of capital, 
however, the Basel Standards permit unrestricted long-term subordinated 
debt \41\ to count as capital. Under paragraph (a)(1)(iii)(B) of 
proposed Appendix G, and consistent with the Basel Standards, 
subordinated debt can be included in allowable capital if it meets four 
criteria, which generally are designed to assure that the subordinated 
debt will provide a long-term source of working capital to the holding 
company and that it has many of the characteristics of capital. First, 
the original weighted average maturity of the CSE's subordinated debt 
must be at least five years. Second, the subordinated debt instrument 
must state clearly on its face that repayment of the debt is not 
protected by the Securities Investor Protection Corporation (``SIPC'') 
or any Federal agency. Third, the debt must be unsecured and 
subordinated in right of payment to all senior indebtedness of the CSE. 
Fourth, the terms of the subordinated debt agreement may permit 
acceleration only in the event of bankruptcy or reorganization of the 
CSE under Chapters 7 (liquidation) or 11 (reorganization) of the U.S. 
Bankruptcy Code. The intent of these four criteria is to provide for 
permanency of capital and to inform subordinated lenders of the risks 
associated with being a subordinated lender.
---------------------------------------------------------------------------

    \41\ By contract, subordinated debt is debt that is subordinated 
in right of payment to all senior indebtedness of the company.
---------------------------------------------------------------------------

    Funds lent under a subordinated debt agreement necessarily are 
subject to the risks of the CSE's business and must be available to pay 
other creditors if the holding company defaults on other obligations or 
fails. Although the customers of certain of the entities which are part 
of the CSE may be entitled to the protection of SIPC or a Federal 
agency under specific circumstances, such as the failure of a broker-
dealer subsidiary, subordinated lenders of the holding company, as 
subordinated lenders, would not be entitled to any such protection.
    Under the proposal, to be included in allowable capital, 
subordinated debt must have characteristics that are consistent with 
capital. Therefore, the subordinated debt must be unsecured and 
subordinated in right of payment to all of the CSE's senior debt. Debt 
that, upon default, can be repaid by conversion of collateral or before 
other debt cannot be considered subordinated in right of repayment to 
all senior indebtedness of the CSE because the debt effectively would 
have priority over at least some other debt.
    Subordinated debt instruments that permit acceleration of payment 
upon events other than bankruptcy or reorganization of the holding 
company would not qualify for inclusion in allowable capital under the 
proposed rules.\42\ Acceleration clauses raise significant supervisory 
concerns because repayment of the debt could be accelerated at a time 
when a CSE may be experiencing financial difficulties. Acceleration, 
therefore, could inhibit a CSE's ability to resolve its financial 
problems in the normal course of business and force the company into 
involuntary bankruptcy, thereby affecting the financial stability of 
the broker-dealer.
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    \42\ The prohibition on acceleration of payment also would 
prohibit inclusion of credit sensitive subordinated debt in 
allowable capital. Credit sensitive subordinated debt ties payments 
to the financial condition of a borrower/holding company or its 
affiliates. This feature of the debt forces a holding company to 
make increased payments as its financial condition deteriorates and, 
therefore, acts as a de facto acceleration clause that may deplete 
the CSE's resources and increase the likelihood of default on debt. 
Furthermore, the clause potentially would allow a subordinated 
lender to obtain payment before senior creditors.
---------------------------------------------------------------------------

    We request comment on the inclusion of subordinated debt in 
allowable capital generally and on the following questions in 
particular:
    [sbull] Is five years the appropriate maturity for subordinated 
debt to be included in allowable capital? Would another term, whether 
longer or shorter, be more appropriate?
    [sbull] To be included in allowable capital, could subordinated 
debt be subject to negative pledge provisions that, for example, would 
restrict a CSE's ability to pledge the equity securities of a 
subsidiary to secure the debt or to sell a subsidiary unless the buyer 
agreed to assume liability for some portion of the debt?
    [sbull] Should subordinated debt that is subject to acceleration 
events other than bankruptcy or reorganization of the CSE under the 
Bankruptcy Code be included in allowable capital?
    [sbull] Should there be a maximum amount of subordinated debt that 
is includible in allowable capital? If so, what should be the amount?
    [sbull] What are the additional costs of issuing subordinated debt 
versus long-term debt of the same maturity?
    Some industry participants have suggested that certain long-term 
debt that cannot be accelerated should be included in allowable capital 
because, since at the holding company level there is no protected class 
of creditors, there is no significant difference between that type of 
long-term debt and subordinated debt. In addition, they assert that 
subordinated debt is more costly to an entity than long-term debt that 
cannot be accelerated because of the restrictive provisions associated 
with subordinated debt and the lack of an active trading market for 
subordinated debt. They see no other legitimate purpose behind the 
requirement that the debt be subordinated in order to count as capital.
    We solicit comment on whether long-term debt, subject to 
appropriate limitations, should be included in allowable capital. 
Specifically, we request comment on the following issues:
    [sbull] If long-term debt is included in allowable capital, what 
restrictions should apply?
    [sbull] Does a holder of a CSE's subordinated debt have a greater 
incentive to monitor the financial condition of CSE than a holder of 
its long-term debt because its claim is more junior? Would trading in 
its subordinated debt provide a more reliable indication of the credit 
quality of the CSE than long-term debt and, if so, why?
    [sbull] Are there debt instruments other than subordinated debt 
that provide an equivalent market signal about the credit quality of 
the issuer?
    [sbull] Is there a material difference between the depth of the 
market for the long-term debt of a CSE and the depth of the market for 
its subordinated debt and, if so, how would any such difference impact 
the cost of financing for the CSE?
    [sbull] Would there be any other adverse effects if the CSE was 
permitted to include long-term debt in allowable capital?
    [sbull] If long-term debt could be included in allowable capital, 
what, if any, requirements should apply to the maturity date of the 
long-term debt? What should permissible events of acceleration be?
    [sbull] Should long-term debt be subject to a negative pledge, 
that, for example, would restrict a holding company's

[[Page 62883]]

ability to pledge the equity securities of a subsidiary to secure the 
debt or to sell a subsidiary unless the pledgor or buyer agreed to 
assume liability for some portion of the debt?
    [sbull] Would the inclusion of long-term debt in allowable capital 
affect the liquidation priority of the customers of entities which are 
part of the CSE in the event of the holding company's bankruptcy?
    [sbull] What other provisions concerning the inclusion of long-term 
debt in allowable capital should be considered?
    We request comment on all aspects of the calculation of allowable 
capital.
b. Group-Wide Calculation of Allowance for Market Risk
    Under proposed paragraph (a)(2) of Appendix G, a CSE would 
calculate a group-wide allowance for market risk on all proprietary 
positions, using a VaR model or an alternative method approved by the 
Commission, multiplied by an appropriate multiplication factor to 
provide an adequate measure of risk during periods of market stress. 
The calculation of the allowance for market risk is important in 
determining what risk due to market factors the broker-dealer may be 
exposed to through its affiliates. The VaR model would have to meet the 
qualitative and quantitative requirements of paragraph (e) of proposed 
Appendix E.\43\ The computation of the allowance for market risk under 
this proposal is consistent with the calculation of the market risk 
capital charge for the broker-dealer under proposed Appendix E. The 
Commission seeks comment on all aspects of the proposed method of 
calculating an allowance for market risk. In particular, should other 
qualitative or quantitative requirements be included in paragraph (e) 
of proposed Appendix E?
---------------------------------------------------------------------------

    \43\ See supra, discussion of the broker-dealer's calculation of 
its market risk capital charge using a VaR model under proposed 
Appendix E.
---------------------------------------------------------------------------

c. Group-Wide Calculation of Allowance for Credit Risk
    Paragraph (a)(3) of proposed Appendix G would require that a CSE 
calculate an allowance for credit risk daily for certain assets on the 
consolidated balance sheet and certain off-balance sheet items. The 
allowance for credit risk would be computed using the methodology set 
forth in paragraph (a)(3)(i) of proposed Appendix G, which is 
consistent with the proposed New Basel Accord, or, pursuant to 
paragraph (a)(3)(ii) of proposed Appendix G, if the Commission approves 
the broker-dealer's request, using a calculation consistent with 
standards published by the Basel Committee, as modified from time to 
time. This choice would provide CSEs with some flexibility while the 
Basel Standards are under review.
    The methodology set forth in paragraph (a)(3)(i) of proposed 
Appendix G would require that a CSE multiply the credit equivalent 
amount of each asset or off-balance sheet item by the appropriate 
credit risk weight of that asset or off-balance sheet item, and then 
multiply the result by 8%.\44\ In general, the assets and off-balance 
sheet items subject to this allowance are loans and loan commitments 
receivable and receivables arising from derivatives contracts, 
repurchase and reverse repurchase agreements, stock lending 
transactions, and similar collateralized transactions, and other 
extensions of credit.
---------------------------------------------------------------------------

    \44\ This is consistent with the calculation of credit risk 
under the OTC derivatives dealers rules (See 17 CFR 240.15c3-
1f(d)(2)). In addition, use of the 8% basic multiplier to calculate 
credit risk is consistent with the Basel Standards.
---------------------------------------------------------------------------

    Paragraph (a)(3)(i) of proposed Appendix G would establish the 
manner in which the ``credit equivalent amount'' of a balance sheet 
item should be calculated, which is consistent with the proposed New 
Basel Capital Accord. The credit equivalent amounts for receivables 
relating to (i) loans and loan commitments receivable; (ii) derivatives 
contracts, repurchase agreements, reverse repurchase agreements, stock 
loans, stock borrows, and other similar collateralized transactions; 
and (iii) other assets would be calculated differently. These 
calculations are set forth in paragraphs (a)(3)(i)(A), (B), and (E) of 
proposed Appendix G, respectively. We request comment on the credit 
conversion factors set forth in paragraph (a)(3)(i)(A) of proposed 
Appendix G. In particular, we request comment on the credit conversion 
factor for margin loans.
    Paragraph (a)(3)(i)(C) of proposed Appendix G would define the 
``current exposure'' of a member of the affiliate group to a 
counterparty as the current replacement value of the counterparty's 
positions with the member of the affiliate group after applying certain 
netting agreements,\45\ taking into account the value of certain 
collateral \46\ pledged to and held by a member of the affiliate group, 
and subtracting the fair market value of any credit derivatives that 
specifically change the CSE's exposure to the counterparty (as long as 
the credit derivatives are not used to change the credit risk weight of 
the counterparty).\47\
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    \45\ Only netting agreements that meet the requirements set 
forth in paragraph (d)(5) of proposed Rule 15c3-1e could be used to 
reduce current or maximum potential exposures. See supra, note 36.
    \46\ Only collateral that meets the requirements set forth in 
paragraph (d)(6) of proposed Rule 15c3-1e could be used to reduce 
current or maximum potential exposures. See supra, note 37.
    \47\ The fair market value of any credit derivatives that 
specifically change the CSE's exposure to the counterparty may be 
used to calculate ``current exposure'' and ``maximum potential 
exposure'' only to the extent that the credit derivative is not used 
to change the credit risk weight of the counterparty as set forth in 
paragraph (a)(3)(i)(I) of proposed Appendix G.
---------------------------------------------------------------------------

    Paragraph (a)(3)(i)(D) of proposed Appendix G would define the 
``maximum potential exposure'' of a member of the affiliate group to a 
counterparty as the increase in the net replacement value of the 
counterparty's positions with the member of the affiliate group, after 
applying certain netting agreements,\48\ taking into account the value 
of certain collateral \49\ pledged to and held by the member of the 
affiliate group, and subtracting the fair market value of any credit 
derivatives that specifically change the CSE's exposure to the 
counterparty (as long as the credit derivatives are not used to change 
the credit risk weight of the counterparty) \50\ that is obtained daily 
using an approved VaR model meeting the applicable qualitative and 
quantitative requirements of paragraph (e) of proposed Appendix E.\51\
---------------------------------------------------------------------------

    \48\ See supra, note 36.
    \49\ See supra, note 37.
    \50\ See supra, note 47.
    \51\ The quantitative requirements for a VaR model used to 
calculate maximum potential exposure would include that the model 
use a 99 percent, one-tailed confidence level with price changes 
equivalent to a five-day movement in rates and prices for repurchase 
agreements, reverse repurchase agreements, stock lending and 
borrowing, and similar collateralized transactions (See paragraph 
(c)(1)(i)(E) of proposed Appendix G) and to a one-year movement in 
rates and prices for other positions (See proposed paragraph 
(e)(2(ii) of proposed Appendix E) (as opposed to a ten business-day 
movement in rates and prices for VaR models used to calculate the 
allowance for market risk. (See paragraph (e)(2)(i) of proposed 
Appendix E).
---------------------------------------------------------------------------

    We request comment on whether the proposed method of calculating 
the credit equivalent amount is appropriate, or whether it should be 
changed. In addition, we request comment on whether the definitions of 
``current exposure'' and ``maximum potential exposure'' are 
appropriate, or if they should be changed. If the proposed method for 
calculating credit equivalent amount or the definitions of ``current 
exposure'' or ``maximum potential exposure'' should be changed, please 
specify how they should be changed.
    Paragraph (a)(3)(i)(F) of proposed Appendix G provides that credit 
risk weights would generally be determined

[[Page 62884]]

according to standards published by the Basel Committee, as modified 
from time to time. If the Commission approves an application by the 
broker-dealer in its initial application or an amendment to the 
application, the CSE may use internal credit ratings \52\ or calculate 
credit risk weights using internal calculations \53\ when calculating 
its allowance for credit risk.
---------------------------------------------------------------------------

    \52\ See paragraph (a)(3)(i)(G) of proposed Appendix G.
    \53\ See paragraph (a)(3)(i)(H) of proposed Appendix G.
---------------------------------------------------------------------------

    In addition, paragraph (a)(3)(i)(J) of proposed Appendix G would 
allow a CSE to adjust credit risk weights of receivables covered by 
certain types of guarantees,\54\ and paragraph (a)(3)(i)(I) of proposed 
Appendix G would allow a CSE to adjust credit risk weights of 
receivables covered by certain credit derivatives (such as credit 
default swaps, total return swaps, and similar instruments used to 
manage credit risk) \55\ in recognition of the credit protection these 
instruments provide.
---------------------------------------------------------------------------

    \54\ The guarantee would be required to be an unconditional and 
irrevocable guarantee of the due and punctual payment and 
performance of the obligation and the holding company or member of 
the affiliate group can demand payment after any payment is missed 
without having to make collection efforts. Further, the guarantee 
would be required to be evidenced by a written obligation of the 
guarantor that allows the holding company or member of the affiliate 
group to substitute the guarantor for the counterparty upon default 
or nonpayment by the counterparty. These proposed requirements are 
designed to allow a CSE to reduce its allowance for credit risk only 
if the guarantee contains features that make it more reliable.
    \55\ The credit derivative would be required to be one that (i) 
provides credit protection equivalent to a guarantee, (ii) is used 
for bona fide hedging purposes to reduce the credit risk weight of a 
counterparty, (iii) is not incorporated into the VaR model used for 
deriving potential exposures, and (iv) is not held for market-making 
purposes.
---------------------------------------------------------------------------

    The Commission requests comment on the determination of credit risk 
weights. In particular, the Commission requests comment on whether an 
additional method of calculating credit risk weights, based on internal 
estimates of annual probabilities of default, should be included in 
proposed Appendix G.\56\
---------------------------------------------------------------------------

    \56\ See supra, discussion of proposed credit risk capital 
charge calculation for the broker-dealer.
---------------------------------------------------------------------------

    The Commission believes that using a VaR model that meets the 
applicable qualitative and quantitative requirements of paragraph (e) 
of proposed Appendix E to calculate maximum potential exposure is a 
more precise method than using a ``notional add-on'' to approximate 
maximum potential exposure. In addition, Commission reviews of risk 
management systems of large U.S. broker-dealers and their affiliates 
indicate that these firms generally use maximum potential exposure to 
measure and manage the credit risk of their portfolios. These firms 
would therefore incur little, if any, additional cost to calculate 
credit risk using maximum potential exposure as opposed to ``notional 
add-ons.''
    We request comment on this approach to the calculation of credit 
risk on derivatives, repurchase agreements, reverse repurchase 
agreements, stock lending and borrowing, and similar collateralized 
transactions. In addition, we request comment on the proposed 
requirements for guarantees used to reduce a CSE's allowance for credit 
risk. We also request comment on the appropriate treatment of credit 
derivatives in this context. Credit derivatives could enter into the 
calculation of credit risk in two ways. The first would be to 
substitute the credit risk weight of the writer of the credit 
derivative for the credit risk weight of the counterparty for the 
portion of the exposure covered by the credit derivative. This is the 
method set forth in paragraph (a)(3)(i)(I) of proposed Appendix G. 
Another method would be to adjust the current exposure and the maximum 
potential exposure by the value of the credit derivative. We request 
comment on these and other methods of treating credit derivatives.
    Certain accounting differences between securities firms and banking 
firms may necessitate certain modifications to the Basel Standards when 
they are applied to securities firms. For instance, broker-dealers must 
mark all positions to market, while banks may use historical cost for 
securities held for investment purposes. The Commission solicits 
comment on how accounting differences might affect the computation of 
the allowance for credit risk, and what modifications the Commission 
should make to the proposed rules to address those differences.
    The Commission seeks comment on all aspects of the proposed method 
of calculating the allowance for credit risk. Because the Basel 
Standards have been implemented by many financial regulators, we 
request comment on whether the proposed method is consistent with the 
Basel Standards as they have been implemented. In addition, we request 
comment on whether the proposed rule is consistent with the proposed 
New Basel Capital Accord and whether it is consistent with how various 
financial regulators have proposed to implement the proposed New Basel 
Capital Accord. Should a CSE have other alternative methods for 
calculating the allowance for credit risk?
d. Group-Wide Calculation of Allowance for Operational Risk
    The calculation of an allowance for operational risk is intended to 
measure risks faced by the firm other than market and credit risk; for 
example, operational risk would include the risk that the prescribed 
procedures of the firm may not be followed in a particular transaction, 
causing the firm to incur potentially significant losses. Such losses 
incurred by the holding company or an affiliate of a broker-dealer 
could have a significant adverse effect on the broker-dealer. The 
proposed rule would, therefore, require that the CSE calculate an 
allowance for operational risk.
    Under proposed Rule 15c3-1g(a)(4), the calculation of the allowance 
for operational risk must be consistent with the proposed New Basel 
Capital Accord. The Basel Committee has proposed three methods for the 
calculation of an allowance for operational risk: the basic approach, 
the standardized approach, and the advanced measurement approach.\57\ 
The basic and standardized approach calculations are based on fixed 
percentages. Under the basic approach, the allowance is 15% of 
consolidated annual revenues net of interest expense averaged over the 
past three years. For the standardized approach, the allowance for 
operational risk is a percentage of revenues net of interest expense, 
ranging from 12% to 18%, for each of eight business lines. The advanced 
measurement approach requires a system for tracking and controlling 
operational risk and provides that the allowance for operational risk 
is the largest operational loss that might be expected over a one-year 
period with 99.9% confidence.
---------------------------------------------------------------------------

    \57\ See The New Basel Capital Accord (April 2003).
---------------------------------------------------------------------------

    We solicit comment on all aspects of the proposed allowance for 
operational risk, including how to best measure operational risk and 
when a calculation of operational risk should be required. We request 
comment on whether any of the methods is preferable and, if so, why. 
Further, could any changes be made to these methods or percentages used 
to calculate the charges that would be more appropriate for the broker-
dealer business? Finally, should we allow a holding company to choose 
one of the three methods, or should the proposal require holding 
companies to use the advanced measurement approach?

