Risk-Based Capital: Regulatory and Industry Approaches to Capital and
Risk (Chapter Report, 07/20/98, GAO/GGD-98-153).

GAO reviewed: (1) the regulatory views on the purpose of capital and
current regulatory requirements; (2) the approaches of some large
financial firms to risk measurement and capital allocation; and (3)
issues in capital regulation and initiatives being considered for
changes to regulatory capital requirements.

GAO noted that: (1) capital requirements differ by financial regulator
due to differences in the regulators' purpose; (2) historically,
regulators based capital regulation on the traditional risks in each
financial sector; (3) within the past decade, both the banking and life
insurance sectors adopted new capital requirements that are specifically
designed to be more sensitive to exposure to multiple risks; (4)
securities broker-dealers and futures commission merchants continue to
operate under net capital rules that the Securities Exchange Commission
and the Commodity Futures Trading Commission use in order to protect
customers and other market participants in the financial markets from
losses due to firm failures, not from bad investments; (5) unlike
regulators, firms analyze their use of capital to help ensure that they
can achieve their business objectives; (6) although many large firms GAO
spoke with use the results of their risk measurements to set limits on
trading activities, some go farther and use them to allocate capital
within the firm; (7) these techniques have limitations; however, firms
and regulators believe they significantly improve firms' ability to
measure and manage their risks; (8) the three principal issues
pertaining to regulatory capital requirements that are important when
considering possible future changes include: (a) the competitive
implications for firms stemming from differences in capital rules of
different financial regulators; (b) whether regulatory capital
requirements create incentives to manage risks inappropriately; and (c)
the administration of regulatory capital rules; and (9) regulatory
agencies and self-regulatory organizations are exploring or have
proposed a number of initiatives for modifying or changing current
capital requirements in the banking, securities, futures, and life
insurance sectors.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-98-153
     TITLE:  Risk-Based Capital: Regulatory and Industry Approaches to 
             Capital and Risk
      DATE:  07/20/98
   SUBJECT:  Insurance regulation
             Banking regulation
             Capital
             Derivative securities
             Futures
             Insured commercial banks
             Internal controls
             Regulatory agencies
             Risk management
             Securities regulation
IDENTIFIER:  Bank Insurance Fund
             BIF
             
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Cover
================================================================ COVER


Report to the Chairman, Committee on Banking, Housing, and Urban
Affairs,
U.  S.  Senate, and the Chairman, Committee on Banking and Financial
Services, House of Representatives

July 1998

RISK-BASED CAPITAL - REGULATORY
AND INDUSTRY APPROACHES TO CAPITAL
AND RISK

GAO/GGD-98-153

Risk-Based Capital

(233513)


Abbreviations
=============================================================== ABBREV

  ACLRBC - Authorized Control Level Risk-Based Capital
  AI - aggregate indebtedness
  AVR - asset valuation reserve
  CBOT - Chicago Board of Trade
  CEA - Commodity Exchange Act
  CFTC - Commodity Futures Trading Commission
  CME - Chicago Mercantile Exchange
  DPG - Derivatives Policy Group
  FCM - futures commission merchant
  FDIC - Federal Deposit Insurance Corporation
  FDICIA - Federal Deposit Insurance Corporation Improvement Act
  FRS - Federal Reserve System
  GAAP - Generally Accepted Accounting Principles
  GARP - Generally Accepted Risk Principles
  NAIC - National Association of Insurance Commissioners
  OCC - Office of the Comptroller of the Currency
  OECD - Organization for Economic Cooperation and Development
  OTC - cover-the-counter
  RAROC - risk-adjusted return on capital
  SEC - Securities and Exchange Commission
  SIPC - Securities Investor Protection Corporation
  SPAN - Standardized Portfolio Analysis of Risk
  SRO - self-regulatory organization
  TAC - Total Adjusted Capital
  TIMS - Theoretical Intermarket Margining System
  VAR - value-at-risk

Letter
=============================================================== LETTER


B-275428

July 20, 1998

The Honorable Alfonse M.  D'Amato
Chairman
The Honorable Paul S.  Sarbanes
Ranking Minority Member
Committee on Banking, Housing, and Urban Affairs
United States Senate

The Honorable James A.  Leach
Chairman
The Honorable John J.  LaFalce
Ranking Minority Member
Committee on Banking and Financial Services
House of Representatives

Recent years have seen dynamic changes in the financial services
industry.  As firms have improved their internal measurement of risk,
regulators have responded by reexamining their capital regulations. 
This report summarizes the results of our self-initiated review of
regulatory capital requirements and financial firms' approaches to
relating capital to risk.  Our review focused on regulatory views of
the purpose of capital and current regulatory capital requirements,
approaches to risk measurement and capital allocation used today by
some of the largest financial firms, and regulatory risk-based
capital initiatives. 

Risk-based capital, although already being used to some degree by
regulators of banks, securities broker-dealers, futures commission
merchants, and life insurers, is evolving as advances in financial
theory and technology enable firms to better understand, measure, and
manage their risk.  We identify a number of issues concerning future
regulatory risk-based capital initiatives of interest to regulators
and financial firms. 

We are sending copies of this report to the Acting Comptroller of the
Currency; the Chairmen of the Board of Governors of the Federal
Reserve System, the Federal Deposit Insurance Corporation, and the
Securities and Exchange Commission; the Chairperson of the Commodity
Futures Trading Commission; the Director of the Office of Thrift
Supervision; the Secretary of the Treasury; and the President of the
National Association of Insurance Commissioners.  We will also make
copies available to others on request. 

This report was prepared under the direction of Lawrence D.  Cluff,
Assistant Director, Financial Institutions and Markets Issues.  Other
major contributors are listed in appendix XI.  If you have any
questions, please call me on (202) 512-8678. 

Thomas J.  McCool
Director, Financial Institutions
 and Markets Issues


EXECUTIVE SUMMARY
============================================================ Chapter 0


   PURPOSE
---------------------------------------------------------- Chapter 0:1

Recent years have seen dynamic changes in the financial services
industry.  Through growth, mergers, and acquisitions, coupled with
regulatory reevaluation of acceptable activities, financial
institutions in different financial sectors are increasingly
competing directly for the same business by offering similar products
and undertaking similar activities.  Advances in financial theory and
technology have enabled financial firms to understand, measure, and
manage the financial risks they face in their business activities far
more effectively than in the past. 

