[Federal Register Volume 69, Number 118 (Monday, June 21, 2004)]
[Rules and Regulations]
[Pages 34428-34472]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-13412]



[[Page 34427]]

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Part II





Securities and Exchange Commission





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17 CFR Parts 200 and 240



Alternative Net Capital Requirements for Broker-Dealers That Are Part 
of Consolidated Supervised Entities; Supervised Investment Bank Holding 
Companies; Final Rules

  Federal Register / Vol. 69 , No. 118 / Monday, June 21, 2004 / Rules 
and Regulations  

[[Page 34428]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 200 and 240

[Release No. 34-49830; 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: Final rule.

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SUMMARY: We are adopting rule amendments under the Securities Exchange 
Act of 1934 that establish a voluntary, alternative method of computing 
deductions to net capital for certain broker-dealers. This alternative 
method permits a broker-dealer to use mathematical models to calculate 
net capital requirements for market and derivatives-related credit 
risk. A broker-dealer using the alternative method of computing net 
capital is subject to enhanced net capital, early warning, 
recordkeeping, reporting, and certain other requirements, and must 
implement and document an internal risk management system. Furthermore, 
as a condition to its use of the alternative method, a broker-dealer's 
ultimate holding company and affiliates (referred to collectively as a 
consolidated supervised entity, or ``CSE'') must consent to group-wide 
Commission supervision. This supervision would impose reporting 
(including reporting of a capital adequacy measurement consistent with 
the standards adopted by the Basel Committee on Banking Supervision), 
recordkeeping, and notification requirements on the ultimate holding 
company. The ultimate holding company (other than an ``ultimate holding 
company that has a principal regulator'') and its affiliates also would 
be subject to examination by the Commission. In addition, we have 
modified the proposed rule amendments on Commission supervision of an 
``ultimate holding company that has a principal regulator'' to avoid 
duplicative or inconsistent regulation. Finally, we are amending the 
risk assessment rules to exempt a broker-dealer using the alternative 
method of computing net capital from those rules if its ultimate 
holding company does not have a principal regulator. The rule 
amendments are intended to improve our oversight of broker-dealers and 
their ultimate holding companies.

EFFECTIVE DATE: August 20, 2004.

FOR FURTHER INFORMATION CONTACT: 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, David Lynch, 
Financial Economist, at (202) 942-0059, Rose Russo Wells, Attorney, at 
(202) 942-0143, Bonnie L. Gauch, Attorney, at (202) 942-0765, or 
Matthew B. Comstock, Attorney, at (202) 942-0156, Division of Market 
Regulation, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-1001.
    With respect to general questions, contact 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.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission is 
amending Sec.  200.19 and Rules 30-3, 15c3-1, 17a-4, 17a-5, 17a-11, 
17h-1T, and 17h-2T under the Securities Exchange Act of 1934 
(``Exchange Act''). We proposed amendments on consolidated supervised 
entities for comment in October of 2003.\1\
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    \1\ Exchange Act Release No. 48690 (Oct. 24, 2003), 68 FR 62872 
(Nov. 6, 2003) (``Proposing Release'').
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I. Introduction

    The Commission is amending Rule 15c3-1 \2\ (the ``net capital 
rule'') under the Securities Exchange Act of 1934 (the ``Exchange 
Act'') to establish a voluntary, alternative method of computing net 
capital for certain broker-dealers. Under the amendments, a broker-
dealer that maintains certain minimum levels of tentative net capital 
and net capital may apply to the Commission for a conditional exemption 
from the application of the standard net capital calculation. As a 
condition to granting the exemption, the broker-dealer's ultimate 
holding company \3\ must consent to group-wide Commission 
supervision.\4\ The amendments should help the Commission to protect 
investors and maintain the integrity of the securities markets by 
improving oversight of broker-dealers and providing an incentive for 
broker-dealers to implement strong risk management practices. 
Furthermore, by supervising the financial stability of the broker-
dealer and its affiliates on a consolidated basis, the Commission may 
monitor better, and act more quickly in response to, any risks that 
affiliates and the ultimate holding company may pose to the broker-
dealer.
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    \2\ 17 CFR 240.15c3-1.
    \3\ We will review, on a case-by-case basis, the broker-dealer's 
designation of its ultimate holding company in its application to 
use the alternative method of computing net capital.
    We use the term ``ultimate holding company'' in the final rules, 
rather than the term ``holding company'' that we used in the 
proposed rules.
    \4\ If a broker-dealer were the ultimate parent company of its 
affiliate group, it would be considered the ultimate holding company 
for purposes of these amendments. The ultimate holding company may 
not be a natural person. Nothing in these amendments is intended to 
create a preference for one organizational structure over another.
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    These amendments are intended to reduce regulatory costs for 
broker-dealers by allowing very highly capitalized firms that have 
developed robust internal risk management practices to use those risk 
management practices, such as mathematical risk measurement models, for 
regulatory purposes. A broker-dealer's deductions for market and credit 
risk probably will be lower under the alternative method of computing 
net capital than under the standard net capital rule.

A. Broker-Dealer Requirements

    The alternative method of computing net capital responds to the 
firms' requests to align their supervisory risk management practices 
and regulatory capital requirements more closely. Under the alternative 
method, firms with strong internal risk management practices may 
utilize mathematical modeling methods already used to manage their own 
business risk, including value-at-risk (``VaR'') models and scenario 
analysis, for regulatory purposes.
    A broker-dealer that applies to the Commission for an exemption 
from the standard net capital rules also must comply with specific 
requirements designed to address various types of risks that the 
broker-dealer assumes. A broker-dealer is eligible to use the 
alternative method of computing net capital only if it maintains 
tentative net capital \5\ of at least $1 billion and net capital of at 
least $500 million.\6\ If the tentative net capital of a broker-dealer 
calculating net capital under this alternative method falls below $5 
billion, the broker-dealer must notify the Commission and the 
Commission then would consider whether the broker-dealer must take 
appropriate remedial action.\7\
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    \5\ See 17 CFR 240.15c3-1(c)(15).
    \6\ 17 CFR 240.15c3-1(a)(7)(i).
    \7\ 17 CFR 240.15c3-1(a)(7)(ii).
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    In addition, a broker-dealer that uses the alternative method must 
have in place comprehensive internal risk management procedures that 
address market, credit, liquidity, legal, and

[[Page 34429]]

operational risk at the firm. These requirements are designed to help 
ensure the integrity of the broker-dealer's 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. Furthermore, a broker-dealer must 
provide the Commission with specified financial, operational, and risk 
management information on a monthly, quarterly, and annual basis.

B. Ultimate Holding Company Requirements

    As a condition to a broker-dealer's use of the alternative method 
of computing net capital, the rule amendments require a broker-dealer's 
ultimate holding company, if that ultimate holding company does not 
have a principal regulator, to consent to certain undertakings. In 
particular, the ultimate holding company must:
     Provide information about the financial and operational 
condition of the ultimate holding company. Specifically, it must 
provide the Commission with certain capital and risk exposure 
information provided to the ultimate holding company's senior risk 
managers. This information would include market and credit risk 
exposures, as well as an analysis of the ultimate holding company's 
liquidity risk;
     Comply with rules regarding the implementation and 
documentation of a comprehensive, group-wide risk management system for 
identifying, measuring, and managing market, credit, liquidity, legal, 
and operational risk;
     Consent to Commission examination of the ultimate holding 
company and its material affiliates; and
     As part of its reporting requirements, compute, on a 
monthly basis, group-wide allowable capital and allowances for market, 
credit, and operational risk in accordance with the standards (``Basel 
Standards'') \8\ adopted by the Basel Committee on Banking Supervision 
(``Basel Committee'').
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    \8\ 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. The Basel 
Committee is currently developing a new international agreement (the 
``proposed New Basel Capital Accord''). It expects to issue a final 
version of the New Basel Capital Accord by the end of June 2004, 
with an effective date for implementation of the standardized and 
foundation approaches by year-end 2006, and implementation of the 
most advanced approaches by year-end 2007.
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    In response to comments about bank holding companies, we have 
revised the proposed rules for an ultimate holding company that has a 
principal regulator. Generally, under the final rules, this type of 
ultimate holding company is not subject either to Commission 
examination or those rules requiring internal risk management controls 
outside of the broker-dealer and is subject to reduced reporting, 
recordkeeping, and notification requirements.
    The rule amendments also respond to international developments. 
Affiliates of certain U.S. broker-dealers that conduct business in the 
European Union (``EU'') have stated that they must demonstrate that 
they are subject to consolidated supervision at the ultimate holding 
company level that is ``equivalent'' to EU consolidated supervision.\9\ 
Commission supervision incorporated into these rule amendments is 
intended to meet this standard. As a result, we believe these 
amendments will 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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    \9\ EU ``consolidated supervision'' consists of a series of 
quantitative and qualitative rules, imposed at the level of the 
ultimate holding company, regarding firms' internal controls, 
capital adequacy, intra-group transactions, and risk concentration. 
Without a demonstration of ``equivalent'' supervision, U.S. 
securities firms have expressed concerns that an affiliate 
institution located in the EU either may 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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II. Proposing Release and Comments

    The Commission proposed rule amendments in October 2003 that would 
have established a voluntary, alternative method for computing net 
capital charges for certain broker-dealers. In the Proposing Release, 
the Commission solicited both general comments on the proposal and 
specific comments on each rule amendment.
    The Commission received 20 comment letters in response to the 
proposed rule amendments: Five from broker-dealers or broker-dealer 
holding companies, five from bank holding companies subject to 
supervision by the Board of Governors of the Federal Reserve System 
(``Federal Reserve'') or a non-domestic ``comprehensive consolidated 
supervisor,'' one from a securities industry representative, six from 
U.S. and international banking industry representatives, two from 
individuals, and one from another regulator.
    The majority of commenters endorsed the Commission's initiative to 
permit certain broker-dealers to use the alternative method of 
computing net capital. These commenters supported the alternative 
capital calculation for broker-dealers that have developed mathematical 
models for measuring risk and group-wide internal risk management 
control systems to control risk. One commenter, however, questioned the 
use of models to the extent that it would lower broker-dealer capital 
requirements, and some commenters questioned the Commission's statutory 
authority to adopt the proposal.
    The commenters that supported the proposal suggested that the 
Commission modify the proposed rule amendments in various ways. Bank 
holding companies generally supported the alternative capital 
computation, but expressed concern that the proposal could impose 
duplicative and inconsistent requirements on holding companies and 
their affiliates that are subject to comprehensive consolidated 
supervision by the Federal Reserve and non-domestic financial 
regulators.
    Generally, commenters addressed various aspects of the methods for 
calculating deductions for market and credit risk at the broker-dealer 
level and allowable capital at the ultimate holding company level. They 
also stated that the Commission should be flexible in permitting firms 
to use interim methods to calculate allowable capital at the ultimate 
holding company level until implementation of the New Basel Capital 
Accord. Some commenters urged the Commission to take measures to ensure 
the confidentiality of information that the Commission obtains as a 
result of the proposed rules and rule amendments. Commenters also 
suggested that the Commission align CSE reporting requirements with 
public company and other reporting requirements.
    Comments on specific rule amendments and the Commission's response 
to those comments are discussed below in the descriptions of the final 
rule amendments.

III. Final Rule Amendments

A. General

    After considering the comment letters, we are adopting rule 
amendments that provide broker-dealers with a voluntary, alternative 
method of computing net capital that permits very highly capitalized 
broker-dealers to use their internal mathematical models for net

[[Page 34430]]

capital purposes, subject to specified conditions. Generally, we 
revised the rule amendments related to the broker-dealer's and the 
ultimate holding company's computation of net capital and allowable 
capital, respectively. We also revised the rule amendments with respect 
to broker-dealers that are affiliated with ultimate holding companies 
that have principal regulators.
    As stated in the Proposing Release, the Commission has broad 
authority under Exchange Act section 15(c)(3) 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.\10\ The Commission has promulgated various 
rules under this provision regarding net capital requirements \11\ and 
protection of customer property.\12\ As part of our oversight of 
broker-dealers, we receive financial and risk management information 
about broker-dealers, their holding companies, and their affiliates. 
The rules and the information received have assisted the Commission and 
the self-regulatory organizations (``SROs'') in identifying, at an 
early stage, firms that are experiencing financial problems.
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    \10\ 15 U.S.C. 78o(c)(3).
    \11\ 17 CFR 240.15c3-1.
    \12\ 17 CFR 240.15c3-3.
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    The principal purposes of Exchange Act Rule 15c3-1 (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.
    Ultimate holding companies that own large broker-dealers also may 
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 
because of their affiliation with unregistered entities. 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 ultimate 
holding company level may attempt to divert 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 
alone would not violate the net capital rule, it could make it more 
likely that the firm would fail during volatile market conditions.
    To help ensure that the Commission can obtain information necessary 
to monitor the financial well-being of a broker-dealer, a broker-dealer 
may use the alternative method of computing net capital only if its 
ultimate holding company agrees to provide the Commission's with 
additional information about the financial condition of the ultimate 
holding company and its affiliates. For an ultimate holding company 
that does not have a principal regulator, this financial information 
includes a monthly computation of group-wide allowable capital and 
allowances for market, credit, and operational risk calculated in 
accordance with the Basel Standards. This type of ultimate holding 
company also must provide the Commission with specified financial, 
operational, and risk management information on a monthly, quarterly, 
and annual basis. Moreover, an ultimate holding company that does not 
have a principal regulator must 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, and make and maintain certain books and records. Both 
the ultimate holding company and its affiliates that do not have 
principal regulators must consent to Commission examination.
    Under the final rules, an ultimate holding company that has a 
principal regulator is subject to substantially fewer requirements than 
one that does not have a principal regulator. As a condition to its 
affiliated broker-dealer's use of the alternative method of computing 
net capital, this category of ultimate holding company consents to 
provide the Commission, on a quarterly basis, with the capital 
measurements that it submits to its principal regulator, consolidated 
and consolidating balance sheets and income statements, and certain 
regular risk reports provided to the persons responsible for managing 
group-wide risk. Annually, an ultimate holding company that has a 
principal regulator must provide audited consolidated balance sheets 
and income statements and capital measurements, as submitted to its 
principal regulator. An ultimate holding company that has a principal 
regulator also is subject to more limited undertaking and information 
requirements related to the broker-dealer's application for exemption 
from the standard net capital rule as well as reduced notification and 
recordkeeping requirements.
    We have included what we believe are prudent parameters for 
measurement of a broker-dealer's deductions for market and credit risk 
and allowances for risk for its ultimate 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, we have 
adopted, as proposed, rules that require the VaR model used to 
calculate market risk for the broker-dealer to be based on a ten 
business-day movement in rates and prices and calculated using a 99% 
confidence level. The VaR measure then must 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.

B. Amendments to Paragraphs (a) and (c) of Rule 15c3-1

1. Minimum and Early Warning Capital Requirements
    We are revising proposed paragraph (a)(7) of Rule 15c3-1. As 
proposed, paragraph (a)(7) of Rule 15c3-1 would have permitted the 
Commission to approve, in whole or part, a broker-dealer's application, 
or amendment to an application, to use the alternative method of 
computing net capital. Proposed paragraph (a)(7) also would have 
required the broker-dealer to maintain at all times tentative net 
capital of at least $1 billion and net capital of at least $500 
million.
    In the Proposing Release, we requested comment on whether the 
proposed required minimum levels of tentative net capital and net 
capital described in proposed paragraph (a)(7) of Rule 15c3-1 should be 
raised or lowered. One commenter stated that we should permit a broker-
dealer with tentative net capital of less than $1 billion to use the 
alternative net capital computation if it is an affiliate of an 
international bank with consolidated capital of over $1 billion. 
Another commenter asserted that ``the Commission should permit other 
broker-dealers in the CSE group-wide affiliate structure'' to use the 
alternative method of computing net capital even if those broker-
dealers do not meet the minimum capital levels. These comments, 
however, do not take into account certain regulatory and

[[Page 34431]]

bankruptcy considerations.\13\ Accordingly, we are adopting the $1 
billion tentative net capital and $500 million net capital requirements 
as proposed, but are setting forth these requirements in paragraph 
(a)(7)(i) of Rule 15c3-1 in the final rules.
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    \13\ Bankruptcy or other statutes, rules, and regulations may 
restrict transfers from an entity in bankruptcy.
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    We also are adding a new requirement to paragraph (a)(7) of Rule 
15c3-1, as adopted. The final rules incorporate changes to the proposed 
rules that may allow firms to take smaller deductions for market and 
credit risk than the proposed rules would have permitted. Consequently, 
the final rules add paragraph (a)(7)(ii), which requires a broker-
dealer to notify the Commission if the broker-dealer's tentative net 
capital falls below $5 billion. This $5 billion early warning 
requirement is based upon the staff's experience and the current levels 
of net capital maintained by the broker-dealers most likely to apply to 
use the alternative method of computing net capital. Upon written 
application, however, the Commission may exempt, either unconditionally 
or on specified terms and conditions, a broker-dealer from the $5 
billion early warning requirement. To obtain an exemption, the broker-
dealer must satisfy the Commission that because of the special nature 
of the firm's business, its financial positions, its internal risk 
management systems, and its compliance history, among other factors, 
application of the requirement is unnecessary or inappropriate in the 
public interest or for the protection of investors.
    We also are revising Rule 15c3-1 to add paragraph (a)(7)(iii). 
Paragraph (a)(7)(iii) generally requires a broker-dealer that computes 
deductions for market and credit risk under Appendix E to comply with 
Rule 15c3-4 \14\ as though it were an OTC derivatives dealer. Paragraph 
(a)(7)(iii) replaces proposed amendments to Rule 15c3-4 and is 
discussed in greater detail in the section of this release that 
addresses that rule.
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    \14\ 17 CFR 240.15c3-4.
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    The requirements of paragraph (a)(7), as revised, are intended to 
help ensure that a broker-dealer maintains prudent amounts of liquid 
assets against various risks that it assumes and that it maintain a 
robust internal risk management system. The current haircut structure 
seeks to ensure that broker-dealers maintain a sufficient capital base 
to account for operational, leverage, and liquidity risk, in addition 
to market and credit risk. We expect that use of the alternative net 
capital computation will reduce deductions for market and credit risk 
substantially for broker-dealers that use that method. Moreover, 
inclusion in net capital of unsecured receivables and securities that 
do not have a ready market under the current net capital rule will 
reduce the liquidity standards of Rule 15c3-1. Thus, the alternative 
method of computing net capital and, in particular, its requirements 
that broker-dealers using the alternative method of computing maintain 
minimum tentative net capital of at least $1 billion, maintain net 
capital of at least $500 million, notify the Commission that same day 
if their tentative net capital falls below $5 billion, and comply with 
Rule 15c3-4 are intended to provide broker-dealers with sufficient 
capital reserves to account for market, credit, operational, and other 
risks.
2. Entities That Have Principal Regulators
    We are revising proposed paragraph (c)(13) of Rule 15c3-1. Proposed 
paragraph (c)(13) would have defined an ``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 
section 15(b)(11) of the Exchange Act) and that belongs to one of two 
categories. Proposed paragraph (c)(13)(i), the first category, would 
have included insured depository institutions, entities registered with 
the Commodities Futures Trading Commission, or licensed or regulated 
insurance companies. Proposed paragraph (c)(13)(ii), the second 
category, would have included bank holding companies, savings and loan 
holding companies, and foreign banks that do business in the U.S. The 
proposed rules would have required entities in this second category to 
have in place appropriate arrangements to ensure that information 
provided to the Commission was sufficiently reliable for the purposes 
of proposed Appendix E and proposed Appendix G. The proposed rules also 
would have required these entities to be primarily in the insured 
depository institutions business (excluding their insurance and 
commercial businesses).
    Several commenters stated that the Commission should revise the 
proposed rules to minimize duplicative or inconsistent requirements for 
holding companies that are subject to another regulator's consolidated 
supervision.\15\ Commenters also stated that the Commission could 
better use its resources to supervise holding companies that do not 
otherwise have principal regulators. Moreover, commenters urged the 
Commission to provide as much clarity as possible, both for regulated 
entities and consolidated supervisors, about provisions intended to 
avoid duplicative or inconsistent requirements.
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    \15\ See, e.g., Letter from Messrs. Michael J. Alix and Mark W. 
Holloway, Co-Chairs, CSE Steering Committee of the Securities 
Industry Association, to Jonathan G. Katz, Secretary, U.S. 
Securities and Exchange Commission, dated February 27, 2004.
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    In response to these comments, we are adopting a revised definition 
of ``entity that has a principal regulator'' and adding a definition of 
an ``ultimate holding company that has a principal regulator.'' 
Creation of two definitions should help to clarify the scope of 
paragraph (c)(13) of Rule 15c3-1. We will not examine any entity that 
has a principal regulator and we will use the reports that it files 
with its principal regulator for our regulatory purposes, to the 
greatest extent possible.
    Under the revised definition in paragraph (c)(13)(i) of Rule 15c3-
1, an entity that has a principal regulator includes certain 
functionally regulated affiliates of the ultimate holding company that 
are not registered as a broker or dealer.\16\ Entities that have 
principal regulators include insured depository institutions; futures 
commission merchants or introducing brokers registered with the 
Commodity Futures Trading Commission; entities registered with or 
licensed by a State insurance regulator that issues any insurance, 
endowment, or annuity policy or contract; and certain foreign 
banks.\17\
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    \16\ This reference is to brokers or dealers registered under 
section 15(b)(11) of the Act (15 U.S.C. 78o(b)(11)).
    \17\ This category is limited to a foreign bank as defined in 
section 1(b)(7) of the International Banking Act of 1978 (12 U.S.C. 
3101(7)) that has its headquarters in a jurisdiction for which any 
foreign bank has been approved by the Federal Reserve to conduct 
business pursuant to the standards set forth in 12 CFR 211.24(c), 
provided such foreign bank represents to that Commission that it is 
subject to the same supervisory regime as the foreign bank 
previously approved by the Federal Reserve.
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    Paragraph (c)(13)(i) also includes Edge Act and Agreement 
Corporations, provided they are not primarily in the securities 
business. We added these entities to the definition of entity that has 
a principal regulator because they are subject to supervision by the 
Federal Reserve. Under these rules, the Commission may examine Edge Act 
and Agreement Corporations that primarily are in the securities 
business.\18\
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    \18\ The Federal Reserve charters an ``Edge Act Corporation'' to 
engage in international banking. Section 25A of the Federal Reserve 
Act (12 U.S.C. 611-633). A state charters an ``Agreement 
Corporation'' to engage in international banking activities. The 
Agreement Corporation enters into an ``agreement'' with the Federal 
Reserve to limit its activities to those that an Edge Act 
Corporation may undertake. Section 25 of the Federal Reserve Act (12 
U.S.C. 601-604a). The purpose of both Edge Act Corporations and 
Agreement Corporations is to aid in financing and stimulating 
foreign trade. These entities may engage only in international 
banking or other financial transactions related to international 
business. The Board of Governors approves or denies applications to 
establish Edge Act Corporations and also examines both Edge Act and 
Agreement Corporations and their subsidiaries.

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[[Page 34432]]

    We also added paragraph (c)(13)(i)(F) of Rule 15c3-1 to the final 
rules. Under this paragraph, the Commission may determine if other 
types of entities subject to comprehensive supervision by other 
regulators qualify as entities that have principal regulators.\19\
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    \19\ The Commission will determine if there are in place 
appropriate arrangements so that information that the person 
provides to the Commission is sufficiently reliable for the purposes 
of determining compliance with Appendices E and G, and it is 
appropriate to deem the person to be an entity that has a principal 
regulator considering all relevant circumstances, including the 
person's mix of business.
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    The new definition of ultimate holding company that has a principal 
regulator in paragraph (c)(13)(ii) recognizes the concept of 
comprehensive, consolidated supervision. Any financial holding company 
or a company that is treated as a financial holding company under the 
Bank Holding Company Act of 1956 \20\ will be considered an ultimate 
holding company that has a principal regulator. Accordingly, any U.S. 
holding company or foreign bank that has elected financial holding 
company status will be an ultimate holding company that has a principal 
regulator.
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    \20\ 12 U.S.C. 1840 et seq.
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    By adopting this new definition of an ultimate holding company that 
has a principal regulator, we are recognizing the comprehensive, 
consolidated supervision of both the Federal Reserve and non-domestic 
bank regulators. In addition, because we will consider the entity that 
elected to be treated as a financial holding company to be an ultimate 
holding company that has a principal regulator, we will not need to 
look for a higher holding company level within a consolidated group. We 
also understand that all of the banking organizations that have 
expressed interest in the CSE proposal would qualify as financial 
holding companies or as companies that are treated as financial holding 
companies.
    A bank holding company may elect to become a financial holding 
company and be eligible to engage in expanded financial activities if 
it is ``well capitalized'' and ``well managed.'' \21\ In connection 
with financial holding company elections by foreign banks, the Federal 
Reserve also evaluates any foreign bank that operates a branch or 
agency, or owns or controls a commercial lending company in the United 
States under capital and management standards that are comparable to 
the standards applicable to U.S. banks and gives due regard to the 
principle of national treatment and equality of competitive 
opportunity.\22\ For these foreign banking organizations, the Federal 
Reserve also reviews whether they are subject to comprehensive 
consolidated supervision.\23\ The Federal Reserve has found that home 
country supervision is an important element in determining if a bank is 
well managed.\24\
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    \21\ 12 U.S.C. 1843(l)(1) and 12 CFR 225.81(b).
    \22\ 12 U.S.C. 1843(l)(3) and 12 CFR 225.90.
    \23\ 12 CFR 225.92(e).
    \24\ Id.
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    Based on these requirements, we would not examine financial holding 
companies or companies that are treated as financial holding companies. 
In addition, under the rules as adopted, these entities are subject to 
a streamlined application process, fewer periodic reporting 
requirements, and may submit to the Commission the same measurement of 
capital that they submit to their primary regulator. Inclusion of these 
entities in the definition of ``ultimate holding company that has a 
principal regulator'' is intended reduce duplicative or inconsistent 
regulation because these entities already are subject to the reporting 
and examination requirements of the Federal Reserve.
    Under paragraph (c)(13)(ii)(B), the Commission may determine that 
other persons also should be included as ultimate holding companies 
that have principal regulators if it finds that the persons are subject 
to consolidated, comprehensive supervision; there are in place 
appropriate arrangements so that information provided to the Commission 
is sufficiently reliable for the purposes of determining compliance 
with Appendix E and Appendix G; and based on the persons' businesses, 
it is appropriate to consider the persons ultimate holding companies 
that have principal regulators for the purposes of Appendix E and 
Appendix G. An affiliated broker-dealer of a domestic entity or a 
foreign bank that has not elected to be treated as a financial holding 
company could apply to use the alternative method of computing net 
capital. Paragraph (c)(13)(ii)(B) permits us to consider whether, in 
appropriate circumstances, the Commission should treat the domestic 
entity or foreign bank as an ultimate holding company that has a 
principal regulator.\25\
---------------------------------------------------------------------------

    \25\ This paragraph also governs the application of 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)).
---------------------------------------------------------------------------

3. Tentative Net Capital
    We are adopting an amended definition of tentative net capital. The 
proposed amendment to paragraph (c)(15) of Rule 15c3-1 would have 
defined ``tentative net capital'' for a broker-dealer using the 
alternative method of computing net capital as the net capital of the 
broker or dealer before deductions for market and credit risk computed 
pursuant to Appendix E to Rule 15c3-1 or paragraph (c)(2)(vi) of Rule 
15c3-1, if applicable, and increased by the balance sheet value 
(including counterparty net exposure) resulting from transactions in 
derivative instruments that otherwise would be deducted by virtue of 
paragraph (c)(2)(iv) of Rule 15c3-1.
    We are amending the definition of tentative net capital to include 
securities for which there is no ready market, as that term is defined 
under paragraph (c)(2)(11) of the net capital rule. This modification 
is necessary because, as discussed below, we eliminated the requirement 
that a security have a ready market to qualify for capital treatment 
using VaR models. Under the final rules, a broker-dealer may include 
securities for which there is no ready market in calculating tentative 
net capital under the alternative method only if the Commission has 
approved the use of mathematical models for purposes of calculating 
deductions to net capital for those securities pursuant to Appendix E.