[[Page 62885]]

e. Holding Companies Subject to Supervision by a Financial Regulator 
Other Than the Commission
    Certain CSEs that own broker-dealers are subject to supervision at 
the holding company level by a financial regulator or supervisor other 
than the Commission. These holding companies may be required by that 
financial regulator to compute a capital assessment similar to that 
required by paragraphs (a)(1) through (a)(4) of proposed Appendix G. To 
reduce regulatory burdens, and because we think that such calculations 
will be sufficient to permit us to evaluate the risk to the broker-
dealer, paragraph (a)(5) of proposed Appendix G provides that, upon 
Commission approval of the broker-dealer's original application or 
amendments to the application, the CSE may compute a capital assessment 
consistent with the standards issued by the Basel Committee that it is 
required to submit to a financial regulator or supervisor in lieu of 
the computations required by paragraphs (a)(1) through (a)(4) of 
proposed Appendix G, provided these computations are consistent with 
the Basel Standards. We request comment on this provision.
f. General Discussion of Basel Pillars
    This proposal would apply a capital reporting requirement 
consistent with the Basel Standards to the CSE. The Basel Committee is 
currently developing a new international agreement (the ``proposed New 
Basel Capital Accord''). The proposed New Basel Capital Accord 
specifies three ``pillars'' for the group-wide supervision of 
internationally active banks and financial enterprises. The first 
pillar, ``minimum regulatory capital'' requirements, requires 
calculations for credit and operational risk and, for firms with 
significant trading activity, market risk. The second pillar, 
``supervisory review,'' requires that capital be assessed relative to 
overall risks and that supervisors review and take action in response 
to those assessments.\58\ We request comment on whether the regulatory 
regime outlined in this proposal together with existing Commission 
regulation of broker-dealers would meet the requirements of the first 
and second pillars of the proposed New Basel Capital Accord or whether 
changes or enhancements should be made. In addition, we request comment 
on whether, if the proposed New Basel Capital Accord is adopted, there 
should be a transition period before the Commission requires its use by 
CSEs.
---------------------------------------------------------------------------

    \58\ Id.
---------------------------------------------------------------------------

    The third pillar requires certain disclosures which will allow 
market participants to assess key pieces of information concerning, for 
example, the capital, risk exposures, and risk assessment processes of 
the institution. The purpose of the third pillar is to complement the 
minimum capital requirements and the supervisory review process by 
encouraging market discipline.\59\
---------------------------------------------------------------------------

    \59\ Id.
---------------------------------------------------------------------------

    The third pillar is discussed in the U.S. banking agencies' 
Advanced Notice of Proposed Rulemaking on the proposed New Basel 
Capital Accord.\60\ As the banking agencies noted, an integral part of 
the proposed New Basel Capital Accord is enhanced public disclosure 
practices. Specific disclosure requirements would be applicable to all 
institutions using the proposed New Basel Capital Accord and would 
encompass capital, credit risk, credit risk mitigation, securitization, 
market risk, operational risk, and interest rate risk.
---------------------------------------------------------------------------

    \60\ See Risk-Based Capital GUidelines; Implementation of New 
Basel Capital Accord, 68 FR 45900 beginning at 45943 (August 4, 
2003).
---------------------------------------------------------------------------

    We request comment on whether any additional disclosures by U.S. 
broker-dealer firms, their holding companies, and affiliates should be 
required to meet the requirements of the third pillar of the proposed 
New Basel Capital Accord. If additional, specific disclosure is 
warranted, commenters are asked to address where that disclosure should 
be made as well as whether disclosures should be made on a quarterly, 
annual, or other periodic basis. In addition, we request comment on 
whether additional required disclosures should depend on whether a firm 
is privately held or is required to file information, documents, and 
reports pursuant to Sec. Sec.  13(a) or 15(d) of the Exchange Act.
2. Reporting Requirements for the CSE
    As a condition of Commission approval, pursuant to proposed 
paragraph (b) of Appendix G, the CSE would be required to file certain 
monthly and quarterly reports, as well as annual audited statements, 
with the Commission. The Commission would use the information filed by 
the CSE to monitor the financial condition, internal risk management 
control system, and activities of the CSE. This would give the 
Commission important information regarding activities of its affiliates 
that could impair the financial and operational stability of the 
broker-dealer. These reports would also allow the Commission to monitor 
the condition of the affiliate group to detect any events or trends 
that may adversely affect the broker-dealer. Failure to require the 
reports would undermine the Commission's ability to monitor the 
financial condition of the CSEs and could jeopardize the financial 
stability of broker-dealers using Appendix E to calculate certain of 
their capital charges. Moreover, requiring timely financial and other 
risk information that identifies which business line or affiliated 
entity may have incurred particular risks is necessary in order to 
identify areas for Commission examination.
    Pursuant to paragraph (b)(1) of proposed Appendix G, the CSE would 
be required to file a monthly report with the Commission within 17 
business days after the end of the month (the FOCUS reporting period) 
that includes certain consolidated financial and credit risk 
information, a graph for each business line reflecting the daily intra-
month VaR calculations, and certain reports the CSE regularly provides 
to its senior management to assist it in monitoring and managing risk. 
We request comment on all aspects of this requirement, including the 
timing of the reports.
    Pursuant to paragraph (b)(2) of proposed Appendix G, the CSE would 
be required to file a quarterly report within 35 calendar days after 
the end of each quarter that includes, in addition to the information 
required in the monthly filing, consolidating financial information, 
the results of backtesting of models used to compute its allowances for 
market and credit risk, a description of all material pending legal or 
arbitration proceedings required to be reported pursuant to generally 
accepted accounting principles (``GAAP''), and certain short-term 
borrowings. Requiring reports to be filed within 35 calendar days after 
the end of each quarter provides time frames similar to those for 
quarterly reports due from companies required to file information, 
documents, and reports pursuant to Sec.  13(a) or 15(d) of the Exchange 
Act. We request comment on all aspects of this requirement, including 
the timing of the reports.
    Paragraph (b)(3) of proposed Appendix G would require that the CSE 
provide the Commission upon request with such other reports as may be 
necessary to monitor the financial condition of the CSE and its risk 
exposures, as they could affect the financial condition of the broker-
dealer. We request comment on this provision.
    Paragraph (b)(4) of proposed Appendix G would require that the CSE 
file an annual audit report with the Commission concurrently with the

[[Page 62886]]

annual audit report filed by the broker-dealer. The annual audit report 
must include consolidated financial statements and must be audited by a 
registered public accounting firm.\61\ Paragraph (b)(5) of Appendix G 
would require that the CSE file accountants' reports prepared by a 
registered public accounting firm, in accordance with agreed-upon 
procedures, regarding management controls and inventory pricing and 
modeling. By performing an independent review of the firm's financial 
condition and risk management practices, auditors have an important 
role in the Commission's regulatory framework by helping to assure that 
the broker-dealer and the holding company are in compliance with the 
conditions of the exemption. We request comment on these requirements.
---------------------------------------------------------------------------

    \61\ See supra, note 32.
---------------------------------------------------------------------------

    The Commission seeks comment on these reporting requirements, 
particularly regarding the timing and other aspects of the reporting 
requirements. In particular, we request comment on whether the audit 
report and accountants' reports should be prepared by a registered 
public accounting firm. We request comment on whether these reporting 
requirements should be modified for a CSE with an affiliate required to 
file information, documents, and reports pursuant to Sec. Sec.  13(a) 
or 15(d) of the Exchange Act or that is subject to supervision at the 
holding company level by a financial regulator or supervisor other than 
the Commission and, if so, how they should be modified. Should the 
reporting requirements under paragraph (b) of proposed Appendix G 
include a requirement that an electronic filing be made with the 
Commission before a quarterly report filed pursuant to reporting 
requirements for companies required to file information, documents, and 
reports pursuant to Sec. Sec.  13(a) or 15(d) of the Exchange Act must 
be filed with the Commission?
3. Records To Be Made and Maintained by the CSE
    The CSE of a broker-dealer that uses proposed Appendix E to 
calculate its capital charges would undertake to make the records 
listed in paragraph (c) of proposed Appendix G. The purpose of this 
requirement is to require that the CSE create records that would allow 
the Commission to determine whether the CSE is in compliance with the 
terms of the exemption. Most or all of these records already are 
generated for internal management purposes because a prudent firm that 
manages risk on a group-wide basis would make and maintain these 
records in the ordinary course of its business. The Commission would 
accept the records in the format used by the firms. The records that 
are made must include a record indicating that the CSE has conducted 
stress tests of the affiliate group's funding and liquidity in response 
to certain events, including a credit downgrade of the CSE or an 
inability of the holding company to obtain short-term financing, the 
results of those stress tests, a record showing that the CSE has a 
contingency plan to respond to those events, and a record of the basis 
for determining credit risk weights in certain circumstances. These 
events are intended to identify possible liquidity and funding stress 
scenarios that could impose significant financial distress on the CSE 
and that could jeopardize the financial stability of the broker-dealer. 
The Commission believes that records of the CSE's contingency plans to 
respond to those events would provide the Commission with important 
information during an examination that would be necessary to adequately 
assess the CSE's financial condition and risk exposures. We request on 
whether there are any other records that the CSE should be required to 
create. We also request comment on whether it would be appropriate to 
expand the list of specified events described above. In addition, we 
request comment on whether Exchange Act Rule 17a-3 should be amended, 
or whether propose Appendix E should be modified, to impose additional 
recordkeeping requirements on broker-dealers using proposed Appendix E 
to calculate certain of their capital charges.
    Paragraph (d) of proposed Appendix G contains record maintenance 
requirements for CSEs. The CSE would be required to maintain, for a 
period of not less than three years, the records it is required to make 
under paragraph (c) of proposed Appendix G, its application and other 
documents, reports, and notices it files with the Commission pursuant 
to proposed Appendix E or proposed Appendix G and any written responses 
from the Commission, and written policies and procedures concerning its 
internal risk management system. Exchange Act Rule 17a-4 requires that 
broker-dealers maintain certain records for this time period, and we 
believe that this time period is sufficient for purposes of this 
proposal to allow effective examinations of CSEs.
    We request comment on the Commission's proposed recordkeeping 
requirements applicable to the holding company and its regulated non-
broker-dealer affiliates and whether, and to what extent, they should 
be modified. With respect to any recordkeeping requirements that should 
be modified because records are already provided to a financial 
regulator, please specifically list the records that a holding company 
provides to its financial regulator that are equivalent to records that 
would be required in this proposal. Are there reports that holding 
companies submit to bank regulators that would provide the information 
required in this proposal? We request comment on whether we should 
amend Exchange Act Rule 17a-4 to require broker-dealers to retain 
certain of these records or whether proposed Appendix E should be 
modified to impose these additional record preservation requirements. 
Should certain of the record preservation requirements of proposed 
Appendix G be imposed on the broker-dealer rather than on the holding 
company?
4. Notification Requirements for the CSE
    Paragraph (e) of proposed Appendix G requires that the CSE promptly 
notify the Commission upon the occurrence of certain events, including: 
the occurrence of any backtesting exception of VaR models that would 
require the CSE to use a higher multiplication factor; a computation 
showing the affiliate group's allowable capital is less than 110% of 
the total of its allowances for market, credit, and operational risk; a 
declaration of bankruptcy by an affiliate; the downgrading of the 
credit rating of an affiliate or certain debt of an affiliate; or the 
receipt of certain regulatory notices regarding an affiliate. The CSE 
would also be required to file a report if there is a material change 
in the organization of the affiliate group, the material affiliate 
status of any affiliate in the affiliate group, or the major business 
functions of any material affiliate. The notification provisions of 
proposed Appendix G are designed to give the Commission advance warning 
of situations that may pose material financial and operational risks to 
the CSE and the broker-dealer. These provisions are integral to 
Commission supervision of broker-dealers that use Appendix E.
    The Commission seeks comment on all aspects of the notice 
requirements for CSEs. Are the events for which CSEs must report to the 
Commission appropriate? Should the CSE notify the Commission regarding 
other events? We request comment on whether these requirements should 
be modified for a CSE that is subject to supervision at the holding 
company level by a financial regulator or supervisor other than the

[[Page 62887]]

Commission and, if so, how they should be modified.

C. Proposed Amendments to Rule 15c3-4

    The proposed amendments to Exchange Act Rule 15c3-4 would expand 
its coverage to include broker-dealers that use Appendix E to calculate 
their capital charges, requiring them to establish a system of internal 
controls for monitoring and managing the risks associated with their 
business activities.\62\ Rule 15c3-4 is designed to improve the 
integrity of the risk measurement, monitoring, and management process, 
and to clarify accountability, at the appropriate organizational level, 
for defining the permitted scope of activity and level of risk.
---------------------------------------------------------------------------

    \62\ 17 CFR 240.15c3-4.
---------------------------------------------------------------------------

    In addition, as a condition for the broker-dealer to use Appendix E 
to compute certain of its capital charges, the CSE would agree to 
establish such a system to manage group-wide risk for the affiliate 
group of the broker-dealer.
    Participants in the securities markets are exposed to various 
risks, including market risk, credit risk, funding risk, legal risk, 
and operational risk. These risks are due, in part, to the diverse 
range of financial instruments now traded by broker-dealers. Risk 
management controls within a broker-dealer promote the stability of the 
firm and, consequently, the stability of the general marketplace. A 
firm that has adopted and follows appropriate risk management controls 
reduces its risk of significant loss, which also reduces the risk of 
spreading the losses to other market participants or throughout the 
financial markets as a whole. Further, as a general prudent business 
practice, most securities firms have developed risk management systems 
to manage risk on a consolidated basis at the holding company level. To 
have a complete understanding of how risks are managed at the broker-
dealer, regulators need to understand how risks are managed at the 
holding company.
    The specific elements of a risk management system will vary 
depending on the size, complexity, and organization of a firm. As a 
result, the design and implementation of a system of internal controls 
for a particular CSE may differ from other firms. However, well-
developed risk management systems generally share certain core 
principles such as establishing clear responsibilities at each level of 
management, separation of certain key responsibilities, and effective 
monitoring and reporting.
Individual firms must have the flexibility to implement specific 
policies and procedures unique to its circumstances. As a result, Rule
15c3-4 establishes only basic elements for the design, implementation, 
and review of a risk management control system. We previously found 
these elements to be the appropriate ones for an entity to use when 
developing such a system.
    Rule 15c3-4 requires a firm to consider a number of aspects of its 
business when adopting its risk management control system. Although 
each firm must develop controls appropriate to its specific 
circumstances, the rule requires certain elements to be included in the 
firm's internal risk management control system. For example, the system 
must include a risk control unit that reports directly to senior 
management and is independent from business trading units. In addition, 
there must be separation of duties between personnel who enter into 
transactions and personnel who record the transactions.
    Finally, the firm's management must periodically review the firm's 
business activities for consistency with established risk management 
guidelines to check whether firm personnel are operating within the 
scope of permissible activity and whether the risk management system 
continues to be adequate.
    We request comment on the proposed amendments to Rule 15c3-4. We 
request comment on whether the holding company undertakings should 
incorporate Rule 15c3-4 or whether the requirement to establish a 
group-wide internal risk management control system should be a stand-
alone rule. We request comment on whether any aspect of Rule 15c3-4 
could be better tailored to reflect unique aspects of group-wide risk 
management or risk management of broker-dealers using proposed Appendix 
E to calculate certain capital charges. We request comment on whether 
Rule 15c3-4 should be amended to require that results of periodic 
reviews conducted by an internal auditor or annual reviews conducted by 
a registered public accounting firm should be reported in writing to 
the Board of Directors. Should we amend Rule 15c3-4 to require all 
broker-dealers to do so?

D. Proposed Amendments to Rule 17a-5; Broker-Dealer Reporting 
Requirements

    The proposed amendments to Exchange Act Rule 17a-5 would require a 
broker-dealer that uses proposed Appendix E to file certain reports 
with the Commission in addition to the reports that all broker-dealers 
must file under the rule. These reports would provide current detailed 
information regarding the financial position of the firm, which would 
assist us in understanding the risk profile of the firm. The Commission 
would use the information collected under the proposed amendment to 
monitor the financial condition, internal risk management control 
system, and activities of broker-dealers that elect the alternative 
capital computation.
    These additional reports would include a monthly report detailing, 
among other things, its derivatives revenues, certain market and credit 
risk information, backtesting results of its mathematical models, and 
regular risk reports it supplies to its management, quarterly reports 
on, among other things, how well its daily VaR and maximum potential 
exposure correspond to the daily net trading loss, and certain 
supplemental reports concerning management controls and inventory 
pricing and modeling prepared by a registered public accounting 
firm.\63\ We request comment on the proposed additional reporting 
requirements for a broker-dealer that uses Appendix E. In particular, 
we request comment on whether the supplemental reports should be 
prepared by a registered public accounting firm.
---------------------------------------------------------------------------

    \63\ See supra, note 32.
---------------------------------------------------------------------------

E. Proposed Amendments to Rule 17a-11; Broker-Dealer Notification 
Requirements

    Exchange Act Rule 17a-11 requires that a broker-dealer provide 
notification of certain net capital levels and certain operational 
problems to the Commission and its designated examining authority 
within specified time periods. Currently, Exchange Act Rule 17a-11 also 
imposes certain additional notification requirements on an OTC 
derivatives dealer.\64\ The Commission proposes to amend Rule 17a-11 to 
provide for additional notification requirements for a broker-dealer 
that uses proposed Appendix E to calculate certain of its capital 
charges. The events that would require Commission notification would 
indicate that the broker-dealer or its holding company may be 
experiencing financial or operational difficulty.
---------------------------------------------------------------------------

    \64\ 17 CFR 240.17a-11(b)(2).
---------------------------------------------------------------------------

    The proposed amendments would expand the additional notification 
requirements that apply to an OTC derivatives dealer to include a 
broker-dealer that uses Appendix E to calculate certain of its capital 
charges. For

[[Page 62888]]

example, the broker-dealer would be required to provide notice if its 
tentative net capital falls below the minimum amount required pursuant 
to proposed Rule 15c3-1(a)(7)\65\ or if its total tentative net capital 
is less than 120% of its required minimum tentative net capital.\66\
---------------------------------------------------------------------------

    \65\ Pursuant to proposed Rule 15c3-1(a)(7), this minimum 
tentative net capital amount is $1 billion.
    \66\ In that case, under current rules, the broker-dealer must 
immediately cease doing business.
---------------------------------------------------------------------------

    In addition, the proposed amendments would impose additional 
reporting requirements on a broker-dealer that uses Appendix E to 
calculate certain of its capital charges. Such a broker-dealer would 
have to provide notice upon the occurrence of any backtesting exception 
of its mathematical models that requires the broker-dealer to use a 
higher multiplication factor in the calculation of its market or credit 
risk capital charges. The amendments would also require that the 
broker-dealer provide notice if it becomes aware that an NRSRO has 
determined to reduce the credit rating of the broker-dealer, one of its 
affiliates, or an outstanding obligation of the broker-dealer or an 
affiliate, if the broker-dealer or one of its affiliates receives a 
notice of noncompliance from a regulatory agency or SRO, or if the 
broker-dealer becomes aware of a situation that may have a material 
adverse effect on the financial or operational condition of the holding 
company or an affiliate of the holding company. These notices would not 
be required when the holding company has provided notice to the 
Commission pursuant to its undertakings. We request comment on all 
aspects of these notification provisions.

F. Proposed Amendments to Rules 17h-1T and 17h-2T

    Rule 17h-1T requires that a broker-dealer maintain and preserve 
records and other information concerning its holding company and 
affiliates, if the affiliates are likely to have a material impact on 
the financial or operational condition of the broker-dealer. Rule 17h-
2T requires broker-dealers to report to the Commission on the 
information required to be maintained and preserved under Rule 17h-1T. 
We propose to amend these rules to exempt broker-dealers that use 
Appendix E to calculate certain of their capital charges. We believe 
that this exemption is appropriate because the holding company of the 
broker-dealer would be required to make and retain documents 
substantially similar to the documents required by Rule 17h-1T and to 
make reports to the Commission that are substantially similar to those 
required by Rule 17h-2T. We request comment on these proposed 
amendments.