As firms have improved their internal measurement of risk, financial
regulators have responded by reexamining their capital regulations
that require firms to hold minimum levels of capital as a buffer
against unexpected losses.  Some regulators have already responded to
changes in their industries by developing capital standards that
attempt to better correlate required regulatory capital with the
actual risks firms face in their activities, while other regulators
are considering similar changes.\1

This report is intended to inform Members of Congress and others of
both regulatory capital requirements and financial firms' approaches
to risk measurement.  More specifically, the objectives of this
report are to describe, for the banking, securities, futures, and
life insurance sectors, (1) regulatory views on the purpose of
capital and current regulatory requirements; (2) the approaches of
some large financial firms to risk measurement and capital
allocation; and (3) issues in capital regulation and initiatives
being considered for changes to regulatory capital requirements. 


--------------------
\1 The term financial regulators refers here to the following:  for
banks, the Office of the Comptroller of the Currency, the Federal
Reserve System, the Federal Deposit Insurance Corporation, and state
banking regulators; for securities broker-dealers, the Securities and
Exchange Commission (SEC) and state securities regulators; for
futures commission merchants, the Commodity Futures Trading
Commission (CFTC); and for insurance companies, state insurance
departments.  The Office of Thrift Supervision, which regulates
thrift institutions, is not a focus of this report because the report
does not cover thrifts. 


   BACKGROUND
---------------------------------------------------------- Chapter 0:2

For financial purposes, capital is generally defined as the long-term
funding for a firm that cushions the firm against unexpected losses. 
Losses are caused by exposure to various risks the financial firm
faces in its business activities.  Although there are different
categorizations of risks, in this report, GAO focuses on a set of
risks that banks, securities, futures, and life insurance regulators
and firms GAO interviewed most frequently identified as the ones they
were most concerned with--credit, market, liquidity, operational, and
business/event; and, for insurance companies only,
insurance/actuarial risk.\2

Financial regulators set minimum standards for the capital that firms
are to hold to protect against these risks.  Regulatory capital
requirements serve to protect customers or depositors and help ensure
the stability of financial markets to which they apply by limiting
firm failures and resulting losses to customers, depositors, or other
firms; they also can affect the efficiency of the financial system by
influencing how firms structure and conduct their business.  Minimum
capital requirements are a tool regulators use in their monitoring
activities to identify when regulatory action against a firm is
warranted to protect customers or depositors and financial markets. 
Moreover, financial regulators recognize that a capital requirement
is only one, though an essential one, of a larger set of prudential
tools used to help protect customers and ensure the stability of
financial markets that they regulate. 

Large financial firms increasingly have complex structures, including
parents, affiliates, and subsidiaries.\3 These component firms may
have one or more financial regulators or, in some cases, no
regulator.  Banks and their holding companies are regulated on a
consolidated basis; but, in the securities, futures, and life
insurance sectors, only the SEC-registered broker-dealers,
CFTC-registered futures commission merchants, and the underwriters or
sellers of insurance are regulated, even though these entities are
usually part of a larger holding company. 

In the past 20 years, a series of market shocks in combination with
advances in modern financial theory and information technology
stimulated the use of new techniques to help firms, particularly
large, diversified ones, better evaluate risks and returns.  They
also resulted in the creation of new financial products, particularly
derivatives.\4 Derivatives permit financial market participants to
better manage risk by transferring the risk from entities less
willing or able to manage it to those more willing and able to do so. 
These advances, as well as certain regulatory changes, also spurred
competition among different types of financial firms.  As a result,
firms in traditionally different financial sectors are competing more
directly with one another, providing similar products and, hence,
facing similar risks in their activities. 

To achieve its objectives, GAO reviewed a wide variety of documents
and interviewed federal and state financial regulators; academics;
rating agencies; self-regulatory organizations (SRO);\5 consultants;
trade associations; and a total of 16 large firms in the commercial
banking, securities, futures, and life insurance sectors.  GAO
developed a set of common questions that was used for its discussions
with firms in these sectors. 


--------------------
\2 Credit risk arises from the potential that a borrower or
counterparty (each party to a financial transaction is a counterparty
to the other) will fail to perform on an obligation.  Market risk
arises from broad movements in prices, such as interest rates,
commodity prices, stock prices, or foreign exchange rates.  Liquidity
risk is the potential that a firm will be unable to meet its
obligations as they come due because of an inability to liquidate
assets or to obtain adequate funding.  Operational risk arises from
the potential that inadequate information systems, operational
problems, breaches in internal controls, or fraud results in an
unexpected loss.  Business/event risk is the risk of losses due to
events, such as credit rating downgrades, breaches of law or
regulation, or factors beyond the control of the firm. 
Insurance/actuarial risk is the risk that an insurance underwriter
covers in exchange for premiums, such as the risk of premature death. 

\3 In this report, GAO refers to these as large, diversified
financial firms. 

\4 Derivatives are financial products that enable risk to be shifted
from one entity to another.  The value of the derivative is based on
an underlying reference rate, index, or asset, such as stocks, bonds,
commodities, interest rates, foreign currency exchange rates, and
various market indexes.  See Financial Derivatives:  Actions Needed
to Protect the Financial System (GAO/GGD-94-133, May 18, 1994) and
Financial Derivatives:  Actions Taken or Proposed Since May 1994
(GAO/GGD/AIMD-97-8, Nov.  1, 1996). 

\5 On a day-to-day basis, the securities and futures sectors
supervise themselves through SROs.  Securities and futures
subsidiaries of larger firms belong to SROs, which include stock
exchanges, futures exchanges, and recognized securities or futures
associations.  SROs establish rules to govern member conduct and
trading, set qualifications for certain market participants, monitor
daily trading activity, examine their members' financial health and
compliance with rules, and investigate alleged violations of those
rules. 


   RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3

Capital requirements differ by financial regulator due to differences
in the regulators' purpose.  In the view of bank regulators, the
primary purposes of bank capital standards are to maintain the safety
and soundness of the banking and payment systems and to protect the
deposit insurance funds.\6 For securities broker-dealers and futures
commission merchants,\7 SEC and CFTC view the primary purposes of
capital requirements as protecting customers and other market
participants from losses caused by a firm failure and protecting the
integrity of their markets.  Life insurance company regulators view
capital standards for life insurers as a way to help limit insurance
company failures and to protect policy holders/claimants.\8 In each
industry, firms that do not meet minimum regulatory capital
requirements are subject to regulatory action. 

Historically, regulators have also based capital regulation on the
traditional risks in each financial sector.  Bank capital
requirements have emphasized credit risk, which has long been the
predominant risk for banks because of their lending activities. 
Capital requirements for securities broker-dealers and futures
commission merchants focused on market risk because of the effect
changing market prices have on the value of their traded assets and,
potentially, customer accounts.  In addition to credit risk, capital
requirements for life insurers also focused on actuarial risk, which
stems from the unique nature of this sector's traditional business. 