C. Broker-Dealer Requirements Under Appendix E

    Appendix E to Exchange Act Rule 15c3-1 describes the alternative 
method of computing net capital that a broker-dealer may use, including 
related application requirements. It also imposes requirements 
regarding internal risk management controls and reporting, and 
describes additional supervisory conditions that the Commission may 
impose on the broker-dealer in appropriate circumstances.\26\ Under the 
final rules, once a broker-dealer has submitted an application, the 
Commission will review how the firm manages its market, credit, 
liquidity and

[[Page 34433]]

funding, legal, and operational risk, and its mathematical models, to 
determine if the broker-dealer has met the requirements of Appendix E 
and is complying with other applicable rules. The Commission also will 
review whether the broker-dealer's ultimate holding company is 
complying with the terms of the undertaking that it agrees to provide 
as a condition of the broker-dealer's use of the alternative method of 
computing net capital.
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    \26\ We have replaced old Appendix E. Old Appendix E outlined a 
phase-in schedule for increased minimum net capital requirements for 
broker-dealers. The increased net capital minimums were fully 
effective as of July 1, 1994. Exchange Act Release No. 31511.
---------------------------------------------------------------------------

    1. Application
    Under proposed paragraph (a) of Appendix E, a broker-dealer would 
have applied to the Commission for an exemption from the standard net 
capital rule and for permission to calculate certain deductions for 
market and credit risk in accordance with Appendix E.\27\ Proposed 
paragraph (a) described the various types of information that the 
broker-dealer would have submitted to allow the Commission to determine 
whether an exemption from the net capital rule was necessary or 
appropriate in the public interest or for the protection of investors.
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    \27\ 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 deduction for market or credit 
risk.
---------------------------------------------------------------------------

a. Information To Be Submitted by the Broker-Dealer
    As proposed, paragraph (a)(1) of Appendix E would have required a 
broker-dealer that applied to use the alternative method of computing 
net capital to include with its application financial, risk management, 
and other information about the firm. Specifically, broker-dealers 
would have been required to submit to the Commission a description of 
their internal risk management control system and how that system 
satisfies the requirements of Rule 15c3-4, together with a description 
of the method the broker-dealer intended to use to calculate deductions 
to net capital. We did not receive substantive comments on this rule 
related to information to be submitted about the broker-dealer and 
paragraph (a)(1) of Appendix E has been adopted as proposed.\28\
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    \28\ As described below, however, the Commission has amended the 
undertaking provisions of paragraph (a)(1) to describe separately 
the requirements for an undertaking that a broker-dealer must submit 
for an ultimate holding company that does not have a principal 
regulator and an ultimate holding company that has a principal 
regulator.
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b. Confidential Treatment
    A broker-dealer's application for exemption from the standard net 
capital rule and all submissions in connection with the application 
will be accorded confidential treatment, to the extent permitted by 
law. We received comments expressing some concern with the Commission's 
ability to maintain the confidentiality of documents and information 
filed with the Commission under these rules. Under the final rules, 
broker-dealers and ultimate holding companies will submit information 
to the Commission based on their understanding that the information 
will remain confidential. The information that we expect to receive 
from these entities is, by its nature, competitively sensitive. For 
example, we understand that broker-dealers and their holding companies 
have a commercial interest in their risk models, risk management 
systems and processes, and data that they obtain through use of these 
models, systems, and processes. We also have been advised that if the 
Commission were unable to afford confidential protection to the 
information that we expect to receive from broker-dealers and their 
ultimate holding companies, firms may hesitate to apply for the 
exemption from the standard net capital rule and consent to Commission 
supervision at the ultimate holding company level. This result would 
undermine and jeopardize the viability of the CSE system.
    The Freedom of Information Act (``FOIA'') provides at least two 
exemptions under which the Commission has authority to grant 
confidential treatment for applications filed under this rule. First, 
FOIA Exemption 4 provides an exemption for ``trade secrets and 
commercial or financial information obtained from a person and 
privileged or confidential.'' \29\ As specified in paragraph (a)(5) of 
new Appendix E, ``all information submitted in connection with the 
application will be accorded confidential treatment to the extent 
permitted by law.'' The information to be filed with the Commission 
concerns firms' trading strategies, risk profiles, financial positions, 
and other information that is protected from disclosure under Exemption 
4.
---------------------------------------------------------------------------

    \29\ See 5 U.S.C. 552(b)(4).
---------------------------------------------------------------------------

    Second, FOIA Exemption 8 provides an exemption for matters that are 
``contained in or related to examination, operating, or condition 
reports prepared by, on behalf of, or for the use of an agency 
responsible for the regulation or supervision of financial 
institutions.'' Similarly, Commission Rule 80(b)(8), Commission Records 
and Information, implementing Exemption 8, states that the Commission 
generally will not publish or make available to any person matters that 
are ``contained in, or related to, any examination, operating, or 
condition report prepared by, on behalf of, or for the use of, the 
Commission, any other Federal, state, local, or foreign governmental 
authority or foreign securities authority, or any securities industry 
self-regulatory organization, responsible for the regulation or 
supervision of financial institutions.'' \30\ Significantly, the courts 
have ruled consistently that Exemption 8 provides categorical 
protection for information related to such reports.
c. Commission Review
    Paragraph (a)(6) of proposed Appendix E would have permitted the 
Commission to approve a broker-dealer's application to use the 
alternative method of computing net capital, subject to the imposition 
of any conditions or limitations that the Commission found were 
necessary or appropriate in the public interest or for the protection 
of investors, after a review of whether the broker-dealer met the 
requirements of Appendix E; the broker-dealer was in compliance with 
other, applicable Exchange Act provisions or rules or rules of a self-
regulatory organization; and the ultimate holding company was in 
compliance with applicable terms of its undertaking, which are 
conditions for the approval. We did not receive comments on this 
provision and the Commission is redesignating paragraph (a)(6) as 
paragraph (a)(7) of Appendix E and adopting it as proposed, with one 
exception.\31\ We clarify in paragraph (a)(7), as adopted, that the 
Commission also must approve amendments to a broker-dealer's 
application to use the alternative method of computing net capital. 
Furthermore, note that paragraph (a)(1)(ix)(D), which describes the 
undertaking that an ultimate holding company that has a principal 
regulator must provide as a condition of its affiliated broker-dealer's 
exemption from the standard net capital rule, limits the conditions 
that the Commission may place on an ultimate holding company that has a 
principal regulator in

[[Page 34434]]

approving the broker-dealer's exemption application.\32\
---------------------------------------------------------------------------

    \30\ See 5 U.S.C. 552(b)(4).
    \31\ In its undertaking, an ultimate holding company agrees to 
comply with the applicable provisions of Appendices E and G as a 
condition to the broker-dealer's use of the alternative method of 
computing net capital. Appendix E, for example, requires a broker-
dealer to include specified information from the ultimate holding 
company with the broker-dealer's application to compute deductions 
for market and credit risk under Appendix E. If the ultimate holding 
company did not produce the requisite information, it would not be 
in compliance with the terms of its undertaking.
    \32\ Refer to section (D)(a)(ii) of this release for a 
discussion of the undertaking for an ultimate holding company that 
has a principal regulator.
---------------------------------------------------------------------------

    Paragraph (a)(7) of proposed Appendix E would have required a 
broker-dealer to amend and resubmit to the Commission its application 
for exemption from the standard net capital rule if the broker-dealer 
desired to change materially a mathematical model used to calculate 
deductions for market or credit risk or its internal risk management 
control system. We did not receive comment on this requirement and are 
redesignating paragraph (a)(7) as paragraph (a)(8) and adopting it as 
proposed.
    Paragraph (a)(8) of proposed Appendix E would have required a 
broker-dealer to report any material changes to its or its ultimate 
holding company's corporate structure. The final rules do not include 
this notification requirement because it is redundant. The Commission 
will receive notification of the changes as part of the regular filings 
that the ultimate holding company submits under paragraph (b) of 
Appendix G.
    Paragraph (a)(9) of proposed Appendix E would have required a 
broker-dealer to notify the Commission 45 days before it ceased using 
the alternative method of computing net capital under Appendix E. Under 
the proposed paragraph, the Commission could have ordered a shorter or 
longer notification period upon broker-dealer consent or if the 
Commission found that a shorter or longer period was necessary or 
appropriate in the public interest or for the protection of investors. 
We did not receive any comments on this requirement. We are 
redesignating paragraph (a)(9) as paragraph (a)(10) and adopting it as 
proposed.
    Paragraph (a)(10) of proposed Appendix E would have permitted the 
Commission, by order, to revoke a broker-dealer's exemption from the 
standard net capital rule under Appendix E if the Commission found that 
the exemption no longer was necessary or appropriate in the public 
interest or for the protection of investors. A broker-dealer that no 
longer could use Appendix E would have been required to compute its 
capital charges using the standard haircut method.
    A commenter suggested that the Commission's authority to revoke a 
broker-dealer's exemption from the standard net capital rule ``should 
clarify that any limitations or remedial action must be narrowly 
circumscribed to address the relevant deficiency.'' The commenter also 
asserted the Commission should limit revocation of the exemption ``to 
instances in which the Commission finds a material capital deficiency 
or a substantial pattern of material non-compliance.''
    In response to comments received, we are amending paragraph 
(a)(10). We also are redesignating paragraph (a)(10) as paragraph 
(a)(11) in Appendix E, as adopted. Paragraph (a)(11) adds a description 
of the factors that the Commission will rely evaluate in determining 
whether to revoke a broker-dealer's exemption from the net capital 
rule. Specifically, the Commission will consider the compliance history 
of the broker-dealer related to its use of models, the financial and 
operational strength of the broker-dealer and its ultimate holding 
company, and the broker-dealer's compliance with its internal risk 
management controls.
2. Risk Management Control System
    Under proposed paragraph (b) of Appendix E, a broker-dealer using 
the alternative method of computing net capital would have been 
required to establish, document, and maintain an internal risk 
management control system that met the requirements of Sec.  240.15c3-
4.\33\ The rule amendments, as adopted, do not include this 
requirement. Proposed paragraph (b) is omitted as unnecessary because 
the broker-dealer must comply with Rule 15c3-4 under Rule 15c3-
1(a)(7)(iii), as adopted.
---------------------------------------------------------------------------

    \33\ See infra, discussion of proposed amendments to Rule 15c3-
4.
---------------------------------------------------------------------------

3. Computation of the Deduction for Market Risk
    Commenters generally supported the method for calculating a broker-
dealer's deductions for market risk described in paragraph (c) of 
proposed Appendix E. They raised several issues with respect to 
specific provisions for calculating the deduction, however. We address 
those issues in the sections that follow.
    As a preliminary matter, we note that a broker-dealer must compute 
its deduction for market risk monthly. Paragraph (c) of proposed 
Appendix E would have required a daily computation of the deduction for 
market risk. Commenters raised a question as to whether a broker-dealer 
would be required to make daily capital computations and, if so, stated 
that daily computations would be unnecessary and burdensome. We have 
revised these sections to clarify that as part of their risk management 
practices, firms must compute VaR and current exposures daily. We note, 
however, that a broker-dealer must be in compliance with net capital 
requirements at all times.
    Under paragraphs (c)(1) and (2) of proposed Appendix E, the 
deduction for market risk would have been equal to the amount of the 
sum of the following: (i) For positions for which the Commission has 
approved the use of VaR models, the VaR of those positions multiplied 
by the appropriate multiplication factor; (ii) for positions for which 
the Commission has approved the use of scenario analysis, the greatest 
adverse movement of the positions, or some multiple thereof based on 
liquidity or, if greater, a minimum deduction; and (iii) for all other 
positions, a deduction under the standard haircut method of paragraph 
(c)(2)(vi) Rule 15c3-1.
    Paragraph (b) \34\ of Appendix E, as adopted, describes the method 
of computing a broker-dealer's deduction for market risk. A broker-
dealer's deduction for market risk under paragraph (b) is an amount 
equal to the sum of the following: (i) For positions for which the 
Commission has approved the broker-dealer's use of VaR models, the VaR 
of those positions multiplied by the appropriate multiplication factor; 
(ii) for positions for which the VaR model does not incorporate 
specific risk, a deduction for specific risk to be determined by the 
Commission based on a review of the broker-dealer's application and the 
positions involved; (iii) for positions for which the Commission has 
approved the use of scenario analysis, the greatest loss resulting from 
the scenario over any ten-day period, or some multiple thereof based on 
liquidity or, if greater, a minimum deduction; and (iv) for all other 
positions, a deduction under Sec.  240.15c3-1(c)(2)(vi), (c)(2)(vii), 
and applicable appendices to Sec.  240.15c3-1. We address each of the 
deductions for market risk in the sections that follow.
---------------------------------------------------------------------------

    \34\ The final rules redesignate paragraph (c) of proposed 
Appendix E as paragraph (b).
---------------------------------------------------------------------------

 a. Deductions for Market Risk Using VaR Models
    As noted, a broker-dealer may use a VaR model to calculate its 
deduction for market risk for those positions for which the Commission 
has approved the use of VaR models. To calculate the deduction, the 
broker-dealer multiplies the VaR of those positions by the appropriate 
multiplication factor. The multiplication factor is intended to help 
provide adequate capital during periods of market stress or other 
eventualities.\35\ The results of quarterly backtests

[[Page 34435]]

determine which of the multiplication factors contained in Table 1 of 
Appendix E a broker-dealer must use, except that the broker-dealer must 
use an initial multiplication factor of three.\36\
---------------------------------------------------------------------------

    \35\ 17 CFR 240.15c3-1e(b)(1).
    \36\ Paragraph (e)(2)(iii) of proposed E would have required the 
VaR model to use an effective historical observation period of at 
least one year and to include periods of market stress in that 
historical observation period. One commenter observed that a one-
year period might not contain periods of market stress. To address 
this concern, under paragraph (d)(2)(iii) of Appendix E, as adopted, 
a broker-dealer must consider the effects of market stress in its 
construction of the model.
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     We have amended the proposed rules with regard to specified 
provisions of the VaR models used for computing a deduction for market 
risk.
i. Elimination of the VaR Phase-in Period
     In response to comments received, Appendix E, as adopted, no 
longer includes the phase-in period for VaR models. Under paragraph 
(c)(3) of proposed Appendix E, the Commission would have phased in the 
use of VaR models to calculate deductions for net capital for three 
bands of positions over a period of at least 18 months. Commenters 
stated that implementation of VaR for calculation of deductions for 
market risk on a phased-in basis would impose unnecessary operational 
costs and inefficiencies. Elimination of the phase-in requirement is 
intended to promote more effective group-wide risk management and 
eliminate unnecessary operational costs and inefficiencies. Therefore, 
upon Commission approval of its VaR models, a broker-dealer may use its 
VaR models to calculate deductions for market risk capital for all 
positions for which the broker-dealer can demonstrate that its modeling 
procedures meet the applicable requirements in the final rules.
 ii. Positions With No ``Ready Market'' Under VaR
    Paragraph (c)(2) of proposed Appendix E generally would have 
prohibited the use of VaR models to compute deductions for market risk 
for positions with no ``ready market''; debt securities that are below 
investment grade; and any derivative instrument based on the value of 
these positions, unless the Commission granted the broker-dealer's 
application to use a VaR model for those positions. Under paragraph 
(c)(2)(vii) of the net capital rule, positions for which there is no 
``ready market,'' as defined in section 240.15c3-1(c)(11),\37\ would 
have excluded these positions from inclusion in VaR models; that is, 
the positions would have been subject to a 100% deduction.
---------------------------------------------------------------------------

    \37\ Under Sec.  240.15c3-1(c)(11), ``[t]he term `ready market' 
shall include a recognized established securities market in which 
there exists independent bona fide offers to buy and sell so that a 
price reasonably related to the last sales price or current bona 
fide competitive bid and offer quotations can be determined for a 
particular security almost instantaneously and where payment will be 
received in settlement of a sale at such price within a relatively 
short time conforming to trade custom.''
---------------------------------------------------------------------------

    Commenters asserted that, while positions with no ready market may 
lack historical data sufficient to allow accurate modeling, the rules 
should require a broker-dealer to demonstrate that its models 
adequately capture the material risks associated with the categories of 
securities in which they transact business, not limit use of VaR to 
those securities that have a ready market. We agree with the commenters 
and, therefore, Appendix E, as adopted, does not limit a broker-
dealer's use of VaR models for computing deductions for market risk to 
securities that have a ``ready market.''
b. Deductions for Specific Risk
    Paragraph (b)(2) of Appendix E may require a deduction for specific 
risk because of the reliance on VaR models for regulatory purposes, 
particularly for determining deductions for market risk for securities 
with no ready market. Generally, specific risk is the risk associated 
with how the price-change on an individual position may differ from 
broad, market-wide changes in prices. If the VaR models that a broker-
dealer uses to compute deductions for market risk incorporate specific 
risk, there is no additional deduction for specific risk in determining 
the deduction for market risk. If, however, the VaR models do not 
incorporate specific risk, paragraph (b)(2) requires a broker-dealer to 
include separate deductions for specific risk. The Commission will 
determine the deduction for specific risk on a case-by-case basis based 
on a review of the broker-dealer's application and the positions 
involved.
c. Deduction for Market Risk Using Scenario Analysis
     The Commission is amending the proposed rule on calculation of 
deductions for market risk using scenario analysis. Under the paragraph 
(c)(5) of proposed Appendix E, the deduction for market risk calculated 
using scenario analysis generally would have been three times the 
greatest adverse movement resulting from the scenario analysis over any 
ten-day period. Paragraph (b)(3) \38\ of Appendix E, as adopted, 
permits a broker-dealer to determine a deduction for market risk using 
scenario analysis for those positions for which the Commission has 
approved the broker-dealer's application to use scenario analysis. The 
deduction will be the greatest loss resulting from a range of adverse 
movements in relevant risk factors, prices, or spreads designed to 
represent a negative movement greater than, or equal to, the worst ten-
day movement over the four years preceding calculation of the loss, or 
some multiple of that movement based on liquidity. Permitting the use 
of scenario analysis to calculate the deduction for market risk will 
provide the broker-dealer with greater flexibility in determining how 
it may use mathematical models to calculate market risk deductions for 
securities for which a deduction calculated using VaR would not be 
appropriate. The minimum deduction for market risk computed for 
positions using scenario analysis is the same under the final rules as 
it was in the proposed rules.
---------------------------------------------------------------------------

    \38\ Paragraph (c)(5) of proposed Appendix E has been 
redesignated as paragraph (b)(4) under Appendix E, as adopted.
---------------------------------------------------------------------------

    The final amendments also change the period over which the greatest 
adverse ten-day movements of data are evaluated. Paragraph (c)(5) of 
proposed Appendix E would have required the scenario to include a range 
of adverse movements of risk factors, prices, or spreads that move by 
the greatest amounts over the past five years, or a three standard 
deviation movement in those risk factors, prices, or spreads over a 
ten-day period. Commenters suggested that the period related to ten-day 
movements be reduced from five to four years. In response to comments 
received, the final amendments reduce the period over which the 
greatest adverse ten-day movements of data are determined to four 
years. This change is intended to approximate more closely a ten-day 
movement of prices to a 99% confidence level.
    The rule as proposed would have allowed for the use of a three 
standard deviations alternative if historical data for use in a 
scenario analysis were limited. Commenters expressed concern that this 
requirement would restrict the use of scenario analysis when historical 
data is limited. We are amending the proposed rule to clarify, under 
paragraph (b)(3) of Appendix E, as adopted, that a broker-dealer may 
use implied data or price histories of similar securities to calculate 
the three standard deviation movement if historical data is 
insufficient.

[[Page 34436]]

d. Deductions for Market Risk Under the Standard Net Capital Rule
    Paragraph (c)(6) of proposed Appendix E would have required a 
broker-dealer to compute a deduction for market risk using the 
``haircut method'' of the standard net capital rule for a position not 
subject to a deduction for market risk computed using VaR models or 
scenario analysis. Haircuts are calculated under paragraphs (c)(2)(vi), 
(c)(2)(vii), and applicable appendices of the standard net capital 
rule, Rule 15c3-1.\39\ By requiring a broker-dealer to use the haircut 
method of the standard net capital rule in appropriate circumstances, 
the Commission intended that a broker-dealer use paragraph (c)(2)(vii), 
if applicable. Proposed paragraph (c)(6), however, did not reference 
paragraph (c)(2)(vii) specifically. Paragraph (b)(4) \40\ of Appendix 
E, as adopted, clarifies that a broker-dealer must compute deductions 
for market risk under both paragraphs (c)(2)(vi) and (c)(2)(vii) of the 
standard net capital rule, if applicable. Paragraph (c)(2)(vii), as 
noted, requires a 100% deduction for positions for which there is no 
ready market.
---------------------------------------------------------------------------

    \39\ See 17 CFR 240.15c3-1(c)(2)(vi) and (vii).
    \40\ Proposed paragraph (c)(6) has been redesignated as 
paragraph (b)(4) under the final rules.
---------------------------------------------------------------------------

4. Computation of the Deduction for Credit Risk
    A broker-dealer approved to calculate deductions for market risk 
using VaR models or scenario analysis must calculate its deduction for 
credit risk according to paragraph (c) \41\ of Appendix E, as adopted, 
on credit exposures arising from the broker-dealer's positions in 
derivatives instruments. The deduction for credit risk is the sum of 
the following three categories of charges: (i) A counterparty exposure 
charge under paragraph (c)(1), (ii) concentration charges by 
counterparty under paragraph (c)(2), and (iii) a portfolio 
concentration charge for all counterparties under paragraph (c)(3). The 
deductions required for each of these categories are designed to 
address different components of credit risk.
---------------------------------------------------------------------------

    \41\ Paragraph (d) of proposed Appendix E has been redesignated 
as paragraph (c) under Appendix E, as adopted.
---------------------------------------------------------------------------

a. Counterparty Exposure Charge
    We are adopting the counterparty exposure charge as proposed, with 
the exception of the determination of counterparty credit risk weights. 
For each counterparty, the broker-dealer must compute a counterparty 
exposure charge equal to the net replacement value in the account of 
each counterparty that is insolvent, in bankruptcy, or has senior, 
unsecured long-term debt in default. For counterparties that are not 
insolvent, in bankruptcy, or in default, the counterparty exposure 
charge also includes the ``credit equivalent amount'' of the broker-
dealer's exposures to the counterparty, multiplied by the credit risk 
weight of the counterparty, then multiplied by 8%.\42\ The credit 
equivalent amount of a broker-dealer's exposure to a counterparty is 
defined in paragraph (c)(4)(i) of Appendix E, as adopted, as the sum 
of: (1) The broker-dealer's maximum potential exposure (``MPE'') to the 
counterparty multiplied by the appropriate multiplication factor, and 
(2) the broker-dealer's current exposure to the counterparty. Under 
paragraph (d)(1)(v) \43\ of Appendix E, as adopted, the multiplication 
factor applicable to MPE generally is determined based on backtesting 
results of the VaR model used to calculate MPE, except that the initial 
multiplication factor is one.
---------------------------------------------------------------------------

    \42\ 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 help ensure that the 
firm maintains a safe level of capital.
    \43\ Paragraph (e) of proposed Appendix E has been redesignated 
as paragraph (d) of Appendix E, as adopted.
---------------------------------------------------------------------------

    Paragraph (c)(4)(ii) of Appendix E defines MPE as VaR of the 
counterparty's positions with the broker-dealer, after applying netting 
agreements, taking into account the value of certain collateral 
received from the counterparty, and taking into account the current 
replacement value of the counterparty's positions with the broker-
dealer. The broker-dealer must calculate MPE using a VaR model that 
meets the applicable quantitative and qualitative requirements of 
Appendix E. Paragraph (c)(4)(iii) of Appendix E, as adopted, defines 
``current exposure'' as the replacement value of the counterparty's 
positions with the broker-dealer, after applying specified netting 
agreements \44\ and taking into account the value of certain collateral 
\45\ received from the counterparty.
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    \44\ Only netting agreements that meet the requirements of 
paragraph (c)(4)(iv) of Appendix E may be used to reduce current 
exposure and maximum potential exposure. For example, the netting 
agreements must be legally enforceable in each relevant 
jurisdiction, including in insolvency proceedings.
    \45\ Only collateral that meets the requirements of paragraph 
(c)(4)(v) of Appendix E may be used to reduce current exposure and 
maximum potential exposure.
---------------------------------------------------------------------------

    In the Proposing Release, the credit risk weights would have ranged 
from 20% to 150%, depending on the credit rating of the counterparty, 
which provides a measure of credit risk. For a counterparty not rated 
by a nationally recognized statistical rating agency (``NRSRO''), the 
broker-dealer could have applied to the Commission for permission to 
determine a credit rating for the counterparty using internal 
calculations and to use that internal rating to determine the credit 
risk weight of the counterparty. For exposures covered by guarantees, a 
broker-dealer could have substituted the average of the credit risk 
weights of the guarantor and the counterparty for the credit risk 
weight of the counterparty, subject to specified conditions. These 
proposed credit risk weights were based on the formulas provided in the 
Foundation Internal Ratings-Based approach to credit risk proposed by 
the Basel Committee \46\ and were derived using a loss given default 
(the percent of the amount owed by the counterparty the firm expects to 
lose if the counterparty defaults) of 75%.
---------------------------------------------------------------------------

    \46\ The New Basel Capital Accord, Basel Committee on Banking 
Supervision (April 2003).
---------------------------------------------------------------------------

    We requested comment on the determination of credit risk weights. 
In particular, we requested comment on whether a broker-dealer should 
be permitted to apply to the Commission for permission to determine the 
credit risk weights of counterparties using internal calculations. We 
also requested comment on whether, in a calculation of credit risk 
weights based on internal estimates of annual probabilities of default, 
the proposed table appropriately matched credit risk weights to annual 
probabilities of default.
    Several commenters stated that broker-dealers should be allowed to 
calculate credit risk weights based on internal estimates of annual 
probabilities of default, but that a 75% loss given default assumption 
was too conservative. One commenter stated that the loss given default 
percentage should be a function of the issuer, industry type, and debt 
class.
    Based on comments received, we are permitting a broker-dealer to 
request Commission approval to determine counterparty credit risk 
weights using internal calculations under paragraph (c)(4)(vi)(E) of 
Appendix E, as adopted. These internally calculated credit risk weights 
are in addition to the credit risk weights contained in paragraphs 
(c)(4)(vi)(A) through (C) of Appendix E, as adopted. Paragraph 
(c)(4)(vi)(E) does not include any specific maturity adjustment factor, 
although we note that the Basel Standards use a maturity

[[Page 34437]]

adjustment factor of 2.5 years in their standard approach. Furthermore, 
in the Proposing Release, we requested comment on whether a proposed 
table of credit risk weights appropriately matched credit risk weights 
to annual probabilities of default. Commenters responded that the 
matches were not appropriate. Accordingly, rather than provide a table 
of credit risk weights corresponding to internal estimates of annual 
probabilities of default in the final rule, we will evaluate the method 
of determining credit risk weights the broker-dealer proposes in its 
application.
b. Concentration Charge by Counterparty
    The Commission is adopting paragraph (c)(2) of Appendix E, the 
concentration charge by counterparty,\47\ as proposed.\48\ This charge 
accounts for the additional risk resulting from a relatively large 
exposure to a single party. The charge consists of concentration 
charges by counterparty that generally would 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 is larger for counterparties with lower credit 
ratings and ranges 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% criterion is based on the OTC 
derivatives dealer rules and the experience of Commission staff.
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    \47\ Concentration charges are intended to provide a liquidity 
cushion if a lack of diversification of positions exposes the 
broker-dealer to additional risk. When evaluating credit risk, 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) would evidence a lack of diversification.
    \48\ We redesignated paragraph (d)(7) of proposed Appendix E as 
paragraph (c)(2) of Appendix E, as adopted.
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c. Portfolio Concentration Charge
    The Commission is adopting an amended portfolio concentration 
charge under paragraph (c)(3) \49\ of Appendix E. The portfolio 
concentration charge for credit risk addresses the risk of holding a 
relatively large amount of unsecured receivables. Proposed paragraph 
(d)(9) would have required firms to take a portfolio concentration 
charge across all counterparties equal to the amount, if any, that the 
broker-dealer's aggregate current exposure arising from transactions in 
derivative instruments across all counterparties exceeded 15% of the 
broker-dealer's tentative net capital. Commenters expressed concern 
that the portfolio concentration charge would be onerous because it 
would attach at a relatively low threshold and, consequently, restrict 
the scope of derivatives activity that could be booked in the broker-
dealer in a capital-efficient manner. In response to comments received, 
the Commission has increased the threshold at which the portfolio 
concentration charge attaches. Under these final rules, a broker-dealer 
is subject to a charge on the amount, if any, that the broker-dealer's 
aggregate current exposure for all counterparties for unsecured 
exposures exceeds 50%, rather than 15%, of the broker-dealer's 
tentative net capital. Based on staff experience, we believe that the 
threshold at which the portfolio concentration charge attaches should 
help a broker-dealer maintain sufficient liquid capital while allowing 
the broker-dealer to book derivative transactions in a capital-
efficient manner.
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    \49\ Paragraph (d)(9) of Appendix E, as proposed, has been 
redesignated as paragraph (c)(3) of Appendix E, as adopted.
---------------------------------------------------------------------------

5. Qualitative and Quantitative Standards Applicable to Calculations 
Under Models
    Paragraph (e) \50\ of proposed Appendix E set forth the qualitative 
and quantitative requirements that broker-dealers would have been 
required to comply with to calculate deductions using VaR models.\51\ 
These requirements were intended to make the capital charges based on 
the VaR measures a more accurate measure of losses that could occur 
during periods of market stress. We derived the requirements from 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 have required that: (i) The VaR models used 
to calculate deductions for market and credit risk be the same models 
used to report market and credit risk to the firm's senior management 
and be integrated into the internal risk management system of the firm; 
(ii) the VaR models 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; \52\ and (iii) for purposes of computing 
market risk, the multiplication factor be determined based on quarterly 
backtesting of the VaR models used to calculate market risk and by 
reference to Table 1 of Appendix E.
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    \50\ Paragraph (e) of proposed Appendix E has been redesignated 
as paragraph (d) of Appendix E, as adopted.
    \51\ 17 CFR 240.15c3-1e(e)(1) and (2).
    \52\ ``Registered public accounting firm'' is defined in section 
2(a)(12) of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7201 et seq.) 
as ``a public accounting firm registered with the [Public Company 
Accounting Oversight] Board in accordance with this Act.''
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    The proposed quantitative standards would have required each model 
to: (i) Use a 99 percent, one-tailed confidence level with price 
changes equivalent to a ten business-day or one-year movement in rates 
and prices for purposes of determining market and credit risk, 
respectively; (ii) use an effective historical observation period of at 
least one year in length that included periods of market stress; and 
(iii) take into account and incorporate all significant, identifiable 
market risk factors applicable to the firm's positions.\53\
---------------------------------------------------------------------------

    \53\ Proposed Rule 15c3-1e(e)(2).
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    In the Proposing Release, we requested comment on the proposed use 
of mathematical models for regulatory capital purposes, including the 
proposed quantitative and qualitative requirements and the proposed 
backtesting procedures for the models. One commenter stated that one 
year might not contain periods of market stress. To address this 
concern, the rule as adopted, in addition to the one-year minimum, 
provides that the broker-dealer must consider the effects of market 
stress in its construction of the model.
    Paragraph (e)(1)(iv) \54\ of proposed Appendix E would have 
required broker-dealers to determine multiplication factors for 
purposes of computing the credit equivalent amount of the firm's 
exposure to a counterparty based on results of backtesting of the model 
used to calculate MPE. This paragraph would have required firms to 
conduct the backtesting by comparing, for at least 40 counterparties, 
the daily change in current exposure based on the end of the previous 
day's positions with the corresponding MPE for the counterparty 
generated by the model.
---------------------------------------------------------------------------

    \54\ Paragraph (e)(1)(iv) of proposed Appendix E has been 
redesignated as paragraph (d)(1)(v) of Appendix E, as adopted.
---------------------------------------------------------------------------

    One commenter stated that because MPE is based on a one-year time 
horizon, it is inconsistent to compare it with a one-day change in 
current exposure. The commenter also stated that the Commission should 
allow the use of VaR models based on information implied from market 
prices for one-year horizon potential exposure calculations. According 
to the commenter, the potential exposure models that utilize implied 
parameters are in widespread use in the financial industry. We will 
consider whether a firm should be