III. General Request for Comment

    The Commission solicits comment on its proposal to permit certain 
broker-dealers to apply for approval to compute capital charges using 
proposed Appendix E to Exchange Act Rule 15c3-1. First, we solicit 
comment on whether this proposed supervisory structure would result in 
adequate Commission oversight on a group-wide basis of eligible broker-
dealers that opt for this voluntary capital computation alternative. 
Second, we solicit comment on whether proposed Appendix E to the net 
capital rule would provide appropriate capital levels for qualifying 
broker-dealers and whether the Commission should modify proposed 
Appendix E in any way. Third, we solicit comment on whether the 
proposal would address any perceived competitive disadvantages that 
impact broker-dealers that intend to conduct a global securities 
business. Fourth, we solicit comment on whether the Commission should 
consider a different approach to setting capital requirements for the 
broker-dealer or to the calculation of allowances for market and credit 
risk for CSEs, and, if so, what that approach should be. Fifth, we 
solicit comment on the effects on competition from making these 
proposals available to only certain broker-dealers. Are there firms 
below the proposed capital thresholds that would benefit from computing 
capital charges using proposed Appendix E? Would permitting such firms 
to use proposed Appendix E provide sufficient net capital reserves for 
these firms?
    In addition, we solicit comment on whether we have adequately 
stated our approach to making this exemption available to firms that 
are subject to holding company supervision by another financial 
regulator. We request comment on whether there are any other approaches 
or issues that we should consider with respect to firms affiliated with 
holding companies supervised by another financial regulator.
    For holding companies that own more than one broker-dealer, the 
alternative net capital computation under this proposal would be 
available only to a broker-dealer that meets the minimum capital 
requirements. We request comment on whether this proposal would create 
an incentive for such a holding company to change its business 
structure, such as combining its securities business into a single 
broker-dealer and, if so, whether there would be any resulting costs or 
benefits.
    We note that on September 12, 2003, the Federal Reserve, OCC, OTS, 
and FDIC requested public comment on an interim final rule and a notice 
of proposed rulemaking to amend their risk-based capital standards for 
the treatment of assets in asset-backed commercial paper programs 
consolidated under the recently issued Financial Accounting Standards 
Board Interpretation No. 46, Consolidation of Variable Interest 
Entities.\67\ The rule would also modify the risk-based capital 
treatment of certain securitizations with early amortization 
provisions. In addition, the treatment of securitization exposures is 
discussed in the banking agencies' Advanced Notice of Proposed 
Rulemaking on the New Basel Capital Accord.\68\ Should the Commission 
consider any modifications to the proposed method for the group-wide 
calculation of allowances for market or credit risk with respect to 
asset-backed securitization programs? If so, how and why should the 
Commission modify the calculations for asset-backed securitization 
programs? Should the Commission consider any other issues related to 
the capital treatment of securitization exposures?
---------------------------------------------------------------------------

    \67\ Risk-Based Capital Guidelines; Capital Adequacy Guidelines; 
Capital Maintenance: Capital Treatment of Consolidated Asset-Backed 
Commercial Paper Program Assets, 68 FR 56568 (proposed rule), 68 FR 
56530 (interim final rule) (Oct. 1, 2003).
    \68\ See Risk-Based Capital Guidelines; Implementation of New 
Basel Capital Accord, 68 FR 45900 beginning at 45932 (August 4, 
2003).
---------------------------------------------------------------------------

    Finally, we invite commenters to provide views and data as to the 
costs and benefits associated with the proposed changes discussed above 
in comparison to the costs and benefits of the current regulatory 
framework. For purposes of the Small Business Regulatory Enforcement 
Fairness Act of 1996, the Commission also requests information 
regarding the potential impact of the proposed amendments and rules on 
the economy on an annual basis. Commenters should provide empirical 
data to support their views. Comments should be submitted by February 
4, 2004.

IV. Paperwork Reduction Act

    Certain provisions of the proposed rule amendments contain 
``collection of information'' requirements within the meaning of the 
Paperwork Reduction Act of 1995.\69\ The Commission has submitted them 
to the Office of Management and Budget (``OMB'') for review in 
accordance with 44 U.S.C.

[[Page 62889]]

3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor, and a 
person is not required to comply with, a collection of information 
unless it displays a currently valid OMB control number. The titles for 
the collections of information are: (1) Appendix E to Rule 15c3-1, 
Market and credit risk capital charges for certain brokers or dealers; 
(2) Appendix G to Rule 15c3-1, Conditions for holding companies of 
certain brokers or dealers; (3) Rule 15c3-4, Internal risk management 
control systems for certain brokers or dealers; (4) Rule 17a-5, Reports 
to be made by certain brokers and dealers; (5) Rule 17a-11, 
Notification procedures for brokers and dealers; (6) Rule 17h-1T, Risk 
assessment recordkeeping requirements for associated persons of brokers 
and dealers; and (7) Rule 17h-2T, Risk assessment reporting 
requirements for brokers and dealers.
---------------------------------------------------------------------------

    \69\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    The Commission proposes to implement a voluntary alternative method 
for computing net capital charges under the Exchange Act for certain 
broker-dealers that are part of a holding company that has a group-wide 
internal risk management system and that consents, as a condition of 
the net capital treatment, to group-wide Commission supervision. A 
broker-dealer that maintains tentative net capital of at least $1 
billion and net capital of at least $500 million could apply to the 
Commission for a conditional exemption from the application of the 
standard net capital computation and, upon Commission approval, elect 
to calculate certain of its market and credit risk net capital charges 
using internally developed mathematical models that the firm uses to 
measure risk. Commission supervision would include reporting and 
recordkeeping requirements and Commission examination of unregulated 
holding companies and affiliates that are not functionally regulated.
    The collection of information obligations imposed by the proposal 
would be mandatory. However, applying for approval to use the 
alternative capital calculation is voluntary.
    The information collected, retained, and/or filed pursuant to the 
proposed rule amendments would be accorded confidential treatment.
    The Commission would use the information collected under the 
proposed amendments to monitor the financial condition, internal risk 
management control system, and activities of broker-dealers that elect 
to compute certain of their market and credit risk capital charges 
under the alternative method and their holding companies and 
affiliates. In particular, the proposed amendments would allow the 
Commission access to important information regarding activities of a 
broker-dealer's affiliates that could impair the financial and 
operational stability of the broker-dealer.
    According to March 31, 2003 FOCUS filings, 28 registered broker-
dealers reported that they had tentative net capital of at least $1 
billion and net capital of at least $500 million. Based on discussions 
with industry representatives, the Commission believes, however, that 
only broker-dealers with at least $1 billion in deductions pursuant to 
(c)(2)(vi) of Rule 15c3-1 (also know as ``haircuts'') will find it cost 
effective to use the alternative capital computation. As of March 2003, 
based on FOCUS filings, there were 12 such broker-dealers. Therefore, 
the PRA estimates are based on the assumption that 12 broker-dealers 
will apply for an exemption under the proposal.
    Many of the estimates are also based on information Commission 
staff receives through the risk assessment rules and meetings with and 
reports from member firms of the Derivatives Policy Group (``DPG'') and 
other broker-dealers and the Commission's experience in implementing 
the OTC derivatives dealer rules.
    A broker-dealer that applies to use proposed Appendix E and its 
affiliates would have discretion in allocating the paperwork burden 
associated with the proposal among the entities in the CSE 
(``consolidated supervised entity''), including the broker-dealer. In 
estimating the total burden associated with the proposal on the broker-
dealer, we have included the burdens arising from each proposed new 
rule amendment.

A. Proposed Appendix E to Rule 15c3-1, Market and Credit Risk Capital 
Charges for Certain Brokers or Dealers

    Exchange Act Rule 15c3-1 requires broker-dealers to maintain 
minimum levels of net capital computed in accordance with the rule's 
provisions. These net capital reserves are intended to ensure that 
broker-dealers have sufficient capital to protect the assets of 
customers and to meet their responsibilities to other broker-dealers.
    The Commission is proposing to add Appendix E to the rule to 
provide an alternative method for determining certain net capital 
charges for certain broker-dealers that manage risk on a group-wide 
basis and that submit to group-wide Commission supervision.
    As part of the exemptive application to use Appendix E, the broker-
dealer and its holding company would submit descriptions of internal 
risk management controls and methods to be used to measure risk, 
including descriptions of all mathematical models used to price 
positions and compute market and credit risk and how those models meet 
the requirements of proposed Appendix E. The application would also 
include sample capital assessments for the affiliate group and sample 
risk reports provided to the firm's management and a written 
undertaking by the holding company to comply with various requirements 
of the proposal, including those listed in proposed Appendix G.
    Proposed Appendix E would also require that mathematical models 
used to compute market and credit risk be reviewed periodically and 
backtested quarterly. For example, the mathematical model used to 
calculate maximum potential exposure would be required to be backtested 
quarterly for at least 40 counterparties by comparing the daily change 
in the firm's daily exposure to the counterparty with the maximum 
potential exposure generated by the model.
    Failure to require the current and proposed collections of 
information included in this proposal would undermine the Commission's 
ability to monitor the financial condition of these firms and could 
jeopardize the financial stability of broker-dealers using Appendix E 
to compute certain of their capital charges.
    We estimate that each broker-dealer that applies under the proposal 
would spend approximately 1,000 hours to create and compile the various 
documents to be included with the application and to work with the 
Commission staff through the application process. This includes 
approximately 100 hours for an in-house attorney to complete a review 
of the application. Consequently, the Commission estimates the total 
burden associated with the application process for the 12 broker-
dealers we expect to apply to be 12,000 hours.
    These estimates are based on estimates the Commission made for the 
OTC derivatives dealer rules, which include a similar application 
requirement.\70\ In that proposing release, we estimated that an OTC 
derivatives dealer would spend approximately 1,000 hours developing and 
submitting its VaR model and description of its risk management control 
system to the

[[Page 62890]]

Commission.\71\ No comments were received in response to the estimates 
in the proposing release, and those burden estimates were not changed 
in the final rule release.\72\ For purposes of this proposal, we note 
that firms applying to use Appendix E will have already developed the 
VaR models that they would use to calculate market and credit risk 
under the proposal and will have already developed internal risk 
management control systems. This conclusion is based on information 
Commission staff has received through the risk assessment rules and 
meetings with and reports from the DPG and other broker-dealers and the 
Commission's experience in implementing the OTC derivatives dealer 
rules. On the other hand, we note that the proposal contains new 
requirements. For example, the firm must establish and document 
procedures to detect and prevent money laundering and terrorist 
financing. We also note that the application under this rule may be 
more complicated than the OTC derivatives dealer application and may 
take more time to complete.
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    \70\ See 17 CFR 240.15c3-1f(a).
    \71\ Exchange Act Release No. 39454 (Dec. 17, 1997), 62 FR 67940 
(December 30, 1997).
    \72\ Exchange Act Release No. 40594 (Oct. 23, 1998), 63 FR 59362 
(November 3, 1998).
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    We estimate that a broker-dealer using Appendix E would spend 
approximately 5,600 hours per year to review the models it uses to 
compute market and credit risk and approximately 160 hours each 
quarter, or approximately 640 hours per year, to backtest the models. 
Consequently, we estimate that the total burden under the proposal 
associated with reviewing and backtesting mathematical models for the 
12 broker-dealers we expect to apply will be approximately 74,880 hours 
per year ((5,600 + 640) * 12).

B. Proposed Appendix G to Rule 15c3-1, Conditions for Holding Companies 
of Certain Brokers or Dealers

    Under proposed Appendix G to Rule 15c3-1, the CSE would be required 
to calculate allowable capital and allowances for market, credit, and 
operational risk monthly on a consolidated basis, file certain monthly, 
quarterly, and annual reports with the Commission, make, keep current, 
and preserve certain records, and notify the Commission of certain 
events. These proposed conditions are needed to allow the Commission to 
properly oversee a broker-dealer that uses proposed Appendix E and to 
monitor the financial and operational condition of its affiliate group.
    Based on Commission experience and discussions with industry 
participants, we estimate that the calculation of allowable capital and 
allowances for market, credit, and operational risk would require 
approximately 90 hours per month, or approximately 1080 hours per year. 
Thus, the aggregate annual burden for the 12 broker-dealers we expect 
to apply under the proposal would be approximately 12,960 hours. In 
addition, we estimate that it would require approximately 5,600 hours 
per year to review and update the mathematical models used to make 
these calculations. Thus, the aggregate annual burden to review and 
update the models for the 12 broker-dealers would be approximately 
67,200 hours. Finally, we estimate that it would require approximately 
160 hours each quarter, or approximately 640 hours each year, to 
backtest the models. Thus, the aggregate annual burden to backtest the 
models for the 12 broker-dealers we expect to apply under the proposal 
would be approximately 7,680 hours.
    The reporting requirements of proposed Appendix G are necessary to 
keep the Commission informed of, among other things, the financial 
condition, financial and operational risk exposures, backtesting 
results, and management controls of the CSE and whether the CSE is in 
compliance with the conditions of the broker-dealer's exemption. These 
reports would help the Commission to anticipate the effect on the CSE 
of significant economic events and their related impact on the broker-
dealer.
    We estimate that the average amount of time necessary to prepare 
and file the monthly reports required by Appendix G would be 
approximately 8 hours per month, or approximately 96 hours per year, 
that the average amount of time necessary to prepare and file the 
quarterly reports would be about 16 hours per quarter, or approximately 
64 hours per year, and that the average amount of time necessary to 
prepare and file the annual audit reports would be approximately 200 
hours per year. Consequently, we estimate that the total annual 
reporting burden of proposed Appendix G for the 12 broker-dealers we 
expect to apply under the proposal would be approximately 4,320 hours.
    We based these estimates on the PRA burden estimates for Exchange 
Act Rule 17a-12, Reports to be made by certain OTC derivatives dealers. 
The PRA burden estimate for Rule 17a-12 is 180 hours per year to 
prepare and file the information required by the rule (based on an 
average of four responses per year and an average of 20 hours preparing 
each response with an additional 100 hours spent preparing the annual 
audit). However, we believe that the burden under this proposal would 
be lower than the Rule 17a-12 burden estimates because CSEs already 
generate many of the required reports for internal management purposes.
    We expect that any additional burden associated with the 
requirements of proposed Appendix G relating to making, keeping, and 
preserving records would be minimal because a prudent firm that manages 
risk on a group-wide basis would make and preserve these records in the 
ordinary course of its business. We estimate that the average one-time 
burden of making and preserving these records would be approximately 40 
hours and that the average annual burden would be approximately 290 
hours. Consequently, we estimate that the total burden for the 12 
broker-dealers we expect will apply under this proposal would be 
approximately 480 hours on a one-time basis and approximately 3,480 
hours per year.
    The notification provisions of proposed Appendix G are designed to 
give the Commission advance warning of situations that may pose 
material, financial and operational risks to the broker-dealer and the 
CSE. These provisions are integral to Commission supervision of broker-
dealers that use Appendix E. We estimate that it would require a total 
of approximately one hour per year for all 12 of the broker-dealers to 
comply with the notification provisions of proposed Appendix G.\73\
---------------------------------------------------------------------------

    \73\ The Commission received approximately 1,067 Rule17a-11 
notifications during calendar year 2002, when there were 
approximately 6,800 active broker-dealers registered with the 
Commission. Thus, approximately 11% of registered broker-dealers 
filed a Rule 17a-11 notice in 2002. We therefore estimate that of 
the 12 broker-dealers we expect will apply under the proposal, one 
may be required to file an Appendix G notice each year. We estimate 
that, consistent with the Rule 17a-11 PRA burden estimate, it will 
take approximately one hour to file that notice.
---------------------------------------------------------------------------

C. Proposed Amendments to Rule 15c3-4, Internal Risk Management Control 
Systems

    We propose to amend Rule 15c3-4, which currently applies to OTC 
derivatives dealers that use Appendix F to calculate certain of their 
capital charges, to expand its coverage to broker-dealers that use 
Appendix E. Rule 15c3-4 is designed to ensure the integrity of the risk 
measurement, monitoring, and management process, and to clarify 
accountability, at the appropriate organizational level, for defining 
the permitted scope of activity and level of risk.

[[Page 62891]]

    The proposed rule amendments would require a broker-dealer that 
elects to use Appendix E to consider a number of issues affecting its 
business environment when creating its risk management control system. 
For example, such a firm would need to consider, among other things, 
the sophistication and experience of relevant trading, risk management, 
and internal audit personnel, as well as the separation of duties among 
these personnel, when designing and implementing its internal control 
system's guidelines, policies, and procedures. This would help to 
ensure that the control system that is implemented would adequately 
address the risks posed by the firm's business and the environment in 
which it is being conducted. In addition, this would enable a broker-
dealer electing to use Appendix E to implement specific policies and 
procedures unique to its circumstances.
    In implementing its policies and procedures, the broker-dealer 
would be required to document and record its system of internal risk 
management controls. In particular, such a firm would be required to 
document its consideration of certain issues affecting its business 
when designing its internal controls. The broker-dealer also would be 
required to prepare and maintain written guidelines that discuss its 
internal control system.
    The proposed rule amendments would be an integral part of the 
Commission's financial responsibility program for broker-dealers whose 
applications under Appendix E are approved by the Commission. The 
information to be collected under the proposed amendments to Exchange 
Act Rule 15c3-4 would be essential to the regulation and oversight of 
major securities firms that voluntarily elect to use Appendix E and to 
the monitoring of their compliance with the proposed financial 
responsibility requirements. More specifically, requiring a broker-
dealer that elects to use Appendix E to document the planning, 
implementation, and periodic review of its risk management controls are 
designed to ensure that all pertinent risk management issues are 
considered, that the risk management controls are implemented properly, 
and that they continue to adequately address the risks faced by major 
securities firms.
    The following estimates of the initial and annual PRA burdens 
associated with the amendments to Rule 15c3-4 are based on the present 
Rule 15c3-4 PRA burden estimates, discussions with potential 
applicants, and the Commission's experience with the implementation of 
Rule 15c3-4 for OTC derivatives dealers. The present Rule 15c3-4 burden 
estimate is an average of 2,000 hours on a one-time basis to implement 
the risk management control system and an average of 200 hours per year 
to review and update the system. This estimate was based on the 
implementation of a risk management control system for a single entity: 
the OTC derivatives dealer. In this proposal, the broker-dealer is 
required to implement a risk management control system and the holding 
company is required to implement a group-wide risk management control 
system. Although the 12 broker-dealers we expect to apply under this 
proposal have already developed internal risk management control 
systems, not all of them have implemented and formally documented a 
group-wide system. We believe that it would take more than 2,000 hours 
for such a broker-dealer to implement a formal, documented group-wide 
risk management control system. On the other hand, if a firm already 
has a formally documented group-wide internal risk management control 
system, we believe that it would take less than 2,000 hours to bring 
that system into compliance with amended Rule 15c3-4. Of the 12 broker-
dealers we expect will apply under this proposal, we estimate that 6 
have formal, documented, group-wide internal risk management control 
systems, and that 6 have internal risk management control systems that 
are not formally documented for the affiliate group. We estimate that a 
firm with a formal, documented group-wide internal risk management 
control system would spend approximately 1,000 hours on a one-time 
basis to comply with the proposed amendments to Rule 15c3-4 and that a 
firm that does not have a formally documented group-wide internal 
control system will spend up to approximately 3,600 hours on a one-time 
basis to comply with the proposed amendments to Rule 15c3-4. The total 
one-time burden for the twelve firms would therefore be approximately 
27,600 hours. In addition, we estimate that each of the 12 broker-
dealers would spend approximately 250 hours per year reviewing and 
updating its risk management control system, for an aggregate annual 
burden of 3,000 hours.