Within the past decade, both the banking and life insurance sectors
adopted new capital requirements that are specifically designed to be
more sensitive to exposure to multiple risks.  U.S.  banking
regulators first adopted quantitative credit risk standards that
incorporated a formula designed to reflect different gradations of
risk.  More recently, they issued rules specifically focused on the
market risk in the trading portfolios of large banks which took
effect in January 1998.  The life insurance industry adopted
risk-based rules that are formula-based and require that capital be
held against exposure to specific risks faced by life insurers. 

Securities broker-dealers and futures commission merchants continue
to operate under what are called net capital rules that SEC and CFTC
use in order to protect customers and other market participants in
the financial markets from losses due to firm failures, not from bad
investments.  These rules are not specifically called "risk-based"
like those developed for banking and insurance.  However, they
explicitly require regulated firms to adjust their capital holdings
to account for risks in their activities. 

Unlike regulators, whose focus on the capital levels of firms is
driven by regulatory public purposes, firms analyze their use of
capital to help ensure that they can achieve their business
objectives.  Capital is provided by investors and by the firm through
retained earnings.  It enables financial firms to continue to fund
operations, earn profits, and grow.  It also provides a cushion to
absorb unexpected losses.  To attract and keep investors, a firm
tries to manage the trade-off between decreasing risks and increasing
returns.  To better assess this trade-off, a number of large
diversified firms are using complex risk measurement techniques. 
Some of these techniques are applied on a firmwide basis, and some
are more quantified and statistical than others.  Market and
insurance/actuarial risks tend to be most amenable to the use of
statistical models.  Credit and liquidity risks also have
quantifiable elements.  Operational and business/event risks are very
difficult to quantify and are not as readily measured. 

Although many large firms GAO spoke with use the results of their
risk measurements to set limits on trading activities, some go
farther and use them to allocate capital within the firm.  These
techniques have limitations; however, firms and regulators believe
they significantly improve firms' ability to measure and manage their
risks.  Financial regulators of large banks, securities
broker-dealers, and futures commission merchants are increasingly
using or are considering the use of firms' own estimates of risk in
setting capital requirements. 

Through discussions with industry representatives, regulators, and
others and review of pertinent literature, GAO identified three
principal issues pertaining to regulatory capital requirements that
are important when considering possible future changes to these
requirements.  First, what are the competitive implications for firms
stemming from differences in the capital rules of different financial
regulators?  Second, do differences between regulators' and firms'
measurement of risks, their views of how to manage those risks, and
their estimates of needed capital, create incentives to manage risks
inappropriately?  Third, how will financial regulators administer
capital rules when the largest firms' operations are increasingly
complex and growing differences exist between large and small firms? 

Regulatory agencies and SROs are exploring or have proposed a number
of initiatives for modifying or changing current capital requirements
in the banking, securities, futures, and life insurance sectors.  The
banking initiatives under consideration range from allowing banks to
use credit ratings to determine risk-based capital assessments for
some products to allowing banks to set their own target capital
levels and then penalizing them if they do not meet their targets. 
SEC and CFTC are monitoring and evaluating the Derivatives Policy
Group's (DPG) voluntary efforts to relate capital to risks.\9 SEC is
exploring the use of a statistical modeling approach to calculate net
capital requirements to better reflect market risks in broker-dealer
activities.  In addition, SEC and CFTC are exploring whether the
regulatory structure should be changed for over-the-counter (OTC)
derivatives dealers.  Life insurance regulators are working to modify
the interest rate risk component of their risk-based capital
requirements, but they have no current plans to change their
formula-based approach to setting capital requirements for other
risks. 


--------------------
\6 Regarding depository institutions, this report focuses on only
commercial banks.  It does not focus on thrifts, because their
capital rules for credit risk are similar to those of commercial
banks and thrifts are generally not engaged in trading activities
like those of the other financial firms mentioned above. 

\7 Broker-dealers are firms that buy or sell stocks, bonds, and other
securities for customers or for themselves.  Futures commission
merchants are firms that buy and sell futures contracts as agents for
customers. 

\8 Regarding the insurance industry, GAO focuses only on life
insurance companies because some of their activities are the most
similar to banks, securities broker-dealers, and futures commission
merchants. 

\9 The Derivatives Policy Group comprises the six U.S.  securities
firms most active in the over-the-counter, as opposed to
exchange-traded, derivatives market--CS First Boston, Goldman Sachs,
Lehman Brothers, Merrill Lynch, Morgan Stanley, and Salomon Brothers. 


   GAO ANALYSIS
---------------------------------------------------------- Chapter 0:4


      REGULATORY CAPITAL
      REQUIREMENTS REFLECT
      DIFFERENCES IN REGULATORY
      PURPOSES OF CAPITAL
-------------------------------------------------------- Chapter 0:4.1

Although there has been a significant amount of convergence in the
activities of the largest U.S.  banks, securities broker-dealers,
futures commission merchants, and life insurance companies, firms in
each of these sectors still have different primary financial
regulators with different oversight purposes and different regulatory
requirements. 

Differences in regulatory capital requirements reflect differences in
the regulators' views of the purposes of capital and the different
historical risks faced by firms in each of the sectors.  Bank capital
regulation is focused on the continued operation of the banking
system and helps ensure that overall payment services and credit
provision to customers will not be disrupted.  Securities and futures
capital regulations are based on whether the liquidation value of a
firm, in the event of a failure, would result in sufficient resources
to ensure that the claims of customers and other market participants
will be met.  State insurance regulators impose capital requirements
to try to limit insurance company failures to ensure the long-run
viability of insurance companies so that they can meet policyholders'
claims in the future. 

Financial regulators issue rules to be used in determining minimum
capital requirements for the firms they oversee; and in varying ways
these rules take into account the risks the firms face.  Both the
banking and life insurance sectors have requirements that are
specifically designed to be more sensitive to exposure to certain
risks.  Bank regulators from industrialized countries adopted rules
for credit risk exposure for internationally active banks in 1988
under the auspices of the Bank for International Settlements.  Known
as the Basle Accord, the rules were fully implemented in 1992.\10
U.S.  federal bank regulators chose to apply these rules to all U.S. 
banks.  The rules are formula-based and apply risk-weights to reflect
different gradations of risk to each asset category.  Since 1992,
there have been a number of amendments, but the most significant one
established risk-based capital requirements to cover market risk in
bank securities and derivatives trading portfolios.  The rule
requires that large banks with a significant amount of market risk
use their own internal models to provide a measure of the firm's
"value-at-risk."\11 The rule establishes minimum requirements for
constructing these models, and it specifies how much capital is to be
held against market risk.  This requirement, which took effect in
January 1998, generally pertains only to the largest 15 to 20 U.S. 
banks with extensive trading activity. 