[[Page 34438]]

permitted to use implied parameters in potential exposure calculations 
if the firm requests consideration of this issue in its application.
    Furthermore, in response to comments received and to strengthen and 
improve the backtesting requirement we have amended both paragraphs 
(d)(1)(v)(A) and (B) of Appendix E, as adopted. Under these paragraphs 
as amended, the MPE horizon is ten business days, rather than one day. 
The ten-day requirement is consistent with the VaR models broker-
dealers use. In conducting backtesting, the broker-dealer must compare 
the change in current exposure to the counterparty based on its 
positions held at the beginning of the ten-business day period to the 
corresponding ten-business day MPE for the counterparty generated by 
the VaR model.
    Moreover, we re-evaluated the requirement that the broker-dealer 
compare at least 40 counterparties in conducting conduct backtesting. 
Based on that re-evaluation and staff experience, we determined that to 
help ensure a sufficient number of data points and, therefore, an 
appropriate sample for backtesting, the broker-dealer must compare at 
least 80 counterparties under paragraph (d)(1)(v)(A) of Appendix E, as 
adopted, rather than 40 counterparties, as proposed.
    Paragraph (e)(2)(ii) of proposed Appendix E would have required the 
VaR model to use a time horizon of one year for purposes of determining 
MPE. Several commenters stated that the time horizon should be ten 
business days if the position is marked to market daily and a written 
agreement enforceable against the counterparty provides that the 
broker-dealer or its affiliate may call for additional collateral 
daily.
    In response to comments received, a broker-dealer may use a time 
horizon of not less than ten business days to calculate MPE under 
paragraph (d)(2)(ii) \55\ of Appendix E, as adopted. Generally, if 
collateral is not posted to, and held by, the broker-dealer, the 
broker-dealer must use the one-year time horizon when calculating MPE. 
If, however, there is a valid collateral agreement, the Commission may 
approve a shorter time horizon based on a review of the broker-dealer's 
procedures for managing collateral. The broker-dealer also must be able 
to mark the collateral to market daily and have the ability to call the 
collateral daily. This modification of the time horizon requirement 
should help a broker-dealer to maintain a liquid capital base while 
promoting operational efficiency.
---------------------------------------------------------------------------

    \55\ Paragraph (e)(2)(ii) of proposed Appendix E has been 
redesignated as paragraph (d)(2)(ii) of Appendix E, as adopted.
---------------------------------------------------------------------------

6. Additional Conditions for Noncompliance With Appendices E and G, 
Model Failures, or Control Failures
    We are revising paragraph (f) of proposed Appendix E and 
redesignating it as paragraph (e) of Appendix E, as adopted. Paragraph 
(f) of proposed Appendix E would have permitted the Commission, in 
specified circumstances, to condition a broker-dealer's continued use 
of the alternative method of computing net capital on the broker-
dealer's or its ultimate holding company's compliance with additional 
conditions. Additional conditions imposed on the broker-dealer could 
have included, but would not have been limited to, restrictions on the 
scope of the broker-dealer's business, submission of a plan to increase 
its net capital or tentative net capital, or calculation of some or all 
of its deductions for market and credit risk according to the standard 
net capital method of Rule 15c3-1.
    Paragraph (e) of Appendix E, as adopted, clarifies in the rule text 
that we may require a broker-dealer to calculate some or all of its 
deductions to net capital under paragraph (c)(2)(vii) of the standard 
net capital rule, if applicable. As noted above, we stated in Proposing 
Release that we intended a broker-dealer using the alternative method 
of computing net capital to use the haircut method of the standard net 
capital rule to compute appropriate deductions to net capital when the 
alternative method could not be applied. A broker-dealer calculates 
haircuts under paragraphs (c)(2)(vi), (c)(2)(vii), and applicable 
appendices of Rule 15c3-1. Although we did not reference paragraph 
(c)(2)(vii) in the proposed rule text, we indicated that haircuts were 
to be used to compute deductions to net capital in specified 
circumstances, thus requiring a broker-dealer to make the computation 
under paragraph (c)(2)(vii), if appropriate, together with (c)(2)(vi) 
and applicable appendices of Rule 15c3-1.
    As noted, paragraph (f) of proposed Appendix E also would have 
permitted the Commission to impose certain additional requirements on 
the broker-dealer's ultimate holding company, subject to specified 
conditions. One commenter stated that if the ultimate holding company 
is a bank holding company that complies with its regulator's capital 
requirements on a consolidated basis, any capital remedies should be 
imposed on the broker-dealer and not on the ultimate holding company. 
Another commenter stated that if the Commission has concerns about the 
risk models or procedures in the ultimate holding company's capital 
calculation, it should address the concerns by imposing additional 
capital charges on the broker-dealer, not by requiring a change in the 
risk models or procedures.
    Paragraph (e) of Appendix E, as adopted, clarifies that the 
Commission only may impose additional conditions on an ultimate holding 
company that does not have a principal regulator. If the Commission has 
concerns with respect to the risk models or risk management system of 
an ultimate holding company that has a principal regulator, the 
Commission may impose additional regulatory requirements on the broker-
dealer.
    Paragraph (e) of Appendix E, as adopted, outlines circumstances 
under which the Commission may impose additional conditions on the 
broker-dealer or the ultimate holding company that does not have a 
principal regulator. First, as discussed above, we added a provision 
that states that the Commission may impose additional conditions if the 
broker-dealer must notify the Commission under paragraph (a)(7)(ii) of 
Rule 15c3-1 that its tentative net capital is below $5 billion. 
Notification is necessary because this event indicates that the broker-
dealer or ultimate holding company might be approaching financial 
difficulty. Second, we added a provision that allows the Commission to 
impose additional regulatory requirements on the broker-dealer or an 
ultimate holding company that does not have a principal regulator if 
the broker-dealer fails to comply with Appendix E. The authority to 
impose these requirements is essential to the Commission's ability to 
address risks to the broker-dealer.
7. Recordkeeping
    The Commission did not propose amendments to Rule 17a-3 because 
that rule already requires a broker-dealer to create and maintain 
records sufficient for the Commission to examine the broker-dealer 
adequately, regardless of whether the broker-dealer uses the 
alternative or standard method of computing net capital. Broker-dealers 
currently must make various records, including blotters containing an 
itemized daily record of all purchases and sales of securities, and all 
receipts and deliveries of securities, cash, and other debits and 
credits. Under the existing requirements in Rule 17a-3, a broker-dealer 
can provide the Commission with a separate record of all transactions 
between itself and all affiliates in the affiliate group. Consistent 
with the Commission's supervision of inter-group transactions,

[[Page 34439]]

the Commission may obtain and review a record of inter-group 
transactions as part of its supervisory reviews under Rule 17a-3.

D. Ultimate Holding Company Requirements

    Under the rule amendments, an ultimate holding company is subject 
to requirements under both Appendix E and Appendix G. Appendix E 
primarily requires the ultimate holding company to submit specified 
information to the Commission with the broker-dealer's application to 
use the alternative method of computing net capital. Appendix G 
outlines the ultimate holding company's obligations with respect to 
calculation of allowable capital, allowances for certain capital 
charges, and certain recordkeeping and reporting requirements.
1. Ultimate Holding Company Requirements Under Appendix E
    Under Appendix E as proposed, a broker-dealer's ultimate holding 
company would have submitted specified information to the Commission 
with the broker-dealer's application to use the alternative method of 
computing net capital. This information would have been similar to the 
information that 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 this information to be 
useful in gaining insight into the financial condition, internal risk 
management control system, risk exposure, and activities of the broker-
dealer and its ultimate holding company and material affiliates.\56\ 
The information provided in these documents would have been key 
considerations in determining the continued viability of the broker-
dealer because serious adverse conditions at the ultimate holding 
company or a material affiliate likely would have exposed the broker-
dealer to liquidity or other risks.
---------------------------------------------------------------------------

    \56\ We will review, on a case-by-case basis, the entities that 
have been identified in the application as material affiliates.
---------------------------------------------------------------------------

    In response to comments received, we have revised the final rules 
to set forth separately the requirements for information that an 
ultimate holding company that has a principal regulator must submit to 
the Commission from the requirements for information that an ultimate 
holding company that does not have a principal regulator must submit to 
the Commission. These requirements are addressed below in detail.
a. Ultimate Holding Company Undertaking
    As a condition to a broker-dealer's use of the alternative method 
of computing net capital, proposed paragraph (a)(1)(viii) of Appendix E 
would have required the broker-dealer to include with its application a 
written undertaking by the broker-dealer's ultimate holding company. 
Other than with respect to holding companies subject to group-wide 
supervision by other regulators, we did not receive specific comments 
on these proposed requirements. Nevertheless, we are revising paragraph 
(a)(1)(viii) to reflect that we no longer are amending Rule 15c3-4. 
Moreover, we have revised the final rules to set forth separately, in 
paragraph (a)(1)(ix), the requirements for an undertaking submitted by 
an ultimate holding company that has a principal regulator.
i. Ultimate Holding Company That Does Not Have a Principal Regulator
    As a condition to its use of the alternative method for computing 
net capital, paragraph (a)(1)(viii) of Appendix E, as adopted, requires 
a broker-dealer to file a written undertaking by its ultimate holding 
company, signed by a duly authorized person at the ultimate holding 
company, in which the ultimate holding company agrees, among other 
things, to:
     Comply with all applicable provisions of Appendices E and 
G to Rule 15c3-1;
     Comply with the provisions of Rule 15c3-4 with respect to 
a group-wide internal risk management control system for the affiliate 
group as if it were an OTC derivatives dealer. Paragraph 
(a)(1)(viii)(C) is discussed in greater detail in the section of this 
release that addresses Rule 15c3-4;
     As part of its group-wide internal risk management control 
system, to establish, document, and maintain procedures for the 
detection and prevention of money laundering and terrorist financing; 
\57\
---------------------------------------------------------------------------

    \57\ This parallels requirements in the proposed New Basel 
Capital Accord, as amended from time to time. 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).
---------------------------------------------------------------------------

     Permit the Commission to examine the books and records of 
any affiliate of the ultimate holding company, if the affiliate is not 
an entity that has a principal regulator; \58\
---------------------------------------------------------------------------

    \58\ The primary purpose of our examination of ultimate holding 
companies and their affiliates is to verify their financial and 
operational conditions and to verify whether the internal risk 
management controls and the methodologies for calculating allowable 
capital and allowances for market, credit, and operational risk are 
consistent with those controls and methodologies approved by the 
Commission. We will not examine an entity that has a principal 
regulator, and we will not examine an ultimate holding company that 
has a principal regulator or the non broker-dealer affiliates of 
such a holding company.
---------------------------------------------------------------------------

     If the disclosure to the Commission of any information 
required as a condition for the broker-dealer to use Appendix E is 
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 material affiliates from providing 
information to the Commission and by discussing the manner in which the 
broker-dealer and the ultimate holding company propose to provide the 
Commission with adequate assurances of access to information; and
     Acknowledge that the Commission may implement additional 
supervisory conditions if the ultimate holding company fails to comply 
in a material manner with any provision of its undertaking.
    Paragraphs (a)(1)(viii)(I) and (J) of proposed Appendix E would 
have required an ultimate holding company, as a condition to a broker-
dealer's use of the alternative method of computing net capital, to 
consent in its undertaking to submit to the Commission, in advance of 
making them, any material changes to mathematical models and other 
methods used to calculate allowances for market, credit, and 
operational risk, and any material changes to the internal risk 
management control system for the affiliate group.
    We are adopting these requirements as paragraph (a)(9) of Appendix 
E. We redesignated as paragraph (a)(9) the obligation to submit to the 
Commission specified material changes for prior approval to emphasize 
that the obligation is ongoing. Furthermore, to avoid unnecessary or 
duplicative requirements, paragraph (a)(9) of Appendix E, as adopted, 
applies only to ultimate holding companies that do not have principal 
regulators.
ii. Undertaking for an Ultimate Holding Company That Has a Principal 
Regulator
    A number of commenters urged the Commission to reduce certain 
requirements applicable to ultimate holding companies that already are 
subject to another regulator's consolidated supervision. These 
commenters asserted that the requirements, including the undertaking

[[Page 34440]]

required as part of the application process, could lead to the 
imposition of duplicative and possibly inconsistent requirements on 
these ultimate holding companies by the Commission and their current 
regulators.
    In response to these comments and to avoid duplicative or 
inconsistent requirements, the Commission has amended paragraph (a)(1) 
to create a new sub-paragraph (ix) that specifies the more limited 
undertaking that a broker-dealer must submit if its ultimate holding 
company has a principal regulator, as that term is defined in new 
paragraph 15c3-1(c)(13). This undertaking, however, still enables the 
Commission to obtain information sufficient to evaluate the risk that 
the ultimate holding company may pose to the broker-dealer.
    As a condition to its use of the alternative method for computing 
net capital, paragraph (a)(1)(ix) of Appendix E, as adopted, requires a 
broker-dealer to file a written undertaking by its ultimate holding 
company that has a principal regulator, signed by a duly authorized 
person at the ultimate holding company, in which the ultimate holding 
company agrees, among other things, to:
     Comply with applicable provisions of Appendices E and G to 
Rule 15c3-1;
     Make available to the Commission information about the 
ultimate holding company that the Commission finds necessary to 
evaluate the financial and operational risk within the ultimate holding 
company and to evaluate compliance with the conditions of eligibility 
of the broker-dealer to compute net capital under the alternative 
method of Appendix E; and
     Acknowledge that the Commission may impose additional 
supervisory conditions on the broker-dealer, described in detail below, 
if the ultimate holding company fails to comply in a material manner 
with any provision of its undertaking.
b. Information To Be Submitted by the Ultimate Holding Company
    Paragraph (a)(2) of proposed Appendix E would have required an 
ultimate holding company to consent to provide specified information to 
the Commission with an affiliated broker-dealer's application as a 
condition of the broker-dealer's use of the alternative method of 
computing net capital. Among other things, the ultimate holding company 
would have consented to include an organizational chart that identified 
the ultimate holding company, the broker or dealer, and the material 
affiliates. According to some commenters, the Commission ``may wish to 
only require broker-dealers to submit an organizational chart that 
identifies the holding company, the broker-dealer, and the material, 
unregulated affiliates of the broker-dealer * * * and such other 
affiliate organizational information as it may request from time to 
time.'' These commenters suggested that the Commission eliminate the 
alphabetical list in paragraph (a)(2)(ii) of Appendix E, as proposed, 
because large financial services firms may have hundreds of affiliates 
and information and the commenters believed that information on these 
affiliates would not assist the Commission in its understanding of the 
risks to broker-dealers.
    Paragraph (a)(2)(ii) of Appendix E, as adopted, retains the 
requirement that the ultimate holding company consent to provide an 
alphabetical list to the Commission of its affiliates (the ``affiliated 
group''). The Commission needs a comprehensive list of entities that 
make up the affiliate group to understand, as completely as possible, 
the organizational structure of which the broker-dealer is a part. 
Moreover, management of the ultimate holding company should have ready 
access to a comprehensive list of affiliates and a designation of 
whether the affiliates have a financial regulator as part of its 
internal risk management systems.
    We also are making technical amendments to paragraph (a)(2)(iii) of 
Appendix E, as adopted. Paragraph (a)(2)(iii) of Appendix E, as 
proposed, would have required an ultimate holding company to consent to 
provide ``an organizational chart that identifies the holding company, 
the broker or dealer, and the material affiliates of the broker or 
dealer.'' Paragraph (a)(2)(ii), both as proposed and adopted, requires 
that the ultimate holding company consent to provide information about 
affiliates material to the ultimate holding company, not the broker-
dealer. Likewise, we intended paragraph (a)(2)(iii) to require an 
ultimate holding company to provide an organizational chart that 
identifies the material affiliates of the ultimate holding company, not 
the broker-dealer. Accordingly, paragraph (a)(2)(iii) of Appendix E, as 
adopted, requires the ultimate holding company's organizational chart 
to identify affiliates material to the ultimate holding company.
    Commenters also suggested that an ultimate holding company that has 
a principal regulator should not be required to provide all of the 
information to the Commission that proposed paragraph (a)(2) of 
Appendix E would have required. According to the commenters, an 
ultimate holding company that has a principal regulator already might 
provide some of the information required under proposed paragraph 
(a)(2) to its principal regulator and, therefore, the information 
requirements could lead to duplicative or inconsistent requirements.
    To avoid potentially duplicative or inconsistent requirements, 
paragraph (a)(2), as adopted, applies only to an ultimate holding 
company that does not have a principal regulator. The Commission has 
revised the rules to set forth separately, in paragraph (a)(3), the 
documents that an ultimate holding company that has a principal 
regulator must submit. The following sections describe the requirements 
under paragraphs (a)(2) and (a)(3).
i. Ultimate Holding Company That Does Not Have a Principal Regulator
    Paragraph (a)(2) of Appendix E, as adopted, specifies the 
information that an ultimate holding company that does not have a 
principal regulator must submit, as a condition of Commission approval, 
with the broker-dealer's application for exemption from the standard 
net capital rule. That information includes the following:
     A narrative description of the business and organization 
of the ultimate holding company;
     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 ultimate 
holding company (``material affiliates'');
     An organizational chart that identifies the ultimate 
holding company, the broker-dealer, and the material affiliates;
     Consolidated and consolidating financial statements;
     Certain sample capital calculations made according to 
Appendix G to Rule 15c3-1;
     A description of the categories of positions held by the 
ultimate holding company and affiliates;
     A description of the methods the ultimate holding company 
intends to use for computing allowances for market,\59\ credit, and 
operational risk;
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    \59\ One commenter argued that the proposed requirement to 
submit a description of all mathematical models was overly broad and 
seemed excessive and unnecessary. In response, the Commission 
eliminated the word ``all'' because, although we require a 
description of and intend to review all models used to calculate 
deductions for market and credit risk, we do not intend to require a 
firm to describe each pricing model because we may not review all 
pricing models during the application process.

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[[Page 34441]]

     A description of any differences between the models used 
by the ultimate holding company and those used by the broker-dealer to 
compute deductions for specified risks on the same instrument or 
counterparty;
     A description of the risk management control system the 
ultimate holding company uses to manage group-wide risk and how that 
system satisfies the requirements of Rule 15c3-4; and
     Sample risk reports that the ultimate holding company 
provides to its senior management.
ii. Ultimate Holding Company That Has a Principal Regulator
    New paragraph (a)(3) of Appendix E, as adopted, specifies the more 
limited information that an ultimate holding company that has a 
principal regulator must include, as a condition of Commission 
approval, with the broker-dealer's application for exemption from the 
standard net capital rule. That information includes the following:
     A narrative description of the business and organization 
of the ultimate holding company;
     An alphabetical list of the affiliates of the broker-
dealer with an identification of the financial regulator, if any, by 
whom the affiliate is regulated and a designation of those affiliates 
that are material to the ultimate holding company;
     An organizational chart that identifies the ultimate 
holding company, the broker-dealer, and the material affiliates;
     Consolidated and consolidating financial statements;
     A capital measurement report as provided to its principal 
regulator;
     A description of any differences between the models used 
by the ultimate holding company and those used by the broker-dealer to 
compute capital charges on the same instrument or counterparty; and
     Sample risk reports that the ultimate holding company 
provides to its senior management.
    Receipt of these documents is intended to provide the Commission 
with insight into the ultimate holding company and the risks that it 
may pose to the broker-dealer without intruding upon the jurisdiction 
of the ultimate holding company's principal regulator.
    Because each ultimate holding company manages its internal risk 
differently, the Commission, during the application process, must 
assess each ultimate holding company's business and internal risk 
management control systems to determine if approval of the application 
is appropriate. The ultimate holding company information that we 
require a broker-dealer to file as a condition of approval of the 
application for the exemption from the standard net capital rule allows 
us to evaluate these management control systems.
iii. Other Information
    Paragraph (a)(3) of proposed Appendix E \60\ would have required a 
broker-dealer to provide supplemental information about it or its 
ultimate holding company upon Commission request. The Commission would 
have requested supplemental information to complete its review of the 
broker-dealer's application to use the alternative method of computing 
net capital. In certain circumstances, such as consideration of the 
particular business or organizational structure of the ultimate holding 
company and its affiliates, the Commission could have conditioned its 
approval on obtaining additional information or documents necessary to 
assess adequately the risks to the ultimate holding company and to the 
broker-dealer. Accordingly, we are adopting paragraph (a)(4) of 
Appendix E as proposed. Paragraph (a)(4) requires a broker-dealer to 
supplement it application with other information or documents relating 
to the internal risk management control system, mathematical models, 
and financial position of the broker-dealer or the ultimate holding 
company that the Commission may request to complete its review of the 
application.
---------------------------------------------------------------------------

    \60\ Paragraph (a)(3) of proposed Appendix E has been 
redesignated as paragraph (a)(4) of Appendix E, as adopted.
---------------------------------------------------------------------------

2. Ultimate Holding Company Requirements Under Appendix G
    As a condition of Commission approval, the ultimate holding company 
of a broker-dealer applying to use the alternative method of computing 
net capital must undertake to comply with the requirements listed in 
Appendix G to Rule 15c3-1, as required by paragraphs (a)(1)(viii) or 
(a)(1)(ix) of Appendix E. Under Appendix G, the ultimate holding 
company that does not have a principal regulator must compute allowable 
capital and allowances for market, credit, and operational risk on a 
consolidated basis for the affiliated group; provide the Commission 
with certain monthly, quarterly, and annual reports; maintain certain 
books and records relating to the ultimate holding company's 
consolidated and consolidating 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 ultimate holding 
company and its potential impact on the risk exposure of the broker-
dealer.
a. Calculation of Allowable Capital and Allowances for Market, Credit, 
and Operational Risk by an Ultimate Holding Company That Does Not Have 
a Principal Regulator
    Under paragraph (a) of Appendix G, as adopted, an ultimate holding 
company must calculate allowable capital and allowances for market, 
credit, and operational risk on a consolidated basis for the affiliate 
group as a condition of the broker-dealer's use of the alternative 
method of computing net capital. The calculations are designed to be 
consistent with the Basel Standards, which should allow for greater 
comparability of ultimate holding companies to international securities 
firms and banking institutions and allow monitoring of the financial 
condition of the affiliate group, which may impact the financial 
stability of the broker-dealer.
    We believe the rules contain prudent parameters for measuring 
allowable capital and risk allowances for the ultimate holding company. 
For example, the rules limit the amount of subordinated debt that may 
be included in allowable capital, require the VaR model used to 
calculate the allowance for market risk to be based on a ten business-
day movement in rates and prices, and require the VaR measure to be 
multiplied by a factor of at least three.
i. Group-Wide Allowable Capital Calculation
a. Components of Allowable Capital
    Under paragraph (a)(1) of proposed Appendix G, the ultimate holding 
company would have calculated allowable capital on a consolidated basis 
for the affiliate group. Consistent with the Basel Standards, allowable 
capital would have included common shareholders' equity (less goodwill, 
deferred-tax assets, and certain other intangible assets), certain 
cumulative and non-cumulative preferred stock,\61\ and certain properly 
subordinated debt. As set forth in detail in the rule, the cumulative 
and non-cumulative

[[Page 34442]]

preferred stock and subordinated debt would have been subject to 
additional limitations based on comparisons of the individual 
components of allowable capital.
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    \61\ To qualify for inclusion in allowable capital, the 
cumulative and noncumulative preferred stock cannot have a maturity 
date, cannot be redeemed at the option of the holder, and cannot 
contain any other provisions that would require future redemption of 
the issue. In addition, the issuer must be able to defer or 
eliminate dividends. Preferred stock that meets these conditions has 
characteristics of capital (as opposed to debt).
---------------------------------------------------------------------------

    In response to comments received, the Commission has expanded the 
definition of allowable capital in paragraph (a)(1) of Appendix G, as 
adopted, to include hybrid capital instruments and certain deferred-tax 
assets. Commenters noted that the Basel Standards and the Federal 
Reserve's definition of Tier 1 and Tier 2 capital include hybrid 
capital instruments and certain deferred-tax assets. To be more 
consistent with both the Basel Standards and the Federal Reserve's 
definition of Tier 1 and Tier 2 capital, an ultimate holding company 
may include in allowable capital both those hybrid capital instruments 
that the Federal Reserve allows for inclusion in Tier 2 capital and 
specified deferred-tax assets, subject to certain limitations.\62\ This 
increased consistency should promote greater comparability of financial 
information among firms.
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    \62\ An ultimate holding company may include hybrid capital 
instruments and deferred-tax assets subject to the terms and 
conditions contained in 12 CFR 225, Appendix A.
---------------------------------------------------------------------------

    Paragraph (a)(1)(iii)(B) of proposed Appendix G would have 
permitted inclusion of subordinated debt in allowable capital subject 
to specified criteria intended to help assure that the subordinated 
debt provides a long-term source of working capital to the holding 
company and that it has many of the characteristics of capital. We did 
not receive comments on inclusion of subordinated debt in allowable 
capital and we adopt paragraph (a)(1)(iii)(B) of Appendix G as 
proposed.
    In the Proposing Release, the Commission solicited comment on 
whether long-term debt, subject to appropriate limitations, should be 
included in allowable capital. A number of commenters argued in favor 
of inclusion. Those commenters noted that economic considerations 
primarily determine the type of debt issued, including the term, 
structure, and cost of borrowing. Some broker-dealer affiliates of 
holding companies, consequently, have relied upon long-term debt for 
management of their capital structures.
    Other commenters suggested that long-term debt be included as 
allowable capital during a phase-out period. They suggested that a 
swift phase-out of long-term debt would be difficult. If each of the 
ultimate holding companies interested in this program simultaneously 
issued subordinated debt to replace long-term debt, these new, large 
issues could impact capital markets negatively, increasing funding 
costs.
    To maintain consistency with the Basel Standards, holding companies 
may not include long-term capital in allowable capital. We understand, 
however, that an ultimate holding company might not be able to convert 
significant amounts of long-term debt to subordinated debt quickly 
without incurring significant costs and causing market disruptions. 
Accordingly, as part of the broker-dealer's application to compute 
deductions for specified risks under Appendix E, an ultimate holding 
company may request to phase-out the inclusion of long-term debt as 
allowable capital over a period of up to three years, if the long-term 
debt meets the criteria specified in paragraph (a)(1)(iii)(C) of 
Appendix G, as adopted. We believe that the three-year phase-out period 
is appropriate based on staff experience. After three years, a broker-
dealer may submit an amendment to its application and request that the 
Commission grant the ultimate holding company up to two additional 
years to complete the phase-out of long-term debt. The Commission will 
determine if the amount of the ultimate holding company's long-term 
debt and market conditions warrant an extension.
b. The ``Aggregate'' or ``Building Block'' Approach to Calculation of 
Allowable Capital
    Some commenters suggested that the Commission permit calculation of 
allowable capital using the ``aggregate,'' or ``building block,'' 
approach, rather than a calculation on a consolidated basis. Under the 
building block approach, an ultimate holding company would have 
sufficient allowable capital if available capital exceeds the sum of 
its subsidiaries' functional regulatory capital requirements.
    In response to comments received, the broker-dealer may request in 
its initial application that the ultimate holding company be permitted 
to use the building block approach to computing allowable capital.\63\ 
The request must describe a proposed building block allowable capital 
calculation approach that is consistent with the methods described in 
the Joint Forum's July 2001 paper entitled, ``Capital Adequacy 
Principles.'' \64\ Use of these principles is appropriate because they 
outline internationally agreed-upon standards for calculating 
consolidated capital.
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    \63\ Use of the building block approach generally would increase 
capital at the holding company level.
    \64\ Capital Adequacy Principles and Supplement to Capital 
Adequacy Principles Papers, Joint Forum Compendium of Documents, 
Basel Committee on Banking Supervision (July 2001).
---------------------------------------------------------------------------

    In aggregating the capital requirements of its subsidiaries, an 
ultimate holding company would use the existing capital adequacy 
calculations prepared for each entity according to the methodology 
prescribed by its principal regulator. Unregulated entities, including 
both subsidiaries and the ultimate holding company, would be subject to 
proxy capital requirements calculated according to the Basel Standards. 
The ultimate holding company then would compare the sum of the capital 
requirements to total capital resources.
ii. Group-Wide Calculation of Allowance for Market Risk
    Paragraph (a)(2) of proposed Appendix G would have required daily 
calculation of a group-wide allowance for market risk. Commenters 
requested that the Commission no longer require an ultimate holding 
company to calculate a group-wide allowance for market risk daily 
because an ultimate holding company only must report this information 
to the Commission monthly. In response to comments received, paragraph 
(a)(2) of Appendix G, as adopted, no longer requires computation of the 
allowance for market risk on a daily basis. Rather, paragraph (c)(4) of 
Appendix G, as adopted, requires an ultimate holding company to compute 
and report its group-wide allowance for market risk monthly. 
Nevertheless, as part of the qualitative and quantitative requirements 
for the use of models, an ultimate holding company must compute VaR on 
a daily basis as part of its internal risk management system.
    We also are modifying paragraph (a)(2)(i) of Appendix G to clarify 
the method that an ultimate holding company must use to calculate 
allowances for market risk using VaR models. Under Appendix G, as 
adopted, an ultimate holding company calculates a group-wide allowance 
for market risk on all proprietary positions using a VaR model, then 
multiplies the VaR of those positions by an appropriate multiplication 
factor to provide an adequate measure of capital during periods of 
market stress. The VaR model used must meet the qualitative and 
quantitative requirements of paragraph (d) of Appendix E, as 
adopted.\65\ Likewise, the ultimate holding company must use a 
multiplication factor from

[[Page 34443]]

Table 1 of paragraph (d) of Appendix E. The use of VaR is intended to 
be generally consistent with the calculation of the deduction for 
market risk for a broker-dealer under Appendix E and with the 
calculation of allowances for market risk under the Basel Standards.
---------------------------------------------------------------------------