D. Proposed Amendments to Rule 17a-5, Reports To Be Made by Certain 
Brokers and Dealers

    The proposed amendments to Exchange Act Rule 17a-5 would require 
broker-dealers using Appendix E to submit monthly, quarterly, and 
annual reports with the Commission. The proposed amendments would be an 
integral part of our financial responsibility program for broker-
dealers electing to use Appendix E. The information to be collected 
under the proposed amendments to Rule 17a-5 would be essential to the 
regulation of these broker-dealers and would assist us and the 
examining authorities responsible for reviewing the activities of these 
firms to monitor and enforce compliance with applicable Commission 
rules, including rules pertaining to financial responsibility. These 
periodic reports would also aid the Commission in evaluating the 
activities conducted by these broker-dealers and in anticipating, where 
possible, how these firms could be affected by significant economic 
events.
    We estimate that the average amount of time necessary to prepare 
and file the additional monthly reports required by this amendment to 
Rule 17a-5 would be about 4 hours per month, or approximately 48 hours 
per year; that the average amount of time necessary to prepare and file 
the additional quarterly reports would be about 8 hours per quarter, or 
approximately 32 hours per year; and that the average amount of time 
necessary to prepare and file the additional supplemental reports with 
the annual audit required would be approximately 40 hours per year. 
Consequently, we estimate that the total annual additional burden 
attributable to the proposed amendments to Rule 17a-5 for the 12 
broker-dealers we expect to apply under the proposal would be 
approximately 1,440 hours.
    These estimates are based on our present PRA burden estimate for 
Rule17a-12. The PRA burden estimate for Rule 17a-12 is 180 hours per 
year to prepare and file the information required by the rule (based on 
an average of four responses per year and an average of 20 hours 
preparing each response with an additional 100 hours spent on preparing 
the annual audit). However, the estimated burden attributable to the 
proposed amendments is less than those estimates because the broker-
dealer is already required to file monthly, quarterly, and annual 
reports with the Commission under Rule 17a-5. In addition, the 
amendments are designed to allow a broker-dealer to provide the 
required information to the Commission in a form that the firm already 
produces for internal management purposes.

E. Proposed Amendments to Rule 17a-11, Notification Procedures for 
Brokers and Dealers

    Under the proposed amendments to Rule 17a-11, a broker-dealer that 
uses

[[Page 62892]]

proposed Appendix E would have to give notice to the Commission of 
certain events beyond those the broker-dealer is currently required to 
give notice of. These events include, for example, that an NRSRO has 
determined to downgrade the credit rating of the obligations of the 
broker-dealer or one of its affiliates, the broker-dealer receives 
notice from a regulator that one of its affiliates is not in compliance 
with rules or agreements with the regulator, the broker-dealer becomes 
aware of a situation that may have a material adverse effect on a 
material affiliate, or the occurrence of certain backtesting exceptions 
of the broker-dealer's mathematical models.
    These events are expected to be rare. However, they are of 
supervisory concern. The Commission received approximately 1,067 Rule 
17a-11 notices from 731 broker-dealers during calendar year 2002. At 
that time, there were approximately 6,800 active broker-dealers 
registered with the Commission. Thus we estimate that approximately 11% 
of active broker-dealers filed a Rule 17a-11 notice during calendar 
year 2002 (731/6,800 = .1075) and that it would take approximately one 
hour to file such a notice. Therefore, we estimate that of the 12 
broker-dealers we expect to apply under this proposal, approximately 
one may be required to file notice pursuant to the proposed amendments 
to Rule 17a-11 each year. Thus, we estimate that the total annual 
burden of the proposed amendments to Rule 17a-11 for the 12 broker-
dealers we expect to apply under the proposal would be about one hour.

F. Proposed Amendments to Rules 17h-1T and 17h-2T, Risk Assessment 
Recordkeeping Requirements for Associated Persons of Brokers and 
Dealers and Risk Assessment Reporting Requirements for Brokers and 
Dealers

    Rules 17h-1T and 17h-2T require that certain broker-dealers make 
records of and file quarterly reports with the Commission regarding the 
financial condition, organization, and risk management practices of 
their affiliated group. The amendments to Rules 17h-1T and 17h-2T would 
exempt a broker-dealer that uses Appendix E from the rules to the 
extent that the holding company of the broker or dealer maintains the 
information pursuant to proposed Appendix G.
    These amendments would reduce the PRA burden for broker-dealers 
that use Appendix E. The current PRA burden estimate for Rules 17h-1T 
and 17h-2T is approximately 10 hours per year for each respondent. We 
estimate that the aggregate savings under the proposed amendments for 
the 12 firms we expect to apply under the proposal would be 
approximately 120 hours per year.

G. Request for Comment

    Under 44 U.S.C. 3506(c)(2)(B), the Commission seeks comment to 
evaluate:
    [sbull] Whether the proposed collection of information is necessary 
for the proper performance of the functions of the Commission, 
including whether the information has practical utility;
    [sbull] The accuracy of our estimates of the burden of the proposed 
collection of information;
    [sbull] Ways in which we might enhance the quality, utility, and 
clarity of the information to be collected; and
    [sbull] Ways in which we might minimize the burden of the 
collection of information on those who respond, including through the 
use of automated collection techniques or other forms of information 
technology.
    Persons wishing to submit comments on the collection of information 
requirements should address them to The Office of Management and 
Budget, Room 3208, Attention: Desk Officer for the Securities and 
Exchange Commission, Office of Information and Regulatory Affairs, New 
Executive Office Building, Washington, DC 20503; and should also send a 
copy of their comments to Jonathan G. Katz, Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. 
The submission should reference File No. S7-21-03. OMB is required to 
make a decision concerning the collection of information between 30 and 
60 days after publication of this document in the Federal Register; 
therefore, comments to OMB are best assured of having full effect if 
OMB receives them within 30 days of this publication.
    The Commission has submitted the proposed collections of 
information to OMB for approval. Requests for the materials submitted 
to OMB by the Commission with regard to these collections of 
information should be in writing, refer to File No. S7-21-03, and be 
submitted to the Securities and Exchange Commission, Records 
Management, Office of Filings and Information Services, 450 Fifth 
Street, NW., Washington, DC 20549-0609.

V. Costs and Benefits of the Proposed Rule Amendments

    To assist the Commission in its evaluation of the costs and 
benefits that may result from the proposed amendments, which establish 
a voluntary alternative method for computing net capital charges for 
certain broker-dealers, commenters are requested to provide analysis 
and data relating to the costs and benefits associated with the 
proposed amendments. In particular, the Commission requests comments on 
the potential costs for any necessary modifications to internal risk 
management control, accounting, information management, and 
recordkeeping systems required to comply with the proposed amendments 
and the potential benefits arising from participation in the regulatory 
scheme.
    The proposed amendments would establish a voluntary alternative 
method for computing net capital charges for certain broker-dealers 
that are part of a holding company that has a group-wide internal risk 
management control system and that consents to group-wide Commission 
supervision. We have identified certain costs and benefits that would 
be associated with the proposal.
    A broker-dealer that maintains tentative net capital of at least $1 
billion and net capital of at least $500 million could apply to the 
Commission for a conditional exemption from the application of the 
standard net capital rule calculation and, upon Commission approval, 
calculate certain of its market and credit risk capital charges using 
the firm's own internal mathematical models for risk measurement, 
including internally developed VaR models and scenario analysis. 
According to March 31, 2003 FOCUS filings, 28 registered broker-dealers 
reported tentative net capital and net capital that equaled or exceeded 
those amounts. Based on discussions with industry representatives, we 
believe, however, that only broker-dealers with at least $1 billion in 
deductions pursuant to paragraph (c)(2)(vi) of Rule 15c3-1 (also known 
as ``haircuts'') will find it cost effective to use the alternative 
capital computation. As of March 2003, based on FOCUS filings, there 
were 12 such broker-dealers. Therefore, our cost-benefit estimates are 
based on the assumption that 12 broker-dealers will apply under the 
proposal.
    Many of the estimates are also based on information Commission 
staff receives through the risk assessment rules and meetings with and 
reports from the DPG and other broker-dealers and the Commission's 
experience in implementing the OTC derivatives dealer rules.
    A broker-dealer that applies to use proposed Appendix E and its 
affiliates have discretion in allocating the costs associated with the 
proposal among the entities in the CSE (``consolidated supervised 
entity''), including the broker-dealer. In estimating the total costs 
associated with the proposal on

[[Page 62893]]

the broker-dealer, we have included the costs arising from each 
proposed new rule amendment.
    The proposed alternative net capital system is designed to increase 
a broker-dealer's operational efficiency by having its supervisory risk 
assessment and the computation of certain capital charges more closely 
aligned to the mathematical model-based methods the firm already uses 
to manage its business risk and capital, while establishing net capital 
requirements sufficient to require maintenance of capital to achieve 
the goals of the net capital rule and Exchange Act Sec.  15(c)(3). The 
incorporation of mathematical risk management techniques into the 
calculation of net capital charges should enable such a broker-dealer 
to reallocate capital from the broker-dealer to affiliates that may 
receive a higher return than the broker-dealer. The proposed rule 
amendments should also allow broker-dealers to increase operational 
efficiency by adopting risk management practices which have become 
industry best practice.
    We anticipate that cost savings would result in several areas. 
Under the proposal, a broker-dealer would become subject to 
specifically tailored capital and other requirements. The broker-dealer 
would be able to compute certain of its net capital charges using 
internally developed mathematical models that the firm uses to manage 
risk and to report risks to the Commission using internal reports that 
the firm already generates for risk management purposes.
    The primary benefit for the broker-dealer would be the reduction in 
net capital charges that we expect would result from the use of the 
alternative method. This benefit, however, is difficult to quantify. 
While reductions in net capital requirements would likely result from 
the use of the alternative method, broker-dealers typically maintain 
higher levels of capital than the rules require. Also, the mix of 
positions held by the broker-dealer may change if the regulatory cost 
of holding certain positions is reduced. Finally, the reduction in net 
capital charges would vary significantly among broker-dealers based on 
the size and risk of their portfolios.
    The 12 firms we expect to apply under this proposal reported 
capital charges ranging from approximately $1 billion to approximately 
$4 billion, for a total of approximately $32 billion, on their first 
quarter of 2003 FOCUS reports. We expect that firms with larger capital 
charges would realize a larger percentage reduction in their capital 
charges than firms with smaller capital charges. We estimate that the 
12 firms would realize an average reduction in capital charges of 
approximately 40%, or a total reduction in capital charges for the 12 
firms of approximately $13 billion. If the firms reallocate that 
capital to fund business activities for which the rate of return is 20 
basis points (0.2%) higher, the 12 broker-dealers could receive a total 
annual benefit of approximately $26 million.
    Firms that do business in the EU have indicated that they may need 
to demonstrate that they are subject to consolidated supervision at the 
holding company level that is ``equivalent'' to EU consolidated 
supervision. Without a demonstration of ``equivalent'' supervision, we 
understand that the affiliate institution located in the EU may either 
be subject to additional capital charges or be required to form a sub-
holding company in the EU. We expect the Commission supervision 
contemplated by this proposal would meet this standard. As a result, we 
believe this proposal would minimize duplicative regulatory burdens on 
firms that are active in the EU as well as in other jurisdictions that 
may have similar laws.
    Based on the responses of five firms to a survey conducted during 
the OTC derivatives dealer rulemaking process, we estimate that it 
would cost approximately $8 million per year for a firm to form and 
maintain a sub-holding company in the EU.\74\ Consequently, for the 12 
broker-dealers we expect will apply under this proposal, not being 
required to form and maintain a sub-holding company in the EU would 
save the firms a total of approximately $96 million per year.
---------------------------------------------------------------------------

    \74\ The five firms estimated that their annual operating costs 
would increase by an average of approximately $7 million to set up a 
separate company operating as an OTC derivatives dealer. We 
multiplied by 1.12 to account for inflation since 1998.
---------------------------------------------------------------------------

    These amendments would exempt broker-dealers that use Appendix E 
from Rules 17h-1T and 17h-2T. The current PRA burden estimate for Rules 
17h-1T and 17h-2T is approximately 10 hours per year for each 
respondent. We estimate that the aggregate savings under the proposed 
amendments for the 12 firms we expect to apply under the proposal would 
be approximately 120 hours per year, and we expect that a financial 
reporting manager would do the work. The staff estimates that the 
hourly salary of a financial reporting manager is $50.63 per hour.\75\ 
The total cost savings for the 12 firms would be approximately $6,000 
(120 * $50.63 = $6,076).
---------------------------------------------------------------------------

    \75\ Securities Industry Association's (SIA) Report on 
Management and Professional Earnings in the Securities Industry--
2002 (``SIA Report''). Generally, to calculate an hourly cost using 
the SIA's Report, the staff takes the median (or, if no median is 
provided, the mean) salary provided in the SIA's Report for the 
position cited, divide that amount by 1,800 hours (in the average 
year), then multiply the result by 135% to account for employee 
overhead costs. (Financial Reporting Manager) + 35% overhead (based 
on end-of-year 2002 figures) ($67,500 per year/1800 hours/year * 
1.35 = $50.63 per hour).
---------------------------------------------------------------------------

    To the extent that firms electing the proposed regulatory system 
improve their internal risk management control systems, we would expect 
that the firms would realize a benefit in the form of reduced borrowing 
costs. This benefit will vary widely depending on the risk management 
practices the firms already have in place. For some firms that already 
have formally documented group-wide control systems, there may be no 
benefit.
    We believe that the proposed regulatory system would also result in 
benefits to regulators and to financial markets. The Commission would 
have access to group-wide information concerning the operation and 
financial condition of the broker-dealer's holding company and 
affiliates. This information would help the Commission to assess 
whether the activities or financial condition of the holding company or 
affiliates may pose risks to the financial health of the broker-dealer. 
Also, the broker-dealer and holding company would have to comply with 
stringent requirements concerning their internal risk management 
control systems. We expect that this requirement would promote the 
financial responsibility of these entities and reduce the risk of 
significant losses by the broker-dealer. By reducing the risk of 
significant losses by a single firm, internal risk management control 
systems would also reduce the risk that the problems of one firm would 
spread, causing defaults by other firms and undermining securities 
markets as a whole.
    Firms electing the alternative capital computation would incur 
various costs. These firms would incur the one-time and ongoing costs 
of submitting an application and amendments to the application to use 
the alternative computation. We estimate that each broker-dealer that 
applies under the proposal would spend approximately 1,000 hours to 
create and compile the various documents to be included with the 
application and to work with the Commission staff through the 
application process. The staff anticipates that this would include 
approximately 100 hours for an in-house attorney and 900 hours for a 
senior compliance staff member. The

[[Page 62894]]

staff estimates that the hourly salary of an attorney is $63.75 per 
hour,\76\ for a total cost of approximately $80,000 ($63.75 * 100 * 12 
= $76,500). The staff estimates that the hourly salary of a senior 
compliance staff person is $56.60 per hour,\77\ for a total cost of 
approximately $610,000 ($56.60 * 900 * 12 = $611,280).
---------------------------------------------------------------------------

    \76\ SIA Report, (Attorney) + 35% overhead (based on end-of-year 
2002 figures) ($85,00 per year/1800 hours/year * 1.35 = $63.75 per 
hour).
    \77\ SIA Report, (Senior Compliance Staff) + 35% overhead (based 
on end-of-year 2002 figures) ($75,464 per year/1800 hours/year * 
1.35 = $56.60 per hour).
---------------------------------------------------------------------------

    These estimates are based on estimates the Commission made for the 
OTC derivatives dealer rules, which include a similar application 
requirement.\78\ We estimated that an OTC derivatives dealer would 
spend approximately 1,000 hours developing and submitting its VaR model 
and description of its risk management control system to the 
Commission.\79\ No comments were received in response to the estimates 
in the proposing release, and those estimates were not changed in the 
final rule release. For purposes of this proposal, we note that firms 
applying to use Appendix E will have already developed the VaR models 
that they will use to calculate market and credit risk under the 
proposal and will have already developed internal risk management 
control systems. This conclusion is based on information Commission 
staff receives through the risk assessment rules and meetings with and 
reports from the DPG and other broker-dealers and the Commission's 
experience in implementing the OTC derivatives dealer rules. On the 
other hand, we note that the proposal contains additional requirements. 
For example, the firm must establish and document procedures to detect 
and prevent money laundering and terrorist financing. We also note that 
the application under this rule may be more complicated than the OTC 
derivatives dealer application and may take more time to complete.
---------------------------------------------------------------------------

    \78\ See 17 CFR 240.15c3-1f(a).
    \79\ Exchange Act Release No. 39454 (Dec. 17, 1997), 62 FR 67940 
(December 30, 1997).
---------------------------------------------------------------------------

    We estimate that a broker-dealer using Appendix E would spend 
approximately 5,600 hours per year to review the models it uses to 
compute market and credit risk and approximately 160 hours each 
quarter, or approximately 640 hours per year, to backtest the models. 
Consequently, we estimate that it will take approximately 74,880 hours 
((5,600 + 640) * 12) per year to review and backtest mathematical 
models for the 12 broker-dealers we expect to apply under the proposal, 
and that a financial reporting specialist would do the work. The staff 
estimates that the hourly salary of a financial reporting manager is 
$50.63 per hour,\80\ for a total cost of approximately $3.8 million per 
year ($50.63 * 74,880 = $3,791,174).
---------------------------------------------------------------------------

    \80\ SIA Report, (Financial Reporting Manager) + 35% overhead 
(based on end-of-year 2002 figures) ($67,500 per year/1800 hours/
year * 1.35 = $50.63 per hour).
---------------------------------------------------------------------------

    Based on Commission experience and discussions with industry 
participants, we estimate that the holding company's calculation of 
allowable capital and allowances for market, credit, and operational 
risk would require approximately 90 hours per month, or approximately 
1,080 hours per year, for a total of approximately 12,960 hours per 
year for the 12 broker-dealers, and that a senior accountant would do 
the work. The staff estimates that the hourly salary of a senior 
accountant is $49.87 per hour.\81\ The total annual cost would be 
approximately $650,000 ($49.87 *12,960 = $646,315). In addition, we 
estimate that it would require approximately 5,600 hours per year to 
review and update the mathematical models used to make these 
calculations, or approximately 67,200 hours per year for the 12 broker-
dealers, and we expect that a financial reporting manager would do the 
work. The staff estimates that the hourly salary of a financial 
reporting manager is $50.63 per hour.\82\ The total annual cost would 
be approximately $3.4 million ($50.63 * 67,200 = $3,402,336). Finally, 
we estimate that it would require approximately 160 hours each quarter, 
or approximately 640 hours each year, to backtest the models. Thus, the 
aggregate annual burden to backtest the models for the 12 broker-
dealers we expect to apply under the proposal would be approximately 
7,680 hours, and we expect that a junior research analyst would do the 
work. The staff estimates that the hourly salary of a junior research 
analyst is $38.92 per hour,\83\ for a total cost of approximately 
$300,000 ($38.92 * 7,680 = $298,906).
---------------------------------------------------------------------------

    \81\ SIA Report, (Senior Accountant) + 35% overhead (based on 
end-of-year 2002 figures) ($66,500 per year/1800 hours/year * 1.35 = 
$49.87 per hour).
    \82\ SIA Report, (Financial Reporting Manager) + 35% overhead 
(based on end-of-year 2002 figures) ($67,500 per year/1800 hours/
year * 1.35 = $50.63 per hour).
    \83\ SIA Report, (Junior Research Analyst) + 35% overhead (based 
on end-of-year 2002 figures) ($51,900 per year/1800 hours/year * 
1.35 = $38.92 per hour).
---------------------------------------------------------------------------

    We estimate that the average amount of time necessary to prepare 
and file the monthly reports required by Appendix G would be 
approximately 8 hours per month, or approximately 96 hours per year, 
that the average amount of time necessary to prepare and file the 
quarterly reports would be about 16 hours per quarter, or approximately 
64 hours per year, and that the average amount of time necessary to 
prepare and file the annual audit reports would be approximately 200 
hours per year. Consequently, we estimate that the total for the 12 
broker-dealers we expect to apply under the proposal would be 
approximately 4,320 hours ((96 + 64 + 200) * 12) per year, and we 
expect that a senior accountant would do the work. The staff estimates 
that the hourly salary of a senior accountant is $49.87 per hour,\84\ 
for a total of approximately $215,000 ($49.87 * 4,320 = $215,438).
---------------------------------------------------------------------------

    \84\ SIA Report, (Senior Accountant) + 35% overhead (based on 
end-of-year 2002 figures) ($66,500 per year/1800 hours/year * 1.35 = 
$49.87 per hour).
---------------------------------------------------------------------------