Both SEC and CFTC use net capital rules to limit excessive leverage
by the firms they regulate.  In addition, they require regulated
entities to calculate similar measures of net capital that represent
the expected net value of their assets and liabilities during a
liquidation.  The net capital rules of both regulators measure
capital according to standard accounting practices and then adjust
this amount to reflect the liquidity of the firm's assets (called
"haircuts") to protect against the possible losses a broker-dealer or
futures commission merchant could incur if it were liquidated.  SEC
requires a broker-dealer to maintain the greater of a specified
minimum dollar amount or a specified percentage of net capital in two
financial ratios.  The first SEC ratio, which is usually used by
smaller broker-dealers, is based on the ratio of net capital to
aggregate indebtedness--the amount owed to customers and other
parties with claims against the broker-dealer.  The second SEC
minimum ratio, which is usually used by large broker-dealers, is
based on the ratio of net capital to customer receivables--funds owed
to the broker-dealer.  Under this requirement, if the firm is also a
futures commission merchant, it is also required to satisfy the CFTC
minimum capital requirement, which is based on the ratio of net
capital to segregated funds--a measure of funds owed to the customers
by the futures commission merchant.  As one step toward a more
risk-based approach, in February 1997, SEC approved the use of a
statistical model to calculate capital requirements for listed
options and their hedge positions, effective September 1, 1997.\12

The National Association of Insurance Commissioners (NAIC)\13

approved risk-based capital rules for life insurance companies in
1992.  These rules are designed to measure exposure to four major
categories of risk used by the insurance industry--asset, insurance,
interest rate, and all other business risk.\14 The approach is risk
weighted, reflecting different gradations of risk, and is similar in
concept to the banking industry's credit risk requirements.  The
rules require life insurance companies to hold capital against their
exposure to the risks listed above. 

Bankers, regulators, and industry and rating agency officials GAO
spoke with generally believe the current risk-based capital standards
for banks are an improvement over the former requirements, but they
still have limitations.  For example, many of them believe the
standards for credit risk are crude and imprecise because the
risk-weights are not adjusted for asset quality within broad
categories of assets.  Representatives of securities firms and other
industry participants GAO spoke with felt that because the current
requirements of the net capital rule do not correlate well with
actual risks in these firms' activities, this constrains their
business decisions and affects both the firms' structure and where
they conduct certain activities, such as derivatives.  In addition,
in their view, the net capital rule does not deal well with
risk-reducing strategies such as hedging.  Life insurance regulators
believe the main strength of the life insurance risk-based capital
rules is that the rules enable regulators to close a failing company
more quickly and easily than they could in the past.  Life insurance
industry officials GAO spoke with said that the current requirements
do not cover all risks equally well and that some changes are needed. 


--------------------
\10 The Bank for International Settlements was established in 1930 in
Basle, Switzerland.  Its objectives are to promote cooperation of
central banks, to provide additional facilities for international
operations, and to act as trustee for international financial
settlements.  The Basle Accord was formulated by the Basle Committee
on Banking Supervision.  Its members are representatives of the
central banks and supervisory authorities of Belgium, Canada, France,
Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden,
Switzerland, the United Kingdom, and the United States. 

\11 "Value-at-risk" represents an estimate of the maximum amount by
which the value of an institution's position in a risk category could
decline due to general market movements during a fixed holding
period, measured with a specified confidence interval. 

\12 Positions refers to an investor's stake (buying or selling) in a
market or particular security.  To hedge is to reduce risk by taking
a position that offsets existing or anticipated exposure to a change
in market prices.  Options are contracts that grant the purchaser the
right, but not the obligation, to buy or sell a specific amount of
the underlying at a particular price within a specified period. 
Listed options are exchange-traded. 

\13 NAIC is the organization of insurance regulators from the 50
states, the District of Columbia, and the 4 U.S.  territories. 
NAIC's basic purpose is to encourage consistency and cooperation
among the various states and territories as they individually
regulate the insurance industry. 

\14 Asset risks are the risks of asset defaults and decreases in
market value.  Insurance risks, which are unique to the insurance
industry, are the risk of underpricing or unfavorable developments in
mortality or morbidity.  Interest rate risk for insurance companies
is the chance that a change in interest rates will result in an
insurer not earning enough return on its investments to meet its
interest obligations under its various insurance and annuity
contracts.  The all other business risk category encompasses risks
not included elsewhere in the standards. 


      SOME LARGE FINANCIAL FIRMS
      ARE USING COMPLEX RISK
      MEASUREMENT TECHNIQUES TO
      MANAGE RISKS INTERNALLY
-------------------------------------------------------- Chapter 0:4.2

For firms, capital is a source of long-term funding and provides a
cushion to absorb unexpected losses.  For the investors in a firm,
the capital they invest is put at risk of loss in order to earn a
return.  For a firm's managers, maintaining the optimal amount of
capital is key to maintaining the firm as an ongoing business.  To
attract and keep investors, a firm tries to manage the trade-off
between decreasing risks and decreasing returns. 

Bondholders and stockholders assess this risk-return trade-off
differently.\15 Bondholders generally seek to limit a firm's risk
because they receive a fixed return (as long as the firm is viable). 
Stockholders generally are willing to accept a higher level of risk
because they can receive a higher return as a result of successful
risk-taking by the firm. 

Over the last decade or so, advances in measuring risk more precisely
have led some of the larger, more complex firms in the financial
sectors to use new techniques to better manage their risks.  In some
cases, these risk measurement techniques fit into a larger risk
management system.  According to the firms GAO interviewed, such
systems are used for a variety of purposes, including to set limits
on risk-taking, to allocate internal capital according to the
measured risk in firm activities, and to better assess profit
performance in relation to the risks being taken. 