    \65\ See supra, discussion of the broker-dealer's calculation of 
its deduction for market risk using a VaR model under Appendix E.
---------------------------------------------------------------------------

iii. Group-Wide Calculation of Allowance for Credit Risk
    We are modifying certain requirements for calculating the allowance 
for credit risk under paragraph (a)(3) of Appendix E, as adopted. 
Paragraph (a)(3) of proposed Appendix G would have required an ultimate 
holding company to calculate an allowance for credit risk for certain 
assets on the consolidated balance sheet and certain off-balance sheet 
items under either paragraph (a)(3)(i) or paragraph (a)(3)(ii). An 
ultimate holding company would have calculated the allowance for credit 
risk under paragraph (a)(3)(i) by multiplying the credit equivalent 
amount of each asset or off-balance sheet item by the appropriate 
credit risk weight \66\ of that asset or off-balance sheet item, then 
multiplying that result by 8%.\67\ We are adopting the calculation of 
the allowance for credit risk in paragraph (a)(3)(i) of Appendix G as 
proposed, although we are revising the methods of determining the 
credit equivalent amount and credit risk weights.
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    \66\ One commenter sought clarification on determination of 
credit risk weights under paragraphs (a)(3)(i)(F) and (H). 
Specifically, the commenter asked whether credit risk weights should 
be adjusted by a maturity adjustment factor to account for the 
effective maturity of exposures. The Commission is not adopting a 
maturity adjustment factor for ultimate holding companies. An 
ultimate holding company that determines credit risk weights 
according to the New Basel Capital Accord, however, may use any 
applicable maturity adjustment factor permitted under the Accord. 
There is no maturity adjustment factor applicable to broker-dealers.
    \67\ This is derived from 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)(A)(2) of proposed Appendix G would have 
required a 5% credit conversion factor for margin loans. Several 
commenters stated that this factor was too high. According to one 
commenter, most margin loans are held in broker-dealers, where the 
application of customer margin requirements often exceed Federal 
Reserve requirements, and actual losses over many decades have been 
very small. Another commenter stated that the proposed conversion 
factor should be eliminated. A commenter also asserted that margin 
loans that are marked to market and subject to collateral calls daily 
should be considered economically equivalent to secured financing 
transactions and should be eligible for VaR-based exposure treatment.
    After considering the comments, we are not including the 5% credit 
conversion factor for margin loans contained in proposed paragraph 
(a)(3)(i)(A)(2). An ultimate holding company may apply to use the VaR-
based exposure treatment under paragraph (a)(3)(i)(B) as a ``similar 
collateralized transaction.'' For unrated counterparties, the 
Commission could determine, after a review of the description of the 
margin loans in the application of the broker-dealer, that the margin 
loans could be treated as a pool with a very low loss history. In this 
case, the ultimate holding company could use internal estimates of 
exposure at default that consider the loss history for the pool.
    Under proposed paragraph (a)(3)(i)(B), the credit equivalent amount 
of the ultimate holding company's exposure to a counterparty would have 
consisted of the ultimate holding company's current exposure to the 
counterparty and its maximum potential exposure, multiplied by the 
appropriate multiplication factor. We are adopting paragraph 
(a)(3)(i)(B) as proposed.
    We are revising the definitions of ``current exposure'' and 
``maximum potential exposure'' and adopting those revised definitions 
in paragraphs (a)(3)(i)(D) and (a)(3)(i)(E), respectively, of Appendix 
G. Paragraph (a)(3)(i)(C) of proposed Appendix G would have defined an 
ultimate holding company's current exposure to a counterparty as the 
current replacement value of a counterparty's positions, after applying 
specified netting agreements with the counterparty, taking into account 
the value of collateral from the counterparty, and subtracting the fair 
market value of any credit derivatives that specifically changed the 
exposure to the counterparty.
    Under paragraph (a)(3)(i)(D) of Appendix G, as adopted, the 
definition of current exposure does not include a provision under which 
the ultimate holding company must subtract the fair market value of any 
credit derivatives that specifically change the exposure to a 
counterparty. Subtraction of the fair market value of credit 
derivatives could have reduced the allowance for credit risk without 
consideration of the ultimate holding company's credit risk exposure to 
the credit derivative counterparty. As part of the broker-dealer's 
application to use the alternative method for computing net capital or 
in an amendment to the application, however, the ultimate holding 
company may request Commission approval to reduce allowances for credit 
risk through the use of credit derivatives.\68\ Under paragraph 
(a)(3)(i)(D) of Appendix G, as adopted, the Commission will consider 
credit risk exposure to the credit derivative counterparty in 
determining whether to approve the ultimate holding company's 
application to reduce the allowance for credit risk through the use of 
credit derivatives.
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    \68\ The credit derivative must 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, 
and (iii) is not held for market timing purposes.
---------------------------------------------------------------------------

    The Commission also is revising the definition of maximum potential 
exposure under paragraph (a)(3)(i)(E) of Appendix G, as adopted. 
Paragraph (a)(3)(i)(D) of proposed Appendix G would have defined the 
MPE 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, taking into account the value of certain collateral 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 ultimate holding company's exposure to the counterparty (as long as 
the credit derivatives are not used to change the credit risk weight of 
the counterparty) that is obtained using an approved VaR model meeting 
the applicable qualitative and quantitative requirements of paragraph 
(e) of Appendix E.\69\
---------------------------------------------------------------------------

    \69\ Under the quantitative requirements, a VaR model used to 
calculate MPE must 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 Appendix G) and equivalent to a one-
year movement in rates and prices for other positions (see paragraph 
(e)(2(ii) of 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 (d)(2)(i) of Appendix E. Based on a 
review of the firm's procedures for managing collateral and if the 
collateral is marked to market daily and the firm has the ability to 
call for additional collateral daily, the Commission may approve a 
time horizon of not less than ten business days. See paragraph 
(d)(2)(ii) of Appendix E.
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    As adopted, paragraph (a)(3)(i)(E) does not require an ultimate 
holding company to subtract the fair market value of any credit 
derivatives that change the ultimate holding company's exposure to a 
counterparty in calculating MPE. The Commission revised this language 
for the same reasons described in the section on the

[[Page 34444]]

amendments to current exposure. Furthermore, under paragraph 
(a)(3)(i)(E), as adopted, an ultimate holding company must calculate 
MPE for repurchase agreements, reverse repurchase agreements, stock 
lending and borrowing, and similar collateralized transactions using a 
time horizon of not less than five days, rather than five days, as 
proposed. This revision clarifies that the Commission intended the time 
horizon to be a minimum period instead of an absolute period.
    We note that under Appendix G, as adopted, an ultimate holding 
company may calculate MPE using a VaR model that meets the applicable 
qualitative and quantitative requirements of paragraph (d), rather than 
by using a ``notional add-on'' under the Basel Standards. We believe 
that the VaR approach is a more precise method of calculating MPE than 
using a ``notional add-on.'' Large U.S. broker-dealers and their 
affiliates with comprehensive internal risk management systems 
generally already have systems in place to calculate MPE using VaR 
models.
    The Commission also is revising the methods of determining credit 
risk weights contained in paragraph (a)(3)(i)(F) of proposed Appendix 
G. Under proposed paragraph (a)(3)(i)(F), an ultimate holding company 
would have been required to use credit risk weights published by the 
Basel Committee. Paragraph (a)(3)(i)(F) of Appendix G, as adopted, 
permits an ultimate holding company to determine credit risk weights 
based on internal calculations, including internal estimates of the 
maturity adjustment. These determinations must be consistent with the 
Basel Standards. The ultimate holding company must follow the standards 
set forth in paragraph (c)(4)(vi)(E) of Appendix E in determining 
credit risk weights based on internal calculations.
    Paragraph (a)(3)(i)(G) of proposed Appendix G would have permitted 
an ultimate holding company to determine credit ratings using internal 
calculations for counterparties that are not rated by an NRSRO. We are 
adopting paragraph (a)(3)(i)(G) of Appendix G as proposed, although we 
note that the ultimate holding company must follow the standards set 
forth in paragraph (c)(4)(vi)(D) of Appendix E in determining credit 
ratings based using internal calculations and that those determinations 
must be consistent with the Basel Standards. We are amending the 
provisions related to determination of credit risk weights and credit 
ratings applicable to the ultimate holding company to align them with 
the credit risk weight and credit risk provisions applicable to the 
broker-dealer. This alignment is intended to promote managerial and 
cost efficiencies.
    Paragraph (a)(3) of proposed Appendix G would have required an 
ultimate holding company to calculate the group-wide allowance for 
credit risk daily. Commenters suggested that daily computation of the 
group-wide allowance for credit risk was unnecessary because the 
ultimate holding company only must report this information to the 
Commission monthly. In response to comments received, paragraph (a)(3) 
of Appendix G, as adopted, no longer requires daily computation of the 
allowance for credit risk. Rather, paragraph (c)(4) of Appendix G, as 
adopted, requires an ultimate holding company to compute and report its 
group-wide allowance for credit risk monthly. Nevertheless, as part of 
the qualitative and quantitative requirements for the use of models, an 
ultimate holding company must compute current exposure daily as part of 
its internal risk management system.
    The Commission adopts the remaining provisions of paragraph (a)(3) 
of Appendix G as proposed.
iv. Group-Wide Calculation of Allowance for Operational Risk
    Proposed paragraph (a)(4) would have required the calculation of 
the allowance for operational risk to be consistent with the proposed 
New Basel Capital Accord. The Basel Committee has proposed three 
methods for calculating an allowance for operational risk: The basic 
approach, the standardized approach, and the advanced measurement 
approach. 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.
    Commenters argued that the basic and standardized approaches to 
calculating operational risk under The New Basel Capital Accord are not 
risk-based and that the advanced measurement approach is too subjective 
(because of scarce data and skewing from infrequent extreme events) to 
be used to compute an allowance for operational risk. In addition, 
another commenter asserted that the proposed capital regime should 
include a flexible framework with respect to any calculation of 
operational risk.
    We are adopting rules governing allowances for operational risk as 
proposed. It is important to account for the operational risk that the 
ultimate holding company and its affiliates may pose to the broker-
dealer. Moreover, the rules are intended to provide ultimate holding 
companies with flexibility by permitting the computation of allowances 
for operational risk in accordance with the standards published by the 
Basel Committee, as modified from time to time. We recognize, however, 
that the New Basel Capital Accord has not been adopted in its final 
form and that we may need to tailor our operational risk requirements. 
If, in finalizing the new Basel Capital Accord, the Basel Committee 
changes the operational risk computations or charges, we will review 
and consider amending our rules.
v. Trading Book Issues
    In the Proposing Release, we requested comment on the use of 
mathematical models for regulatory capital purposes. Several commenters 
stated that the use of VaR or other risk-based capital models should be 
available for all securities that meet the definition of ``trading 
book'' (including initial public offering securities and below 
investment grade securities). The trading book \70\ includes positions 
in financial instruments and commodities that are held for trading or 
for purposes of hedging other positions in the trading book, that are 
frequently valued, and that are part of a portfolio that is actively 
managed. Some securities firms believe that under this definition, a 
trading book would include funded loans and assets purchased in 
anticipation of a securitization. Commenters were concerned that 
unnecessarily high ``banking book'' \71\ capital charges might be 
imposed on positions that are marked to market daily and that a hedge 
might be treated separately from the underlying position, which could 
be unduly punitive. That is, commenters were concerned that banking 
books charges might be

[[Page 34445]]

imposed on trading book positions. According to commenters, 
categorization of trading book positions as banking book positions 
could significantly impact the firms' capital charges. In response to 
comments received, we note that in reviewing firms' proposed methods of 
calculating deductions for market and credit risk, we intend to apply 
the definitions of trading book and banking book contained in the Basel 
Standards.
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    \70\ See paragraphs 642-647 of Consultative Document to the New 
Basel Capital Accord (April 2003).
    \71\ Generally, a ``banking book'' would consist of positions 
that a firm does not mark to market or intend to sell as part of its 
business. See paragraphs 642-647 the New Basel Capital Accord.
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vi. Ultimate Holding Companies That Have Principal Regulators
    In response to comments, we are modifying the proposed rules to 
permit certain ultimate holding companies to submit to the Commission 
capital measurements created for other regulators. Ultimate holding 
companies that have principal regulators may be required to compute and 
report to their principal regulators a capital measurement similar to 
that required by paragraphs (a)(1) through (a)(4) of Appendix G. 
Paragraph (b)(2)(i)(B) of Appendix G, as adopted, allows an ultimate 
holding company that has a principal regulator to submit that capital 
measurement to the Commission on a quarterly basis. This provision 
should reduce regulatory burdens on the ultimate holding company while 
permitting the Commission to evaluate the risks that the ultimate 
holding company and its material affiliates may pose to the broker-
dealer.
vii. General Discussion of Basel Pillars
    These amendments apply a capital reporting requirement consistent 
with the Basel Standards to the ultimate holding company. 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.
    The third pillar of the current draft of the New Basel Capital 
Accord requires certain disclosures that are intended to allow market 
participants to assess key pieces of information about, for example, 
the capital, risk exposures, and risk assessment processes of the 
institution. Enhanced public disclosure practices are an integral part 
of the proposed New Basel Capital Accord. The purpose of the third 
pillar is to complement the minimum capital requirements and the 
supervisory review process by encouraging market discipline. Specific 
disclosure requirements would apply to all institutions that use the 
proposed New Basel Capital Accord and would encompass capital, credit 
risk, credit risk mitigation, securitization, market risk, operational 
risk, and interest rate risk. However, the proposed New Basel Capital 
Accord has not yet been finalized.
    We requested comment on whether U.S. broker-dealers, their holding 
companies, and affiliates should be required to make additional 
disclosures to meet the requirements of the third pillar of the 
proposed New Basel Capital Accord. Two commenters indicated that the 
Commission should not require additional, specific disclosures from 
broker-dealers and their ultimate holding companies.
    The securities industry has taken important steps to enhance public 
disclosure of material risks. For example, in June 1999, the 
Counterparty Risk Management Group (``CRMG'') (representing 12 major 
securities firms and banks) published a report on Improving 
Counterparty Risk Management Practices.\72\ In addition, a private-
sector Working Group on Public Disclosure (representing 11 major 
securities firms and banks), issued a report in January 2001.\73\ The 
group recommended enhanced and more frequent public disclosure of 
financial information by banking and securities organizations. It also 
stated that financial information should be disclosed based on a firm's 
internal methodologies and exposure categories, and that quantitative 
information on a firm's risk exposure should be balanced with 
qualitative information describing its risk management process.
---------------------------------------------------------------------------

    \72\ CRMG was formed in January 1999, after the near collapse of 
Long-Term Capital Management. The group's ultimate mission was to 
redevelop standards for strengthening risk management practices at 
banks, securities firms, and other dealers to avoid similar 
difficulties in the future. Its findings were publicly released on 
June 21, 1999, and are available at: http://financialservices.house.gov/banking/62499crm.pdf. A hearing was held 
on June 24, 1999, regarding the group's findings and 
recommendations, before the U.S. House of Representatives, 
Subcommittee on Capital Markets, Securities and Government Sponsored 
Enterprises, Committee on Banking and Financial Services. A 
transcript of the hearing, at which the CRMG chairs gave testimony, 
is available at: http://commdocs.house.gov/committees/bank/hba57791.000/hba57791_0f.htm.
    \73\ Walter V. Shipley, retired chairman of Chase Manhattan 
Bank, chaired the working group. His letter to the Board of 
Governor's of the Federal Reserve System, summarizing the group's 
findings, is available at: http://www.federalreserve.gov/boarddocs/press/general/2001/20010111/DisclosureGroupLetter.pdf (Jan. 11, 
2001).
---------------------------------------------------------------------------

    The Commission staff has taken a leading role to enhance public 
disclosure by financial intermediaries. It was a member of the 
Multidisciplinary Working Group on Enhanced Disclosure (Fisher II 
working group) that provided advice to its sponsoring organizations 
\74\ on steps that would advance the state of financial institutions' 
disclosures of financial risks to enhance the role of market 
discipline. More recently, Commission staff chaired a Joint Forum \75\ 
Working Group on Enhanced Disclosure (``Working Group''), established 
by the Basel Committee, IAIS and IOSCO, that is following up on the 
recommendations contained in the Fisher II report.\76\ The Working 
Group expects to publish its report shortly.
---------------------------------------------------------------------------

    \74\ The Basel Committee, the Committee on the Global Financial 
System of the G-10 central banks (``CGFS''), the International 
Association of Insurance Supervisors (``IAIS'') and the 
International Organisation of Securities Commissions (``IOSCO'').
    \75\ The Joint Forum was established in 1996 under the aegis of 
the Basel Committee, IOSCO, and the IAIS to address issues common to 
the banking, securities and insurance sectors.
    \76\ Final Report of the Multidisciplinary Working Group on 
Enhanced Disclosure (April 26, 2001). The report is available at: 
http://www.bis.org/publ/joint01.pdf.
---------------------------------------------------------------------------

    Some issues remain, however. For instance, broker-dealers are 
interested in finding a balance so they do not have to disclose 
sensitive proprietary information. Because the proposed New Basel 
Capital Accord has not yet been finalized, we do not believe it would 
be appropriate to adopt additional disclosure requirements as part of 
these amendments.
b. Reporting Requirements for the Ultimate Holding Company
    We are modifying the ultimate holding company reporting 
requirements contained in the Proposing Release. As a condition of 
Commission approval of a broker-dealer's use of the alternative method 
of computing net capital, paragraph (b) of proposed Appendix G would 
have required an ultimate holding company to file certain reports with 
the Commission. The Commission needs the information in the reports 
from the ultimate holding company to monitor the financial condition, 
internal risk management control system, and activities of the ultimate 
holding company. These reports will 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 ultimate

[[Page 34446]]

holding companies and could jeopardize the financial stability of 
broker-dealers using the alternative method of computing net capital. 
Moreover, requiring timely financial and other risk information that 
identifies which business line or affiliated entity may have incurred 
particular risks is necessary to identify areas for Commission 
focus.\77\
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    \77\ All reports required under paragraph (b) of Appendix G must 
be filed with the Division of Market Regulation at the Commission's 
principal office in Washington, DC.
---------------------------------------------------------------------------

    As a condition to the broker-dealer's use of the alternative method 
of computing net capital, paragraph (b)(1) of proposed Appendix G would 
have required its ultimate holding company to file a monthly report 
with the Commission within 17 business days after the end of the month 
(the FOCUS reporting period). The monthly report would have included 
certain consolidated financial and credit risk information, including a 
consolidated balance sheet and income statement (with notes to the 
financial statements), a graph for each business line reflecting the 
daily intra-month VaR calculations, and certain reports that the 
ultimate holding company regularly provides to its senior management to 
assist in monitoring and managing risk.
    As a condition to the broker-dealer's use of the alternative method 
of computing net capital, paragraph (b)(2) of proposed Appendix G would 
have required an ultimate holding company to file a quarterly report 
within 35 calendar days after the end of each quarter that included, 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. In the 
Proposing Release, we stated that requiring reports to be filed within 
35 calendar days after the end of each quarter provided a filing 
timeframe similar to those for quarterly reports due from companies 
required to file information, documents, and reports pursuant to 
section 13(a) or 15(d) of the Exchange Act.
    As a condition to the broker-dealer's use of the alternative method 
of computing net capital, paragraph (b)(3) of Appendix G would have 
required the ultimate holding company to provide to the Commission, 
upon request, other reports necessary to monitor the financial 
condition of the ultimate holding company and its affiliates to 
determine if those entities presented risks to the broker-dealer.
    As a condition to the broker-dealer's use of the alternative method 
of computing net capital, paragraph (b)(4) of proposed Appendix G would 
have required the ultimate holding company to file an annual audited 
report with the Commission. Proposed paragraph (b)(4) would have 
required the annual audited report to include consolidated financial 
statements and to be audited by a registered public accounting firm.
    As a condition to the broker-dealer's use of the alternative method 
of computing net capital, paragraph (b)(5) of proposed Appendix G would 
have required the ultimate holding company to file a supplemental 
report prepared by a registered public accounting firm, in accordance 
with agreed-upon procedures,\78\ regarding management controls. In the 
Proposing Release, we stated that by performing an independent review 
of the firm's financial condition and risk management practices, 
auditors would have an important role in the Commission's regulatory 
framework by helping to assure that the broker-dealer and the ultimate 
holding company complied with the conditions of the exemption.
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    \78\ Paragraph (b)(5)(iii) of proposed Appendix G would have 
required the ultimate holding company to file with the Commission's 
principal office in Washington, DC, and the regional office of the 
Commission for the region in which its subsidiary broker-dealer that 
uses the alternative method of computing net capital has its 
principal place of business, the agreed-upon procedures agreed to by 
the ultimate holding company and the accountant. Moreover, before 
the commencement of each subsequent review, the ultimate holding 
company would have been required to notify the Commission of any 
change in procedures.
---------------------------------------------------------------------------

    We requested comment in the Proposing Release concerning the 
reporting requirements for ultimate holding companies. Several 
commenters stated that the Commission should require fewer reports from 
an entity that has a consolidated regulator. In addition, one commenter 
stated that ``notes to the financial statements'' should consist of 
significant highlights of the financial statements.
    A commenter also stated that the requirement for the quarter-end 
coinciding with a firm's fiscal year end be amended to align with the 
dates by which public companies are required to submit their annual 
report on Form 10-K. Another commenter stated that the 17- and 35-day 
requirements were too aggressive because the proposed reports will 
require detailed risk and capital information that typically is not 
readily available and takes greater time to produce. The commenter 
asserted that the rules should conform the content and timing of 
reporting requirements applicable to other Commission public reporting 
requirements. A commenter argued that footnotes to the financial 
statements should only be required with quarterly reports.
    In response to comments received, we are amending the ultimate 
holding company reporting requirements. Paragraph (b) of Appendix G, as 
adopted, separates reporting requirements applicable to ultimate 
holding companies that do not have principal regulators into paragraph 
(b)(1) and those applicable to ultimate holding companies that have 
principal regulators into paragraph (b)(2). In light of the supervision 
that their principal regulators provide, ultimate holding companies 
that have principal regulators are subject to fewer reporting 
requirements than those that do not have principal regulators.
    In response to comments received, we have extended the ultimate 
holding company's deadline for filing monthly reports under paragraph 
(b)(1)(i) to 30 calendar days after month-end from 17 business days 
after month-end.\79\ We agree that an extension of the filing deadline 
is appropriate because an ultimate holding company must include 
detailed information, potentially from a number of affiliates, in these 
reports. The extension, moreover, does not delay significantly the time 
at which the Commission will receive the reports and, therefore, should 
provide the Commission with timely and accurate information about risks 
that the ultimate holding company and its affiliates may pose to the 
broker-dealer. Furthermore, under paragraph (b)(1)(i), a monthly report 
need not be filed for a month-end that coincides with a fiscal quarter-
end because the quarterly report required to be filed under (b)(1)(ii) 
would include the information that otherwise would be contained in the 
monthly report.
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    \79\ Only ultimate holding companies that are not ultimate 
holding companies that have principal regulators must file monthly 
reports.
---------------------------------------------------------------------------

    As a condition to the broker-dealer's use of the alternative method 
of computing net capital, paragraph (b)(1)(i) also requires an ultimate 
holding company that does not have a principal regulator to include 
footnotes to the financial statement. In response to comments received, 
we are clarifying this requirement. Although we prefer that ultimate 
holding companies submit quarterly consolidated financials statements 
that include GAAP footnotes, we understand that the GAAP footnotes

[[Page 34447]]

are not always available. Firms therefore must supply financial 
statements that include footnote explanations either in accordance with 
GAAP, when available, or as necessary for a complete understanding of 
the financial statements.
    We have revised paragraph (b)(1)(ii) of Appendix G, as adopted. 
Paragraph (b)(1)(ii) clarifies that the quarterly reports must contain 
all of the information included in the monthly reports, as well as 
consolidating balance sheets and income statements and other specified 
information. We have not extended the deadline for filing the quarterly 
reports, however. The information that the ultimate holding company 
includes in the quarterly report must be as recent as practicable to 
allow the Commission to evaluate potential risks that the ultimate 
holding company and its affiliates may pose to the broker-dealer. Any 
extension of the deadline creates the risk that the Commission will 
receive information that is stale and, therefore, does not reflect 
accurately the risks to the broker-dealer. Furthermore, the deadline 
for submission of the quarterly reports already is five days longer 
than the deadline for submission of monthly reports.
    Paragraphs (b)(1)(i) and (ii) of Appendix G, as adopted, allow an 
ultimate holding company that does not have a principal regulator to 
delay filing certain information that generally must be included in its 
monthly and quarterly reports under specified circumstances. Under 
paragraph (b)(1)(i), an ultimate holding company is not required to 
include consolidated balance sheets and income statements with the 
monthly report due during the first month of the fiscal year. The 
ultimate holding company may file this information at a later time to 
which the ultimate holding company and the Commission agree. Ultimate 
holding companies may delay submitting this information to the 
Commission because the information has not yet been made public in the 
ultimate holding company's annual report on Form 10-K. Likewise, under 
paragraph (b)(1)(ii), the consolidated and consolidating balance sheets 
and income statements need not be included in quarterly reports filed 
for the last quarter of the fiscal year. The consolidating balance 
sheets and income statements that otherwise would have been included in 
the quarterly report shall be filed simultaneously with the annual 
report, but need not be audited.\80\ These provisions allow ultimate 
holding companies that are publicly traded to coordinate their filings 
of financial information with other reports that they submit to the 
Commission.
---------------------------------------------------------------------------

    \80\ Audited consolidated balance sheets and income statements 
will be included in the annual audited report.
---------------------------------------------------------------------------

    Paragraph (b)(2) of Appendix G, as adopted, contains the reporting 
requirements that an ultimate holding company that has a principal 
regulator must comply with as a condition to the broker-dealer's use of 
the alternative method of computing net capital. Paragraph (b)(2) 
requires the ultimate holding company to file a quarterly report that 
contains consolidated and consolidating balance sheets and income 
statements for the ultimate holding company; its most recent capital 
measurements under the Basel Standards, as reported to its principal 
regulator; and certain risk reports, as the Commission may request, 
provided to persons responsible for managing group-wide risk. The 
ultimate holding company also must provide an annual audited report as 
of the end of its fiscal year when required to be filed with any 
regulator. These requirements permit the Commission to review the 
financial and operational risk of the ultimate holding company and its 
affiliates to assess the risk that those entities may pose to the 
broker-dealer. The reporting requirements, however, should help to 
avoid duplicative or inconsistent requirements because the ultimate 
holding company already may provide the information in the quarterly 
and annual reports to its regulators.
    As discussed, proposed paragraph (b)(3) of Appendix G would have 
required the ultimate holding company, as a condition of its broker-
dealer's exemption from the standard net capital rule, to provide to 
the Commission, upon request, other reports necessary to monitor the 
financial condition of the ultimate holding company and its affiliates. 
We are eliminating this provision because the undertaking contained in 
Appendix E already imposes that same requirement on ultimate holding 
companies.
    Paragraph (b)(6) of proposed Appendix G would have required an 
ultimate holding company, as a condition to the broker-dealer's ability 
use of the alternative method of computing net capital under Appendix 
E, to file reports required under paragraph (b)(1) and (b)(2) of this 
Appendix with the Commission at its offices in Washington, DC. We are 
modifying proposed paragraph (b)(6) and redesignating it as paragraph 
(b)(3). Paragraph (b)(3) of Appendix G, as adopted, retains the filing 
requirements of proposed paragraph (b)(6). It also advises ultimate 
holding companies seeking confidential treatment of reports filed under 
paragraph (b) of Appendix G to mark each page or segregable portion of 
each page with the words ``Confidential Treatment Requested.''
    Paragraph (b)(4) of proposed Appendix G has been redesignated as 
paragraph (b)(1)(iii)(A) under Appendix G, as adopted. Paragraph (b)(5) 
of proposed Appendix G has been redesignated as paragraph (b)(4) of 
Appendix G, as adopted. This provision states that the Commission will 
accord confidential treatment, to the extent permitted by law, to the 
reports that ultimate holding companies file with the Commission under 
Appendix G.
c. Records To Be Made and Preserved by the Ultimate Holding Company
    We are modifying the provisions of Appendix G related to the 
records that an ultimate holding company must make as a condition to a 
broker-dealer's use of the alternative method of computing net capital. 
We are revising paragraph (c) to limit its application to ultimate 
holding companies that do not have principal regulators. We amended 
this requirement to avoid imposing inconsistent or duplicative 
requirements on ultimate holding companies that have principal 
regulators. Commenters informed us that these regulators already impose 
recordkeeping requirements on the ultimate holding companies.
    We are adding a requirement, however, that an ultimate holding 
company that does not have a principal regulator make a record of the 
calculations of allowable capital and allowances for market, credit, 
and operational risk computed on at least a monthly, consolidated 
basis. We are adopting the remaining provisions of paragraph (c) as 
proposed.
    We require creation of these records to assist the Commission in 
determining whether the ultimate holding company is complying with the 
terms of the broker-dealer's exemption from the standard net capital 
rule. 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 will accept the records in the 
format used by the ultimate holding companies. The records must show 
that the ultimate holding company has conducted stress tests of the 
affiliate

[[Page 34448]]

group's funding and liquidity in response to certain events, including 
a credit downgrade of the ultimate holding company or an inability of 
the ultimate holding company to obtain unsecured, short-term financing; 
the results of those stress tests; a record showing that the ultimate 
holding company has a contingency plan to respond to those events; and 
a record of the basis for determining credit risk weights in certain 
circumstances. The tests are intended to identify possible liquidity 
and funding stress scenarios that could impose significant financial 
distress on the ultimate holding company that, in turn, could 
jeopardize the financial stability of the broker-dealer.
    We also are revising paragraph (d) of proposed Appendix G. Proposed 
paragraph (d) would have required an ultimate holding company to 
maintain, for a period of not less than three years, the records it 
would have been required to make under paragraph (c)(1) of Appendix G; 
applications, reports, notices and other documents filed with the 
Commission under Appendices E or G; and written policies and procedures 
concerning its internal risk management system.
    Paragraph (d)(1)(iv) of Appendix G, as adopted, only requires an 
ultimate holding company that does not have a principal regulator to 
maintain records of all written policies and procedures concerning the 
group-wide internal risk management control system established under 
paragraph (a)(1)(viii)(C) of Appendix E, as adopted. The Commission 
narrowed the scope of this provision to avoid duplicative or 
inconsistent requirements. The remaining provisions of paragraph (d) of 
Appendix G are adopted as proposed. The requirement to preserve records 
for three years is based on the retention periods in Exchange Act Rule 
17a-4 and we believe that this same period of time is sufficient to 
meet the Commission's supervisory needs.
d. Notification Requirements for the Ultimate Holding Company
    The Commission is revising paragraph (e) of proposed Appendix G. 
Proposed paragraph (e) would have conditioned the broker-dealer's use 
of the alternative method of computing net capital on the ultimate 
holding company's consent to specified notice provisions. Under 
proposed paragraphs (e)(1) and (2), an ultimate holding company would 
have agreed to notify the Commission promptly upon the occurrence of 
certain events, including the occurrence of any backtesting exception 
of VaR models that would require the ultimate holding company to use a 
higher multiplication factor; a computation showing the affiliate 
group's allowable capital was 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 of certain debt of an affiliate; or the receipt of certain 
regulatory notices regarding an affiliate. The ultimate holding company 
would have filed a notification if there were 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.
    Paragraph (e) of Appendix G, as adopted, modifies the notification 
requirements applicable to ultimate holding companies. Under the final 
rules, certain notification provisions apply to both types of ultimate 
holding companies and some apply only to ultimate holdings companies 
that do not have principal regulators. As a condition to a broker-
dealer's use of the alternative method of computing net capital, an 
ultimate holding company, regardless of whether it has a principal 
regulator, must notify the Commission promptly (within 24 hours) under 
paragraphs (e)(1)(i) through (iii) if certain early warning indicators 
of low capital occur; \81\ it files a Form 8-K with the Commission; or 
a material affiliate declares bankruptcy or otherwise becomes 
insolvent.
---------------------------------------------------------------------------

    \81\ The Commission and the ultimate holding company will 
determine what the appropriate indicators of low capital are as part 
of the application process.
---------------------------------------------------------------------------

    In addition to the notification requirements contained in paragraph 
(e)(1), an ultimate holding company that does not have a principal 
regulator also must notify the Commission under paragraphs (e)(2)(i) 
through (iii), as a condition to the broker-dealer's net capital 
exemption, if an NRSRO materially reduces its assessment of the 
creditworthiness of a material affiliate or of the credit rating(s) 
assigned to one or more outstanding short or long-term obligation of a 
material affiliate; a financial regulator or self-regulatory 
organization takes significant enforcement or regulatory action against 
a material affiliate; or any backtesting exception occurs under section 
240.15c-1e(d)(1)(iii) or (iv) that would increase the ultimate holding 
company's multiplication factor in calculating its allowances for 
market or credit risk.
    These notification provisions are designed to give the Commission 
advance warning of situations that may pose material financial and 
operational risks to the ultimate holding company and the broker-dealer 
and are integral to Commission supervision of broker-dealers that use 
Appendix E. The reduced requirements applicable to an ultimate holding 
company that has a principal regulator, as set forth in paragraph 
(e)(1), are necessary to avoid imposing duplicative or inconsistent 
requirements.