    We based these estimates on the PRA burden estimates for Exchange 
Act Rule 17a-12, Reports to be made by certain OTC derivatives dealers. 
The PRA burden estimate for Rule 17a-12 is 180 hours per year to 
prepare and file the information required by the rule (based on an 
average of four responses per year and an average of 20 hours preparing 
each response with an additional 100 hours spent on preparing the 
annual audit). However, we believe that the cost under this proposal 
would be lower than the Rule 17a-12 estimates because CSEs already 
generate many of the required reports for internal management purposes.
    We expect that any additional costs associated with the 
requirements of proposed Appendix G relating to making, keeping, and 
preserving records would be minimal because a prudent firm that manages 
risk on a group-wide basis would make and preserve these records in the 
ordinary course of its business. We estimate it would take 
approximately 40 one-time hours and that the average annual time spent 
would be approximately 290 hours. Consequently, we estimate that the 12 
broker-dealers we expect will apply under this proposal would spend 
approximately 480 hours on a one-time basis and approximately 3,480 
hours per year, and we expect that a senior accountant would do the 
work. The staff estimates that the hourly salary of a senior accountant 
is $49.87 per hour,\85\ for a total one-time cost of approximately 
$24,000 ($49.87 * 480 = $23,938) and a total annual cost of

[[Page 62895]]

approximately $170,000 ($49.87 * 3,480 = $173,548).
---------------------------------------------------------------------------

    \85\ SIA Report, (Senior Accountant) + 35% overhead (based on 
end-of-year 2002 figures) ($66,500 per year/1800 hours/year * 1.35 = 
$49.87 per hour).
---------------------------------------------------------------------------

    We estimate that it would require a total of approximately one hour 
per year for all 12 of the broker-dealers to comply with the 
notification provisions of proposed Appendix G,\86\ and that a senior 
compliance staff person would do the work. The staff estimates that the 
hourly salary of a senior compliance staff person is $56.60 per 
hour,\87\ for a total cost for the 12 firms of approximately $60.
---------------------------------------------------------------------------

    \86\ The Commission received 692 Rule17a-11 notifications during 
calendar year 2001, when there were approximately 7,217 broker-
dealers registered with the Commission. Thus, approximately 10% of 
registered broker-dealers filed a Rule 17a-11 notice in 2001. We 
therefore estimate that of the 12 broker-dealers we expect will 
apply under the proposal, one may be required to file an Appendix G 
notice each year. We estimate that, consistent with the Rule 17a-11 
PRA burden estimate, it will take approximately one hour to file 
that notice.
    \87\ SIA Report, (Senior Compliance Staff) + 35% overhead (based 
on end-of-year 2002 figures) ($75,464 per year/1800 hours/year 1.35 
= $56.60 per hour).
---------------------------------------------------------------------------

    The cost estimates regarding the amendments to Rule 15c3-4 are 
based on the present Rule 15c3-4 PRA burden estimates, discussions with 
potential applicants, and the Commission's experience with 
implementation of Rule 15c3-4 for OTC derivatives dealers. The present 
Rule 15c3-4 PRA burden estimate is an average of 2,000 hours on a one-
time basis to implement the risk management control system and an 
average of 200 hours per year to review and update the system. This 
estimate was based on the implementation of a risk management control 
system for a single entity: the OTC derivatives dealer. In this 
proposal, the broker-dealer is required to implement a risk management 
control system and the holding company is required to implement a 
group-wide risk management control system. Although the 12 broker-
dealers we expect to apply under this proposal have already developed 
internal risk management control systems, not all of them have 
implemented and formally documented a group-wide system. We believe 
that it would take more than 2,000 hours for such a broker-dealer to 
implement a formal, documented group-wide risk management control 
system. On the other hand, if a firm already has a formally documented 
group-wide internal risk management control system, we believe that it 
would take less than 2,000 hours to bring that system into compliance 
with amended Rule 15c3-4. Of the 12 broker-dealers we expect will apply 
under this proposal, we estimate that 6 have formal, documented, group-
wide internal risk management control systems, and that 6 have internal 
risk management control systems that are not formally documented for 
the affiliate group. We estimate that a firm with a formal, documented 
group-wide internal risk management control system would spend 
approximately 1,000 hours on a one-time basis to comply with the 
proposed amendments to Rule 15c3-4 and that a firm that does not have a 
formally documented group-wide internal control system will spend up to 
approximately 3,600 hours on a one-time basis to comply with the 
proposed amendments to Rule 15c3-4. The total for the twelve firms 
would therefore be approximately 27,600 hours ((6 * 1,000) + (6 * 
3,600)) on a one-time basis and, on the basis of an estimate of 
approximately 250 hours per year to review and update its risk 
management control system, a total of 3,000 hours per year for the 12 
firms. We expect that a senior compliance staff person would do the 
work. The staff estimates that the hourly salary of a senior compliance 
staff person is $56.60 per hour,\88\ for a total one-time cost of 
approximately $1.6 million ($56.60 * 27,600 = $1,562,160) and a total 
annual cost of approximately $170,000 ($56.60 * 3,000 = $169,800).
---------------------------------------------------------------------------

    \88\ SIA Report, (Senior Compliance Staff) + 35% overhead (based 
on end-of-year 2002 figures) ($75,464 per year/1800 hours/year * 
1.35 = $56.60 per hour).
---------------------------------------------------------------------------

    The information technology systems used by CSEs to manage risk, 
make and retain records, and report and calculate capital differ widely 
depending on the size of the CSE and the types of business it engages 
in. These information technology systems may be in varying stages of 
readiness to enable the CSE to meet the requirements of the proposal. 
Based on Commission experience and informal discussions with potential 
applicants, we estimate that it will cost a CSE that has well-developed 
information technology systems approximately $5 million to upgrade its 
systems, that it will cost a CSE that has less well-developed systems 
approximately $50 million to upgrade its systems, and that, on average, 
it will cost a CSE approximately $27.5 million to upgrade its systems. 
Consequently, we estimate that the 12 broker-dealers we expect to apply 
under the proposal would spend a total of approximately $330 million to 
upgrade their information technology systems. We believe that this 
would be a one-time cost.
    We estimate that the average amount of time necessary to prepare 
and file the additional monthly reports required by the proposed 
amendment to Rule 17a-5 would be about 4 hours per month, or 
approximately 48 hours per year; that the average amount of time 
necessary to prepare and file the additional quarterly reports would be 
about 8 hours per quarter, or approximately 32 hours per year; and that 
the average amount of time necessary to prepare and file the additional 
supplemental reports with the annual audit would be approximately 40 
hours per year. Consequently, the 12 broker-dealers would spend 
approximately 1,440 hours ((48 + 32 + 40) * 12) per year to comply, and 
we expect that a senior accountant would do the work. The staff 
estimates that the hourly salary of a senior accountant is $49.87 per 
hour,\89\ for a total annual cost of approximately $72,000 ($49.87 * 
1,440 = $71,813).
---------------------------------------------------------------------------

    \89\ SIA Report, (Senior Accountant) + 35% overhead (based on 
end-of-year 2002 figures) ($66,500 per year/1800 hours/year * 1.35 = 
$49.87 per hour).
---------------------------------------------------------------------------

    We estimate that approximately 10% of active broker-dealers filed a 
Rule 17a-11 notice during calendar year 2001 and that it would take 
approximately one hour to file such a notice. Therefore, we estimate 
that of the 12 broker-dealers we expect to apply under this proposal, 
at most one may be required to file notice pursuant to the proposed 
amendments to Rule 17a-11 each year. Thus, we estimate that the total 
for the 12 broker-dealers we expect to apply under the proposal would 
be about one hour. The staff estimates that the hourly salary of a 
senior compliance staff person is $56.60 per hour,\90\ for a total cost 
of approximately $60.
---------------------------------------------------------------------------

    \90\ SIA, Management and Professional Earnings, (Senior 
Compliance Staff) + 35% overhead (based on end-of-year 2002 figures) 
($75,464 per year/1800 hours/year * 1.35 = $56.60 per hour).
---------------------------------------------------------------------------

VI. Burden on Competition and Promotion of Efficiency, Competition, and 
Capital Formation

    Section 3(f) of the Exchange Act \91\ requires us, when engaging in 
rulemaking that requires us to consider or determine whether an action 
is necessary or appropriate in the public interest, to consider whether 
the action will promote efficiency, competition, and capital formation. 
Section 23(a)(2) of the Exchange Act \92\ requires us to consider the 
anticompetitive effects of any rules that we adopt under the Exchange 
Act. Section 23(a)(2) prohibits us from adopting any rule that would 
impose a burden on competition not necessary or appropriate in 
furtherance of the purposes of the Exchange Act.
---------------------------------------------------------------------------

    \91\ 15 U.S.C. 78c(f).
    \92\ 15 U.S.C. 78w(a)(2).

---------------------------------------------------------------------------

[[Page 62896]]

    The Commission's preliminary view is that the proposed rule 
amendments should promote efficiency, competition, and capital 
formation. These amendments should provide eligible broker-dealers an 
opportunity to increase operational efficiency by having their 
supervisory risk assessment and the computation of certain capital 
charges more closely aligned to the sophisticated methods the firms 
already use to manage their business risk and capital, while at the 
same time requiring sufficient net capital. The incorporation of 
mathematical risk management techniques into the calculation of net 
capital charges should enable such a broker-dealer to reallocate 
capital from the broker-dealer to affiliates that may receive a higher 
return than the broker-dealer. The proposed rule amendments should also 
allow broker-dealers to increase operational efficiency by adopting 
risk management practices which have become industry best practice. In 
addition, the proposed amendments should enhance the ability of U.S. 
securities firms to compete effectively in global securities markets.
    We solicit comments on these matters with respect to the proposed 
rule amendments. Would the amendments have an adverse effect on 
competition that is neither necessary nor appropriate in furtherance of 
the purposes of the Exchange Act? Would the proposed amendments, if 
adopted, promote efficiency, competition, and capital formation? 
Commenters are requested to provide empirical data and other factual 
support for their views, if possible.

VII. Regulatory Flexibility Act Certification

    The Commission hereby certifies, pursuant to 5 U.S.C. 605(b), that 
proposed amendments to Rules 15c3-1, 15c3-4, 17a-5, 17a-11, 17h-1T, and 
17h-2T, if adopted, would not have a significant economic impact on a 
substantial number of small entities.
    These provisions would be available only to broker-dealers that 
have tentative net capital of at least $1 billion and net capital of at 
least $500 million. According to March 2003 FOCUS reports, there are 
only 28 such firms, and, of these firms, none were small 
businesses.\93\ Further, election to apply for the alternative capital 
regime is voluntary. The proposed rules and rule amendments, therefore, 
should not have a significant impact on a substantial number of small 
entities.
---------------------------------------------------------------------------

    \93\ Pursuant to 17 CFR 240.0-10, ``the term small business or 
small organization shall: [* * *] (c) [w]hen used with reference to 
a broker or dealer, mean a broker or dealer that: (1) [h]ad total 
capital (net worth plus subordinated liabilities) of less than 
$500,000 on the date in the prior fiscal year as of which its 
audited financial statements were prepared pursuant to Sec.  240.17-
5(d) or, if not required to file such statements, a broker or dealer 
that had total capital (net worth plus subordinated liabilities) of 
less than $500,000 on the last business day of the preceding fiscal 
year (or in the time that it has been in business, if shorter); and 
(2) [i]s not affiliated with any person (other than a natural 
person) that is not a small business or small organization as 
defined in this section * * *'' (17 CFR 240.0-10(c)). Further, 
pursuant to Sec.  240.0-10(i), ``[f]or purposes of paragraph (c) of 
this section, a broker or dealer is affiliated with another person 
if [* * *] [s]uch broker or dealer introduces transactions in 
securities, other than registered investment company securities or 
interests or participations in insurance company separate accounts, 
to such other person or introduces accounts of customers or other 
brokers or dealers, other than accounts that hold only registered 
investment company securities or interests or participations in 
insurance company separate accounts, to such other person that 
carries such accounts on a fully disclosed basis.'' (17 CFR 240.0-
10(i)).
---------------------------------------------------------------------------

    We encourage written comments regarding this certification. We 
solicit comment on whether the proposed rule amendments could have an 
effect that we have not considered. We request that commenters describe 
the nature of any impact on small entities and provide empirical data 
to support the extent of the impact.

VIII. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \94\ a rule is ``major'' if it has 
resulted, or is likely to result, in:
---------------------------------------------------------------------------

    \94\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996) (codified 
in various sections of 5 U.S.C., 15 U.S.C. and as a note to 5 U.S.C. 
601).
---------------------------------------------------------------------------

    [sbull] An annual effect on the economy of $100 million or more;
    [sbull] A major increase in costs or prices for consumers or 
individual industries; or
    [sbull] Significant adverse effect on competition, investment or 
innovation.
    We request comment on the potential impact of the proposed 
amendments on the economy on an annual basis. We request that 
commenters provide empirical data and other factual support for their 
views.

IX. Statutory Authority

    The Commission proposes to amend Title 17, Chapter II of the Code 
of Federal Regulations pursuant to the Exchange Act (15 U.S.C. 78a et 
seq.) (particularly sections 15(c), 17(a), 23, 24(b), and 36 thereof 
(15 U.S.C. 78o(c), 78q(a), 78w, 78x(b), and 78mm)).

List of Subjects in 17 CFR Part 240

    Broker-dealers, Reporting and recordkeeping requirements, 
Securities.

Text of Proposed Rule Amendments

    For the reasons set forth in the preamble, Title 17, Chapter II of 
the Code of Federal Regulations is proposed to be amended as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    1. The authority citation for Part 240 continues to read, in part, 
as follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 
78w, 78x, 78ll, 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-
3, 80b-4, 80b-11, 7202, 7241, 7262, and 7263; and 18 U.S.C. 1350, 
unless otherwise noted.
* * * * *
    2. Remove the authority citations following Sec. Sec.  240.15c3-1 
and 240.17a-5.
    3. Section 240.15c3-1 is amended by:
    a. Revising the undesignated section heading preceding paragraph 
(a)(7);
    b. Adding text to paragraph (a)(7);
    c. Revising the undesignated section heading preceding paragraph 
(c)(13);
    d. Adding text to paragraph (c)(13); and
    e. Adding a sentence to the end of paragraph (c)(15).
    The additions and revisions read as follows:


Sec.  240.15c3-1  Net capital requirements for brokers or dealers.

    (a) * * *
Alternative Net Capital Computation for Broker-Dealers That Elect to be 
Supervised on a Consolidated Basis
    (7) In accordance with Appendix E to this section (Sec.  240.15c3-
1e), the Commission may approve, in whole or in part, an application or 
an amendment to an application by a broker or dealer, when calculating 
net capital, to use the market risk standards of Appendix E to 
calculate the market risk capital charge on some or all of its 
positions instead of the provisions of paragraph (c)(2)(vi) of this 
section, and to use the credit risk standards of Appendix E to 
calculate the credit risk capital charge on certain credit exposures 
arising from transactions in derivatives instruments instead of the 
provisions of paragraph (c)(2)(iv) of this section, subject to any 
conditions or limitations the Commission may require as necessary or 
appropriate in the public interest and consistent with the protection 
of investors. Such a broker or dealer must at all times maintain 
tentative net capital of not less than $1 billion and net capital of 
not less than $500 million.
    (c) * * *

[[Page 62897]]

Entity That Has a Principal Regulator
    (13) For purposes of Appendix E (Sec.  240.15c3-1e) and Appendix G 
(Sec.  240.15c3-1g) of this section, the term entity that has a 
principal regulator shall mean a person (other than a natural person) 
that is not a registered broker or dealer (other than a broker or 
dealer registered under section 15(b)(11) of the Act (15 U.S.C. 
78o(b)(11)), provided that:
    (i) The person is:
    (A) An insured depository institution as defined in section 3(c)(2) 
of the Federal Deposit Insurance Act (12 U.S.C 1813(c)(2));
    (B) Registered with the Commodity Futures Trading Commission; or
    (C) Registered with or licensed by a State insurance regulator and 
issues any insurance, endowment, or annuity policy or contract; or
    (ii) There are in place appropriate arrangements so that 
information provided to the Commission is sufficiently reliable for the 
purposes of Appendix E and Appendix G, the person is primarily in the 
insured depository institutions business (excluding its insurance and 
commercial businesses), and the person is:
    (A) A bank holding company as defined in section 2 of the Bank 
Holding Company Act of 1956 (12 U.S.C. 1841(a));
    (B) A savings and loan holding company as defined in Section 
10(a)(1)(D) of the Home Owners' Loan Act (12 U.S.C. 1467a(1)(D)); or
    (C) A foreign bank as defined in section 1(b)(7) of the 
International Banking Act of 1978 (12 U.S.C. 3101(7)) that is from a 
jurisdiction for which any foreign bank has been approved by the Board 
of Governors of the Federal Reserve System to conduct business under 12 
CFR 211.24(c), provided such foreign bank represents that it is subject 
to the same supervisory regime as the foreign bank previously approved 
by the Board of Governors of the Federal Reserve System.
* * * * *
    (15) * * * For a broker or dealer whose application for exemption 
under paragraph (a)(7) of this section has been granted by the 
Commission, the term tentative net capital means the net capital of the 
broker or dealer before deducting the market and credit risk capital 
charges computed pursuant to Appendix E to this section (Sec.  
240.15c3-1e) or paragraph (c)(2)(vi) of this section, if applicable, 
and increased by the balance sheet value (including counterparty net 
exposure) resulting from transactions in derivative instruments which 
would otherwise be deducted by virtue of paragraph (c)(2)(iv) of this 
section.
* * * * *
    4. Section 240.15c3-1e is revised to read as follows:


Sec.  240.15c3-1e  Market and credit risk capital charges for certain 
brokers or dealers (Appendix E to 17 CFR 240.15c3-1).