All of the financial service firms GAO spoke with said that advances
in technology have enabled them to refine their risk measurement
techniques in recent years.  Depending on their own requirements that
stem from their business mix, these firms may have computer-based
risk measurement systems that feed into firm decisions on risk
management.  Market risk analysis is often the most statistically
sophisticated form of risk analysis these firms do.  Some firms in
each of these sectors said they use internal models to determine the
firm's "value-at-risk," which is a measurement of their market risk
exposure.  Several of the large securities firms GAO spoke with have
developed risk measurement computer systems that monitor the risks
being taken in different parts of the firm.  Capital is then
allocated in accordance with the degree of risk being undertaken by
each different part of the firm.  In conjunction with the use of
value-at-risk models, many of the firms GAO spoke with said they also
use stress testing,\16

scenario analysis,\17 and backtesting\18 as risk management tools. 
The results of these tests give an indication of the firm's
sensitivity to market movements. 

The firms GAO spoke with tend to use a variety of techniques, some
more statistical and quantifiable than others, to measure credit
risk.  Liquidity risks are not modeled on a statistical basis,
because this risk generally occurs due to a sudden or unexpected
event.  Instead, liquidity stresses tend to be analyzed using
worst-case scenarios developed by each firm.  Models for
insurance/actuarial risks are more likely statistical in nature and
apply many of the same techniques that are used in modeling market
risk.  Operational and business/event risks are the most difficult
risks to measure due to the lack of data necessary for such
measurements.  One large bank GAO spoke with said that it is using
proxies for these two risks in its quantitative risk measurement
techniques.  Nonetheless, all firms GAO spoke with agree that they
have the least confidence in the results of their operational and
business/event risk analyses. 

Most of the firms GAO spoke with said they have a firmwide risk
management framework in place to identify and control risk, and all
of their approaches emphasize the importance of top-level management
involvement in risk management in their firms.  Most of these firms
have risk management committees made up of senior managers of the
firms.  Although they use advanced risk measurement techniques, they
all stressed that management judgment and good internal controls are
more important than the risk measurement numbers for effective risk
management. 


--------------------
\15 The stockholders' returns include dividends out of profits from
operations and capital gains based on the market value of their
shares.  Bondholders' returns, in contrast, are based on interest,
repayment of principal, and capital gains on the bond. 

\16 Stress tests measure the potential impact of various large market
movements on the value of the firm's portfolio.  Such tests are a
useful tool for identifying exposures that appear to be relatively
small in the current environment but that grow more than
proportionally with changes in risk factors. 

\17 Scenario analysis generates forward-looking "what-if" simulations
for specified changes in market factors that quantify revenue
implications of such scenarios for the firm. 

\18 Backtesting is used retrospectively to evaluate the accuracy of
assumptions by comparing system predictions with actual trading
results. 


      IN RESPONSE TO ISSUES IN
      CAPITAL REGULATION, SOME
      REGULATORY CHANGE IS BEING
      CONSIDERED IN EACH FINANCIAL
      SECTOR
-------------------------------------------------------- Chapter 0:4.3

Through discussions with industry representatives, regulatory
officials, and others and a review of the pertinent literature, GAO
identified and categorized a number of issues that are relevant to
possible changes in the regulatory capital requirements.  The
principal issue in the first category, differences among financial
regulators, is that although financial firms that were traditionally
in different sectors are increasingly offering similar products and
taking on similar risks, differences in capital regulation across
their primary regulators may have competitive implications for the
firms.  Issues in the second category, differences between firms and
regulators in their approaches to capital and risk, include the
concern that because regulatory capital requirements are not
adequately sensitive to the risks inherent in particular products or
activities, they may create inappropriate incentives for firms in
managing their risk.  Another issue is the concern that the increased
use by regulators of financial firms' internal estimates of risk to
set regulatory capital requirements may be inappropriate, because the
firms and regulators have different purposes for capital.  Issues in
the third category, administrative, include whether it makes sense to
apply the same approach to capital regulation to firms of all sizes
and degrees of complexity, as well as how the regulators can
effectively oversee the increasing use of statistical models for
regulatory purposes. 

Financial regulators are considering some degree of change to
regulatory capital requirements in banking, securities, futures, and
life insurance.  Some of these changes would make regulatory capital
requirements more sensitive to the risks in firm activities, while
others would represent more fundamental changes in the regulators'
approaches to capital regulation.  In November 1997, bank regulators
issued proposed revisions to the risk-based capital standards that
would use credit ratings from rating agencies and possibly
alternative approaches to match the risk-based capital assessments
for certain products more closely to a bank's relative risk of loss
in asset securitizations.\19 Also, in banking, research is being done
into an internal models-based approach for credit risk that could
potentially supplement or replace the current formula-based
requirements. 

The "precommitment" approach, if adopted, would represent a more
fundamental change to capital requirements.  In this approach, a bank
would commit to manage its trading portfolio to limit market risk
losses over a subsequent interval to a specified amount.  If the bank
exceeded its limit, it would face penalties that could range from
public disclosure to additional capital requirements or monetary
fines. 

The New York Clearing House conducted a 1-year pilot test of the
precommitment approach that was designed to assist the bank
regulators and the participants in evaluating and assessing the
usefulness and viability of the approach for regulatory capital
purposes.  Although views of industry analysts differ on the value of
such an approach, the 10 bank and bank holding company pilot
participants believe that it is a viable alternative to the internal
models approach and that it provides strong incentives for prudent
risk management and more efficient capital allocation compared to
existing capital standards. 

There are a number of new risk-based initiatives for securities and
futures firms.  Since 1995, under the auspices of DPG, six securities
firms have been participating in a program in which they use their
own models to calculate their "capital at risk"\20 on their
over-the-counter derivative activities and voluntarily report the
results to their primary regulators.  In December 1997, SEC issued a
concept release\21 soliciting comments on how the existing haircut
structure could be modified and whether the net capital rule should
be amended to allow firms to use statistical models in setting
capital requirements for a broker-dealer's proprietary positions. 
Much of a broker-dealer's OTC derivatives activities are currently
conducted in unregulated entities.  In order to allow broker-dealers
to take better advantage of counterparty netting\22 and to adjust the
capital rule to better reflect the risks of OTC derivatives, SEC, in
a December 1997 initiative, issued a proposed rule that would create
a new class of broker-dealers, called OTC derivatives dealers, whose
derivatives business would be subject to modified regulatory capital,
margin, and other requirements.  Also in December 1997, in order to
better match capital charges with actual market risk hedging
practices employed by broker-dealers, SEC proposed amendments to the
net capital rule that would treat most types of interest rate
products as part of a single portfolio and would recognize hedges
among a number of instruments.  As part of its comprehensive
regulatory reform efforts to update its oversight of both exchange
and off-exchange markets, CFTC published a concept release in May
1998 on issues relating to the OTC derivatives market. 