E. Amendments to Rule 15c3-4

    The Commission proposed to amend Rule 15c3-4. Rule 15c3-4 requires 
an OTC derivatives dealer to establish, document, and maintain a system 
of internal risk management controls that consider specified factors 
and are subject to periodic review by management. Under the Proposing 
Release, the Commission would have amended Rule 15c3-4 to apply to 
broker-dealers that use the alternative method of computing net capital 
under Appendix E and to affiliated ultimate holding companies.
    The Commission is not amending Rule 15c3-4. Instead, under 
paragraph (a)(7)(iii) of Rule 15c3-1, as adopted, a broker-dealer that 
uses the alternative method of computing net capital must comply with 
Rule 15c3-4 with respect to all of its business activities as if it 
were an OTC derivatives dealer, subject to certain limitations.\82\ 
Similarly, under paragraph (a)(1)(viii)(C) of Appendix E, as adopted, 
as a condition to its broker-dealer's use of the alternative method of 
computing net capital, an ultimate holding company that does not have a 
principal regulator must comply with Rule 15c3-4 with respect to all of 
its business activities as if were an OTC derivatives dealer, subject 
to certain limitations.\83\ Paragraphs (a)(7)(iii) of Rule 15c3-1 and 
(a)(1)(viii)(C) of Appendix E require the broker-dealer or ultimate 
holding company to comply with Rule 15c3-4 with respect to all business 
activities. That is, compliance with Rule 15c3-4 is not limited to OTC 
derivatives transactions.\84\ The Commission is not amending Rule 15c3-
4 because we determined that we could accomplish our goal--compliance 
with the rule--in a more streamlined manner by requiring compliance 
with

[[Page 34449]]

the rule, rather than by amending the rule.
---------------------------------------------------------------------------

    \82\ Paragraphs (c)(5)(xiii), (c)(5)(xiv), (d)(8), and (d)(9) 
would not apply to a broker-dealer that uses the alternative method 
of computing net capital or to ultimate holding companies that do 
not have a principal regulator because those paragraphs relate 
solely to limitations on the types of transactions an OTC 
derivatives dealer may undertake.
    \83\ See footnote 82.
    \84\ See 17 CFR 240.15c3-4(c)(5)(x), (c)(5)(xi), (d)(1), (d)(5), 
and (d)(10).
---------------------------------------------------------------------------

    Participants in the securities markets are exposed to various 
risks, including market, credit, funding, legal, and operational risk. 
These risks result, in part, from the diverse range of financial 
instruments that broker-dealers now trade. Risk management controls 
within a broker-dealer promote the stability of the firm and, 
consequently, the stability of the marketplace. A firm that adopts 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. Furthermore, as a prudent business practice, large securities 
firms have developed risk management systems to manage risk on a 
consolidated basis at the ultimate holding company level. To understand 
how risks are managed at the broker-dealer, regulators must understand 
how risks are managed at the ultimate holding company.

F. Amendment to Rule 17a-4, Broker-Dealer Record Preservation 
Requirements

    We are amending Rule 17a-4 to add paragraph (b)(12). This amendment 
requires a broker-dealer that uses the alternative method of computing 
net capital to preserve certain records required to be made under the 
final rules. Paragraph (d)(7)(iv) of proposed Appendix E would have 
required a broker-dealer to make and preserve a record related to its 
determination of credit ratings. We amended proposed paragraph 
(d)(7)(iv) and redesignated it as paragraph (c)(4)(vi)(D) of Appendix 
E, as adopted. Paragraph (c)(4)(vi)(D) requires a broker-dealer to keep 
a record related to the determination of credit ratings, but the 
preservation requirement for that record has been moved to Rule 17a-
4(b)(12). The final rules also add paragraph (c)(4)(vi)(E) to Appendix 
E. Paragraph (c)(4)(vi)(E) is a new provision that permits a broker-
dealer to determine credit risk weights based on internal calculations 
and requires the broker-dealer to make a record of this calculation to 
assist the Commission in monitoring financial and other risks to the 
broker-dealer. Rule 17a-4(b)(12) requires a broker-dealer to preserve 
the record of the calculation of credit risk weights. We placed the 
record preservation requirements for paragraphs (c)(4)(vi)(D) and (E) 
in Rule 17a-4(b)(12) because Rule 17a-4 is the broker-dealer record 
retention rule.

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

    The Commission is adopting amendments to Rule 17a-5 as proposed, 
except as described below. The amendments to Exchange Act Rule 17a-5 
require a broker-dealer that uses the alternative method of computing 
net capital to file certain reports with the Commission in addition to 
the reports that all broker-dealers must file under the rule. These 
reports provide current, detailed information regarding the financial 
position of the firm, which will assist us in understanding its risk 
profile. The Commission will use the information collected under the 
amendment to monitor the financial condition, internal risk management 
control system, and activities of a broker-dealer that elects the 
alternative method.
    These additional reports include a monthly report detailing, among 
other things, the broker-dealer's derivatives revenues, certain market 
and credit risk information, and regular risk reports supplied to firm 
management, as well as quarterly reports on, among other things, how 
well the firm's daily VaR and maximum potential exposure calculations 
correspond to the daily net trading loss and backtesting results of 
mathematical models. As part of its annual audit, the broker-dealer 
also must include a supplemental report concerning management controls 
prepared by a registered public accounting firm in accordance with 
procedures agreed-upon by the broker-dealer and the accountant before 
the audit.\85\
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    \85\ The broker-dealer must file a description of the agreed-
upon procedures agreed to by the broker-dealer and the accountant 
and a notification of subsequent changes in those agreed-upon 
procedures, if any, with the Commission's principal office in 
Washington, DC.
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    Under paragraphs (a)(5)(i)(E)(2) and (4) of paragraph 17a-5, as 
revised and adopted, the broker-dealer no longer must report the five 
largest exposures to financial institutions for current exposure and 
maximum potential exposure. We have re-evaluated this requirement and 
believe that receipt of these reports on a monthly basis is not likely 
to aid the Commission in evaluating a broker-dealer's risk exposure. 
The remaining amendments to Rule 17a-5 are adopted as proposed.

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

    We are revising the proposed amendments to Rule 17a-11. Exchange 
Act Rule 17a-11 requires a broker-dealer to notify the Commission and 
its designated examining authority of certain events within specified 
time periods. The occurrence of the events that require Commission 
notification indicate that the firm may be experiencing financial or 
operational difficulty.
    The amendments to Rule 17a-11, as proposed, would have imposed 
additional notification requirements on broker-dealers that use the 
alternative method of computing net capital. Under these amendments, 
the broker-dealer would have notified the Commission if it became aware 
of certain credit rating downgrades relating to the broker-dealer or an 
affiliate of the broker-dealer; it received a notice of non-compliance 
from a regulatory authority; it became aware of a situation that may 
have had a material adverse effect on the ultimate holding company or 
on an affiliate of the holding company; or a backtesting exception of 
its mathematical models occurred that required the broker-dealer to use 
a higher multiplication factor in the calculation of its deductions for 
market or credit risk.
    The revisions to Rule 17a-11, as adopted, amend only paragraphs 
(b)(2) and (h). Paragraph (b)(2) of Rule 17a-11, as adopted, requires a 
broker-dealer that computes its net capital under the alternative 
method of Appendix E to notify the Commission if its tentative net 
capital falls below the amount specified in Rule 15c3-1, which is $1 
billion under Rule 15c3-1e(a)(7)(i). The notice must specify the 
broker-dealer's net capital and tentative net capital requirements and 
the current amount of its net capital and tentative net capital. We 
eliminated the other proposed amendments to Rule 17a-11 because they 
were redundant. Those proposed amendments would have required a broker-
dealer to provide information to the Commission that its ultimate 
holding company must provide as a condition to the broker-dealer's use 
of the alternative method of computing net capital.
    Paragraph (h), as adopted, notes that there is a notification 
provision in paragraph (a)(7)(ii) of Rule 15c3-1. That provision 
requires a broker-dealer to notify the Commission that same day if its 
tentative net capital falls below $5 billion. These notification 
provisions are necessary for the Commission to monitor the financial 
position of a broker-dealer that uses the alternative method of 
computing net capital.

I. Amendments to Rules 17h-1T and 17h-2T

    The Commission is amending Rules 17h-1T and 17h-2T. Rule 17h-1T 
requires a broker-dealer to maintain and

[[Page 34450]]

preserve records and other information concerning its ultimate 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 the 
information required to be maintained and preserved under Rule 17h-1T. 
Under the proposed amendments, all broker-dealers using the alternative 
method of computing net capital would have been exempt from Rules 17h-
1T and 17h-2T. The amendments to these rules, as adopted, exempt only 
broker-dealers that use the alternative method of computing net capital 
and are affiliated with ultimate holding companies that do not have 
principal regulators. This exemption is appropriate because an ultimate 
holding company that does not have a principal regulator 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. Under 
the rules as adopted, an ultimate holding company that has a principal 
regulator is not required to make and maintain these documents and, 
therefore, exemptions from Rules 17h-1T and 17h-2T are not appropriate.

J. Amendments to Section 240.19 and Rule 30-3

    We have amended Sec.  200.19a to expand the responsibilities of the 
Director of Division of Market Regulation to include administering the 
Commission's rules related to supervised investment bank holding 
companies and consolidated supervised entities, including the 
assessment of the internal risk management controls and mathematical 
models used to calculate net capital and allowances for market, credit, 
and operational risk.
    The Commission also has adopted amendments to Rule 30-3 of its 
Rules of Organization and Program Management.\86\ Through this rule, 
the Commission delegates authority to the Director of the Division of 
Market Regulation (``Director''). The amendments delegate the authority 
to the Director to: (i) Review amendments to applications of broker-
dealers filed pursuant to Appendix E and Appendix G and to approve the 
amendments, unconditionally or subject to specified terms and 
conditions; (ii) grant extensions and exemptions from the notification 
requirements of paragraph (e) of Appendix G, unconditionally or subject 
to specified terms and conditions; (iii) impose additional conditions, 
pursuant to paragraph (e) of Appendix E, on a broker-dealer or on the 
ultimate holding company of a broker-dealer; (iv) require that a broker 
or dealer or the ultimate holding company of a broker or dealer provide 
information to the Commission pursuant to paragraphs (a)(1)(viii)(G), 
(a)(1)(ix)(C), and (a)(4) of Appendix E and paragraphs (b)(1)(i)(H) and 
(b)(2)(i)(C) of Appendix G; and (v) determine, pursuant to paragraph 
(a)(10)(ii) of Appendix E, that the notice that a broker-dealer 
provides to the Commission will become effective for a shorter or 
longer period of time.
---------------------------------------------------------------------------

    \86\ 17 CFR 200.30-3.
---------------------------------------------------------------------------

    The Commission is delegating its authority to the Director for the 
limited purposes described above. These delegations of authority are 
intended to conserve Commission resources. The Commission anticipates 
that the delegation of authority will facilitate the implementation of 
the rule amendments. The staff, however, may submit matters to the 
Commission for consideration as it deems appropriate.\87\
---------------------------------------------------------------------------

    \87\ 17 CFR 200.30-3(e) and 200.30-3(g).
---------------------------------------------------------------------------

    The Commission finds, in accordance with the Administrative 
Procedure Act, 5 U.S.C. 553(b)(3)(A), that these amendments to Rule 30-
3 relate solely to agency organization, procedure, or practice. 
Accordingly, notice and opportunity for public comment, as well as 
publication 30 days before their effective date, are unnecessary.

IV. Paperwork Reduction Act

    As discussed in the Proposing Release, certain provisions of the 
rule amendments contain ``collection of information'' requirements 
within the meaning of the Paperwork Reduction Act of 1995.\88\ The 
Commission submitted them to the Office of Management and Budget 
(``OMB'') for review in accordance with 44 U.S.C. 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 OMB approved the information 
collections. The titles and OMB control numbers for the collections of 
information are: (1) Net capital requirements for brokers or dealers, 
OMB No. 3235-0200; (2) Rule 15c3-4, Internal risk management control 
systems for certain brokers or dealers, OMB No. 3235-0497; (3) Rule 
17a-5, Reports to be made by certain brokers and dealers, OMB No. 3235-
0123; (4) Rule 17a-11, Notification procedures for brokers and dealers, 
OMB No. 3235-0085; (5) Rule 17h-1T, Risk assessment recordkeeping 
requirements for associated persons of brokers and dealers, OMB No. 
3235-0410; and (6) Rule 17h-2T, Risk assessment reporting requirements 
for brokers and dealers, OMB No. 3235-0410.
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    \88\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    The rule amendments provide a voluntary alternative method for 
computing certain deductions from net capital for market and credit 
risk under the Exchange Act for certain broker-dealers that are part of 
an ultimate 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. The alternative net 
capital computation involves the use of internally developed 
mathematical models that the firm uses to measure risk.
    As noted in the Proposing Release, the collection of information 
obligations imposed by the rule amendments is mandatory. However, 
applying for approval to use the alternative capital calculation is 
voluntary. The information collected, retained, and/or filed pursuant 
to the rule amendments will be accorded confidential treatment to the 
extent permitted by law.
    The Commission will use the information collected under the rule 
amendments to monitor the financial condition, internal risk management 
control system, and activities of broker-dealers that elect to use the 
alternative method of computing net capital and their ultimate holding 
companies and affiliates. In particular, the amendments 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. Failure to require the 
collections of information included in the rule amendments would 
undermine the Commission's ability to monitor the financial condition 
of these firms and could jeopardize the financial stability of broker-
dealers using the alternative method of computing net capital.
    The Proposing Release solicited comments on the proposed 
collections of information. We received no comments that addressed the 
PRA submission. However, we did receive comments on other aspects of 
the proposed amendments. The Commission is adopting rule amendments 
that contain various modifications to the proposed amendments. As 
discussed below, some of those modifications, as well as comments 
received on other aspects of

[[Page 34451]]

the proposed amendments result in changes to the PRA estimates.
    Under proposed paragraph (a)(7) of Rule 15c3-1, a broker-dealer 
that maintained tentative net capital of at least $1 billion and net 
capital of at least $500 million could apply to the Commission for 
permission to use the alternative method of calculating net capital. 
Under paragraph (a)(7) as adopted, a broker-dealer is also required to 
notify the Commission if its tentative net capital falls below $5 
billion. If a broker-dealer is required to provide that notice to the 
Commission, the Commission may impose additional regulatory conditions, 
as set forth in paragraph (e) of Appendix E, on either the broker-
dealer or, if the ultimate holding company of the broker-dealer is not 
an ultimate holding company that has a principal regulator, on the 
ultimate holding company. The PRA burden associated with this 
notification requirement is included in the PRA burden for Rule 17a-11, 
which is discussed below.
    We noted in the Proposing Release that, 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, 
we believed that only broker-dealers with at least $1 billion in 
deductions pursuant to Rule 15c3-1(c)(2)(vi) (also known as 
``haircuts'') would 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 were based on 
the assumption that 12 broker-dealers would apply to use the 
alternative net capital computation.
    According to September 30, 2003 FOCUS filings, only six registered 
broker-dealers reported that they had tentative net capital of at least 
$5 billion. Some firms, however, make certain deductions in arriving at 
the FOCUS tentative net capital figure (for example, relating to 
securities without a ready market) that would not be subtracted in the 
calculation of tentative net capital for purposes of the rule 
amendments. Based on the final rule amendments, the comments received 
in response to the proposal, and these facts, we now estimate that 11 
broker-dealers will apply to use the alternative net capital 
computation.
    In addition, based on comments received, the Commission has 
modified the proposed rules to establish exemptions from certain 
requirements for an ultimate holding company of a broker-dealer using 
the alternative method of computing net capital that is ``an ultimate 
holding company that has a principal regulator.'' These exemptions are 
intended to avoid duplicative or inconsistent regulation of these 
entities. Of the 11 broker-dealers that we now estimate will apply 
under the rule amendments, we estimate that six have an ultimate 
holding company that has a principal regulator. The streamlined 
supervisory regime for these financial holding companies affects 
application requirements, internal risk management control system 
requirements, and examination and reporting requirements, and generally 
results in lower PRA burden estimates.
    The estimates are based on information from a variety of sources, 
including information that 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.
    Some of the changes in our estimates result from use of certain 
updated data. The revised PRA burden estimates are discussed below for 
each rule amendment.

A. Rule 15c3-1. Net Capital Requirements for 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 has added Appendix E to the rule to provide an 
alternative method for determining certain deductions from net capital 
for market and credit risk for certain broker-dealers that manage risk 
on a group-wide basis and that submit to group-wide Commission 
supervision.
    As part of the application to use Appendix E, the broker-dealer and 
its ultimate holding company must submit various documents to the 
Commission. The documents the broker-dealer must submit as part of the 
application are the same regardless of whether the ultimate holding 
company of the broker-dealer is an ultimate holding company that has a 
principal regulator, except that the scope of the written undertaking 
of the ultimate holding company is reduced if the ultimate holding 
company has a principal regulator. If the ultimate holding company has 
a principal regulator, however, the ultimate holding company is 
required to submit fewer documents with the application of the broker-
dealer than an ultimate holding company that does not have a principal 
regulator. For example, an ultimate holding company that has a 
principal regulator will not be required to submit a description of the 
risk management control system for the affiliate group and will not be 
required to submit sample capital measurement calculations and 
descriptions of those calculations. An ultimate holding company that 
has a principal regulator will be required to submit a capital 
measurement that it has reported to its principal regulator.
    In the Proposing Release, we estimated that each broker-dealer that 
applied under the rule amendments 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 included approximately 100 hours for an in-
house attorney to complete a review of the application. We received no 
comments on these estimates and we believe that whether or not the 
ultimate holding company of a broker-dealer has a principal regulator, 
the PRA burden associated with the application process still will be 
approximately 1,000 hours because the documents to be submitted by the 
broker-dealer are substantially the same in either case. As we now 
estimate that approximately 11 firms will apply under the rule 
amendments, instead of the 12 firm-estimate we used in the Proposing 
Release, the new one-time PRA burden associated with the application 
process is approximately 11,000 hours.
    As we noted in the Proposing Release, firms we expect to apply to 
use Appendix E already have developed the VaR models that they will use 
to calculate market and credit risk under these rules and already have 
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 rule 
amendments contain additional requirements that firms may not yet have 
incorporated into their models and control systems.
    In the Proposing Release, we estimated that a broker-dealer using 
Appendix E would spend approximately 5,600 hours per year to

[[Page 34452]]

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. We believe that whether or not the 
ultimate holding company of a broker-dealer has a principal regulator, 
the PRA burden would be the same. Consequently, we estimate that the 
total burden under the rule amendments for reviewing and backtesting 
mathematical models for the 11 broker-dealers we now expect to apply 
will be approximately 69,000 hours per year ((5,600 + 640) x 11 = 
68,640).
    Under proposed Appendix G to Rule 15c3-1, the ultimate holding 
company of a broker-dealer using the alternative method of computing 
net capital was 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. As we noted in the Proposing 
Release, capital measurement, reporting, and recordkeeping conditions 
are necessary to allow the Commission to oversee properly a broker-
dealer that uses Appendix E and to monitor the financial and 
operational condition of its affiliate group. In particular, the 
reporting requirements of 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 ultimate holding company and affiliates of 
the broker-dealer and whether the holding company is in compliance with 
the conditions of the broker-dealer's exemption. These reports will 
help the Commission to anticipate the effect on the ultimate holding 
company and affiliates of the broker-dealer of significant economic 
events and their impact on the broker-dealer.
    The Commission has modified the capital measurement and reporting 
conditions in the final rule amendments for an ultimate holding company 
of a broker-dealer using the alternative method of computing net 
capital that has a principal regulator. For such an ultimate holding 
company, there is no requirement to calculate allowable capital and 
allowances for market, credit, and operational risk monthly. Also, the 
ultimate holding company is not required to file monthly reports with 
the Commission. An ultimate holding company that has a principal 
regulator must file quarterly reports containing consolidated and 
consolidating financial statements, a capital measurement it provides 
to its principal regulator, and certain regular risk reports provided 
to the persons responsible for managing group-wide risk as the 
Commission may request. The holding company also must file an annual 
report consisting of audited consolidating and consolidated financial 
statements and a report of the holding company's capital measurement, 
as provided to its principal regulator.
    In addition, the Commission has modified the reporting requirements 
in the final rule amendments for an ultimate holding company that does 
not have a principal regulator. The deadlines for the submission of the 
monthly and annual reports have been extended and certain financial 
information does not have to be filed with the monthly or quarterly 
reports if the information has not yet been made public in the ultimate 
holding company's annual report on Form 10-K. These changes should not 
materially affect the PRA burden estimates for the ultimate holding 
company that does not have a principal regulator.
    In the Proposing Release, based on Commission experience and 
discussions with industry participants, we estimated that the 
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. In addition, we estimated that it 
would require approximately 5,600 hours per year to review and update 
the mathematical models that the ultimate holding company uses to make 
these calculations. Finally, we estimated that it would require 
approximately 160 hours each quarter, or approximately 640 hours each 
year, to backtest the models.
    The models used by the broker-dealer and the ultimate holding 
company to calculate risk on similar classes of products will generally 
be the same models. However, we expect that the ultimate holding 
company will use models in its risk calculations for additional 
products. These additional products could include, for example, loans 
and loan commitments, structured financial products, or various types 
of derivatives business not conducted in the broker-dealer.
    For the five ultimate holding companies that do not have a 
principal regulator whose broker-dealers we expect to apply to operate 
under the rule amendments, our burden estimate for each ultimate 
holding company to comply with the capital measurement and mathematical 
model review, updating, and backtesting requirements of the rule 
amendments has not changed. Thus, the total burden on these five 
ultimate holding companies is approximately 37,000 hours per year 
((5,600 + 640 + 1,080) x 5 = 36,600).
    The rule amendments do not require an ultimate holding company that 
has a principal regulator to compute allowable capital or allowances 
for market, credit, and operational risk or to review, update, and 
backtest its mathematical models. As a result, we conclude that there 
is no PRA burden on these ultimate holding companies as a result of the 
capital measurement requirements of the rule amendments. The ultimate 
holding company must provide its principal regulator with a capital 
measurement, and must review, update, and backtest the mathematical 
models it uses to derive that measurement.
    In the Proposing Release, we estimated 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. These estimates were described in the 
Proposing Release and elicited no comments. For each of the five 
broker-dealer ultimate holding companies that do not have principal 
regulators, our PRA burden estimate for preparing and filing the 
reports required under the rule amendments is unchanged. Therefore, for 
these holding companies, the PRA burden is approximately 1,800 hours 
per year ((96 + 64 + 200) x 5 = 1,800).
    For ultimate holding companies that have a principal regulator, the 
ultimate holding company will be required only to send to the 
Commission reports it has prepared for other purposes. No monthly 
reports are required under the rule amendments, and the quarterly and 
annual reports consist of reports the ultimate holding company has 
provided to persons in the ultimate holding company responsible for 
managing risk or reports the ultimate holding company provides to its 
principal regulator. Therefore, we expect that the PRA burden for an 
ultimate holding company with a principal regulator as a result of the 
reporting requirements under the amendments will be approximately 40 
hours per year. For the six ultimate holding companies that have a 
principal

[[Page 34453]]

regulator, the total burden will therefore be approximately 240 hours 
per year.
    In the Proposing Release, we stated that we expected that any 
additional burden associated with the requirements of 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 estimated 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.
    As the record creation and record preservation requirements under 
the final rule amendments for an ultimate holding company that does not 
have a principal regulator have not been changed from the proposal, we 
estimate that the one-time burden for the five ultimate holding 
companies will be 40 * 5 = 200 hours and the annual burden will be 
approximately 290 * 5 = 1,450 hours.
    The final rule amendments do not impose record creation 
requirements on an ultimate holding company that has a principal 
regulator, so there will be no burden on the ultimate holding company 
for record creation as a result of the rule amendments. An ultimate 
holding company that has a principal regulator must preserve only any 
application or documents and all reports and notices filed with the 
Commission under the rule amendments and any written responses received 
from the Commission. We do not expect that an ultimate holding company 
with a principal regulator will incur any PRA burden as a result of the 
record preservation requirements of the rule amendments because the 
principal regulator will already require preservation of these records.
    The notification provisions of 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 its ultimate 
holding company and affiliates. These provisions are integral to 
Commission supervision of broker-dealers that use Appendix E. We 
estimated in the Proposing Release that it would require a total of 
approximately one hour per year for all 12 of the ultimate holding 
companies of the broker-dealers we expected to apply under the proposal 
to comply with the notification provisions of Appendix G. We have not 
changed that estimate for the ultimate holding companies of the 11 
broker-dealers we now expect to apply under the rule amendments.\89\
    Rule 15c3-4 requires an OTC derivatives dealer that uses Appendix F 
to calculate certain its net capital to establish, document, and 
maintain a system of internal risk management controls. In the 
Proposing Release, we proposed amendments to Rule 15c3-4 to expand its 
coverage to broker-dealers that use Appendix E, and we proposed that 
the ultimate holding company of the broker-dealer, as a condition to a 
broker-dealer's use of the alternative method of computing net capital, 
would be required to comply with Rule 15c3-4 with respect to an 
internal risk management control system for the affiliate group. The 
final rule amendments do not include amendments to Rule 15c3-4. 
However, under the final amendments to Rule 15c3-1, a broker-dealer 
that uses Appendix E to calculate net capital must comply with 
applicable provisions of Rule 15c3-4 as though it were an OTC 
derivatives dealer that uses Appendix F and ultimate holding company 
that does not have a principal regulator must agree to comply with 
applicable provisions of Rule 15c3-4 with respect to an internal risk 
management control system for the affiliate group. Under the final rule 
amendments, however, an ultimate holding company that has a principal 
regulator is no longer required to agree to comply with Rule 15c3-4 
with respect to a group-wide internal risk management control system 
because the principal regulator already imposes risk management control 
system requirements on the ultimate holding company. The additional PRA 
burden for Rule 15c3-4 of 3,000 hours was proposed and approved. That 
burden, adjusted as discussed below, is now included in the PRA burden 
for Rule 15c3-1.
---------------------------------------------------------------------------

    \89\ The Commission received approximately 841 Rule 17a-11 
notifications from 562 broker-dealers during calendar year 2003, 
when there were approximately 6,800 active broker-dealers registered 
with the Commission. Thus, approximately 8% of registered broker-
dealers filed a Rule 17a-11 notice in 2003 (562 / 6,800 = .0826). 
Therefore, we estimate that of the 11 ultimate holding companies of 
broker-dealers we expect to apply under the rule amendments, 
approximately one may be required to file notice under this 
provision. We estimate that, consistent with the Rule 17a-11 PRA 
burden estimate, it will take approximately one hour to prepare and 
file that notice.
---------------------------------------------------------------------------

    Rule 15c3-4 requires that in implementing its internal risk 
management control system policies and procedures, the broker-dealer 
must document its system of internal risk management controls. In 
particular, such a firm must document its consideration of certain 
issues affecting its business when designing its internal controls. The 
broker-dealer also must prepare and maintain written guidelines that 
discuss its internal risk management control system.
    The rule amendments are 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 Exchange Act Rule 15c3-4 is essential to the regulation 
and oversight of major securities firms that voluntarily elect to use 
Appendix E. More specifically, requiring a broker-dealer that elects to 
use Appendix E (and the ultimate holding company of the broker-dealer, 
if the holding company does not have a principal regulator) to document 
the planning, implementation, and periodic review of its risk 
management controls is 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 11 broker-dealers we now expect to apply under these rules and 
their ultimate holding companies already have developed internal risk 
management control systems. Each broker-dealer, however, (and the 
ultimate holding company of the broker-dealer, if the ultimate holding 
company does not have a principal regulator) will have to take some 
additional steps to review and enhance its control system for purposes 
of the final rule amendments. This assessment is based on examinations 
of and discussions with the firms. We expect that the amount of time 
necessary to accomplish this will vary by broker-dealer. In the 
Proposing Release, we estimated that of the 12 broker-dealers we 
expected to apply under the amendments, six would spend approximately 
1,000 hours and six would spend approximately 3,600 hours to amodify 
their internal risk management control systems for purposes of the rule 
amendments. In addition, we estimated that each of the 12 broker-
dealers would spend approximately 250 hours per year reviewing and 
updating its risk management control system.
    We now estimate that 11 broker-dealers will apply under the final 
rule amendments and that, although the amount of time required to 
modify its internal risk management control system to comply with the 
final rule amendments will vary, we estimate that on average a broker-
dealer (and its ultimate holding company, if

[[Page 34454]]

applicable) will spend approximately 2,000 hours to accomplish this 
task. The total burden is therefore approximately 22,000 hours on a 
one-time basis. As in the Proposing Release, we expect that it will 
take an average of approximately 250 hours per year for each firm to 
review and update its internal risk management control system, for a 
total annual burden of 2,750 hours (250 * 11 = 2,750).