Application

    (a) A broker or dealer may apply to the Commission for 
authorization to compute market risk capital charges pursuant to this 
Appendix E in lieu of computing haircuts pursuant to Sec.  240.15c3-
1(c)(2)(vi) and to compute credit risk capital charges pursuant to this 
Appendix E on some or all of its credit exposures arising from 
transactions in derivatives instruments (if this Appendix E is used to 
calculate market risk capital charges on these instruments) in lieu of 
computing credit risk capital charges pursuant to Sec.  240.15c3-
1(c)(2)(iv).
    (1) The documents and information submitted to the Commission by 
the broker or dealer as part of its application shall include the 
following:
    (i) An executive summary of the documents and information provided 
to the Commission as part of the application and a description of the 
holding company of the broker or dealer, which may not be a natural 
person;
    (ii) A comprehensive description of the internal risk management 
control system of the broker or dealer and how that system satisfies 
the requirements set forth in Sec.  240.15c3-4;
    (iii) A detailed list of the categories of positions that the 
broker or dealer holds in its proprietary accounts and a brief 
description of the methods that the broker or dealer will use to 
calculate market and credit risk capital charges on those categories of 
positions;
    (iv) A description of all mathematical models used to price 
positions and to compute market and credit risk capital charges; a 
description of the creation, use, and maintenance of the mathematical 
models; a description of the broker's or dealer's internal risk 
management controls over those models, including a description of 
persons who may input data into the model and persons who have access 
to any or all of the model's outputs; a statement regarding whether the 
firm has developed its own mathematical models; if a mathematical model 
incorporates empirical correlations across risk categories, a 
description of the process for measuring correlations; a description of 
the backtesting procedures the broker or dealer will use to backtest 
the mathematical model used to calculate maximum potential exposure; a 
description of how each mathematical model satisfies the qualitative 
and quantitative requirements set forth in paragraph (e) of this 
Appendix E; and for each mathematical model, a statement that the model 
is used to analyze and report risk to senior management;
    (v) If the broker or dealer is applying to the Commission for 
approval to use scenario analysis to calculate market risk capital 
charges for certain positions, a list of those positions, a description 
of how those charges will be calculated using scenario analysis, and an 
explanation of why scenario analysis is appropriate to calculate market 
risk capital charges on those positions;
    (vi) A description of how the broker or dealer will calculate 
current exposure;
    (vii) A description of how the broker or dealer will determine 
internal credit ratings of counterparties, if applicable; and
    (viii) A written undertaking by the holding company of the broker 
or dealer, in a form acceptable to the Commission, signed by a duly 
authorized person at the holding company, to the effect that, as a 
condition of Commission approval of the application of the broker or 
dealer to compute certain market and credit risk capital charges 
pursuant to this Appendix E, the holding company agrees to:
    (A) Comply with the provisions of Sec.  240.15c3-1g;
    (B) Comply with all applicable provisions of this Appendix E;
    (C) Comply with the provisions of Sec.  240.15c3-4 with respect to 
an internal risk management control system for the affiliate group as 
though it were a broker-dealer that computes certain of its capital 
charges in accordance with this Appendix E;
    (D) As part of the internal risk management control system for the 
affiliate group, establish, document, and maintain procedures for the 
detection and prevention of money laundering and terrorist financing;
    (E) Permit the Commission to examine the books and records of any 
affiliate of the broker or dealer, including the holding company, if 
the affiliate is not an entity that has a principal regulator, as 
defined in Sec.  240.15c3-1(c)(13);
    (F) Make available to the Commission, for an entity that has a 
principal regulator, as defined specifically in Sec.  240.15c3-
1(c)(13)(ii), such information concerning the operations of the entity 
that the Commission finds is necessary

[[Page 62898]]

to evaluate the financial and operational risk within the affiliate 
group of the broker or dealer (including any risks that may affect the 
reputation of the holding company or the broker or dealer) and to 
evaluate compliance with the conditions of eligibility for computing 
certain capital charges pursuant to this Appendix E;
    (G) If the disclosure to the Commission of any information required 
as a condition for the broker or dealer to compute certain capital 
charges pursuant to this Appendix E would be prohibited by law or 
otherwise, cooperate with the Commission as needed, including by 
describing any secrecy laws or other impediments that could restrict 
the ability of the broker or dealer or any affiliates from providing 
information on their operations or activities and by discussing the 
manner in which the holding company and the broker or dealer propose to 
provide the Commission with adequate assurances of access to 
information;
    (H) For any non-U.S. holding company, consent to the jurisdiction 
of the Commission and agree to maintain a U.S. registered agent;
    (I) Submit to the Commission all material changes to mathematical 
models and other methods used to calculate allowances for market, 
credit, and operational risk;
    (J) Submit to the Commission all material changes to the internal 
risk management control system for the affiliate group; and
    (K) Acknowledge that, if the holding company fails to comply with 
any provision of its undertaking, the Commission may, in addition to 
any other supervisory conditions necessary or appropriate in the public 
interest and consistent with the protection of investors, increase the 
multiplication factors the holding company uses to calculate allowances 
for market and credit risk as defined in Sec.  240.15c3-1g(a)(2) and 
(a)(3) or impose any regulatory condition with respect to the broker or 
dealer listed in paragraph (f) of this Appendix E;
    (2) As a condition of Commission approval, the documents and 
information submitted to the Commission by the holding company of the 
broker or dealer as part of the application of the broker or dealer 
shall include the following:
    (i) A narrative description of the business and organization of the 
holding company;
    (ii) An alphabetical list of the affiliates of the broker or dealer 
(the ``affiliate group''), with an identification of the financial 
regulator, if any, with whom the affiliate is registered, and a 
designation of those affiliates that are material to the holding 
company (``material affiliates'');
    (iii) An organizational chart that identifies the holding company, 
the broker or dealer, and the material affiliates of the broker or 
dealer;
    (iv) Consolidated and consolidating financial statements of the 
affiliate group as of the end of the quarter preceding the filing of 
the application;
    (v) The following sample computations for the affiliate group:
    (A) Allowable capital and allowances for market risk, credit risk, 
and operational risk, determined pursuant to Sec.  240.15c3-1g(a)(1)--
(4); or
    (B) A capital assessment calculated pursuant to Sec.  240.15c3-
1g(a)(5);
    (vi) A detailed list of the categories of positions that the 
affiliate group holds in its proprietary accounts and a brief 
description of the method that the holding company proposes to use to 
calculate allowances for market and credit risk, pursuant to Sec.  
240.15c3-1g(a)(2) and (3), on those positions;
    (vii) A description of all mathematical models used to price 
positions and to compute market and credit risk capital charges; a 
description of the creation, use, and maintenance of the mathematical 
models; a description of the holding company's internal risk management 
controls over those models, including a description of persons who may 
input data into the model and persons who have access to any or all of 
the model's outputs; a statement regarding whether the firm has 
developed its own mathematical models; if a mathematical model 
incorporates empirical correlations across risk categories, a 
description of the process for measuring correlations; a description of 
the backtesting procedures the holding company will use to backtest the 
mathematical model used to calculate maximum potential exposure; a 
description of how each mathematical model satisfies the qualitative 
and quantitative requirements set forth in paragraph (e) of this 
Appendix E; for each mathematical model, a statement that the model is 
used to analyze and report risk to senior management; and a description 
of any positions for which the holding company proposes to use an 
alternative method for computing an allowance for market risk and a 
description of how that allowance would be determined;
    (viii) A description of how the holding company will calculate 
current exposure;
    (ix) A description of how the holding company will calculate the 
credit risk weights of counterparties and internal credit ratings of 
counterparties, if applicable;
    (x) A description of how the holding company will calculate its 
allowance for operational risk;
    (xi) For each instance in which a mathematical model used by the 
broker or dealer to calculate a market risk capital charge or maximum 
potential exposure for a particular product or counterparty differs 
from the mathematical model used by the holding company to calculate an 
allowance for credit risk or maximum potential exposure for that same 
product or counterparty, a description of the difference(s) between the 
mathematical models;
    (xii) A comprehensive description of the risk management control 
system for the affiliate group that the holding company has established 
to manage affiliate group-wide risk, including market, credit, 
liquidity and funding, legal and compliance, and operational risks, and 
how that system satisfies the requirements of Sec.  240.15c3-4; and
    (xiii) Sample risk reports provided to the persons who are 
responsible for managing group-wide risk that the holding company will 
provide to the Commission pursuant to Sec.  240.15c3-1g(b)(1)(viii);
    (3) The application of the broker or dealer shall be supplemented 
by such other information or documents relating to the internal risk 
management control system, mathematical models, and financial position 
of the broker or dealer or the holding company of the broker or dealer 
that the Commission may request to complete its review of the 
application;
    (4) The application shall be considered filed when received at the 
Commission's principal office in Washington, DC. All information and 
documents submitted in connection with the application will be accorded 
confidential treatment;
    (5) If any of the information or documents filed with the 
Commission as part of the application of the broker or dealer is found 
to be or becomes inaccurate before the Commission approves the 
application, the broker or dealer must promptly notify the Commission 
and provide the Commission with a description of the circumstances in 
which the information or documents was found to be or has become 
inaccurate along with updated, accurate information and documents;
    (6) The Commission may approve the application, in whole or in 
part, subject to any conditions or limitations the Commission may 
require if the Commission finds it to be necessary or

[[Page 62899]]

appropriate in the public interest and consistent with the protection 
of investors after determining, among other things, whether: The broker 
or dealer has met the requirements of this Appendix E; the broker or 
dealer is in compliance with other applicable rules promulgated under 
the Act and self-regulatory organization rules; and the holding company 
of the broker or dealer is in compliance with the terms of its 
undertaking, provided to the Commission pursuant to paragraph 
(a)(1)(viii) of this Appendix E;
    (7) The broker or dealer shall amend and resubmit to the Commission 
its application to calculate certain market and credit risk capital 
charges in accordance with this Appendix E if the broker or dealer or 
its holding company desires to make any material change to a 
mathematical model used to calculate market or credit risk or its 
internal risk management control system as described in the 
application;
    (8) The broker or dealer shall notify the Commission of any 
material change to the corporate structure of the broker or dealer or 
the holding company as described in the application;
    (9) As a condition for the broker or dealer to compute its capital 
charges under this Appendix E, the broker or dealer agrees that:
    (i) The broker or dealer will provide 45 days written notice to the 
Commission if it intends to cease to use the market risk standards of 
this Appendix E to calculate its market risk capital charge instead of 
the provisions of Sec.  240.15c3-1(c)(2)(vi) and the credit risk 
standards of this Appendix E to calculate its credit risk capital 
charge on certain credit exposures arising from transactions in 
derivatives instruments instead of the provisions of Sec.  240.15c3-
1(c)(2)(iv); and
    (ii) The Commission may determine by order that such notice will 
become effective after a shorter or longer period of time if the broker 
or dealer consents or if the Commission determines that the shorter or 
longer period of time is necessary or appropriate in the public 
interest and consistent with the protection of investors; and
    (10) Notwithstanding paragraph (a)(9) of this section, the 
Commission, by order, may revoke a broker's or dealer's exemption that 
allows it to use the market risk standards of this Appendix E to 
calculate the market risk capital charge instead of the provisions of 
Sec.  240.15c3-1(c)(2)(vi), and the exemption to use the credit risk 
standards of this Appendix E to calculate the credit risk capital 
charge on certain credit exposures arising from transactions in 
derivatives instruments instead of the provisions of Sec.  240.15c3-
1(c)(2)(iv), if the Commission finds that such exemption is no longer 
necessary or appropriate in the public interest, or is no longer 
consistent with the protection of investors.

Compliance With Sec.  240.15c3-4

    (b) A broker or dealer that computes its market and credit risk 
capital charges under this Appendix E must comply in all material 
respects with Sec.  240.15c3-4 regarding its internal risk management 
control system in order to be in compliance with Sec.  240.15c3-1.

Market Risk

    (c) A broker or dealer whose application has been approved under 
paragraph (a) of this Appendix E shall compute a market risk capital 
charge daily in accordance with the following:
    (1) The broker or dealer shall compute a market risk capital charge 
on eligible positions, in accordance with the phase-in schedule of 
paragraph (c)(3) of this Appendix E, equal to the VaR of those 
positions multiplied by the appropriate multiplication factor. The VaR 
of the positions must be obtained using approved VaR models meeting the 
applicable qualitative and quantitative requirements of paragraph (e) 
of this Appendix E. The broker or dealer must use the multiplication 
factor determined according to paragraph (e)(1)(iii) of this Appendix 
E, except that the initial multiplication factor shall be three, unless 
the Commission determines, based on a review of the broker's or 
dealer's internal risk management control system and practices, 
including a review of the VaR models, that another multiplication 
factor is appropriate;
    (2) The broker or dealer may not use a VaR model to determine a 
capital charge for positions having no ready market or for debt 
securities which are below investment grade or for any derivative 
instrument based on the value of these positions, unless the Commission 
has granted, pursuant to Sec.  240.15c3-1(a)(7), its application to use 
its VaR model for any such positions. The broker or dealer may apply 
pursuant to paragraph (c)(5) of this Appendix E to calculate its market 
risk capital charge for any such positions using scenario analysis. If 
that application is denied, the broker or dealer must calculate the 
market risk capital charge for such positions under Sec.  240.15c3-
1(c)(2)(vi);
    (3) The broker or dealer shall use approved VaR models to compute 
its market risk capital charge in accordance with the following phase-
in schedule:
    (i) Upon Commission approval of its application under paragraph (a) 
of this Appendix E, the broker or dealer may use approved VaR models to 
calculate its market risk capital charge for the following positions:
    (A) U.S. government securities and derivatives on those securities;
    (B) Corporate debt securities rated in one of the four highest 
rating categories by two nationally recognized statistical rating 
organizations (``NRSROs'') and derivatives on those securities;
    (C) Foreign government securities rated in one of the four highest 
rating categories by two NRSROs and derivatives on those securities;
    (D) Derivatives on major market foreign currencies as defined in 
Sec.  240.15c3-1a(b)(1)(i)(C);
    (E) Asset-backed securities with less than 5 years to maturity that 
are rated in one of the four highest rating categories by two NRSROs 
and derivatives on those securities; and
    (F) Municipal securities rated in one of the four highest rating 
categories by two NRSROs and derivatives on those securities;
    (ii) Nine months after Commission approval of its application under 
paragraph (a) of this Appendix E, the broker or dealer may amend its 
application to request approval to use one or more approved VaR models 
to calculate its market risk capital charge for equities and 
derivatives on equities; and
    (iii) Nine months after the amendment filed pursuant to paragraph 
(c)(3)(ii) of this Appendix E has been approved, a broker or dealer may 
amend its application to request approval to use one or more approved 
VaR models to calculate its market risk capital charge for other 
eligible positions;
    (4) Notwithstanding any other provision in this Appendix E, a 
broker or dealer that computes its capital charges under this Appendix 
E may use a VaR model to determine market risk capital charges only for 
positions for which there is adequate historical data to support a VaR 
model;
    (5) The broker or dealer must request, either in its initial 
application or an amendment, to use scenario analysis to compute its 
market risk capital charge for a category of positions. For positions 
for which the Commission has approved the broker's or dealer's 
application to use scenario analysis, the market risk capital charge 
shall be three times the greatest adverse movement resulting from the 
scenario analysis over any ten-day period on a daily basis, except that 
the resulting market risk capital charge must be at least $25 per 100 
share equivalent contract for equity positions, or one-half of one 
percent of the face value of the contract for all other types

[[Page 62900]]

of contracts, even if the scenario analysis indicates a lower amount. A 
scenario qualifying for use under this Appendix E must include:
    (i) A set of pricing equations for the positions or derivatives 
based on, for example, arbitrage relations, statistical analysis, 
historic relationships, merger evaluation, or fundamental valuation of 
an offering of securities;
    (ii) A range of adverse movements of risk factors, prices, or 
spreads that moved by the greatest amounts over the past 5 years or a 3 
standard deviation movement in those risk factors, prices, or spreads 
over a ten day period;
    (iii) Auxiliary relationships mapping risk factors to prices; and
    (iv) Data demonstrating the effectiveness of the scenario in 
capturing market risk; and
    (6) For all other positions, the broker or dealer must compute a 
market risk capital charge pursuant to Sec.  240.15c3-1(c)(2)(vi) and 
applicable Appendices.

Credit Risk

    (d) A broker or dealer whose application, including amendments, has 
been approved under paragraph (a) of this Appendix E shall compute its 
credit risk capital charge daily on credit exposures to all 
counterparties arising from the broker's or dealer's transactions in 
derivatives instruments (if this Appendix E is used to calculate the 
market risk capital charge on those instruments) that is the sum of: A 
counterparty exposure charge to each counterparty, concentration 
charges by counterparty, and a portfolio concentration charge across 
all counterparties, determined as follows:
    (1) For each counterparty, the counterparty exposure charge is:
    (i) The net replacement value in the account of the counterparty 
that is insolvent, or in bankruptcy, or that has senior unsecured long-
term debt in default; or
    (ii) As to a counterparty not otherwise described in paragraph 
(d)(1)(i) of this Appendix E, the credit equivalent amount of the 
broker's or dealer's exposure to the counterparty, as defined in 
paragraph (d)(2) of this Appendix E, multiplied by the credit risk 
weight of the counterparty, as determined according to paragraph (d)(7) 
of this Appendix E, multiplied by 8%;
    (2) The credit equivalent amount of the broker's or dealer's 
exposure to a counterparty is the sum of the broker's or dealer's 
maximum potential exposure to the counterparty, as defined in paragraph 
(d)(4) of this Appendix E, multiplied by the appropriate multiplication 
factor, and the broker's or dealer's current exposure to the 
counterparty, as defined in paragraph (d)(3) of this Appendix E. The 
broker or dealer must use the multiplication factor determined 
according to paragraph (e)(1)(iv) of this Appendix E, except that the 
initial multiplication factor shall be one, unless the Commission 
determines, based on a review of the broker's or dealer's internal risk 
management control system and practices, including a review of the VaR 
models, that another multiplication factor is appropriate;
    (3) The current exposure of the broker or dealer to a counterparty 
is the current replacement value of the counterparty's positions with 
the broker or dealer, after applying netting agreements with the 
counterparty meeting the requirements of paragraph (d)(5) of this 
Appendix E and taking into account the value of collateral from the 
counterparty held by the broker or dealer in accordance with paragraph 
(d)(6) of this Appendix E;
    (4) The maximum potential exposure of the broker or dealer to a 
counterparty is the increase in the replacement value of the 
counterparty's positions with the broker or dealer, after applying 
netting agreements with the counterparty meeting the requirements of 
paragraph (d)(5) of this Appendix E and taking into account the value 
of collateral from the counterparty held by the broker or dealer in 
accordance with paragraph (d)(6) of this Appendix E, that is computed 
daily using approved VaR models meeting the applicable quantitative and 
qualitative requirements of paragraph (e) of this Appendix E;
    (5) Netting agreements. When calculating current exposure or 
maximum potential exposure, a broker or dealer may include the effect 
of netting agreements that allow a broker or dealer to net gross 
receivables and gross payables with a counterparty upon default of the 
counterparty if:
    (i) The netting agreement is legally enforceable in each relevant 
jurisdiction, including in insolvency proceedings;
    (ii) The gross receivables and gross payables subject to the 
netting agreement with a counterparty can be determined at any time; 
and
    (iii) For internal risk management purposes, the broker or dealer 
monitors and controls its exposure to the counterparty on a net basis;
    (6) Collateral. When calculating current exposure and maximum 
potential exposure, the fair market value of collateral pledged and 
held may be taken into account provided:
    (i) The collateral is marked to market each day and is subject to a 
daily margin maintenance requirement;
    (ii) The collateral has a ready market or consists of major market 
foreign currency as defined in Sec.  240.15c3-1a(b)(1)(i)(C) or United 
States currency;
    (iii) The collateral agreement is legally enforceable by the broker 
or dealer against the counterparty and any other parties to the 
agreement;
    (iv) The collateral does not consist of securities issued by the 
counterparty or a party related to the broker or dealer or to the 
counterparty;
    (v) The Commission has approved the broker's or dealer's use of a 
VaR model to calculate market risk capital charges for the type of 
security used as collateral in accordance with Sec.  240.15c3-1(a)(7) 
and paragraphs (g)(2) and (g)(3) of this Appendix E; and
    (vi) The collateral is not used in determining the credit rating of 
the counterparty;
    (7) Credit risk weights of counterparties. A broker or dealer that 
computes its credit risk capital charges pursuant to this Appendix E 
shall determine the credit risk weight of a counterparty as follows:
    (i) 20% credit risk weight for transactions with counterparties 
with ratings for senior unsecured long-term debt or commercial paper in 
one of the two highest rating categories by an NRSRO or equivalent 
internal rating, if applicable;
    (ii) 50% credit risk weight for transactions with counterparties 
with ratings for senior unsecured long-term debt or commercial paper in 
the third and fourth highest rating categories by an NRSRO or 
equivalent internal rating, if applicable;
    (iii) 150% credit risk weight for transactions with counterparties 
with ratings for senior unsecured long-term debt or commercial paper 
below the fourth highest rating category by an NRSRO or equivalent 
internal rating, if applicable;
    (iv) As part of its initial application or in an amendment, the 
broker or dealer may request Commission approval to determine credit 
ratings using internal calculations for counterparties that are not 
rated by an NRSRO, and the broker or dealer may use these internal 
credit ratings in lieu of ratings issued by an NRSRO for purposes of 
determining credit risk weights. Based on the strength of the broker's 
or dealer's internal credit risk management system, the Commission may 
approve the application. The broker or dealer must make and keep 
current a record of the basis for the credit rating for each 
counterparty. The record must be preserved for a period of not less 
than three years, the first two years in an easily accessible place; 
and

[[Page 62901]]

    (v) For the portion of a current exposure covered by a guarantee 
where that guarantee is an unconditional and irrevocable guarantee of 
the due and punctual payment and performance of the obligation and the 
broker or dealer can demand immediate payment from the guarantor after 
any payment is missed without having to make collection efforts, the 
broker or dealer may substitute the credit risk weight of the guarantor 
for the credit risk weight of the counterparty if the guarantee is 
evidenced by a written obligation of the guarantor that allows the 
broker or dealer to substitute the guarantor for the counterparty upon 
default or nonpayment by the counterparty;
    (8) Concentration charges by counterparty. The concentration 
charge, where the current exposure of the broker or dealer to a 
counterparty exceeds 5% of the tentative net capital of the broker or 
dealer, is calculated as follows:
    (i) For counterparties with credit risk weights of 20%, 5% of the 
amount of the current exposure to the counterparty in excess of 5% of 
the tentative net capital of the broker or dealer;
    (ii) For counterparties with credit risk weights of 50%, 20% of the 
amount of the current exposure to the counterparty in excess of 5% of 
the tentative net capital of the broker or dealer; and
    (iii) For counterparties with credit risk weights of 150%, 50% of 
the amount of the current exposure to the counterparty in excess of 5% 
of the tentative net capital of the broker or dealer; and
    (9) Portfolio concentration charge across all counterparties. The 
concentration charge across all counterparties for unsecured 
receivables is 100% of the amount of the broker's or dealer's aggregate 
current exposure arising from the broker's or dealer's transactions in 
derivatives instruments across all counterparties in excess of 15% of 
the tentative net capital of the broker or dealer.