In 1995, two futures exchanges, which are SROs, informally proposed
to CFTC a risk-based capital approach that would base capital
requirements on "funds at risk" as opposed to the current "funds
required to be segregated" approach.\23 CFTC consulted with the
exchanges on the parameters of their risk model and positively
received the exchanges' proposals.  In November 1997, the exchanges
adopted a risk-based capital requirement for their members effective
January 1, 1998. 

Life insurance regulators seem generally satisfied with the current
risk-based capital approach for this sector; however, some changes
are being studied.  Regulators and industry officials told GAO that
refinements are being made on an as-needed basis to the risk-based
capital formulas; and industry groups are studying alternative,
possibly model-based, approaches to the interest rate risk component. 
They told GAO that they currently have no plans to significantly
modify the formula-based approach to the other risk-based capital
components at this time. 


--------------------
\19 Asset securitization is the process by which loans and other
assets are pooled and used as collateral for one or more classes of
securities, which are then sold.  Securitization provides an
efficient mechanism for banks to sell loan assets and thereby to make
the loan assets more liquid. 

\20 "Capital-at-risk" as defined by DPG is conceptually the same as
"value-at-risk" used elsewhere in this report. 

\21 A concept release is a paper issued by regulators to elicit
discussion and comment from the industry and others on a potential
regulatory change. 

\22 Netting is an agreed-upon offsetting of positions or obligations
by trading partners that can reduce a large number of individual
obligations or positions to a smaller number. 

\23 Funds-at-risk are the initial margin requirements imposed by the
various exchanges on all open positions held at those exchanges. 
Segregation means to keep customer assets physically and accountably
separate from assets owned by the futures commission merchant. 


   RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5

GAO is not making recommendations in this report. 


   AGENCY COMMENTS
---------------------------------------------------------- Chapter 0:6

The Office of the Comptroller of the Currency, the Board of Governors
of the Federal Reserve System, the Federal Deposit Insurance
Corporation, the Securities and Exchange Commission, and the
Commodity Futures Trading Commission provided written comments on a
draft of this report.  Their comments are discussed in chapter 1. 
The agencies generally believed the report was comprehensive and
balanced.  In their comments, the Office of the Comptroller of the
Currency, the Federal Deposit Insurance Corporation, and the
Securities and Exchange Commission expand on a number of points made
in the report pertaining to their industries.  The National
Association of Insurance Commissioners provided oral comments in
which it characterized the report as reasonable.  These organizations
also provided technical comments, which have been incorporated where
appropriate. 


INTRODUCTION
============================================================ Chapter 1

Through rules known as capital requirements, financial regulators\1

set minimum levels for capital that banks and bank holding
companies,\2 securities broker-dealers,\3 futures commission
merchants (FCM),\4 and life insurance companies\5 hold as a cushion
against unexpected losses that can result from risks faced by these
firms in their business activities.  Regulatory capital requirements
are one tool financial regulators use to help protect customers from
losses and ensure the stability of financial markets.  In addition to
serving these general regulatory purposes, capital requirements can
affect the way the financial system functions by influencing how
market participants allocate capital resources and conduct business. 

Capital requirements can also have competitive effects within the
financial services industry, to the extent that capital requirements
differ among competing financial institutions and firms.  Today,
regulators in all sectors have either adopted or are considering
changes in capital requirements that compared to earlier approaches,
more quickly and precisely respond to changes that occur in a firm's
actual risk profile.\6 In addition, some regulators are considering
more fundamental changes that would simplify capital regulation. 
Changes in capital regulation are being undertaken or considered in a
highly dynamic financial services industry that is itself undergoing
change in response to competitive pressures as well as advances in
telecommunications, computer technology, and financial analysis--all
of which have led to new and innovative financial products and
services.  This report is provided to help Members of Congress and
others understand current regulatory capital requirements,
developments in those requirements, issues these developments raise,
and financial firms' approaches to risk measurement. 


--------------------
\1 The term financial regulators refers here to the following:  for
banks, the Office of the Comptroller of the Currency (OCC), the
Federal Reserve System (FRS), the Federal Deposit Insurance
Corporation (FDIC), and state banking regulators; for securities
broker-dealers, the Securities and Exchange Commission (SEC) and
state securities regulators; for futures commissions merchants, the
Commodity Futures Trading Commission (CFTC); and, for insurance
companies, state insurance departments. 

\2 The bank holding company structure consists of a parent company
with one or more subsidiaries that may include banks, thrifts, and
other entities providing services that the regulator considers
closely related to banking.  This report focuses only on commercial
banks.  It does not focus on thrifts because their capital rules for
credit risk are similar to those of commercial banks and thrifts are
generally not engaged in trading activities like those of the other
financial firms mentioned above. 

\3 Brokers are persons who engage in the business of effecting
transactions in securities for the account of others, but does not
include banks.  Dealers are persons who engage in the business of
buying and selling securities for their own account, through a broker
or otherwise, but does not include banks or persons insofar as they
buy or sell securities for their own accounts, either individually or
in some fiduciary capacity, but not as part of a regular business. 
Broker-dealers combine the functions of brokers and dealers.  See
Section 3(a)(4) and (5) of the Securities Exchange Act of 1934. 

\4 An FCM is an individual, association, partnership, corporation or
trust that solicits or accepts orders for the purchase or sale of any
commodity for future delivery on or subject to the rules of any
contract market and that accepts payment from or extends credit to
those whose orders are accepted. 

\5 In this report, we focus only on life insurance companies because
their activities are the most similar to those of banks, securities
broker-dealers, and FCMs. 

\6 The results of such changes in capital requirements are referred
to in banking and life insurance as "risk-based capital."


   BACKGROUND
---------------------------------------------------------- Chapter 1:1

Banks, securities broker-dealers, FCMs, and life insurance companies
increase the efficiency of the economy by facilitating the flow of
savings to investment and providing other financial services.\7 As
discussed in chapter 3 of this report, these financial firms use
capital to manage the trade-off between risks and returns in order to
increase the firms' efficiency and maximize the returns for
stockholders.  The capital that a financial firm holds serves a
number of firm-specific purposes--chiefly to provide long-term
funding of operations and to protect the firm by serving as a cushion
to absorb unexpected losses. 

For public purposes, regulators of banks, securities broker-dealers,
FCMs, and life insurance companies promulgate capital regulations
that set mandatory minimum levels for capital that the firms are to
hold as a cushion against unexpected losses.  The specific public
purposes differ somewhat among the regulators.  Generally speaking,
however, the financial regulators seek to protect customers of the
financial firms from losses and help ensure the stability of
financial markets and systems that they regulate.  Chapter 2 of this
report discusses the capital standards set for banks, securities
broker-dealers, FCMs, and life insurance companies and the more
specific purposes of each of the financial regulators in setting
regulatory capital requirements. 