B. Rule 17a-4. Records To Be Preserved by Certain Exchange Members, 
Brokers and Dealers

    The final rules add an amendment to Rule 17a-4, which was not 
contained in the proposed rule amendments. The amendment requires a 
broker-dealer taking advantage of the alternative capital calculation 
to preserve records made under paragraphs (c)(4)(vi)(D) and (E) of 
Appendix E. These records relate to the broker-dealer's determination 
of credit ratings and credit risk weights, respectively.
    Paragraph (c)(4)(vi)(E) was not contained in the proposed rule 
amendments. The Proposing Release, however, would have required a 
broker-dealer to preserve the record made pursuant to paragraph 
(c)(4)(vi)(D) (designated as paragraph (d)(7)(iv) in the Proposing 
Release). Rule 17a-4 is the broker-dealer record retention rule and it 
is therefore appropriate to amend Rule 17a-4 to require a broker-dealer 
to preserve the records made under paragraphs (c)(4)(vi)(D) and (E). We 
estimate that it will take an average of approximately one hour per 
year for the 11 broker-dealers we expect to apply under the rule 
amendments to comply with this record preservation requirement, for a 
total burden of 11 hours per year for the 11 broker-dealers.

C. Rule 17a-5. Reports To Be Made by Certain Brokers and Dealers

    The amendments to Exchange Act Rule 17a-5 require broker-dealers 
using Appendix E to submit monthly, quarterly, and annual reports to 
the Commission. The amendments are an integral part of our financial 
responsibility program for broker-dealers electing to use Appendix E. 
The information to be collected under the amendments to Rule 17a-5 are 
essential to the regulation of these broker-dealers and will assist us 
and the SROs responsible for reviewing the activities of these broker-
dealers to monitor and enforce compliance with applicable Commission 
rules, including rules pertaining to financial responsibility. These 
periodic reports will 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.
    In the Proposing Release, we estimated 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. The final amendments to Rule 17a-5 are 
similar to those proposed. We therefore estimate for the 11 broker-
dealers we now expect to apply under the rule amendments that the total 
annual burden is approximately 1,320 hours ((48 + 32 + 40)* 11 = 
1,320).

D. Rule 17a-11. Notification Procedures for Brokers and Dealers

    We are revising the proposed amendments to Rule 17a-11. Exchange 
Act Rule 17a-11 requires that a broker-dealer provide notification of 
certain events to the Commission and its designated examining authority 
within specified time periods. The events that require Commission 
notification indicate that the firm may be experiencing financial or 
operational difficulty.
    The amendments to Rule 17a-11, as proposed, would have imposed 
additional notification requirements on broker-dealers that use the 
alternative method of computing net capital. Under these amendments, 
the broker-dealer would have notified the Commission if it became aware 
of certain credit rating downgrades relating to the broker-dealer or an 
affiliate of the broker-dealer; it received a notice of non-compliance 
from a regulatory authority; it became aware of a situation that may 
have had a material adverse effect on the ultimate holding company or 
on a material affiliate of the holding company; or a backtesting 
exception of its mathematical models occurred that required the broker-
dealer to use a higher multiplication factor in the calculation of its 
deductions for market or credit risk.
    The revisions to Rule 17a-11, as adopted, amend only paragraphs 
(b)(2) and (h). Paragraph (b)(2) of Rule 17a[dash]11, as adopted, 
requires a broker-dealer that computes its net capital under the 
alternative method of Appendix E to notify the Commission if its 
tentative net capital falls below $1 billion, the required minimum 
under Rule 15c3-1e(a)(7)(i). The notice must specify the broker-
dealer's net capital and tentative net capital requirements and the 
current amount of its net capital and tentative net capital. Paragraph 
(h), as adopted, notes that there is a notification provision in Rule 
15c3-1e(a)(7)(ii). That provision requires a broker-dealer to notify 
the Commission that same day if its tentative net capital falls below 
$5 billion. These notification provisions are necessary for the 
Commission to monitor the financial position of a broker-dealer that 
uses the alternative method of computing net capital.
    Although they are of supervisory concern, the events requiring 
notification under the rule amendments are expected to be rare. In the 
Proposing Release, we based our estimate of the number of broker-
dealers who might be required to file notice pursuant to the amendments 
on the number of Rule 17a-11 notices we received in calendar year 2002. 
We are now basing our estimate on year 2003 data.
    The Commission received approximately 841 Rule 17a-11 notices from 
562 broker-dealers during calendar year 2003. At that time, there were 
approximately 6,800 active broker-dealers registered with the 
Commission, so we estimate that approximately 8% of active broker-
dealers filed a Rule 17a-11 notice during calendar year 2003 (562/6,800 
= .0826). Therefore, we estimate that, of the 11 broker-dealers we now 
expect to apply under the rule amendments, approximately one may be 
required to file notice pursuant to these amendments. In the Proposing 
Release, we estimated that it would take approximately one hour per 
year to prepare and file such a notice. As the notification 
requirements of the final amendments to Rule 17a-11 are similar, we 
have not changed that estimate.

E. 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 current burden estimate for Rules 17h-1T 
and 17h-2T is approximately 10 hours per year for each respondent. The 
proposed amendments to Rules 17h-1T and 17h-2T exempted a broker-dealer 
that used Appendix E from the rules to the extent

[[Page 34455]]

that the ultimate holding company of the broker or dealer maintained 
the information pursuant to Appendix G.
    In the final rule amendments, only a broker-dealer with an ultimate 
holding company that does not have a principal regulator is exempted 
from Rules 17h-1T and 17h-2T. As we estimate that five broker-dealers 
that have holding companies that do not have a principal regulator will 
apply under the rule amendments, the savings will be approximately 50 
hours per year.

F. Conclusion

    Based on the above analysis, we estimate that the total additional 
PRA burden as a result of the final rule amendments is approximately 
33,200 hours on a one-time basis and approximately 113,600 hours per 
year. We estimate that the PRA burden will be reduced by approximately 
50 hours per year as a result of the rule amendments.

V. Costs and Benefits of the Rule Amendments

A. Introduction

    The rule amendments provide a voluntary, alternative method for 
computing net capital deductions for market and credit risk under the 
Exchange Act for certain broker-dealers that are part of an ultimate 
holding company that has a group-wide internal risk management control 
system and that consents, as a condition of the net capital treatment, 
to group-wide Commission supervision. The alternative net capital 
computation involves the use of internally developed mathematical 
models that the firm uses to measure risk.
    The Commission is sensitive to the costs and benefits that result 
from its rules. We have identified certain costs and benefits 
associated with the rule amendments.
    The Proposing Release solicited comments relating to the costs and 
benefits associated with the proposed rule amendments. We received no 
comments that addressed the costs and benefits of the proposal. 
However, we did receive comments on other aspects of the proposed 
amendments. The Commission is adopting rule amendments that contain 
various modifications to the proposed amendments. As discussed below, 
some of those modifications, as well as comments received on other 
aspects of the proposed amendments, result in changes to the costs and 
benefits of the rule amendments.
    Under proposed paragraph (a)(7) of Rule 15c3-1, a broker-dealer 
that maintained tentative net capital of at least $1 billion and net 
capital of at least $500 million could apply to the Commission for 
permission to use the alternative method of calculating net capital. 
Under paragraph (a)(7) as adopted, a broker-dealer is also required to 
notify the Commission if its tentative net capital falls below $5 
billion. If a broker-dealer is required to provide that notice to the 
Commission, the Commission may impose additional regulatory conditions 
on either the broker-dealer or, if the ultimate holding company of the 
broker-dealer does not have a principal regulator, on the ultimate 
holding company.
    We noted in the Proposing Release that, based on discussions with 
industry representatives, we believed that 12 broker-dealers would have 
sufficient net capital deductions pursuant to Rule 15c3-1(c)(2)(vi) 
(also known as ``haircuts'') to find it cost effective to use the 
alternative capital computation. Therefore, the cost-benefit analysis 
was based on the assumption that 12 broker-dealers would apply to use 
the alternative capital computation.
    According to September 30, 2003 FOCUS filings, only six registered 
broker-dealers reported that they had tentative net capital of at least 
$5 billion. Some firms, however, make certain deductions in arriving at 
the FOCUS tentative net capital figure (for example, relating to 
securities without a ready market) that would not be subtracted in the 
calculation of tentative net capital for purposes of the rule 
amendments. Based on the final rule amendments, the comments received 
in response to the proposal, and these facts, we now estimate that 11 
broker-dealers will apply to use the alternative net capital 
computation.
    In addition, the Commission has modified the proposed rules to 
establish a streamlined group-wide supervisory regime for an ultimate 
holding company of a broker-dealer taking advantage of the rule 
amendments that is ``an ultimate holding company that has a principal 
regulator'' to avoid duplicative or inconsistent regulation of these 
entities. Of the 11 broker-dealers we now estimate will apply under the 
rule amendments, we estimate that six have an ultimate holding company 
that has a principal regulator. The streamlined supervisory regime for 
these holding companies reduces application requirements, internal risk 
management control system requirements, and examination and reporting 
requirements, and generally results in lower costs.
    The estimates are based on information from a variety of sources, 
including information that Commission staff receives through the risk 
assessment rules and meetings with and reports from member firms of the 
DPG and other broker-dealers and the Commission's experience in 
implementing the OTC derivatives dealer rules.
    Some of the changes to our estimates result from use of certain 
updated data. The revised cost and benefit estimates are discussed 
below for each rule amendment.

B. Benefits

    We anticipate that cost savings will result in several areas. If 
permitted to operate under the amendments, a broker-dealer will become 
subject to specifically tailored capital and other requirements. The 
broker-dealer will be able to compute certain of its deductions for 
market and credit risk 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 incorporation of mathematical risk management 
techniques into the capital calculation 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.
    A major benefit for the broker-dealer will be lower deductions from 
net capital for market and credit risk that we expect will result from 
the use of the alternative method. This benefit, however, is difficult 
to quantify. While reductions in net capital requirements will 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 deductions will vary significantly among broker-dealers 
based on the size and risk of their portfolios.
    We expect that firms with larger net capital deductions will 
realize a larger percentage reduction than firms with smaller capital 
deductions. In the Proposing Release, we estimated that broker-dealers 
taking advantage of the alternative capital computation would realize 
an average reduction in capital deductions of approximately 40%. We 
estimated that a broker-dealer could reallocate capital to fund 
business activities for which the rate of return would be approximately 
20 basis points (0.2%) higher.

[[Page 34456]]

    According to third quarter 2003 FOCUS data, the 11 firms we expect 
to apply under the rule amendments could realize a total reduction in 
haircuts of approximately $13 billion. We estimate that they will 
realize a total annual benefit of approximately $26 million (.2% * $13 
billion = $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 
ultimate 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 net capital deductions or be 
required to form a sub-holding company in the EU. We expect that the 
Commission supervision contemplated by these amendments will meet this 
standard. As a result, we believe these amendments will minimize 
duplicative regulatory burdens on firms that do not have ultimate 
holding companies that have a principal regulator that are active in 
the EU as well as in other jurisdictions that may have similar laws.
    Based on staff experience, 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. Consequently, for the five broker-
dealers we expect will apply under these amendments that do not have an 
ultimate holding company that has a principal regulator, not being 
required to form and maintain a sub-holding company in the EU would 
save the firms a total of approximately $40 million per year.
    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 current PRA estimate for Rules 17h-1T and 
17h-2T is approximately 10 hours per year for each respondent. The 
proposed amendments to Rules 17h-1T and 17h-2T exempted a broker-dealer 
that used Appendix E from the rules to the extent that the ultimate 
holding company of the broker or dealer maintained the information 
pursuant to Appendix G.
    In the final rule amendments, only a broker-dealer that has an 
ultimate holding company that does not have a principal regulator is 
exempted from Rules 17h-1T and 17h-2T. As we estimate that five broker-
dealers will apply under the rule amendments that have ultimate holding 
companies that do not have a principal regulator, the savings are 
approximately 50 hours per year. We expect that a financial reporting 
manager will do this work. The staff estimates that the hourly salary 
of a financial reporting manager is $92 per hour.\90\ We estimate that 
the total cost savings for the 5 firms will be approximately $4,600 per 
year (50 * $92 = $4,600).
---------------------------------------------------------------------------

    \90\ Generally, to calculate an hourly cost, the staff takes the 
median (or, if no median is provided, the mean) salary provided in 
the latest annual Securities Industry Association's Report on 
Management and Professional Earnings in the Securities Industry 
(``SIA Report'') for the position cited, divides that amount by 
1,800 hours (in the average work year), then multiplies the result 
by 135% to account for employee overhead costs. For a Financial 
Reporting Manager, the hourly cost is computed as follows: $123,000 
salary per year (based on end of year 2003 SIA Report figures)/1800 
hours per year * 1.35 = $92 per hour.
---------------------------------------------------------------------------

    To the extent that firms electing this regulatory system improve 
their internal risk management control systems, we expect that the 
firms will 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 this regulatory system also will result in benefits 
to regulators and, as a result, to financial markets. The Commission 
will have access to group-wide information concerning the operation and 
financial condition of the broker-dealer's ultimate holding company and 
affiliates. This information will help the Commission to assess whether 
the activities or financial condition of the ultimate holding company 
or affiliates may pose risks to the financial health of the broker-
dealer and should therefore promote the stability of the financial 
markets.
    Also, the broker-dealer must comply with stringent requirements 
concerning its internal risk management control system. We expect that 
these requirements will reduce the risk of significant losses by the 
broker-dealer. The internal risk management control system requirements 
also should reduce the risk that the problems of one firm will spread, 
causing defaults by other firms and undermining securities markets as a 
whole.

C. Costs

    Firms electing the alternative capital computation will incur 
various costs. In estimating the total costs associated with the 
amendments on the broker-dealer, we have included the costs arising 
from each rule amendment.
    As part of the application to use Appendix E, the broker-dealer and 
its ultimate holding company must submit various documents to the 
Commission. We estimate that each broker-dealer that applies to 
calculate its net capital under the amendments will 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 will include 
approximately 100 hours for an in-house attorney and 900 hours for a 
senior compliance staff member. The staff estimates that the hourly 
salary of an attorney is $82 per hour,\91\ for a total cost for the 11 
firms of approximately $90,000 ($82 * 100 * 11 = $90,200). The staff 
estimates that the hourly salary of a senior compliance staff person is 
$71 per hour,\92\ for a total cost of approximately $703,000 ($71 * 900 
* 11 = $702,900).
---------------------------------------------------------------------------

    \91\ SIA Report (Attorney) + 35% overhead (based on end-of-year 
2003 figures) ($109,000 per year/1800 hours/year * 1.35 = $82 per 
hour).
    \92\ SIA Report (Senior Compliance Staff) + 35% overhead (based 
on end-of-year 2003 figures) ($94,700 per year/1800 hours/year * 
1.35 = $71 per hour).
---------------------------------------------------------------------------

    We note that broker-dealers we expect to apply to use Appendix E 
already have developed the VaR models that they will use to calculate 
market and credit risk under the amendments and already have 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 amendments contain 
additional requirements that broker-dealers may not yet have 
incorporated into their models and control systems.
    We estimate that a broker-dealer using Appendix E will spend 
approximately 5,600 hours per year to review and update 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. 
We believe that whether or not the ultimate holding company of a 
broker-dealer is an ultimate holding company that has a principal 
regulator, this time requirement would be the same. Consequently, we 
estimate that it would take approximately 69,000 hours per year ((5,600 
+ 640) * 11 = 68,640) to review, update, and backtest mathematical 
models for the 11 broker-dealers we now expect to apply under the 
amendments and that a financial

[[Page 34457]]

reporting specialist will do the work. The staff estimates that the 
hourly salary of a financial reporting manager is $92 per hour,\93\ for 
a total cost of approximately $6.3 million per year ($92 * 69,000 = 
$6,348,000).
---------------------------------------------------------------------------

    \93\ SIA Report (Financial Reporting Manager) + 35% overhead 
(based on end-of-year 2003 figures) ($123,000 per year/1800 hours/
year * 1.35 = $92 per hour).
---------------------------------------------------------------------------

    Under proposed Appendix G to Rule 15c3-1, the ultimate holding 
company of a broker-dealer using the alternative capital computation 
would have been 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. As we noted in the Proposing 
Release, capital measurement, reporting, and recordkeeping conditions 
are necessary to allow the Commission to oversee properly a broker-
dealer that uses Appendix E and to monitor the financial and 
operational condition of its affiliate group. In particular, the 
proposed reporting requirements of 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 ultimate holding company and affiliates of 
the broker-dealer and whether the ultimate holding company is in 
compliance with the conditions of the broker-dealer's exemption. These 
reports will help the Commission to anticipate the effect on the 
ultimate holding company and affiliates of significant economic events 
and their impact on the broker-dealer.
    The Commission has modified the capital measurement and reporting 
conditions in the final rule amendments for an ultimate holding company 
that is an ultimate holding company that has a principal regulator. For 
such an ultimate holding company, there is no requirement to calculate 
allowable capital and allowances for market, credit, and operational 
risk monthly. Also, the ultimate holding company is not required to 
file monthly reports with the Commission. An ultimate holding company 
that has a principal regulator must file quarterly reports containing 
consolidated and consolidating financial statements, a capital 
measurement it provides to its principal regulator, and certain regular 
risk reports provided to the persons responsible for managing group-
wide risk as the Commission may request. The ultimate holding company 
also must file an annual report consisting of audited consolidating and 
consolidated financial statements and a report of the ultimate holding 
company's capital measurement, as provided to its principal regulator.
    In addition, the Commission has modified the reporting requirements 
in the final rule amendments for an ultimate holding company that does 
not have a principal regulator. The deadlines for the submission of the 
monthly and annual reports have been extended and certain financial 
information does not have to be filed with the monthly or quarterly 
reports if the information has not yet been made public in the holding 
company's annual report on Form 10-K. These changes should not 
materially affect the burden estimates for the ultimate holding company 
that does not have a principal regulator.
    In the Proposing Release, based on Commission experience and 
discussions with industry participants, we estimated that the 
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. In addition, we estimated that it 
would require approximately 5,600 hours per year to review and update 
the mathematical models the holding company uses to make these 
calculations. Finally, we estimated that it would require approximately 
160 hours each quarter, or approximately 640 hours each year, to 
backtest the models.
    The broker-dealer and the ultimate holding company generally will 
use the same models to calculate risk on similar classes of products. 
However, we expect that the ultimate holding company will use models in 
its risk calculations for additional products. These additional 
products could include, for example, loans and loan commitments, 
structured financial products, or various types of derivatives business 
not conducted in the broker-dealer.
    For the five ultimate holding companies that do not have a 
principal regulator whose broker-dealers we expect to apply to operate 
under the rule amendments, our estimates from the Proposing Release 
have not changed. We estimate that to compute allowable capital and 
allowances for market, credit, and operational risk for the five 
ultimate holding companies would take approximately 5,400 hours (1,080 
* 5 = 5,400). We expect that a senior accountant would do the work. The 
staff estimates that the hourly salary of a senior accountant is $55 
per hour.\94\ The total annual cost is approximately $300,000 ($55 * 
5,400 = $297,000). 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 
28,000 hours per year for the five ultimate holding companies, 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 
$92 per hour.\95\ The total annual cost is approximately $2.6 million 
($92 * 28,000 = $2,576,000). Finally, we estimate that it will require 
approximately 640 hours per year per firm to backtest the models, or 
approximately 3,200 hours for the five ultimate holding companies, 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 $50 
per hour,\96\ for a total annual cost of approximately $160,000 ($50 * 
3,200 = $160,000).
---------------------------------------------------------------------------

    \94\ SIA Report (Senior Accountant) + 35% overhead (based on 
end-of-year 2003 figures) ($72,850 per year/1800 hours/year * 1.35 = 
$55 per hour).
    \95\ SIA Report (Financial Reporting Manager) + 35% overhead 
(based on end-of-year 2003 figures) ($123,000 per year/1800 hours/
year * 1.35 = $92 per hour).
    \96\ SIA Report (Junior Research Analyst) + 35% overhead (based 
on end-of-year 2003 figures) ($67,200 per year/1800 hours/year * 
1.35 = $50 per hour).
---------------------------------------------------------------------------

    The rule amendments do not require an ultimate holding company that 
has a principal regulator to compute allowable capital or allowances 
for market, credit, and operational risk or to review, update, and 
backtest its mathematical models. As a result, we conclude that there 
will be minimal costs, if any, to such ultimate holding companies as a 
result of the capital measurement requirements of the rule amendments. 
The ultimate holding company must provide its principal regulator with 
a capital measurement, and must review, update, and backtest the 
mathematical models it uses to derive that measurement.
    In the Proposing Release, we estimated 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

[[Page 34458]]

approximately 200 hours per year. These estimates were described in the 
Proposing Release and elicited no comments. For the five broker-dealer 
ultimate holding companies that do not have principal regulators, our 
estimate for the amount of time necessary for preparing and filing the 
reports required under the rule amendments is unchanged. Therefore, for 
these firms, it will take a total of approximately 1,800 hours ((96 + 
64 + 200) * 5 = 1,800) to comply with these requirements.
    For ultimate holding companies that have a principal regulator, the 
ultimate holding company must send to the Commission only the reports 
it has prepared for other purposes. No monthly reports are required 
under the rule amendments, and the quarterly and annual reports consist 
of reports the ultimate holding company has provided to persons in the 
ultimate holding company responsible for managing risk or reports the 
ultimate holding company provides to its principal regulator. 
Therefore, we expect that the time required for an ultimate holding 
company with a principal regulator as a result of the reporting 
requirements under the amendments will be minimal. We estimate that 
this time requirement is approximately 40 hours per year. For the six 
broker-dealers with ultimate holding companies that have principal 
regulators that we expect to apply under the rule amendments, the total 
time required will therefore be approximately 240 hours per year.
    We expect that a senior accountant will do the work necessary to 
comply with the reporting requirements of the rule amendments. The 
staff estimates that the hourly salary of a senior accountant is $55 
per hour,\97\ for a total annual cost of approximately $110,000 ((1,800 
+ 240) * $55 = $112,200).
---------------------------------------------------------------------------

    \97\ SIA Report (Senior Accountant) + 35% overhead (based on 
end-of-year 2003 figures) ($72,850 per year/1800 hours/year * 1.35 = 
$55 per hour).
---------------------------------------------------------------------------

    In the Proposing Release, we stated that we expected that any 
additional cost associated with the requirements of 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 
estimated that the average time required to make and preserve these 
records would be approximately 40 hours and that the average annual 
time requirement would be approximately 290 hours.
    As the record creation and record preservation requirements under 
the final rule amendments for an ultimate holding company that does not 
have a principal regulator have not been changed from the proposal, we 
estimate that for the five ultimate holding companies it would take 
approximately 200 hours (40 * 5 = 200) on a one-time basis and 
approximately 1450 hours per year (290 * 5 = 1,450) to comply with 
these requirements. We expect that a senior accountant would do the 
work. The staff estimates that the hourly salary of a senior accountant 
is $55 per hour,\98\ for a total one-time cost of approximately $11,000 
(200 *55 = $11,000) and a total annual cost of approximately $80,000 
(1,450 * $55 = $79,750).
---------------------------------------------------------------------------

    \98\ SIA Report (Senior Accountant) + 35% overhead (based on 
end-of-year 2003 figures) ($72,850 per year/1800 hours/year * 1.35 = 
$55 per hour).
---------------------------------------------------------------------------

    The final rule amendments do not impose record creation 
requirements on an ultimate holding company that has a principal 
regulator, so there will be no costs to the ultimate holding company 
for record creation as a result of the rule amendments. An ultimate 
holding company that has a principal regulator must preserve only any 
application or documents and all reports and notices filed with the 
Commission under the rule amendments and any written responses received 
from the Commission. We expect that an ultimate holding company that 
has a principal regulator will incur minimal costs, if any, as a result 
of the record preservation requirements of the rule amendments because 
the principal regulator will already require preservation of these 
records.
    We estimated in the Proposing Release that it would require a total 
of approximately one hour per year for all 12 of the ultimate holding 
companies of the broker-dealers we expected to apply under the proposal 
to comply with the notification provisions of Appendix G. We have not 
changed that estimate for the ultimate holding companies of the 11 
broker-dealers we now expect to apply under the rule amendments.\99\ We 
expect that a senior compliance staff person will do the work. The 
staff estimates that the hourly salary of a senior compliance staff 
person is $71 per hour,\100\ for a total annual cost for each of the 11 
firms of approximately $71.
---------------------------------------------------------------------------

    \99\ The Commission received approximately 841 Rule17a-11 
notifications from 562 broker-dealers during calendar year 2003, 
when there were approximately 6,800 active broker-dealers registered 
with the Commission. Thus, approximately 8% of registered broker-
dealers filed a Rule 17a-11 notice in 2003 (562/6,800 = .0826). 
Therefore, we estimate that of the 11 ultimate holding companies of 
broker-dealers we expect to apply under the rule amendments, 
approximately one may be required to file notice under this 
provision. We estimate that it will take approximately one hour to 
prepare and file that notice.
    \100\ SIA Report (Senior Compliance Staff) + 35% overhead (based 
on end-of-year 2003 figures) ($94,700 per year/1800 hours/year * 
1.35 = $71 per hour).
---------------------------------------------------------------------------

    Rule 15c3-4 requires an OTC derivatives dealer that uses Appendix F 
to calculate net capital to establish, document, and maintain a system 
of internal risk management controls. In the Proposing Release, we 
proposed amendments to Rule 15c3-4 to expand its coverage to broker-
dealers that use Appendix E, and we proposed that the ultimate holding 
company of the broker-dealer agree to comply with Rule 15c3-4 with 
respect to an internal risk management control system for the affiliate 
group. The final rule amendments do not include amendments to Rule 
15c3-4. However, under Rule 15c3-1(a)(7)(iii), as adopted, a broker-
dealer that uses Appendix E to calculate net capital must comply with 
applicable provisions of Rule 15c3-4 as though it were an OTC 
derivatives dealer that uses Appendix F. The final rule amendments also 
continue to require an ultimate holding company that does not have a 
principal regulator to agree to comply with applicable provisions of 
Rule 15c3-4 with respect to an internal risk management control system 
for the affiliate group. Under the final rule amendments, however, an 
ultimate holding company that has a principal regulator is no longer 
required to agree to comply with Rule 15c3-4 with respect to a group-
wide internal risk management control system because the principal 
regulator already imposes risk management control system requirements 
on the ultimate holding company.
    Rule 15c3-4 requires that in implementing its internal risk 
management control system policies and procedures, the broker-dealer 
must document its system of internal risk management controls. In 
particular, such a firm must document its consideration of certain 
issues affecting its business when designing its internal controls. The 
broker-dealer also must prepare and maintain written guidelines that 
discuss its internal risk management control system.
    The rule amendments are 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 Exchange Act Rule 15c3-4 is essential to the regulation 
and

[[Page 34459]]

oversight of major securities firms that voluntarily elect to use 
Appendix E. More specifically, requiring a broker-dealer that elects to 
use Appendix E (and the ultimate holding company of the broker-dealer, 
if the holding company does not have a principal regulator) to document 
the planning, implementation, and periodic review of its risk 
management controls is designed to ensure that all pertinent risk 
management issues are considered, that the risk management controls are 
implemented properly, and that they continue to address adequately the 
risks faced by major securities firms.
    The 11 broker-dealers we now expect to apply to use Appendix E and 
their ultimate holding companies already have developed internal risk 
management control systems. Each broker-dealer, however, (and the 
ultimate holding company of the broker-dealer, if the holding company 
does not have a principal regulator) must take some additional steps to 
review and enhance its control system for purposes of the final rule 
amendments. This assessment is based on examinations of and discussions 
with the firms. We expect that the amount of time necessary to 
accomplish this will vary by broker-dealer. In the Proposing Release, 
we estimated that of the 12 broker-dealers we expected to apply under 
the amendments, six would spend approximately 1,000 hours each and six 
would spend approximately 3,600 hours each to modify their internal 
risk management control system for purposes of the rule amendments. In 
addition, we estimated that each of the 12 broker-dealers would spend 
approximately 250 hours per year reviewing and updating its risk 
management control system.
    We now estimate that 11 broker-dealers will apply under the final 
rule amendments and that, although the amount of time required to 
modify its internal risk management control system to comply with 
paragraph (a)(7)(iii) of Rule 15c3-1 will vary, we estimate that, on 
average, a broker-dealer (and its holding company, if applicable) will 
spend approximately 2,000 hours to accomplish this task, for a total of 
22,000 hours for the 11 firms. We estimate that each of the 11 broker-
dealers will spend an average of approximately 250 hours per year 
reviewing and updating its internal risk management control system for 
a total for the 11 broker-dealers of 2,750 hours per year (250 * 11 = 
2,750). We expect that a senior compliance staff person will do the 
work. The staff estimates that the hourly salary of a senior compliance 
staff person is $71 per hour,\101\ for a total one-time cost of 
approximately $1,600,000 (22,000 * 71 = $1,562,000) and a total annual 
cost of approximately $195,000 (2,750 * 71 = $195,250).
---------------------------------------------------------------------------

    \101\ 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 broker-dealers to manage 
risk, make and retain records, and report and calculate capital differ 
widely depending on the size of the firm and the types of business it 
engages in. Based on discussions with the firms, we believe that the 11 
broker-dealers we expect to apply under the amendments have strong 
information technology systems. These information technology systems 
may be in varying stages of readiness to enable the holding company to 
meet the requirements of the amendments, however, so the cost of 
modifying their information technology systems to meet these 
requirements could vary significantly for the 11 firms. In the 
Proposing Release, we estimated that, on average, it would cost a 
broker-dealer an average of approximately $27.5 million to modify its 
systems. To take account of the fact that these firms regularly update 
their information technology systems for business purposes, we have 
lowered our estimate of the average amount that it would cost broker-
dealers to modify their systems to meet the requirements of the rule 
amendments. We now estimate that it will cost broker-dealers an average 
of approximately $8 million each to modify their information technology 
systems to meet the requirements of the rule amendments, for a total 
for the 11 broker-dealers of approximately $88 million.
    The final rule amendments add an amendment to Rule 17a-4, which was 
not contained in the proposed rule amendments. The amendment requires a 
broker-dealer using the alternative method of computing net capital to 
preserve records made under paragraphs (c)(4)(vi)(D) and (E) of 
Appendix E. These records relate to the broker-dealer's determination 
of credit ratings and credit risk weights, respectively.
    Paragraph (c)(4)(vi)(E) was not contained in the proposed rule 
amendments. The Proposing Release, however, would have required a 
broker-dealer to preserve the record made pursuant to paragraph 
(c)(4)(vi)(D) (designated as paragraph (d)(7)(iv) in the Proposing 
Release). Rule 17a-4 is the broker-dealer record retention rule and it 
is therefore appropriate to amend Rule 17a-4 to require a broker-dealer 
to preserve the records made under paragraphs (c)(4)(vi)(D) and (E). We 
estimate that it will take an average of approximately one hour per 
year for the 11 broker-dealers we expect to apply under the rule 
amendments to comply with this record preservation requirement, for a 
total of 11 hours per year for the 11 broker-dealers, and we expect 
that a senior compliance staff person will do the work. The staff 
estimates that the average salary for a senior compliance staff person 
is $71 per hour \102\ for a total annual cost of approximately $800 
($71 * 11 = $781).
---------------------------------------------------------------------------