VaR Models

    (e) Each VaR model must meet the following minimum qualitative and 
quantitative requirements:
    (1) Qualitative requirements. (i) The VaR model used to calculate 
market or credit risk for a position must be the same model used to 
report the market or credit risk of that position to senior management 
and must be integrated into the daily internal risk management system 
of the firm;
    (ii) The VaR model must be reviewed both periodically and annually. 
The periodic review may be conducted by the firm's internal audit 
staff, but the annual review must be conducted by a registered public 
accounting firm, as that term is defined in section 2(a)(12) of the 
Sarbanes-Oxley Act of 2002 (Pub. L. 107-204);
    (iii) For purposes of computing market risk, the firm must 
determine the appropriate multiplication factor as follows:
    (A) Beginning three months after the firm begins using the VaR 
model to calculate market risk, the firm must conduct backtesting of 
the model by comparing its actual daily net trading profit or loss with 
the corresponding VaR measure generated by the VaR model, using a 99 
percent, one-tailed confidence level with price changes equivalent to a 
one business-day movement in rates and prices, for each of the past 250 
business days;
    (B) On the last business day of each quarter, the firm must 
identify the number of backtesting exceptions of the VaR model, that 
is, the number of business days in the past 250 business days for which 
the actual net trading loss, if any, exceeds the corresponding VaR 
measure; and
    (C) The firm must use the multiplication factor indicated in Table 
1 of this Appendix E in determining its market risk until it obtains 
the next quarter's backtesting results, unless the Commission 
determines, based, among other relevant factors, on a review of the 
firm's internal risk management control system, including a review of 
its VaR model, that a different adjustment or other action is 
appropriate; and

   Table 1.--Multiplication Factor Based on the Number of Backtesting
        Exceptions of the VaR Model in the Past 250 Business Days
------------------------------------------------------------------------
                                                          Multiplication
                  Number of exceptions                        factor
------------------------------------------------------------------------
4 or fewer..............................................            3.00
5.......................................................            3.40
6.......................................................            3.50
7.......................................................            3.65
8.......................................................            3.75
9.......................................................            3.85
10 or more..............................................            4.00
------------------------------------------------------------------------

    (iv) For purposes of computing the credit equivalent amount of the 
firm's exposures to a counterparty, the firm must determine the 
appropriate multiplication factor as follows:
    (A) Beginning three months after the firm begins using the VaR 
model to calculate maximum potential exposure, the firm must conduct 
backtesting of the model by comparing, for at least 40 counterparties 
with widely varying types and sizes of positions with the firm, the 
daily change in its current exposure to the counterparty based on the 
end of the previous day's positions with the corresponding maximum 
potential exposure for the counterparty generated by the VaR model;
    (B) Once each quarter, on the last business day of the quarter, the 
firm must identify the number of backtesting exceptions of the VaR 
model, that is, the number of business days in the past 250 business 
days for which the change in current exposure to a counterparty exceeds 
the corresponding maximum potential exposure; and
    (C) Based on the number of backtesting exceptions of the VaR model, 
the firm will propose, as part of its application, a schedule of 
multiplication factors, which must be approved by the Commission. The 
firm must use the multiplication factor indicated in the approved 
schedule in determining the credit equivalent amount of the firm's 
exposures to a counterparty until it obtains the next quarter's 
backtesting results, unless the Commission determines, based, among 
other relevant factors, on a review of the firm's internal risk 
management control system, including a review of the VaR model, that a 
different adjustment or other action is appropriate;
    (2) Quantitative requirements. (i) For purposes of determining 
market risk, the VaR model must use a 99 percent, one-tailed confidence 
level with price changes equivalent to a ten business-day movement in 
rates and prices;
    (ii) For purposes of determining maximum potential exposure, the 
VaR model must use a 99 percent, one-tailed confidence level with price 
changes equivalent to a one-year movement in rates and prices;
    (iii) The VaR model must use an effective historical observation 
period of at least one year. The historical observation period must 
include periods of market stress. Historical data sets must be updated 
at least monthly and reassessed whenever market prices or volatilities 
change significantly; and
    (iv) The VaR model must take into account and incorporate all 
significant, identifiable market risk factors applicable to positions 
in the accounts of the firm, including:
    (A) Risks arising from the non-linear price characteristics of 
derivatives and the sensitivity of the market value of the positions to 
changes in the volatility of options positions due to different 
maturities;
    (B) Empirical correlations with and across risk factors or, 
alternatively, risk factors sufficient to cover all the market risk 
inherent in the positions in the

[[Page 62902]]

proprietary or other trading accounts of the firm, including interest 
rate risk, equity price risk, foreign exchange risk, and commodity 
price risk;
    (C) Spread risk, where applicable, and segments of the yield curve 
sufficient to capture differences in volatility and imperfect 
correlation of rates along the yield curve for securities and 
derivatives that are sensitive to different interest rates; and
    (D) Specific risk for individual securities and derivatives.

Additional Regulatory Conditions

    (f) As a condition for the broker or dealer to use this Appendix E 
to calculate certain of its capital charges, the Commission may impose 
additional regulatory conditions on the broker or dealer, which may 
include: Restricting its business (on a product-specific, category-
specific, or general basis); submitting to the Commission a plan to 
increase its net capital or tentative net capital; filing more frequent 
reports with the Commission; Modifying its internal risk management 
control procedures; or computing its market and credit risk capital 
charges in accordance with Sec.  240.15c3-1(c)(2)(vi) and (c)(2)(iv), 
as appropriate. The Commission may also require, as a condition of 
continuation of the exemption, the holding company of the broker or 
dealer to file more frequent reports or to modify its group-wide 
internal risk management control procedures. The Commission may impose 
such additional regulatory conditions if:
    (1) The broker or dealer or the holding company of the broker or 
dealer fails to meet the reporting requirements set forth in Sec.  
240.17a-5 or 240.15c3-1g(b), as applicable;
    (2) Any event specified in Sec.  240.17a-11 or 240.15c3-1g(e) 
occurs;
    (3) There is a material deficiency in the internal risk management 
control system or in the mathematical models used to price securities 
or to calculate market and credit risk capital charges or allowances 
for market and credit risk, as applicable, of the broker or dealer or 
the holding company of the broker or dealer;
    (4) The holding company of the broker or dealer fails to comply 
with its undertakings that the broker or dealer has filed with its 
application pursuant to paragraph (a)(1)(viii) of this Appendix E;
    (5) The broker or dealer or the holding company of the broker or 
dealer materially amends a mathematical model or its internal risk 
management control system or its corporate structure as described in 
the application the broker or dealer has submitted to the Commission 
under this Appendix E; or
    (6) The Commission finds that imposing other regulatory conditions 
are necessary or appropriate in the public interest, and for the 
protection of investors.
    5. Section 240.15c3-1g is added to read as follows:


Sec.  240.15c3-1g  Conditions for holding companies of certain brokers 
or dealers (Appendix G to 17 CFR 240.15c3-1).

    As a condition for a broker or dealer to compute certain of its 
capital charges in accordance with Sec.  240.15c3-1e, the holding 
company of the broker or dealer shall comply with the conditions set 
forth below:

Conditions Regarding Computation of Allowable Capital and Risk 
Allowances

    (a) As a condition of the exemption, the holding company of a 
broker or dealer that computes certain of its capital charges in 
accordance with Sec.  240.15c3-1e must calculate allowable capital and 
allowances for market, credit, and operational risk on a consolidated 
basis as follows:
    (1) Allowable capital. The holding company must compute allowable 
capital monthly as the sum of:
    (i) Common shareholders' equity on the consolidated balance sheet 
of the holding company less:
    (A) Goodwill;
    (B) Deferred tax assets;
    (C) Other intangible assets; and
    (D) Other deductions from common stockholders' equity as required 
by the Federal Reserve Board in calculating Tier 1 capital (as defined 
in 12 CFR 225, Appendix A);
    (ii) Cumulative and non-cumulative preferred stock, provided that:
    (A) The stock does not have a maturity date;
    (B) The stock cannot be redeemed at the option of the holder of the 
instrument;
    (C) The stock has no other provisions that will require future 
redemption of the issue; and
    (D) The issuer of the stock can defer or eliminate dividends, 
except that the amount of such cumulative preferred stock may not 
exceed 33% of the items included in allowable capital pursuant to 
paragraph (a)(1)(i) of this Appendix G; and
    (iii) The sum of the following items on the consolidated balance 
sheet, to the extent that the sum does not exceed the sum of the items 
included in allowable capital pursuant to paragraphs (a)(1)(i) and (ii) 
of this Appendix G:
    (A) Cumulative preferred stock in excess of the 33% limit specified 
in paragraph (a)(1)(ii) of this Appendix G; and
    (B) Subordinated debt if the original weighted average maturity of 
the subordinated debt is at least five years; each subordinated debt 
instrument states clearly on its face that repayment of the debt is not 
protected by any Federal agency or the Securities Investor Protection 
Corporation; the subordinated debt is unsecured and subordinated in 
right of payment to all senior indebtedness of the holding company; and 
the subordinated debt instrument permits acceleration only in the event 
of bankruptcy or reorganization of the holding company under Chapters 7 
(liquidation) and 11 (reorganization) of the U.S. Bankruptcy Code;
    (2) Allowance for market risk. The holding company shall compute an 
allowance for market risk daily for all proprietary positions, 
including debt instruments, equity instruments, commodity instruments, 
foreign exchange contracts, and derivative contracts, as the aggregate 
of the following:
    (i) Value at risk. The VaR of its positions, multiplied by the 
appropriate multiplication factor. The VaR of the positions must be 
obtained using approved VaR models meeting the applicable qualitative 
and quantitative requirements of Sec.  240.15c3-1e(e). The holding 
company must use the multiplication factor determined according to 
Sec.  240.15c3-1e(e)(1)(iii), except that the initial multiplication 
factor shall be three, unless the Commission determines, based on a 
review of the group-wide internal risk management control system and 
practices, including a review of the VaR models, that another 
multiplication factor is appropriate. The VaR model must be one that 
can be disaggregated by each line of business exposed to market risk 
and by each legal entity exposed to market risk. The holding company 
may use a VaR model to determine an allowance for market risk only for 
positions for which there is adequate historical data to support a VaR 
model; and
    (ii) Alternative method. For positions for which there does not 
exist adequate historical data to support a VaR model, an allowance for 
market risk using a method described in the broker's or dealer's 
application to use Sec.  240.15c3-1e to calculate certain of its 
capital charges that produces a suitable allowance for market risk for 
those positions;
    (3) Allowance for credit risk. The holding company shall compute an 
allowance for credit risk daily for

[[Page 62903]]

certain assets on the consolidated balance sheet and certain off-
balance sheet items, including loans and loan commitments, exposures 
due to derivatives contracts, structured financial products, and other 
extensions of credit, and credit substitutes as follows:
    (i) The credit equivalent amount of the asset or off-balance sheet 
item multiplied by the appropriate credit risk weight of the asset or 
off-balance sheet item or counterparty, determined according to 
paragraph (a)(3)(i)(F) of this Appendix G, multiplied by 8%, in 
accordance with the following:
    (A) For certain loans and loan commitments made by members of the 
affiliate group of the broker-dealer, the credit equivalent amount is 
determined by multiplying the nominal amount of the contract by the 
following credit conversion factors:
    (1) 0% credit conversion factor for loan commitments that:
    (i) May be unconditionally cancelled by the lender; or
    (ii) May be cancelled by the lender due to credit deterioration of 
the borrower;
    (2) 5% credit conversion factor for margin loans extended by 
members of the affiliate group of the broker or dealer in compliance 
with applicable self-regulatory organization regulations;
    (3) 20% credit conversion factor for:
    (i) Loan commitments of less than one year; or
    (ii) Short term self-liquidating trade related contingencies, 
including letters of credit;
    (4) 50% credit conversion factor for loan commitments with an 
original maturity of greater than one year that contain transaction 
contingencies, including performance bonds, revolving underwriting 
facilities, note issuance facilities and bid bonds; and
    (5) 100% credit conversion factor for bankers' acceptances, stand-
by letters of credit, and forward purchases of assets, and similar 
direct credit substitutes;
    (B) For derivatives contracts and for repurchase agreements, 
reverse repurchase agreements, stock lending and borrowing, and similar 
collateralized transactions, the credit equivalent amount of the 
holding company's exposure to a counterparty is the sum of the holding 
company's maximum potential exposure to the counterparty, as defined in 
paragraph (a)(3)(i)(D) of this Appendix G, multiplied by the 
appropriate multiplication factor, and the holding company's current 
exposure to the counterparty, as defined in paragraph (a)(3)(i)(C) of 
this Appendix G. The holding company must use the multiplication factor 
determined according to Sec.  240.15c3-1e(e)(1)(iv), except that the 
initial multiplication factor shall be one, unless the Commission 
determines, based on a review of the group-wide internal risk 
management control system and practices, including a review of the VaR 
models, that another multiplication factor is appropriate;
    (C) The current exposure of a member of the affiliate group to a 
counterparty is the current replacement value of the counterparty's 
positions with the member of the affiliate group, after applying 
netting agreements with that counterparty meeting the requirements of 
Sec.  240.15c3-1e(d)(5), taking into account the value of collateral 
from the counterparty pledged to and held by any member of the 
affiliate group in accordance with Sec.  240.15c3-1e(d)(6), and 
subtracting the fair market value of any credit derivatives that 
specifically change the exposure to the counterparty (as long as the 
credit derivatives are not used to change the credit risk weight of the 
counterparty as provided in paragraph (a)(3)(i)(I) of this Appendix G);
    (D) The maximum potential exposure of a member of the affiliate 
group to a counterparty is the increase in the net replacement value of 
the counterparty's positions with the member of the affiliate group, 
after applying netting agreements with that counterparty meeting the 
requirements of Sec.  240.15c3-1e(d)(5), taking into account the value 
of collateral from the counterparty held by any member of the affiliate 
group in accordance with Sec.  240.15c3-1e(d)(6), and subtracting the 
fair market value of any credit derivatives that specifically change 
the exposure to the counterparty (as long as the credit derivatives are 
not used to change the credit risk weight of the counterparty as 
provided in paragraph (a)(3)(i)(I) of this Appendix G), that is 
obtained daily using an approved VaR model meeting the applicable 
qualitative and quantitative requirements of Sec.  240.15c3-1e(e), 
except that for repurchase agreements, reverse repurchase agreements, 
stock lending and borrowing, and similar collateralized transactions, 
maximum potential exposure must be calculated using a time horizon of 
five days;
    (E) The credit equivalent amount for other assets shall be the 
asset's book value on the holding company's consolidated balance sheet;
    (F) The credit risk weights that shall be applied to certain assets 
and counterparties shall be determined according to standards published 
by the Basel Committee on Banking Supervision, as modified from time to 
time;
    (G) The holding company or other member of the affiliate group may, 
upon approval by the Commission of a request by the broker or dealer in 
its initial application or in an amendment, determine credit ratings 
using internal calculations for counterparties that are not rated by an 
NRSRO, and the holding company may use these internal credit ratings in 
lieu of ratings issued by an NRSRO for purposes of determining credit 
risk weights;
    (H) The holding company or other member of the affiliate group may, 
upon approval by the Commission of a request by the broker or dealer in 
its initial application or in an amendment, determine credit risk 
weights of counterparties using internal calculations;
    (I) The holding company or member of the affiliate group may reduce 
the credit risk weight of a counterparty by using credit derivatives 
such as credit default swaps, total return swaps, and similar 
instruments used to manage credit risk that provide credit protection 
equivalent to guarantees, that are used for bona fide hedging purposes 
to reduce the credit risk weight of a counterparty, that are not 
incorporated into the VaR model used for deriving potential exposures, 
and that are not held for market making purposes. The credit risk 
weight for the covered portion of the exposure shall be the credit risk 
weight of the writer of the derivative. The uncovered portion of the 
exposure shall be assigned the credit risk weight of the counterparty;
    (J) For the portion of a current exposure covered by a guarantee, 
where that guarantee is an unconditional and irrevocable guarantee of 
the due and punctual payment and performance of the obligation and the 
holding company or member of the affiliate group can demand payment 
after any payment is missed without having to make collection efforts, 
the holding company or member of the affiliate group may substitute the 
credit risk weight of the guarantor for the credit risk weight of the 
counterparty if the guarantee is evidenced by a written obligation of 
the guarantor that allows the holding company or member of the 
affiliate group to substitute the guarantor for the counterparty upon 
default or nonpayment by the counterparty;
    (K) The holding company may recognize a cross-product netting 
agreement that meets the requirements set forth in Sec.  240.15c3-
1e(j); and
    (L) The fair market value of collateral may be used to offset the 
net replacement value of receivables from a

[[Page 62904]]

counterparty provided the requirements set forth in Sec.  240.15c3-
1e(k) are met; or
    (ii) If the Commission approves the request of the broker or 
dealer, in its initial application or in an amendment, the holding 
company may use a calculation consistent with standards published by 
the Basel Committee on Banking Supervision, as modified from time to 
time;
    (4) Allowance for operational risk. The holding company shall 
compute an allowance for operational risk determined consistent with 
appropriate standards published by the Basel Committee on Banking 
Supervision, as modified from time to time; and
    (5) If the Commission approves the request of the broker or dealer, 
in its initial application or in an amendment, after reviewing the 
methodology of the computation, the holding company may compute a 
capital assessment consistent with standards promulgated by the Basel 
Committee on Banking Supervision (as modified from time to time) that 
it is required to submit to a financial regulator or supervisor in lieu 
of the computations described in paragraphs (a)(1) through (a)(4) of 
this Appendix G.