Traditionally, banks, securities broker-dealers and FCMs, and life
insurance companies were engaged in mostly different businesses and
faced different risks.  After the stock market crash of 1929,
Congress created a regulatory and industry structure that separated
banking, investment banking, and other financial institutions.  Banks
were restricted to taking deposits, making loans, and other
activities closely related to banking.  Broker-dealers (the
SEC-regulated portion of investment banks) were restricted to
brokering securities, underwriting new security issues, and trading
securities.  Insurance companies continued to be regulated by the
states, and their activities were limited to insurance sales and
underwriting.  As discussed later in this chapter, significant
changes have occurred in the financial services industry within the
past two decades.  As a result, firms that were in traditionally
separate sectors are more directly competing with one another;
providing similar products; and, hence, facing similar risks in their
activities. 


--------------------
\7 In modern financial theory, financial firms enhance the efficiency
of the economy by providing means of wholesale and retail payments,
holding funds for customers or depositors in the form of savings
accounts or life insurance policies, providing brokerage services for
securities that permit investors to sell financial assets and
purchase or invest in other assets, underwriting security issuances
by business so that business can acquire investment funds when they
are needed and investors can purchase newly issued securities,
lending funds as a principal, providing equity capital, or providing
risk management services for clients such as futures and foreign
exchange services so that business can limit or accept risk taking as
called for by their business strategies. 


      CAPITAL IS THE SOURCE OF
      FUNDING THAT CUSHIONS A FIRM
      AGAINST LOSSES THAT ARISE
      FROM RISKS
-------------------------------------------------------- Chapter 1:1.1

Capital is most generally defined as the long-term source of funding
for a firm that earns a return for investors (debt and equity) and
cushions the firm against losses.  Such funding is contributed
largely by (1) equity stockholders in anticipation of profits and (2)
the firm's own returns in the form of retained earnings.  In some
instances, long-term debt is also considered capital. 

Losses cushioned by capital arise from risks that firms face in their
business activities.  In our work, we found no definitive list of
risk categories applicable to all firms covered in our review.  For
example, the Federal Reserve uses a list of six risk categories, and
OCC delineates nine.  A group of leading individuals from firms and
regulators developed what they termed Generally Accepted Risk
Principles (GARP), which lists six risk categories.\8 Most of the
financial firms we spoke with told us they use four categories of
risk; some said they use as few as three.  The listings of risks we
reviewed covered much the same causes of possible loss, but they
varied in how risks were grouped and in the nomenclature used.  This
report generally focuses on the following six categories, because
regulators and the representatives of financial firms we interviewed
identified them as the risks of greatest concern. 

  -- Credit risk is the potential for financial loss resulting from
     the failure of a borrower or counterparty\9 to perform on an
     obligation.  Credit risk may arise from either an inability or
     unwillingness to perform as required by a loan, a bond, an
     interest rate swap,\10 or any other financial contract.  All
     financial firms face credit risk.  For example, banks face
     credit risks in loans and bonds, insurance companies face credit
     risks in corporate and municipal bonds, and securities
     broker-dealers and FCMs face credit risks if other firms that
     they deal with do not meet their contractual obligations. 

  -- Market risk is the potential for financial losses due to the
     increase or decrease in the value or price of an asset resulting
     from broad movements in prices, such as interest rates,
     commodity prices, stock prices, or the relative value of
     currencies (foreign exchange).  Because all financial firms hold
     assets, all financial firms face market risks.  However, they
     may not all face all types of market risks. 

  -- Liquidity Risk is the potential for financial losses due to the
     inability of a firm to meet its obligations on time because of
     an inability to liquidate assets or obtain adequate funding,
     such as might occur if most depositors or other creditors were
     to withdraw their funds from a firm.  This is referred to as
     "funding liquidity risk." Liquidity risk also refers to the
     potential that a firm cannot easily reverse negative financial
     positions or offset specific exposures without significantly
     lowering market prices because of inadequate market depth or
     market disruptions ("market liquidity risk").  Financial firms
     face liquidity risk inasmuch as the loss of revenues due to
     interruptions of cash inflows affects a firm's ability to cover
     its liabilities as they come due. 

  -- Operational Risk is the potential for unexpected financial
     losses due to inadequate information systems, operational
     problems, breaches in internal controls, or fraud.  Operational
     risk is associated with problems of accurately processing or
     settling transactions and taking or making deliveries on trades
     in exchange for cash, and with breakdowns in controls and risk
     limits.  Individual operating problems are considered
     small-probability but potentially high-cost events for well-run
     firms.  Operational risk includes many risks that are not easily
     quantified but control of which is crucial to the firm's
     successful operation.  Operational risk can be addressed through
     prudent management oversight of firm operations, including the
     establishment of internal controls.\11 All firms face some type
     of operational risk. 

  -- Business/event risk is the potential for financial losses due to
     events not covered above, such as credit rating downgrades
     (which affect a firm's access to funding); breaches of law or
     regulation (which may result in heavy penalties or other costs);
     or factors beyond the control of the firm, such as major shocks
     in the firm's markets.  Included in business/event risk is a
     shift in legal status or changes in regulations.  All types of
     financial firms face business/event risk. 

  -- Insurance/actuarial risk is the risk of financial losses that an
     insurance underwriter takes on in exchange for premiums, such as
     the risk of premature death.  Although this risk is most
     commonly associated with insurance companies, it can exist in
     other firms.  For example, banks are authorized to underwrite
     credit life insurance, which is subject to actuarial risk. 

These risks can be discussed on a risk-by-risk basis, but the
potential effect on a firm's overall financial condition or risk
profile cannot be obtained by summing the risks in each category,
because risks interact in various ways.  That is, the net potential
loss from a combination of risks could be greater or less than the
sum of potential losses from each individual risk, depending upon the
economic relationship among the risks involved.  The economic
relationship among a firm's risks depends on the correlation among
prices of assets--that is, how the prices move in relation to one
another--and the business strategies and holdings of the firm. 

Because the traditional activities of banks, securities
broker-dealers, FCMs, and life insurers differed, each of these types
of financial firms once tended to have a correspondingly distinct
type of risk profile.  The predominant risk for banks was credit
risk, for securities broker-dealers and FCMs it was market risk, and
for life insurance companies it was insurance/actuarial risk. 
However, for a variety of reasons discussed later in this chapter,
the activities and risks of large, diversified financial firms in the
highly competitive financial services industry are becoming
increasingly similar. 