    \102\ SIA Report (Senior Compliance Staff) + 35% overhead (based 
on end-of-year 2003 figures) ($94,700 per year/1800 hours/year * 
1.35 = $71 per hour).
---------------------------------------------------------------------------

    The amendments to Exchange Act Rule 17a-5 require broker-dealers 
using Appendix E to submit monthly, quarterly, and annual reports to 
the Commission. The amendments are an integral part of our financial 
responsibility program for broker-dealers electing to use Appendix E. 
The information to be collected under the amendments to Rule 17a-5 are 
essential to the regulation of these broker-dealers and will assist us 
and the SROs 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 also will 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.
    In the Proposing Release, we estimated 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. The final amendments to Rule 17a-5 are 
similar to those proposed. We therefore estimate for the 11 broker-
dealers we now expect to apply under the rule amendments that the total 
annual time required is approximately 1,320 hours per year ((48 + 32 + 
40)* 11 = 1,320). We expect that a senior accountant would do the work. 
The staff estimates that the hourly salary of a senior

[[Page 34460]]

accountant is $55 per hour,\103\ for a total annual cost of 
approximately $73,000 (1,320 * $55 = $72,600).
---------------------------------------------------------------------------

    \103\ SIA Report (Senior Accountant) + 35% overhead (based on 
end-of-year 2003 figures) ($72,850 per year/1800 hours/year * 1.35 = 
$55 per hour).
---------------------------------------------------------------------------

    We are revising the proposed amendments to Rule 17a-11. Exchange 
Act Rule 17a-11 requires that a broker-dealer provide notification of 
certain events to the Commission and its designated examining authority 
within specified time periods. The events that require Commission 
notification indicate that the firm may be experiencing financial or 
operational difficulty.
    The amendments to Rule 17a-11, as proposed, would have imposed 
additional notification requirements on broker-dealers that use the 
alternative method of computing net capital. Under these amendments, 
the broker-dealer would have notified the Commission if it became aware 
of certain credit rating downgrades relating to the broker-dealer or an 
affiliate of the broker-dealer; it received a notice of non-compliance 
from a regulatory authority; it became aware of a situation that may 
have had a material adverse effect on the ultimate holding company or 
on an affiliate of the holding company; or a backtesting exception of 
its mathematical models occurred that required the broker-dealer to use 
a higher multiplication factor in the calculation of its deductions for 
market or credit risk.
    The revisions to Rule 17a-11, as adopted, amend only paragraphs 
(b)(2) and (h). Paragraph (b)(2) of Rule 17a-11, as adopted, requires a 
broker-dealer that computes its net capital under the alternative 
method of Appendix E to notify the Commission if its tentative net 
capital falls below $1 billion, the required minimum under Rule 15c3-
1e(a)(7)(i). The notice must specify the broker-dealer's net capital 
and tentative net capital requirements and the current amount of its 
net capital and tentative net capital. Paragraph (h), as adopted, notes 
that there is a notification provision in Rule 15c3-1e(a)(7)(ii). That 
provision requires a broker-dealer to notify the Commission that same 
day if its tentative net capital falls below $5 billion. These 
notification provisions are necessary for the Commission to monitor the 
financial position of a broker-dealer that uses the alternative method 
of computing net capital.
    Although they are of supervisory concern, the events requiring 
notification under the rule amendments are expected to be rare. In the 
Proposing Release, we based our estimate of the number of broker-
dealers who might be required to file notice pursuant to the amendments 
on the number of Rule 17a-11 notices we received in calendar year 2002. 
We are now basing our estimate on year 2003 data.
    The Commission received approximately 841 Rule 17a-11 notices from 
562 broker-dealers during calendar year 2003. At that time, there were 
approximately 6,800 active broker-dealers registered with the 
Commission, so we estimate that approximately 8% of active broker-
dealers filed a Rule 17a-11 notice during calendar year 2003 (562 / 
6,800 = .0826). Therefore, we estimate that, of the 11 broker-dealers 
we now expect to apply under the rule amendments, approximately one may 
be required to file notice pursuant to these amendments. In the 
Proposing Release, we estimated that it would take approximately one 
hour to prepare and file such a notice. As the notification 
requirements of the final amendments to Rule 17a-11 are similar, we 
estimate that it will take approximately one hour to prepare and file 
such a notice and that a senior compliance staff person will do the 
work. The staff estimates that the hourly salary of a senior compliance 
staff person is $71 per hour,\104\ for a total annual cost of 
approximately $71.
---------------------------------------------------------------------------

    \104\ SIA Report (Senior Compliance Staff) + 35% overhead (based 
on end-of-year 2003 figures) ($94,700 per year/1800 hours/year * 
1.35 = $71 per hour).
---------------------------------------------------------------------------

D. Conclusion
    Based on the above analysis, we estimate that the quantifiable 
benefits of the rule amendments are approximately $66 million per year. 
We estimate that the quantifiable costs of the rule amendments are 
approximately $10 million per year and approximately $90 million on a 
one-time basis.

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

    Section 3(f) of the Exchange Act \105\ requires us, when engaging 
in rulemaking that requires us to consider or determine whether an 
action is necessary or appropriate in the public interest or for the 
protection of investors, to consider whether the action will promote 
efficiency, competition, and capital formation. Section 23(a)(2) of the 
Exchange Act \106\ 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.
---------------------------------------------------------------------------

    \105\ 15 U.S.C. 78c(f).
    \106\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    The Commission believes that the amendments should promote 
efficiency, competition, and capital formation. The amendments are 
intended to reduce regulatory costs for broker-dealers by allowing very 
highly capitalized firms that have developed sophisticated internal 
risk management systems and procedures, such as mathematical risk 
measurement models, to use those risk management systems and procedures 
(with any modifications required by the amendments) for regulatory 
purposes. The Commission believes that it would not be cost effective 
for a firm that does not maintain the requisite capital levels to 
develop the systems and procedures required under the amendments. The 
amendments should provide eligible broker-dealers an opportunity to 
increase operational efficiency by aligning their supervisory risk 
assessment and their computation of certain net capital deductions more 
closely with the sophisticated methods the firms already use to manage 
their business risk and capital, while at the same time requiring that 
the firms maintain sufficient capital. The incorporation of 
mathematical risk management techniques into the calculation of net 
capital deductions 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. In addition, the amendments should 
enhance the ability of U.S. securities firms to compete effectively in 
global securities markets.

VII. Regulatory Flexibility Act Certification

    The Commission has certified, pursuant to section 605(b) of the 
Regulatory Flexibility Act,\107\ that the amendments to Rules 15c3-1, 
17a-4, 17a-5, 17a-11, 17h-1T, and 17h-2T would not have a significant 
economic impact on a substantial number of small entities. This 
certification was incorporated into the Proposing Release. We received 
no comments concerning the impact on small entities or the Regulatory 
Flexibility Act certification.
---------------------------------------------------------------------------

    \107\ 5 U.S.C. 605(b).
---------------------------------------------------------------------------

VIII. Statutory Authority

    The Commission is amending 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, 23, 24(b), and 36 thereof (15 
U.S.C. 78o(c), 78q(a), 78w, 78x(b), and 78mm)).

[[Page 34461]]

List of Subjects

17 CFR Part 200

    Administrative practice and procedure, Authority delegations 
(Government agencies).

17 CFR Part 240

    Broker-dealers, Reporting and recordkeeping requirements, 
Securities.

Text of Rule Amendments

0
For the reasons set forth in the preamble, Title 17, Chapter II of the 
Code of Federal Regulations is amended as follows:

PART 200--ORGANIZATION; CONDUCT AND ETHICS; AND INFORMATION AND 
REQUESTS

Subpart A--Organization and Program Management

0
1. The authority citation for Part 200, subpart A, is revised to read 
as follows:

    Authority: 15 U.S.C. 77s, 77o, 77sss, 78d, 78d-1, 78d-2, 78w, 
7811(d), 78mm, 79t, 80a-37, 80b-11, and 7202, unless otherwise 
noted.
* * * * *

0
2. Section 200.19a is amended by adding two sentences following the 
third sentence in the introductory text to read as follows:


Sec.  200.19a  Director of the Division of Market Regulation.

    * * * In addition, these responsibilities include administering the 
Commission's rules related to supervised investment bank holding 
companies and ultimate holding companies of brokers or dealers that 
compute deductions for market and credit risk pursuant to Sec.  
240.15c3-1e of this chapter. This supervision includes the assessment 
of internal risk management controls and mathematical models used to 
calculate net capital and allowances for market, credit, and 
operational risks. * * *
* * * * *
0
3. Section 200.30-3 is amended by:
0
a. Removing the period after paragraph (a)(7)(v) and in its place 
adding ``; and''; and
0
b. Adding paragraph (a)(7)(vi).
    The addition reads as follows:


Sec.  200.30-3  Delegation of authority to Director of Division of 
Market Regulation.

* * * * *
    (a) * * *
    (7) * * *
    (vi) (A) To review amendments to applications of brokers or dealers 
filed pursuant to Sec.  240.15c3-1e and Sec.  240.15c3-1g of this 
chapter and to approve such amendments, unconditionally or subject to 
specified terms and conditions;
    (B) To grant extensions and exemptions from the notification 
requirements of Sec.  240.15c3-1g(e) of this chapter, unconditionally 
or subject to specified terms and conditions;
    (C) To impose additional conditions, pursuant to Sec.  240.15c3-
1e(e) of this chapter, on a broker or dealer that computes certain of 
its net capital deductions pursuant to Sec.  240.15c3-1e of this 
chapter or on an ultimate holding company of the broker or dealer that 
is not an ultimate holding company that has a principal regulator, as 
defined in Sec.  240.15c3-1(c)(13)(ii) of this chapter;
    (D) To require that a broker or dealer or the ultimate holding 
company of the broker or dealer provide information to the Commission 
pursuant to Sec.  240.15c3-1e(a)(1)(viii)(G), Sec.  240.15c3-
1e(a)(1)(ix)(C), Sec.  240.15c3-1e(a)(4), Sec.  240.15c3-
1g(b)(1)(i)(H), and Sec.  240.15c3-1g(2)(i)(C) of this chapter; and
    (E) To determine, pursuant to Sec.  240.15c3-1e(a)(10)(ii), that 
the notice that a broker or dealer must provide to the Commission 
pursuant to Sec.  240.15c3-1e(a)(10)(i) of this chapter will become 
effective for a shorter or longer period of time.
* * * * *

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

0
4. 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, and 7202 et seq.; and 18 U.S.C. 1350, unless 
otherwise noted.
* * * * *

0
5. Section 240.15c3-1 is amended by:
0
a. Removing the authority citations following Sec.  240.15c3-1;
0
b. Revising the undesignated section heading preceding paragraph 
(a)(7);
0
c. Adding text to paragraph (a)(7);
0
d. Revising the undesignated section heading preceding paragraph 
(c)(13);
0
e. Adding text to paragraph (c)(13); and
0
f. Adding two sentences 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 to calculate net 
capital using the market risk standards of Appendix E to compute a 
deduction for market risk on some or all of its positions, instead of 
the provisions of paragraphs (c)(2)(vi) and (c)(2)(vii) of this 
section, and using the credit risk standards of Appendix E to compute a 
deduction for credit risk 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 on the broker or dealer the Commission may require as 
necessary or appropriate in the public interest or for the protection 
of investors. A broker or dealer that has been approved to calculate 
its net capital under Appendix E must:
    (i) At all times maintain tentative net capital of not less than $1 
billion and net capital of not less than $500 million;
    (ii) Provide notice that same day in accordance with Sec.  240.17a-
11(g) if the broker's or dealer's tentative net capital is less than $5 
billion. The Commission may, upon written application, lower the 
threshold at which notification is necessary under this paragraph 
(a)(7)(ii), either unconditionally or on specified terms and 
conditions, if a broker or dealer satisfies the Commission that 
notification at the $5 billion threshold is unnecessary because of, 
among other factors, the special nature of its business, its financial 
position, its internal risk management system, or its compliance 
history; and
    (iii) Comply with Sec.  240.15c3-4 as though it were an OTC 
derivatives dealer with respect to all of its business activities, 
except that paragraphs (c)(5)(xiii), (c)(5)(xiv), (d)(8), and (d)(9) of 
Sec.  240.15c3-4 shall not apply.
* * * * *
    (c) * * *

Entities That Have a Principal Regulator

    (13)(i) For purposes of Sec.  240.15c3-1e and Sec.  240.15c3-1g, 
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 the person is:
    (A) An insured depository institution as defined in section 3(c)(2) 
of the

[[Page 34462]]

Federal Deposit Insurance Act (12 U.S.C. 1813(c)(2));
    (B) Registered as a futures commission merchant or an introducing 
broker with the Commodity Futures Trading Commission;
    (C) Registered with or licensed by a State insurance regulator and 
issues any insurance, endowment, or annuity policy or contract;
    (D) A foreign bank as defined in section 1(b)(7) of the 
International Banking Act of 1978 (12 U.S.C. 3101(7)) that has its 
headquarters in a jurisdiction for which any foreign bank has been 
approved by the Board of Governors of the Federal Reserve System to 
conduct business pursuant to the standards set forth in 12 CFR 
211.24(c), provided such foreign bank represents to the Commission 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;
    (E) Not primarily in the securities business, and the person is:
    (1) A corporation organized under section 25A of the Federal 
Reserve Act (12 U.S.C. 611 through 633); or
    (2) A corporation having an agreement or undertaking with the Board 
of Governors of the Federal Reserve System under section 25 of the 
Federal Reserve Act (12 U.S.C. 601 through 604a); or
    (F) A person that the Commission finds is another entity that is 
subject to comprehensive supervision, has in place appropriate 
arrangements so that information that the person provides to the 
Commission is sufficiently reliable for the purposes of determining 
compliance with Sec.  240.15c3-1e and Sec.  240.15c3-1g, and it is 
appropriate to consider the person to be an entity that has a principal 
regulator considering all relevant circumstances, including the 
person's mix of business.
    (ii) For purposes of Sec.  240.15c3-1e, Sec.  240.15c3-1g, Sec.  
240.17h-1T, and Sec.  240.17h2T, the term ultimate holding company that 
has a principal regulator shall mean a person (other than a natural 
person) that:
    (A) Is a financial holding company or a company that is treated as 
a financial holding company under the Bank Holding Company Act of 1956 
(12 U.S.C. 1840 et seq.), or
    (B) The Commission determines to be an ultimate holding company 
that has a principal regulator, if that person is subject to 
consolidated, comprehensive supervision; there are in place appropriate 
arrangements so that information that the person provides to the 
Commission is sufficiently reliable for the purposes of determining 
compliance with Sec.  240.15c3-1e and Sec.  240.15c3-1g; and it is 
appropriate to consider the person to be an ultimate holding company 
that has a principal regulator in view of all relevant circumstances, 
including the person's mix of business.
* * * * *
    (15) * * * For purposes of paragraph (a)(7) of this section, the 
term tentative net capital means the net capital of the broker or 
dealer before deductions for market and credit risk computed pursuant 
to 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. Tentative net capital shall include 
securities for which there is no ready market, as defined in paragraph 
(c)(11) of this section, if the use of mathematical models has been 
approved for purposes of calculating deductions from net capital for 
those securities pursuant to Sec.  240.15c3-1e.
* * * * *

0
6. Section 240.15c3-1e is revised to read as follows:


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

    Preliminary Note: Appendices E and G to the net capital rule set 
forth a program that allows a broker or dealer to use an alternative 
approach to computing net capital deductions, subject to the 
conditions described in the Appendices, including supervision of the 
broker's or dealer's ultimate holding company under the program. The 
program is designed to reduce the likelihood that financial and 
operational weakness in the holding company will destabilize the 
broker or dealer, or the broader financial system. The focus of this 
supervision of the ultimate holding company is its financial and 
operational condition and its risk management controls and 
methodologies.

Application

    (a) A broker or dealer may apply to the Commission for 
authorization to compute deductions for market risk pursuant to this 
Appendix E in lieu of computing deductions pursuant to Sec. Sec.  
240.15c3-1(c)(2)(vi) and (c)(2)(vii) and to compute deductions for 
credit risk pursuant to this Appendix E on credit exposures arising 
from transactions in derivatives instruments (if this Appendix E is 
used to calculate deductions for market risk on these instruments) in 
lieu of computing deductions pursuant to Sec.  240.15c3-1(c)(2)(iv):
    (1) A broker-dealer shall submit the following information to the 
Commission with its application:
    (i) An executive summary of the information provided to the 
Commission with its application and an identification of the ultimate 
holding company of the broker or dealer;
    (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 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 deductions for 
market and credit risk on those categories of positions;
    (iv) A description of the mathematical models to be used to price 
positions and to compute deductions for market risk, including those 
portions of the deductions attributable to specific risk, if 
applicable, and deductions for credit risk; 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 each category of 
persons who may input data into the 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 applicable 
qualitative and quantitative requirements set forth in paragraph (d) of 
this Appendix E; and a statement describing the extent to which each 
mathematical model used to compute deductions for market and credit 
risk will be used as part of the risk analyses and reports presented to 
senior management;
    (v) If the broker or dealer is applying to the Commission for 
approval to use scenario analysis to calculate deductions for market 
risk for certain positions, a list of those types of positions, a 
description of how those deductions will be calculated using scenario 
analysis, and an explanation of why each scenario analysis is 
appropriate to calculate deductions for market risk on those types of 
positions;
    (vi) A description of how the broker or dealer will calculate 
current exposure;

[[Page 34463]]

    (vii) A description of how the broker or dealer will determine 
internal credit ratings of counterparties and internal credit risk 
weights of counterparties, if applicable;
    (viii) A written undertaking by the ultimate holding company of the 
broker or dealer, if it is not an ultimate holding company that has a 
principal regulator, in a form acceptable to the Commission, signed by 
a duly authorized person at the ultimate holding company, to the effect 
that, as a condition of Commission approval of the application of the 
broker or dealer to compute deductions for market and credit risk 
pursuant to this Appendix E, the ultimate holding company agrees to:
    (A) Comply with all applicable provisions of this Appendix E;
    (B) Comply with all applicable provisions of Sec.  240.15c3-1g;
    (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 an OTC derivatives dealer with respect to all of its 
business activities, except that paragraphs (c)(5)(xiii), (c)(5)(xiv), 
(d)(8), and (d)(9) of Sec.  240.15c3-4 shall not apply;
    (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 the 
ultimate holding company and any of its affiliates, if the affiliate is 
not an entity that has a principal regulator;
    (F) If the disclosure to the Commission of any information required 
as a condition for the broker or dealer to compute deductions for 
market and credit risk pursuant to this Appendix E could be prohibited 
by law or otherwise, cooperate with the Commission, to the extent 
permissible, including by describing any secrecy laws or other 
impediments that could restrict the ability of material affiliates to 
provide information on their operations or activities and by discussing 
the manner in which the ultimate holding company and the broker or 
dealer propose to provide the Commission with adequate information or 
assurances of access to information;
    (G) Make available to the Commission information about the ultimate 
holding company or any of its material affiliates that the Commission 
finds is necessary to evaluate the financial and operational risk 
within the ultimate holding company and its material affiliates and to 
evaluate compliance with the conditions of eligibility of the broker or 
dealer to compute deductions to net capital under the alternative 
method of this Appendix E;
    (H) Make available examination reports of principal regulators for 
those affiliates of the ultimate holding company that are not subject 
to Commission examination; and
    (I) Acknowledge that, if the ultimate holding company fails to 
comply in a material manner with any provision of its undertaking, the 
Commission may, in addition to any other conditions necessary or 
appropriate in the public interest or for the protection of investors, 
increase the multiplication factors the ultimate 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 condition with respect to 
the broker or dealer listed in paragraph (e) of this Appendix E; and
    (ix) A written undertaking by the ultimate holding company of the 
broker or dealer, if the ultimate holding company has a principal 
regulator, in a form acceptable to the Commission, signed by a duly 
authorized person at the ultimate holding company, to the effect that, 
as a condition of Commission approval of the application of the broker 
or dealer to compute deductions for market and credit risk pursuant to 
this Appendix E, the ultimate holding company agrees to:
    (A) Comply with all applicable provisions of this Appendix E;
    (B) Comply with all applicable provisions of Sec.  240.15c3-1g;
    (C) Make available to the Commission information about the ultimate 
holding company that the Commission finds is necessary to evaluate the 
financial and operational risk within the ultimate holding company and 
to evaluate compliance with the conditions of eligibility of the broker 
or dealer to compute net capital under the alternative method of this 
Appendix E; and
    (D) Acknowledge that if the ultimate holding company fails to 
comply in a material manner with any provision of its undertaking, the 
Commission may, in addition to any other conditions necessary or 
appropriate in the public interest or for the protection of investors, 
impose any condition with respect to the broker or dealer listed in 
paragraph (e) of this Appendix E;
    (2) As a condition of Commission approval, the ultimate holding 
company of the broker or dealer, if it is not an ultimate holding 
company that has a principal regulator, shall include the following 
information with the application:
    (i) A narrative description of the business and organization of the 
ultimate holding company;
    (ii) An alphabetical list of the affiliates of the ultimate holding 
company (referred to as the ``affiliate group,'' which shall include 
the ultimate holding company), with an identification of the financial 
regulator, if any, that regulates the affiliate, and a designation of 
the members of the affiliate group that are material to the ultimate 
holding company (``material affiliates'');
    (iii) An organizational chart that identifies the ultimate holding 
company, the broker or dealer, and the material affiliates;
    (iv) Consolidated and consolidating financial statements of the 
ultimate holding company as of the end of the quarter preceding the 
filing of the application;
    (v) Sample computations for the ultimate holding company of 
allowable capital and allowances for market risk, credit risk, and 
operational risk, determined pursuant to Sec.  240.15c3-1g(a)(1)-
(a)(4);
    (vi) A list of the categories of positions that the affiliate group 
holds in its proprietary accounts and a brief description of the method 
that the ultimate holding company proposes to use to calculate 
allowances for market and credit risk, pursuant to Sec.  240.15c3-
1g(a)(2) and (a)(3), on those categories of positions;
    (vii) A description of the mathematical models to be used to price 
positions and to compute the allowance for market risk, including those 
portions of the allowance attributable to specific risk, if applicable, 
and the allowance for credit risk; a description of the creation, use, 
and maintenance of the mathematical models; a description of the 
ultimate holding company's internal risk management controls over those 
models, including a description of each category of persons who may 
input data into the 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 ultimate holding company will use to backtest the 
mathematical model used to calculate maximum potential exposure; a 
description of how each mathematical model satisfies the applicable 
qualitative and quantitative requirements set forth in paragraph (d) of 
this Appendix E; a statement describing the extent to which each 
mathematical model used to compute allowances for market and credit 
risk is used as part of the risk analyses and

[[Page 34464]]

reports presented to senior management; and a description of any 
positions for which the ultimate holding company proposes to use a 
method other than VaR to compute an allowance for market risk and a 
description of how that allowance would be determined;
    (viii) A description of how the ultimate holding company will 
calculate current exposure;
    (ix) A description of how the ultimate holding company will 
determine the credit risk weights of counterparties and internal credit 
ratings of counterparties, if applicable;
    (x) A description of how the ultimate holding company will 
calculate an allowance for operational risk under Sec.  240.15c3-
1g(a)(4);
    (xi) For each instance in which a mathematical model used by the 
broker or dealer to calculate a deduction for market risk or to 
calculate maximum potential exposure for a particular product or 
counterparty differs from the mathematical model used by the ultimate 
holding company to calculate an allowance for market risk or to 
calculate 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 ultimate 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 that are provided to the persons at the 
ultimate holding company who are responsible for managing group-wide 
risk and that will be provided to the Commission pursuant to Sec.  
240.15c3-1g(b)(1)(i)(H);
    (3) As a condition of Commission approval, the ultimate holding 
company of the broker or dealer, if the ultimate holding company has a 
principal regulator, shall include the following information with the 
broker's or dealer's application:
    (i) A narrative description of the business and organization of the 
ultimate holding company;
    (ii) An alphabetical list of the affiliates of the ultimate holding 
company (referred to as the ``affiliate group,'' which shall include 
the ultimate holding company), with an identification of the financial 
regulator, if any, that regulates the affiliate, and a designation of 
those affiliates that are material to the ultimate holding company 
(``material affiliates'');
    (iii) An organizational chart that identifies the ultimate holding 
company, the broker or dealer, and the material affiliates;
    (iv) Consolidated and consolidating financial statements of the 
ultimate holding company as of the end of the quarter preceding the 
filing of the application;
    (v) The most recent capital measurements of the ultimate holding 
company, as reported to its principal regulator, calculated in 
accordance with the standards published by the Basel Committee on 
Banking Supervision, as amended from time to time;
    (vi) For each instance in which a mathematical model to be used by 
the broker or dealer to calculate a deduction for market risk or to 
calculate maximum potential exposure for a particular product or 
counterparty differs from the mathematical model used by the ultimate 
holding company to calculate an allowance for market risk or to 
calculate maximum potential exposure for that same product or 
counterparty, a description of the difference(s) between the 
mathematical models; and
    (vii) Sample risk reports that are provided to the persons at the 
ultimate holding company who are responsible for managing group-wide 
risk and that will be provided to the Commission under Sec.  240.15c3-
1g(b)(1)(i)(H);
    (4) The application of the broker or dealer shall be supplemented 
by other information relating to the internal risk management control 
system, mathematical models, and financial position of the broker or 
dealer or the ultimate holding company of the broker or dealer that the 
Commission may request to complete its review of the application;
    (5) The application shall be considered filed when received at the 
Commission's principal office in Washington, DC. A person who files an 
application pursuant to this section for which it seeks confidential 
treatment may clearly mark each page or segregable portion of each page 
with the words ``Confidential Treatment Requested.'' All information 
submitted in connection with the application will be accorded 
confidential treatment, to the extent permitted by law;
    (6) If any of the information 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 notify the Commission promptly and provide the 
Commission with a description of the circumstances in which the 
information was found to be or has become inaccurate along with 
updated, accurate information;
    (7) The Commission may approve the application or an amendment to 
the application, in whole or in part, subject to any conditions or 
limitations the Commission may require, if the Commission finds the 
approval to be necessary or appropriate in the public interest or for 
the protection of investors, after determining, among other things, 
whether the broker or dealer has met the requirements of this Appendix 
E and is in compliance with other applicable rules promulgated under 
the Act and by self-regulatory organizations, and whether the ultimate 
holding company of the broker or dealer is in compliance with the terms 
of its undertakings, as provided to the Commission;
    (8) A broker or dealer shall amend its application to calculate 
certain deductions for market and credit risk under this Appendix E and 
submit the amendment to the Commission for approval before it may 
change materially a mathematical model used to calculate market or 
credit risk or before it may change materially its internal risk 
management control system;
    (9) As a condition to the broker's or dealer's calculation of 
deductions for market and credit risk under this Appendix E, an 
ultimate holding company that does not have a principal regulator shall 
submit to the Commission, as an amendment to the broker's or dealer's 
application, any material changes to a mathematical model or other 
methods used to calculate allowances for market, credit, and 
operational risk, and any material changes to the internal risk 
management control system for the affiliate group. The ultimate holding 
company must submit these material changes to the Commission before 
making them;
    (10) As a condition for the broker or dealer to compute deductions 
for market and credit risk under this Appendix E, the broker or dealer 
agrees that:
    (i) It will notify the Commission 45 days before it ceases to 
compute deductions for market and credit risk under this Appendix E; 
and
    (ii) The Commission may determine by order that the notice will 
become effective after a shorter or longer period of time if the broker 
or dealer consents or if the Commission determines that a shorter or 
longer period of time is necessary or appropriate in the public 
interest or for the protection of investors; and
    (11) Notwithstanding paragraph (a)(10) of this section, the 
Commission, by order, may revoke a broker's or

[[Page 34465]]

dealer's exemption that allows it to use the market risk standards of 
this Appendix E to calculate deductions for market risk, instead of the 
provisions of Sec.  240.15c3-1(c)(2)(vi) and (c)(2)(vii), and the 
exemption to use the credit risk standards of this Appendix E to 
calculate deductions for credit risk 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 for the protection of investors. In making its finding, the 
Commission will consider the compliance history of the broker or dealer 
related to its use of models, the financial and operational strength of 
the broker or dealer and its ultimate holding company, the broker's or 
dealer's compliance with its internal risk management controls, and the 
ultimate holding company's compliance with its undertakings.

Market Risk

    (b) A broker or dealer whose application, including amendments, has 
been approved under paragraph (a) of this Appendix E shall compute a 
deduction for market risk in an amount equal to the sum of the 
following:
    (1) For positions for which the Commission has approved the 
broker's or dealer's use of value-at risk (``VaR'') models, the VaR of 
the positions multiplied by the appropriate multiplication factor 
determined according to paragraph (d)(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 application or an amendment to the application under paragraph 
(a) of this Appendix E, including a review of its internal risk 
management control system and practices and VaR models, that another 
multiplication factor is appropriate;
    (2) For positions for which the VaR model does not incorporate 
specific risk, a deduction for specific risk to be determined by the 
Commission based on a review of the broker's or dealer's application or 
an amendment to the application under paragraph (a) of this Appendix E 
and the positions involved;
    (3) For positions for which the Commission has approved the 
broker's or dealer's application to use scenario analysis, the greatest 
loss resulting from a range of adverse movements in relevant risk 
factors, prices, or spreads designed to represent a negative movement 
greater than, or equal to, the worst ten-day movement over the four 
years preceding calculation of the greatest loss, or some multiple of 
the greatest loss based on the liquidity of the positions subject to 
scenario analysis. If historical data is insufficient, the deduction 
shall be the largest loss within a three standard deviation movement in 
those risk factors, prices, or spreads over a ten-day period, 
multiplied by an appropriate liquidity adjustment factor. Irrespective 
of the deduction otherwise indicated under scenario analysis, the 
resulting deduction for market risk 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 of contracts, even 
if the scenario analysis indicates a lower amount. A qualifying 
scenario must include the following:
    (i) A set of pricing equations for the positions based on, for 
example, arbitrage relations, statistical analysis, historic 
relationships, merger evaluation, or fundamental valuation of an 
offering of securities;
    (ii) Auxiliary relationships mapping risk factors to prices; and
    (iii) Data demonstrating the effectiveness of the scenario in 
capturing market risk, including specific risk; and
    (4) For all remaining positions, the deductions specified in 
Sec. Sec.  240.15c3-1(c)(2)(vi), (c)(2)(vii), and applicable appendices 
to Sec.  240.15c3-1.