Conditions Regarding Reporting Requirements

    (b) As a condition of the exemption, the holding company of a 
broker or dealer that computes certain of its capital charges in 
accordance with Sec.  240.15c3-1e must file the following reports with 
the Commission:
    (1) A monthly report as of the end of the month, filed not later 
than 17 business days after the end of each month that does not end a 
quarter, which shall include:
    (i) A consolidated balance sheet and income statement (including 
notes to the financial statements) for the holding company and 
computations of allowable capital and allowances for market, credit, 
and operational risk computed pursuant to paragraph (a) of this 
Appendix G;
    (ii) A graph reflecting, for each business line, the daily intra-
month VaR;
    (iii) Consolidated credit risk information, including aggregate 
current exposure and current exposures (including commitments) listed 
by counterparty for:
    (A) The 15 largest exposures; and
    (B) The 5 largest exposures to regulated financial institutions;
    (iv) The 10 largest commitments listed by counterparty;
    (v) Maximum potential exposure listed by counterparty for:
    (A) The 15 largest exposures; and
    (B) The 5 largest exposures to regulated financial institutions;
    (vi) The aggregate maximum potential exposure;
    (vii) A summary report reflecting the geographic distribution of 
the holding company's exposures on a consolidated basis for each of the 
top ten countries to which it is exposed (by residence of the main 
operating group of the counterparty); and
    (viii) Certain regular risk reports provided to the persons 
responsible for managing group-wide risk as the Commission may request 
from time to time;
    (2) A quarterly report as of the end of the quarter, which may be 
unaudited, not later than 35 calendar days after the end of each 
calendar quarter, which shall include:
    (i) The information that the holding company files monthly pursuant 
to paragraph (b)(1) of this Appendix G;
    (ii) A consolidating balance sheet and income statement (including 
notes to the financial statements). The consolidating balance sheet 
must provide information regarding each material affiliate of the 
holding company in a separate column, but may aggregate information 
regarding members of the affiliate group that are not material 
affiliates into one column;
    (iii) The results of backtesting of all internal models used to 
compute allowable capital and allowances for market and credit risk 
indicating, for each model, the number of backtesting exceptions;
    (iv) A description of all material pending legal or arbitration 
proceedings, involving either the holding company or any of its 
affiliates, that are required to be disclosed by the holding company 
under generally accepted accounting principles;
    (v) The aggregate amount of commercial paper, secured and other 
unsecured borrowing, bank loans, lines of credit, or any other 
borrowings, and the principal installments of long-term or medium-term 
debt, scheduled to mature within twelve months from the most recent 
fiscal quarter by each subsidiary broker or dealer and each material 
affiliate; and
    (vi) A capital assessment computed pursuant to paragraph (a) of 
this Appendix G;
    (3) Upon receiving written notice from the Commission, such other 
financial or operational information as the Commission may request in 
order to monitor the holding company's financial condition or risk 
exposures;
    (4) Annually, on a calendar or fiscal year basis, financial 
statements which must be audited by a registered public accounting 
firm, as that term is defined in Section 2(a)(12) of the Sarbanes-Oxley 
Act of 2002 (Pub. L. 107-204), in accordance with the following:
    (i) The audited financial statements must include a consolidated 
balance sheet, income statement, and computations of allowable capital 
and allowances for market, credit, and operational risk computed 
pursuant to paragraph (a) of this Appendix G; and
    (ii) The audited financial statements must meet the substantive and 
administrative requirements of Sec.  240.17a-12(b)(5), (b)(6), (c)(1), 
(c)(3), (d), (e)(1), (e)(2), (e)(3), (f), (g), (h), (i), (j), (n), and 
(o), as to the holding company and the audited financial statements it 
must file in accordance with this paragraph;
    (5) Concurrently with the audited financial statements, 
supplemental reports prepared by a registered public accounting firm, 
as that term is defined in Section 2(a)(12) of the Sarbanes-Oxley Act 
of 2002 (Pub. L. 107-204), in accordance with the following:
    (i) The supplemental reports must include:
    (A) Accountant's report on management controls. A supplemental 
report by the registered public accounting firm indicating the results 
of the registered public accounting firm's review of holding company's 
compliance with Sec.  240.15c3-4. The procedures are to be performed 
and the report is to be prepared in accordance with procedures agreed 
to by the holding company and the registered public accounting firm 
conducting the review; and
    (B) Accountant's report on inventory pricing and modeling. A 
supplemental report by the registered public accounting firm indicating 
the results of the registered public accounting firm's review of the 
inventory pricing and modeling procedures. This review must be 
conducted in accordance with procedures agreed to by the holding 
company and the registered public accounting firm conducting the 
review. The purpose of the review is to confirm that the pricing and 
modeling procedures relied upon by the holding company conform to the 
procedures submitted to the Commission as part of the application of 
the broker or dealer, comply with written guidelines pursuant to Sec.  
240.15c3-4, and comply with the qualitative and quantitative standards 
of Sec.  240.15c3e(e);
    (ii) The agreed upon procedures are to be performed and the report 
is to be prepared in accordance with rules promulgated by the Public 
Company Accounting Oversight Board; and

[[Page 62905]]

    (iii) The holding company must file, prior to the commencement of 
the initial review, the procedures agreed to by the holding company and 
the registered public accounting firm with the Commission's principal 
office in Washington, DC. Prior to the commencement of each subsequent 
review, the holding company must notify the Commission of any changes 
in the procedures;
    (6) The reports that the holding company must file pursuant to 
paragraph (b) of this Appendix G shall be considered filed when two 
copies are received at the Commission's principal office in Washington, 
DC, and one copy is received at the regional or district office of the 
Commission for the region or district in which the broker or dealer has 
its principal place of business. The copies sent to the Commission's 
principal office shall be addressed to the Division of Market 
Regulation, Risk Assessment Group; and
    (7) The statements filed by the holding company with the Commission 
pursuant to paragraph (b) of this Appendix G will be accorded 
confidential treatment.

Conditions Regarding Records To Be Made

    (c) As a condition of the exemption, the holding company of a 
broker or dealer that computes certain of its capital charges in 
accordance with Sec.  240.15c3-1e must make and keep current the 
following records:
    (1) A record of the results of stress tests the holding company has 
conducted of the holding company's funding and liquidity in response to 
the following events at least once each quarter and a record of the 
contingency plan to respond to these events:
    (i) A credit rating downgrade of the holding company;
    (ii) An inability of the holding company to access capital markets 
for short-term funding;
    (iii) An inability of the holding company to access liquid assets 
in regulated entities across international borders when the events 
described in paragraphs (c)(1)(i) or (ii) of this Appendix G occur; and
    (iv) An inability of the holding company to access credit or assets 
held at a particular institution when the events described in 
paragraphs (c)(1)(i) or (ii) of this Appendix G occur;
    (2) A record of the basis for the determination of credit risk 
weights for each counterparty; and
    (3) A record of the basis for the determination of internal credit 
ratings for each counterparty.

Conditions Regarding Preservation of Records

    (d)(1) As a condition of the exemption, the holding company of a 
broker or dealer that computes certain of its capital charges in 
accordance with Sec.  240.15c3-1e must preserve the following 
information, documents, and reports for a period of not less than three 
years in an easily accessible place using any media acceptable under 
Sec.  240.17a-4(f):
    (i) The documents created in accordance with paragraph (c)(1) of 
this Appendix G;
    (ii) Any application or documents filed with the Commission 
pursuant to Sec.  240.15c3-1e and this Appendix G and any written 
responses received from the Commission;
    (iii) All reports and notices filed with the Commission pursuant to 
Sec.  240.15c3-1e and this Appendix G; and
    (iv) All written policies and procedures concerning the group-wide 
internal risk management control system established pursuant to Sec.  
240.15c3-1e(a)(1)(viii)(B); and
    (2) The holding company may maintain the records referred to in 
paragraph (d)(1) of this Appendix G either at the holding company, at 
an affiliate, or at a records storage facility, provided that the 
records are located within the boundaries of the United States. If the 
records are maintained by an entity other than the holding company, the 
holding company shall obtain and file with the Commission a written 
undertaking by the entity maintaining the records, in a form acceptable 
to the Commission, signed by a duly authorized person at the entity 
maintaining the records, to the effect that the records will be treated 
as if the holding company were maintaining the records pursuant to this 
section and that the entity maintaining the records will permit 
examination of such records at any time or from time to time during 
business hours by representatives or designees of the Commission and 
will promptly furnish the Commission or its designee a true, correct, 
complete and current hard copy of any or all or any part of such 
records. The election to operate pursuant to the provisions of this 
paragraph shall not relieve the holding company that is required to 
maintain and preserve such records from any of its reporting or 
recordkeeping responsibilities under this section.

Conditions Regarding Notification

    (e) As a condition of the exemption, the holding company of a 
broker or dealer that computes certain of its capital charges in 
accordance with Sec.  240.15c3-1e shall notify the Commission of 
certain events as follows:
    (1) The holding company shall send notice promptly (but within 24 
hours) after the occurrence of the following events:
    (i) The occurrence of any backtesting exception under Sec.  
240.15c3-1e(e)(1)(iii) or (iv) that would require that the holding 
company use a higher multiplication factor in the calculation of its 
allowances for market or credit risk;
    (ii) A computation shows that allowable capital (as defined in 
Sec.  240.15c3-1g(a)(1)) is less than 110% of the sum of the allowances 
for market, credit, and operational risk (as defined in Sec.  240.15c3-
1g(a)(2)-(a)(4));
    (iii) An affiliate declares bankruptcy or otherwise goes into 
default;
    (iv) The holding company becomes aware that an NRSRO has determined 
to materially reduce its assessment of the creditworthiness of an 
affiliate or the credit rating(s) assigned to one or more outstanding 
short or long-term obligations of an affiliate; or
    (v) The holding company becomes aware that any financial regulatory 
agency or self-regulatory organization has taken enforcement or 
regulatory action against an affiliate;
    (2) The holding company shall file a report if there is a material 
change, along with a description of the reason for the change, in:
    (i) Its corporate structure;
    (ii) The material affiliate status of any member of the affiliate 
group; or
    (iii) The major business functions of any material affiliate; and
    (3) Every notice or report given or transmitted by paragraph (e) of 
this Appendix G will be given or transmitted to the principal office of 
the Commission in Washington, DC, and to the regional or district 
office of the Commission for the region or district in which the broker 
or dealer has its principal place of business. For the purposes of this 
Appendix G, ``notice'' shall be given or transmitted by telegraphic 
notice or facsimile transmission. The report described by paragraph 
(e)(2) of this Appendix G may be transmitted by overnight delivery. 
Notices and reports filed pursuant to this paragraph will be accorded 
confidential treatment.
    (f) The holding company of a broker or dealer that computes certain 
of its capital charges in accordance with Sec.  240.15c3-1e must comply 
with the requirements listed in Sec.  240.15c3-1e(a)(1)(viii)(B) 
through (K) and

[[Page 62906]]

understands that failure to comply may result in revocation of the 
exemption.
    6. Section 240.15c3-4 is amended by:
    a. Revising the section heading;
    b. In paragraph (a) and the introductory text of paragraph (b), 
revising the phrase ``An OTC derivatives dealer'' to read ``A broker or 
dealer that computes certain of its capital charges in accordance with 
Sec.  240.15c3-1e or Sec.  240.15c3-1f'';
    c. Revising the introductory text of paragraphs (c) and (d) and 
paragraphs (b)(5), (c)(5)(xiii) and (xiv), (d)(1), (d)(8), and (d)(9);
    d. Adding paragraph (c)(5)(xv);
    e. Revising the phrase ``OTC derivatives dealer'' to read ``broker 
or dealer'' in paragraphs (b)(1), (b)(2), (b)(3), (c)(2), (c)(5)(xii), 
and (d)(7);
    f. Revising the phrase ``OTC derivatives dealer's'' to read 
``broker's or dealer's'' in paragraph (c)(3), the introductory text of 
paragraph (c)(5), paragraphs (c)(5)(i), (c)(5)(iii), and the 
introductory text of paragraph (d)(3);
    g. Revising the phrase ``an OTC derivatives transaction'' to read 
``a securities transaction'' in paragraph (d)(5); and
    h. Revising the phrase ``OTC derivatives'' to read ``securities'' 
in paragraphs (c)(5)(x), (c)(5)(xi), and (d)(10).
    The revisions and additions read as follows:


Sec.  240.15c3-4  Internal risk management control systems for certain 
brokers or dealers.

* * * * *
    (b) * * *
    (5) For a broker or dealer that computes certain of its capital 
charges in accordance with Sec.  240.15c3-1e, the scope and nature of 
the permissible OTC derivatives activities.
* * * * *
    (c) The internal risk management control system of the broker or 
dealer that computes certain of its capital charges in accordance with 
Sec.  240.15c3-1e or Sec.  240.15c3-1f shall include the following 
elements:
* * * * *
    (5) * * *
    (xiii) For a broker or dealer that computes certain of its capital 
charges in accordance with Sec.  240.15c3-1e, the procedures to prevent 
the broker or dealer from engaging in any securities transaction that 
is not permitted under Sec.  240.15a-1;
    (xiv) For a broker or dealer that computes certain of its capital 
charges in accordance with Sec.  240.15c3-1e, the procedures to prevent 
the broker or dealer from improperly relying on the exceptions to Sec.  
240.15a-1(c) and Sec.  240.15a-1(d), including the procedures to 
determine whether a counterparty is acting in the capacity of principal 
or agent; and
    (xv) The procedures for reviewing the pricing of positions 
independent of the business unit.
* * * * *
    (d) Management must periodically review, in accordance with written 
procedures, the business activities of the broker or dealer that 
computes certain of its capital charges in accordance with Sec.  
240.15c3-1e or 240.15c3-1f:
    (1) Risks arising from the broker's or dealer's trading activities 
are consistent with prescribed guidelines;
* * * * *
    (8) For a broker or dealer that computes certain of its capital 
charges in accordance with Sec.  240.15c3-1e, procedures are in place 
to prevent the broker or dealer from engaging in any securities 
transaction that is not permitted under Sec.  240.15a-1;
    (9) For a broker or dealer that computes certain of its capital 
charges in accordance with Sec.  240.15c3-1e, procedures are in place 
to prevent the broker or dealer from improperly relying on the 
exceptions to Sec.  240.15a-1(c) and Sec.  240.15a-1(d), including the 
procedures to determine whether a counterparty is acting in the 
capacity of principal or agent;
* * * * *
    7. Section 240.17a-5 is amended by:
    a. Redesignating paragraph (a)(5) as paragraph (a)(6), and adding 
new paragraph (a)(5); and
    b. Redesignating paragraphs (k), (l), (m), (n), and (o) as 
paragraphs (l), (m), (n), (o), and (p) and adding new paragraph (k).
    The additions read as follows:


Sec.  240.17a-5  Reports to be made by certain brokers and dealers.

    (a) Filing of monthly and quarterly reports.* * *
    (5) Each broker or dealer that computes certain of its capital 
charges in accordance with Sec.  240.15c3-1e must file the following 
additional reports:
    (i) Within 17 business days after the end of each month that is not 
a quarter, as of month-end:
    (A) For each product for which the broker or dealer calculates a 
market risk capital charge other than in accordance with Sec.  
240.15c3-1e(c)(1) or (c)(5), the product category and the amount of the 
market risk capital charge;
    (B) A graph reflecting, for each business line, the daily 
intramonth VaR;
    (C) The aggregate value at risk for the broker or dealer;
    (D) For each product for which the broker or dealer uses scenario 
analysis, the product category and the market risk capital charge;
    (E) Credit risk information on derivatives exposures, including:
    (1) Overall current exposure;
    (2) Current exposure (including commitments) listed by counterparty 
for:
    (i) The 15 largest exposures; and
    (ii) The 5 largest exposures to regulated financial institutions;
    (3) The 10 largest commitments listed by counterparty;
    (4) The broker or dealer's maximum potential exposure listed by 
counterparty for:
    (i) The 15 largest exposures; and
    (ii) The 5 largest exposures to regulated financial institutions;
    (5) The broker or dealer's aggregate maximum potential exposure;
    (6) A summary report reflecting the broker or dealer's current and 
maximum potential exposures by credit rating category; and
    (7) A summary report reflecting the broker or dealer's current 
exposure for each of the top ten countries to which the broker or 
dealer is exposed (by residence of the main operating group of the 
counterparty); and
    (F) Regular risk reports supplied to the broker's or dealer's 
senior management in the format described in the application;
    (ii) Within 17 business days after the end of each quarter:
    (A) Each of the reports required to be filed in paragraph (a)(5)(i) 
of this section;
    (B) A report identifying the number of business days for which the 
actual daily net trading loss exceeded the corresponding daily VaR; and
    (C) The results of backtesting of all internal models used to 
compute allowable capital, including VaR and credit risk models, 
indicating the number of backtesting exceptions.
* * * * *
    (k) Supplemental reports. Each broker or dealer that computes 
certain of its capital charges in accordance with Sec.  240.15c3-1e 
shall file concurrently with the annual audit report supplemental 
reports, which shall be prepared by a registered public accounting firm 
(as that term is defined in section 2(a)(12) of the Sarbanes-Oxley Act 
of 2002 (Public Law 107-204)), in accordance with the following:
    (1) Accountant's report on management controls. The broker or 
dealer shall file a supplemental report indicating the results of the 
accountant's review of the internal risk management control system 
established and documented by the broker or dealer in

[[Page 62907]]

accordance with Sec.  240.15c3-4. This review shall be conducted in 
accordance with procedures agreed to by the broker or dealer and the 
registered public accounting firm conducting the review. The purpose of 
the review is to confirm that the broker or dealer has established, 
documented, and is in compliance with the internal risk management 
controls established in accordance with Sec.  240.15c3-4;
    (2) Accountant's report on inventory pricing and modeling. The 
broker or dealer shall file a supplemental report indicating the 
results of the accountant's review of the procedures for pricing 
financial instrument inventory (including modeling procedures) 
established by the broker or dealer and approved for use by the 
Commission. This review shall be conducted in accordance with 
procedures agreed to by the broker or dealer and the registered public 
accounting firm conducting the review. The purpose of the review is to 
confirm that the financial instrument pricing procedures relied upon by 
the broker or dealer conform to the procedures established by the 
broker or dealer pursuant to Sec.  240.15c3-4 and comply with the 
qualitative and quantitative standards set forth in Sec.  240.15c3-
1e(e); and
    (3) The broker or dealer shall file, prior to the commencement of 
the review and no later than December 10 of each year, a statement with 
the Commission's principal office in Washington, DC that includes:
    (i) A description of the agreed-upon procedures agreed to by the 
broker or dealer and the registered public accounting firm (pursuant to 
paragraphs (l)(1) and (l)(2) of this section); and
    (ii) A notice describing changes in those agreed-upon procedures, 
if any. If there are no changes, the broker or dealer should so 
indicate.
* * * * *
    8. Section Sec.  240.17a-11 is amended by:
    a. Revising the phrase ``an OTC derivatives dealer'' to read ``a 
broker or dealer that computes certain of its capital charges in 
accordance with Sec.  240.15c3-1e or 240.15c3-1f'' in paragraphs (b)(2) 
and (c)(3); and
    b. Adding paragraph (j);
    The addition reads as follows:


Sec.  240.17a-11  Notification procedures for brokers and dealers.

* * * * *
    (j) A broker or dealer that computes certain of its capital charges 
in accordance with Sec.  240.15c3-1e shall also give notice that same 
day in accordance with paragraph (g) of this section whenever:
    (1) The broker or dealer is notified by an NRSRO or otherwise 
becomes aware that an NRSRO has determined to reduce its assessment of 
the creditworthiness of the broker or dealer or of an affiliate of the 
holding company of the broker or dealer, or has determined to reduce 
the credit rating(s) assigned to one or more outstanding short or long-
term obligations of the broker or dealer or an affiliate of the holding 
company of the broker or dealer;
    (2) The broker or dealer becomes subject to any supervisory 
agreement, order, resolution, or other notice of non-compliance from, 
or report of an instance of non-compliance, issued by an appropriate 
regulatory agency or self-regulatory organization;
    (3) The broker or dealer becomes aware of a situation that may have 
a material adverse effect on the financial or operational condition of 
the holding company of the broker or dealer or an affiliate of the 
holding company of the broker or dealer; or
    (4) The occurrence of any backtesting exception under Sec.  
240.15c3-1e(e)(1)(iii) or (iv) that would require that the broker or 
dealer use a higher multiplication factor in the calculation of its 
market or credit risk capital charges.
    9. Section 240.17h-1T is amended by:
    a. Redesignating paragraph (d)(4) as paragraph (d)(5); and
    b. Adding new paragraph (d)(4).
    The addition reads as follows:


Sec.  240.17h-1T  Risk assessment recordkeeping requirements for 
associated persons of brokers and dealers.

* * * * *
    (d) Exemptions. * * *
    (4) The provisions of this section shall not apply to a broker or 
dealer that computes certain of its capital charges in accordance with 
Sec.  240.15c3-1e.
    10. Section 240.17h-2T is amended by:
    a. Redesignating paragraph (b)(4) as paragraph (b)(5); and
    b. Adding new paragraph (b)(4).
    The addition reads as follows:


Sec.  240.17h-2T  Risk assessment reporting requirements for brokers 
and dealers.

* * * * *
    (b) Exemptions. * * *
    (4) The provisions of this section shall not apply to a broker or 
dealer that computes certain of its capital charges in accordance with 
Sec.  240.15c3-1e.
* * * * *

    Dated: October 24, 2003.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-27306 Filed 11-5-03; 8:45 am]
BILLING CODE 8010-01-P