Credit Risk

    (c) A broker or dealer whose application, including amendments, has 
been approved under paragraph (a) of this Appendix E shall compute a 
deduction for credit risk on transactions in derivative instruments (if 
this Appendix E is used to calculate a deduction for market risk on 
those instruments) in an amount equal to the sum of the following:
    (1) A counterparty exposure charge in an amount equal to the sum of 
the following:
    (i) The net replacement value in the account of each counterparty 
that is insolvent, or in bankruptcy, or that has senior unsecured long-
term debt in default; and
    (ii) For a counterparty not otherwise described in paragraph 
(c)(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 (c)(4)(i) of this Appendix E, multiplied by the credit risk 
weight of the counterparty, as defined in paragraph (c)(4)(vi) of this 
Appendix E, multiplied by 8%;
    (2) A concentration charge by counterparty in an amount equal to 
the sum of the following:
    (i) For each counterparty with a credit risk weight of 20% or less, 
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 each counterparty with a credit risk weight of greater 
than 20% but less than 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 each counterparty with a credit risk weight of greater 
than 50%, 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
    (3) A portfolio concentration charge of 100% of the amount of the 
broker's or dealer's aggregate current exposure for all counterparties 
in excess of 50% of the tentative net capital of the broker or dealer;
    (4) Terms. (i) 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 (c)(4)(ii) 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 (c)(4)(iii) of this Appendix 
E. The broker or dealer must use the multiplication factor determined 
according to paragraph (d)(1)(v) 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 application 
or an amendment to the application approved under paragraph (a) of this 
Appendix E, including a review of its internal risk management control 
system and practices and VaR models, that another multiplication factor 
is appropriate;
    (ii) The maximum potential exposure is the VaR of the 
counterparty's positions with the broker or dealer, after applying 
netting agreements with the counterparty meeting the requirements of 
paragraph (c)(4)(iv) of this Appendix E, taking into account the value 
of collateral from the counterparty held by the broker or dealer in 
accordance with paragraph (c)(4)(v) of this Appendix E, and taking into 
account the current replacement value of the counterparty's positions 
with the broker or dealer;
    (iii) 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

[[Page 34466]]

meeting the requirements of paragraph (c)(4)(iv) 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 (c)(4)(v) of this 
Appendix E;
    (iv) Netting agreements. A broker or dealer may include the effect 
of a netting agreement that allows the broker or dealer to net gross 
receivables from and gross payables to a counterparty upon default of 
the counterparty if:
    (A) The netting agreement is legally enforceable in each relevant 
jurisdiction, including in insolvency proceedings;
    (B) The gross receivables and gross payables that are subject to 
the netting agreement with a counterparty can be determined at any 
time; and
    (C) For internal risk management purposes, the broker-dealer 
monitors and controls its exposure to the counterparty on a net basis;
    (v) Collateral. When calculating maximum potential exposure and 
current exposure to a counterparty, the fair market value of collateral 
pledged and held may be taken into account provided:
    (A) The collateral is marked to market each day and is subject to a 
daily margin maintenance requirement;
    (B) The collateral is subject to the broker's or dealer's physical 
possession or control;
    (C) The collateral is liquid and transferable;
    (D) The collateral may be liquidated promptly by the firm without 
intervention by any other party;
    (E) The collateral agreement is legally enforceable by the broker 
or dealer against the counterparty and any other parties to the 
agreement;
    (F) The collateral does not consist of securities issued by the 
counterparty or a party related to the broker or dealer or to the 
counterparty;
    (G) The Commission has approved the broker's or dealer's use of a 
VaR model to calculate deductions for market risk for the type of 
collateral in accordance with this Appendix E; and
    (H) The collateral is not used in determining the credit rating of 
the counterparty;
    (vi) Credit risk weights of counterparties. A broker or dealer that 
computes its deductions for credit risk pursuant to this Appendix E 
shall determine the credit risk weight of a counterparty as follows:
    (A) 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;
    (B) 50% credit risk weight for transactions with counterparties 
with ratings for senior unsecured long-term debt in the third and 
fourth highest rating categories by an NRSRO or equivalent internal 
rating, if applicable;
    (C) 150% credit risk weight for transactions with counterparties 
with ratings for senior unsecured long-term debt below the fourth 
highest rating category by an NRSRO or equivalent internal rating, if 
applicable;
    (D) 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;
    (E) As part of its initial application or in an amendment, the 
broker or dealer may request Commission approval to determine credit 
risk weights based on internal calculations, including internal 
estimates of the maturity adjustment. 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 risk weight of 
each counterparty;
    (F) For the portion of a current exposure covered by a written 
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; 
and
    (G) As part of its initial application or in an amendment, the 
broker or dealer may request Commission approval to reduce deductions 
for credit risk through the use of credit derivatives.

VaR Models

    (d) To be approved, 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 integrated into the daily internal risk management 
system of the broker or dealer;
    (ii) The VaR model must be reviewed both periodically and annually. 
The periodic review may be conducted by the broker's or dealer'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 (15 U.S.C. 7201 et seq.); 
and
    (iii) For purposes of computing market risk, the broker or dealer 
must determine the appropriate multiplication factor as follows:
    (A) Beginning three months after the broker or dealer begins using 
the VaR model to calculate market risk, the broker or dealer 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, or other period as may 
be appropriate for the first year of its use;
    (B) On the last business day of each quarter, the broker or dealer 
must identify the number of backtesting exceptions of the VaR model, 
that is, the number of business days in the past 250 business days, or 
other period as may be appropriate for the first year of its use, for 
which the actual net trading loss, if any, exceeds the corresponding 
VaR measure; and
    (C) The broker or dealer 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;

   Table 1.--Multiplication factor based on the number of backtesting
                       exceptions of the VaR model
------------------------------------------------------------------------
                                                          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 incorporating specific risk into a VaR model, 
a broker or dealer must demonstrate that it has methodologies in place 
to capture liquidity, event, and default risk adequately for each 
position.

[[Page 34467]]

Furthermore, the models used to calculate deductions for specific risk 
must:
    (A) Explain the historical price variation in the portfolio;
    (B) Capture concentration (magnitude and changes in composition);
    (C) Be robust to an adverse environment; and
    (D) Be validated through backtesting; and
    (v) For purposes of computing the credit equivalent amount of the 
broker's or dealer's exposures to a counterparty, the broker or dealer 
must determine the appropriate multiplication factor as follows:
    (A) Beginning three months after it begins using the VaR model to 
calculate maximum potential exposure, the broker or dealer must conduct 
backtesting of the model by comparing, for at least 80 counterparties 
with widely varying types and sizes of positions with the firm, the 
ten-business day change in its current exposure to the counterparty 
based on its positions held at the beginning of the ten-business day 
period with the corresponding ten-business day maximum potential 
exposure for the counterparty generated by the VaR model;
    (B) As of the last business day of each quarter, the broker or 
dealer must identify the number of backtesting exceptions of the VaR 
model, that is, the number of ten-business day periods in the past 250 
business days, or other period as may be appropriate for the first year 
of its use, for which the change in current exposure to a counterparty 
exceeds the corresponding maximum potential exposure; and
    (C) The broker or dealer will propose, as part of its application, 
a schedule of multiplication factors, which must be approved by the 
Commission based on the number of backtesting exceptions of the VaR 
model. The broker or dealer must use the multiplication factor 
indicated in the approved schedule in determining the credit equivalent 
amount of its exposures to a counterparty until it obtains the next 
quarter's backtesting results, unless the Commission determines, based 
on, among other relevant factors, a review of the broker's or dealer'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; or based 
on a review of the broker's or dealer's procedures for managing 
collateral and if the collateral is marked to market daily and the 
broker or dealer has the ability to call for additional collateral 
daily, the Commission may approve a time horizon of not less than ten 
business days;
    (iii) The VaR model must use an effective historical observation 
period of at least one year. The broker or dealer must consider the 
effects of market stress in its construction of the model. 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 broker or dealer, including:
    (A) Risks arising from the non-linear price characteristics of 
derivatives and the sensitivity of the market value of those positions 
to changes in the volatility of the derivatives' underlying rates and 
prices;
    (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 proprietary or other trading accounts 
of the broker or dealer, 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 positions.

Additional Conditions

    (e) 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 conditions on the broker or dealer, which may include, but 
are not limited to restricting the broker's or dealer's business on a 
product-specific, category-specific, or general basis; submitting to 
the Commission a plan to increase the broker's or dealer's net capital 
or tentative net capital; filing more frequent reports with the 
Commission; modifying the broker's or dealer's internal risk management 
control procedures; or computing the broker's or dealer's deductions 
for market and credit risk in accordance with Sec.  240.15c3-
1(c)(2)(vi), (c)(2)(vii), and (c)(2)(iv), as appropriate. If it is not 
an ultimate holding company that has a principal regulator, the 
Commission also may require, as a condition of continuation of the 
exemption, the ultimate holding company of the broker or dealer to file 
more frequent reports or to modify its group-wide internal risk 
management control procedures. If the Commission finds it is necessary 
or appropriate in the public interest or for the protection of 
investors, the Commission may impose additional conditions on either 
the broker-dealer, or the ultimate holding company, if it is an 
ultimate holding company that does not have a principal regulator, if:
    (1) The broker or dealer is required by Sec.  240.15c3-1(a)(7)(ii) 
to provide notice to the Commission that the broker's or dealer's 
tentative net capital is less than $5 billion;
    (2) The broker or dealer or the ultimate 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;
    (3) Any event specified in Sec.  240.17a-11 occurs;
    (4) There is a material deficiency in the internal risk management 
control system or in the mathematical models used to price securities 
or to calculate deductions for market and credit risk or allowances for 
market and credit risk, as applicable, of the broker or dealer or the 
ultimate holding company of the broker or dealer;
    (5) The ultimate 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) or (a)(1)(ix) of 
this Appendix E;
    (6) The broker or dealer fails to comply with this Appendix E; or
    (7) The Commission finds that imposition of other conditions is 
necessary or appropriate in the public interest or for the protection 
of investors.

0
7. Section 240.15c3-1g is added to read as follows:


Sec.  240.15c3-1g  Conditions for ultimate 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 
deductions to capital in accordance with Sec.  240.15c3-1e, pursuant to 
its undertaking, the ultimate holding company of the broker or dealer 
shall:

[[Page 34468]]

Conditions Regarding Computation of Allowable Capital and Risk 
Allowances

    (a) If it is not an ultimate holding company that has a principal 
regulator, as that term is defined in Sec.  240.15c3-1(c)(13), 
calculate allowable capital and allowances for market, credit, and 
operational risk on a consolidated basis as follows:
    (1) Allowable capital. The ultimate holding company must compute 
allowable capital as the sum of:
    (i) Common shareholders' equity on the consolidated balance sheet 
of the holding company less:
    (A) Goodwill;
    (B) Deferred tax assets, except those permitted for inclusion in 
Tier 1 capital by the Board of Governors of the Federal Reserve System 
(``Federal Reserve'') (12 CFR 225, Appendix A);
    (C) Other intangible assets; and
    (D) Other deductions from common stockholders' equity as required 
by the Federal Reserve in calculating Tier 1 capital (as defined in 12 
CFR 225, Appendix A);
    (ii) Cumulative and non-cumulative preferred stock, except that the 
amount of cumulative preferred stock may not exceed 33% of the items 
included in allowable capital pursuant to paragraph (a)(1)(i) of this 
Appendix G, excluding 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;
    (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 subject to the 
conditions of paragraphs (a)(1)(ii)(A) through (D) of this Appendix G;
    (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 ultimate holding 
company; and the subordinated debt instrument permits acceleration only 
in the event of bankruptcy or reorganization of the ultimate holding 
company under Chapters 7 (liquidation) and 11 (reorganization) of the 
U.S. Bankruptcy Code; and
    (C) As part of the broker's or dealer's application to calculate 
deductions for market and credit risk under Sec.  240.15c3-1e, an 
ultimate holding company may request to include, for a period of three 
years after adoption of this Appendix G, long-term debt that has an 
original weighted average maturity of at least five years and that 
cannot be accelerated, except upon the occurrence of certain events as 
the Commission may approve. As part of a subsequent amendment to the 
broker's or dealer's application, the broker or dealer may request 
permission for the ultimate holding company to include long-term debt 
that meets these criteria in allowable capital for up to an additional 
two years; and
    (iv) Hybrid capital instruments that are permitted for inclusion in 
Tier 2 capital by the Federal Reserve (as defined in 12 CFR 225, 
Appendix A);
    (2) Allowance for market risk. The ultimate holding company shall 
compute an allowance for market risk 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 as set forth in Sec.  240.15c3-1e(d). 
The VaR of the positions must be obtained using approved VaR models 
meeting the applicable qualitative and quantitative requirements of 
Sec.  240.15c3-1e(d); and
    (ii) Alternative method. For positions for which there does not 
exist adequate historical data to support a VaR model, the ultimate 
holding company must propose a model that produces a suitable allowance 
for market risk for those positions;
    (3) Allowance for credit risk. The ultimate holding company shall 
compute an allowance for credit risk for 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) By multiplying the credit equivalent amount of the ultimate 
holding company's exposure to the counterparty, as defined in 
paragraphs (a)(3)(i)(A), (B) and (C) of this Appendix G, by the 
appropriate credit risk weight, as defined in paragraph (a)(3)(i)(F) of 
this Appendix G, of the asset, off-balance sheet item, or counterparty, 
then multiplying that product by 8%, in accordance with the following:
    (A) For certain loans and loan commitments, 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) 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;
    (3) 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
    (4) 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 is the sum of 
the ultimate holding company's maximum potential exposure to the 
counterparty, as defined in paragraph (a)(3)(i)(E) of this Appendix G, 
multiplied by the appropriate multiplication factor, and the ultimate 
holding company's current exposure to the counterparty, as defined in 
paragraph (a)(3)(i)(D) of this Appendix G. The ultimate holding company 
must use the multiplication factor determined according to Sec.  
240.15c3-1e(d)(1)(v), 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 credit equivalent amount for other assets shall be the 
asset's book value on the ultimate holding company's consolidated 
balance sheet or other amount as determined according to the standards 
published by the Basel Committee on Banking

[[Page 34469]]

Supervision, as amended from time to time;
    (D) The current exposure is the current replacement value of a 
counterparty's positions, after applying netting agreements with that 
counterparty meeting the requirements of Sec.  240.15c3-1e(c)(4)(iv) 
and taking into account the value of collateral from the counterparty 
in accordance with Sec.  240.15c3-1e(c)(4)(v);
    (E) The maximum potential exposure is the VaR of the counterparty's 
positions with the member of the affiliate group, after applying 
netting agreements with the counterparty meeting the requirements of 
paragraph (c)(4)(iv) of Sec.  240.15c3-1e, taking into account the 
value of collateral from the counterparty held by the member of the 
affiliate in accordance with paragraph (c)(4)(v) of Sec.  240.15c3-1e, 
and taking into account the current replacement value of the 
counterparty's positions with the member of the affiliate group, 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 not less 
than five days;
    (F) Credit ratings and credit risk weights shall be determined 
according to the provisions of paragraphs (c)(4)(vi)(D) and 
(c)(4)(vi)(E) of Sec.  240.15c3-1e, respectively;
    (G) As part of the broker's or dealer's initial application or in 
an amendment, the ultimate holding company may request Commission 
approval to reduce allowances for credit risk through the use of credit 
derivatives;
    (H) For the portion of a current exposure covered by a written 
guarantee, where that guarantee is an unconditional and irrevocable 
guarantee of the due and punctual payment and performance of the 
obligation and the ultimate holding company or member of the affiliate 
group can demand payment after any payment is missed without having to 
make collection efforts, the ultimate 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; or
    (ii) As part of the broker's or dealer's initial application or in 
an amendment to the application, the ultimate holding company may 
request Commission approval to use a method of calculating credit risk 
that is consistent with standards published by the Basel Committee on 
Banking Supervision in International Convergence of Capital Measurement 
and Capital Standards (July 1988), as amended from time to time; and
    (4) Allowance for operational risk. The ultimate holding company 
shall compute an allowance for operational risk in accordance with the 
standards published by the Basel Committee on Banking Supervision, as 
amended from time to time.

Conditions Regarding Reporting Requirements

    (b) File reports with the Commission in accordance with the 
following:
    (1) If it is not an ultimate holding company that has a principal 
regulator, as that term is defined in Sec.  240.15c3-1(c)(13), the 
ultimate holding company shall file with the Commission:
    (i) A report as of the end of each month, filed not later than 30 
calendar days after the end of the month. A monthly report need not be 
filed for a month-end that coincides with a fiscal quarter-end. The 
monthly report shall include:
    (A) A consolidated balance sheet and income statement (including 
notes to the financial statements) for the ultimate holding company and 
statements of allowable capital and allowances for market, credit, and 
operational risk computed pursuant to paragraph (a) of this Appendix G, 
except that the consolidated balance sheet and income statement for the 
first month of the fiscal year may be filed at a later time to which 
the Commission agrees (when reviewing the affiliated broker's or 
dealer's application under Sec.  240.15c3-1e(a)).
    (B) A graph reflecting, for each business line, the daily intra-
month VaR;
    (C) Consolidated credit risk information, including aggregate 
current exposure and current exposures (including commitments) listed 
by counterparty for the 15 largest exposures;
    (D) The 10 largest commitments listed by counterparty;
    (E) Maximum potential exposure listed by counterparty for the 15 
largest exposures;
    (F) The aggregate maximum potential exposure;
    (G) A summary report reflecting the geographic distribution of the 
ultimate 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
    (H) Certain regular risk reports provided to the persons 
responsible for managing group-wide risk as the Commission may request 
from time to time;
    (ii) A quarterly report as of the end of each fiscal quarter, filed 
not later than 35 calendar days after the end of the quarter. The 
quarterly report shall include, in addition to the information 
contained in the monthly report as required by paragraph (b)(1)(i) of 
this Appendix G, the following:
    (A) Consolidating balance sheets and income statements for the 
ultimate holding company. The consolidating balance sheet must provide 
information regarding each material affiliate of the ultimate holding 
company in a separate column, but may aggregate information regarding 
members of the affiliate group that are not material affiliates into 
one column;
    (B) 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;
    (C) A description of all material pending legal or arbitration 
proceedings, involving either the ultimate holding company or any of 
its affiliates, that are required to be disclosed by the ultimate 
holding company under generally accepted accounting principles;
    (D) The aggregate amount of unsecured borrowings and lines of 
credit, segregated into categories, scheduled to mature within twelve 
months from the most recent fiscal quarter as to each material 
affiliate; and
    (E) For a quarter-end that coincides with the ultimate holding 
company's fiscal year-end, the ultimate holding company need not 
include consolidated and consolidating balance sheets and income 
statements in its quarterly reports. The consolidating balance sheet 
and income statement for the quarter-end that coincides with the fiscal 
year-end may be filed at a later time to which the Commission agrees 
(when reviewing the affiliated broker's or dealer's application under 
Sec.  240.15c3-1e(a));
    (iii) An annual audited report as of the end of the ultimate 
holding company's fiscal year, filed not later than 65 calendar days 
after the end of the fiscal year. The annual report shall include:
    (A) Consolidated financial statements for the ultimate holding 
company audited by a registered public accounting firm, as that term is 
defined in section 2(a)(12) of the Sarbanes-Oxley Act of 2002 (15 
U.S.C. 7201 et seq.). The audit shall be made in accordance with the 
rules promulgated by the Public Company Accounting Oversight Board. The 
audited financial statements must include a supporting schedule 
containing statements of allowable capital and allowances for market,

[[Page 34470]]

credit, and operational risk computed pursuant to paragraph (a) of this 
Appendix G; and
    (B) A supplemental report entitled ``Accountant's Report on 
Internal Risk Management Control System'' prepared by a registered 
public accounting firm, as that term is defined in section 2(a)(12) of 
the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7201 et seq.), indicating the 
results of the registered public accounting firm's review of the 
ultimate 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 upon by the ultimate holding company 
and the registered public accounting firm conducting the review. 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. The ultimate holding company must file, 
before commencement of the initial review, the procedures agreed upon 
by the ultimate holding company and the registered public accounting 
firm with the Division of Market Regulation, Office of Financial 
Responsibility, at Commission's principal office in Washington, DC. 
Before commencement of each subsequent review, the ultimate holding 
company must notify the Commission of any changes in the procedures;
    (iv) An organizational chart, as of the ultimate holding company's 
fiscal year-end, concurrently with its quarterly report for the 
quarter-end that coincides with its fiscal year-end. The ultimate 
holding company must provide quarterly updates of the organizational 
chart if a material change in the information provided to the 
Commission has occurred;
    (2) If the ultimate holding company is an entity that has a 
principal regulator, as that term is defined in Sec.  240.15c3-
1(c)(13), the ultimate holding company must file with the Commission:
    (i) A quarterly report as of the end of each fiscal quarter, filed 
not later than 35 calendar days after the end of the quarter, or a 
later time to which the Commission may agree upon application. The 
quarterly report shall include:
    (A) Consolidated (including notes to the financial statements) and 
consolidating balance sheets and income statements for the ultimate 
holding company;
    (B) Its most recent capital measurements computed in accordance 
with the standards published by the Basel Committee on Banking 
Supervision, as amended from time to time, as reported to its principal 
regulator;
    (C) Certain regular risk reports provided to the persons 
responsible for managing group-wide risk as the Commission may request 
from time to time; and
    (D) For a quarter-end that coincides with the ultimate holding 
company's fiscal year-end, the ultimate holding company need not 
include consolidated and consolidating balance sheets and income 
statements in its quarterly reports. The consolidating balance sheet 
and income statement for the quarter-end that coincides with the fiscal 
year-end may be filed at a later time to which the Commission agrees 
(when reviewing the affiliated broker's or dealer's application under 
Sec.  240.15c3-1e(a)).
    (ii) An annual audited report as of the end of the ultimate holding 
company's fiscal year, filed with the Commission when required to be 
filed by any regulator;
    (3) The reports that the ultimate holding company must file in 
accordance with paragraph (b) of this Appendix G will be considered 
filed when two copies are received at the Commission's principal office 
in Washington, DC. A person who files reports pursuant to this section 
for which he or she seeks confidential treatment may clearly mark each 
page or segregable portion of each page with the words ``Confidential 
Treatment Requested.'' The copies shall be addressed to the Division of 
Market Regulation, Risk Assessment Group; and
    (4) The reports that the ultimate holding company must file with 
the Commission in accordance with paragraph (b) of this Appendix G will 
be accorded confidential treatment to the extent permitted by law.

Conditions Regarding Records To Be Made

    (c) If it is not an ultimate holding company that has a principal 
regulator, make and keep current the following records:
    (1) A record of the results of funding and liquidity stress tests 
that the ultimate holding company has conducted in response to the 
following events at least once each quarter and a record of the 
contingency plan to respond to each of these events:
    (i) A credit rating downgrade of the ultimate holding company;
    (ii) An inability of the ultimate holding company to access capital 
markets for unsecured short-term funding;
    (iii) An inability of the ultimate 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 ultimate 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;
    (3) A record of the basis for the determination of internal credit 
ratings for each counterparty; and
    (4) A record of the calculations of allowable capital and 
allowances for market, credit and operational risk computed currently 
at least once per month on a consolidated basis.

Conditions Regarding Preservation of Records

    (d)(1) 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) 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) If the ultimate holding company does not have a principal 
regulator, all written policies and procedures concerning the group-
wide internal risk management control system established pursuant to 
Sec.  240.15c3-1e(a)(1)(viii)(C); and
    (2) The ultimate holding company may maintain the records referred 
to in paragraph (d)(1) of this Appendix G either at the ultimate 
holding company, at an affiliate, or at a records storage facility, 
provided that the records are located within the United States. If the 
records are maintained by an entity other than the ultimate holding 
company, the ultimate 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 ultimate 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

[[Page 34471]]

representatives or designees of the Commission and will promptly 
furnish the Commission or its designee a true, legible, complete, and 
current paper 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 ultimate 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) The ultimate holding company of a broker or dealer that 
computes certain of its capital charges in accordance with Sec.  
240.15c3-1e shall:
    (1) Send notice promptly (but within 24 hours) after the occurrence 
of the following events:
    (i) The early warning indications of low capital as the Commission 
may agree;
    (ii) The ultimate holding company files a Form 8-K (17 CFR 249.308) 
with the Commission; and
    (iii) A material affiliate declares bankruptcy or otherwise becomes 
insolvent; and
    (2) If it is not an ultimate holding company that has a principal 
regulator, as defined in Sec.  240.15c3-1(c)(13), send notice promptly 
(but within 24 hours) after the occurrence of the following events:
    (i) The ultimate holding company becomes aware that an NRSRO has 
determined to reduce materially its assessment of the creditworthiness 
of a material affiliate or the credit rating(s) assigned to one or more 
outstanding short or long-term obligations of a material affiliate;
    (ii) The ultimate holding company becomes aware that any financial 
regulatory agency or self-regulatory organization has taken significant 
enforcement or regulatory action against a material affiliate; and
    (iii) The occurrence of any backtesting exception under Sec.  
240.15c3-1e(d)(1)(iii) or (iv) that would require that the ultimate 
holding company use a higher multiplication factor in the calculation 
of its allowances for market or credit risk;
    (3) Every notice given or transmitted by paragraph (e) of this 
Appendix G will be given or transmitted to the Division of Market 
Regulation, Office of Financial Responsibility, at the principal office 
of the Commission in Washington, DC. A person who files notification 
pursuant to this section for which he or she seeks confidential 
treatment may clearly mark each page or segregable portion of each page 
with the words ``Confidential Treatment Request.'' For the purposes of 
this Appendix G, ``notice'' shall be given or transmitted by 
telegraphic notice or facsimile transmission. The notice described by 
paragraph (e)(2) of this Appendix G may be transmitted by overnight 
delivery. Notices filed pursuant to this paragraph will be accorded 
confidential treatment to the extent permitted by law; and
    (4) Upon the written request of the ultimate holding company, or 
upon its own motion, the Commission may grant an extension of time or 
an exemption from any of the requirements of this paragraph (e) either 
unconditionally or on specified terms and conditions as are necessary 
or appropriate in the public interest or for the protection of 
investors.

0
8. Section 240.17a-4 is amended by adding paragraph (b)(12) to read as 
follows:


Sec.  240.17a-4  Records to be preserved by certain exchange members, 
brokers and dealers.

* * * * *
    (b) * * *
    (12) The records required to be made pursuant to Sec.  240.15c3-
1e(c)(4)(vi)(D) and (E).
* * * * *
0
9. Section 240.17a-5 is amended by:
0
a. Redesignating paragraph (a)(5) as paragraph (a)(6), and adding new 
paragraph (a)(5); and
0
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) * * *
    (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 
deduction for market risk other than in accordance with Sec.  240.15c3-
1e(b)(1) or (b)(3), the product category and the amount of the 
deduction for market risk;
    (B) A graph reflecting, for each business line, the daily intra-
month 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 deduction for market risk;
    (E) Credit risk information on derivatives exposures, including:
    (1) Overall current exposure;
    (2) Current exposure (including commitments) listed by counterparty 
for the 15 largest exposures;
    (3) The 10 largest commitments listed by counterparty;
    (4) The broker or dealer's maximum potential exposure listed by 
counterparty for the 15 largest exposures;
    (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; and
    (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 a supplemental 
report on management controls, 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 (15 U.S.C. 7201 et seq.)). The 
supplemental report shall indicate the results of the accountant's 
review of the internal risk management control system established and 
documented by the broker or dealer in accordance with Sec.  240.15c3-4. 
This review shall be conducted in accordance with procedures agreed 
upon by the broker or dealer and the registered public accounting firm 
conducting the review. The agreed upon procedures are to be performed 
and the report is to be prepared in accordance with the rules 
promulgated by the Public Company Accounting Oversight

[[Page 34472]]

Board. 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. Before commencement of the review and no later than 
December 10 of each year, the broker or dealer shall file a statement 
with the Division of Market Regulation, Office of Financial 
Responsibility, at the Commission's principal office in Washington, DC 
that includes:
    (1) A description of the agreed-upon procedures agreed to by the 
broker or dealer and the registered public accounting firm; and
    (2) A notice describing changes in those agreed-upon procedures, if 
any. If there are no changes, the broker or dealer should so indicate.
* * * * *
0
10. Section Sec.  240.17a-11 is amended by revising paragraph (b)(2) 
and (h) to read as follows:


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

* * * * *
    (b)(1) * * *
    (2) In addition to the requirements of paragraph (b)(1) of this 
section, an OTC derivatives dealer or broker or dealer permitted to 
compute net capital pursuant to the alternative method of Sec.  
240.15c3-1e shall also provide notice if its tentative net capital 
falls below the minimum amount required pursuant to Sec.  240.15c3-1. 
The notice shall specify the tentative net capital requirements, and 
current amount of net capital and tentative net capital, of the OTC 
derivatives dealer or the broker or dealer permitted to compute net 
capital pursuant to the alternative method of Sec.  240.15c3-1e.
* * * * *
    (h) Other notice provisions relating to the Commission's financial 
responsibility or reporting rules are contained in Sec.  240.15c3-
1(a)(6)(iv)(B), Sec.  240.15c3-1(a)(6)(v), Sec.  240.15c3-1(a)(7)(ii), 
Sec.  240.15c3-1(a)(7)(iii), Sec.  240.15c3-1(c)(2)(x)(B)(1), Sec.  
240.15c3-1(c)(2)(x)(F)(3), Sec.  240.15c3-1(e), Sec.  240.15c3-
1d(c)(2), Sec.  240.15c3-3(i), Sec.  240.17a-5(h)(2) and Sec.  240.17a-
12(f)(2).
* * * * *

0
11. Section 240.17h-1T is amended by:
0
a. Redesignating paragraph (d)(4) as paragraph (d)(5); and
0
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) * * *
    (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 if that broker or dealer is affiliated with an 
ultimate holding company that is not an ultimate holding company that 
has a principal regulator, as defined in Sec.  240.15c3-1(c)(13).
* * * * *
0
12. Section 240.17h-2T is amended by:
0
a. Redesignating paragraph (b)(4) as paragraph (b)(5); and
0
b. Adding new paragraph (b)(4).
    The addition reads as follows:


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

* * * * *
    (b) * * *
    (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 if that broker or dealer is affiliated with an 
ultimate holding company that is not an ultimate holding company that 
has a principal regulator, as defined in Sec.  240.15c3-1(c)(13).
* * * * *

    By the Commission.

    Dated: June 8, 2004.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 04-13412 Filed 6-18-04; 8:45 am]
BILLING CODE 8010-01-P