--------------------
\8 The Federal Reserve uses credit, market, liquidity, operational,
legal, and reputational risks.  OCC uses strategic, reputational,
credit, interest rate, liquidity, price, foreign exchange,
transaction, and compliance.  GARP uses credit, market, portfolio
concentration, liquidity, operational, and business/event risks. 

\9 In any financial transaction, each party is the counterparty to
the other. 

\10 A swap is an agreement between counterparties to make periodic
payments to each other for a specified period.  In a simple interest
rate swap, one party makes payments based on a fixed interest rate,
while the counterparty makes payments based on a variable rate.  The
contractual payments are based on a notional amount that for most
interest rate swaps is never actually exchanged. 

\11 Internal controls have limitations and provide reasonable
assurance, not absolute assurance, that internal control objectives
will be met. 


   VARIOUS AGENCIES ARE
   RESPONSIBLE FOR REGULATING THE
   CAPITAL OF BANKS, SECURITIES
   BROKER-DEALERS, FCMS, AND LIFE
   INSURERS
---------------------------------------------------------- Chapter 1:2

The scope of authority and oversight practices of financial
regulatory agencies vary in a number of ways.  The activities of
banks, bank holding companies, securities broker-dealers, FCMs, and
life insurance companies are regulated and overseen by a number of
different types of agencies and organizations.\12 Bank holding
companies are regulated by the Board of Governors of the Federal
Reserve System (Federal Reserve Board), and banks are regulated on an
individual institution basis by various federal and state agencies. 
Securities broker-dealers and FCMs are regulated by SEC\13

and CFTC,\14 respectively.  State agencies and self-regulatory
organizations (SRO)\15 are also involved in supervising
broker-dealers and FCMs.  Life insurance companies are regulated and
overseen by state regulatory agencies.  No formal/statutory holding
company regulatory oversight currently exists for securities firms,
futures firms, or insurance companies in the United States at the
federal level. 


--------------------
\12 This report focuses on regulation of capital requirements and
thus does not provide a comprehensive description of the authority or
activities of these regulators. 

\13 The definition of a security subject to SEC regulation includes
instruments, such as stocks, corporate and treasury bonds, notes,
mutual funds, and securities options.  SEC's mission is to administer
federal securities laws and issue rules and regulations to provide
protection for investors and to help assure that the securities
markets are fair and honest.  This is accomplished primarily by
promoting adequate and effective disclosure of information to the
investing public.  SEC also regulates firms engaged in the purchase
or sale of securities, people who provide investment advice, and
investment companies. 

\14 The Commodity Exchange Act gives CFTC exclusive jurisdiction,
with certain exceptions, over the regulation of the nation's futures
and options markets, including on- and off-exchange transactions in
futures and options.  Futures are contracts that obligate the holder
to buy or sell a specific amount or value of an underlying asset,
reference rate, or index at a specified price on a specified future
date.  Options are contracts that grant the purchaser the right, but
not the obligation, to buy or sell a specific amount of the
underlying at a particular price within a specified period.  Listed
options are exchange-traded.  CFTC is responsible for ensuring the
economic utility of these markets by guarding the integrity of the
markets; protecting market users from fraud and other trading abuses;
monitoring the markets to detect and prevent price distortions and
manipulation; and fostering open, competitive, efficient, and
financially sound markets. 

\15 SROs play an extensive role in the regulation of the U.S. 
securities and futures industries.  They assist SEC and CFTC in
implementing and enforcing federal securities and commodities laws. 
SROs include all of the U.S.  securities and commodities exchanges,
the National Association of Securities Dealers, the National Futures
Association, and the Municipal Securities Rulemaking Board. 


      AUTHORITY OF THE FINANCIAL
      REGULATORY AGENCIES VARIES
      IN SCOPE
-------------------------------------------------------- Chapter 1:2.1

Many of the largest financial legal entities are part of a holding
company structure that generally has affiliates conducting business
activities in the formerly more separate sectors of banking, life
insurance, securities trading, and futures trading sectors.  In this
report, we often refer to these holding company structures as large,
diversified firms. 

The dominant form of banking structure in the United States is the
holding company.  A number of the larger bank holding companies have
established nonbank subsidiaries that engage in securities
underwriting and brokerage services, insurance sales, and futures
trading, as well as other nonbanking activities permitted because
they are deemed to be closely related to the business of banking and
to produce a public benefit.\16 Figure 1.1 is a simplified
illustration of a hypothetical holding company with wholly owned
banking and nonbanking subsidiaries and the regulators that oversee
the various entities. 

   Figure 1.1:  Simplified
   Structure of a Hypothetical
   Bank Holding Company

   (See figure in printed
   edition.)

Source:  GAO. 

Many large U.S.  securities broker-dealers, life insurers, and FCMs
have also expanded their range of activities by establishing holding
companies at the top of their corporate structures.  When creating or
acquiring affiliates, these other types of financial firms are not
limited to creating or acquiring those that engage in activities
related to their own.  Banks are allowed to affiliate only with
companies engaging in activities closely related to banking and must
demonstrate some public benefit in creating or acquiring an
affiliate, but other types of financial firms have no such
limitations.  Figure 1.2 shows a simplified structure of a
hypothetical nonbank\17 financial holding company with affiliates
engaged in banking activities (through a thrift institution),\18

securities and futures trading, and life insurance sales, among many
other types of activities. 

   Figure 1.2:  Simplified
   Structure of a Hypothetical
   Nonbank Financial Holding
   Company

   (See figure in printed
   edition.)



   (See figure in printed
   edition.)

Source:  GAO. 


--------------------
\16 Section 4 of the Bank Holding Company Act of 1956 generally
prohibits bank holding companies from owning or controlling any
company that is not a bank.  The law, however, lists several
exemptions to this rule.  The most important of these authorizes the
Federal Reserve Board to approve the acquisition or formation of a
nonbank affiliate where the board determines that the activities of
the affiliate are "so closely related to banking.  .  .  as to be a
proper incident thereto" and would produce a public benefit.  12
U.S.C.  S 1843.  Section 16 of the Glass-Steagall Act limits the
securities activities of national banks essentially to brokerage
services.  Section 20 prohibits member banks from affiliating with
organizations engaged principally in securities activities, although
with approval of the Federal Reserve, a bank holding company may
engage in limited securities activities through a subsidiary which is
called a section 20 subsidiary. 

\17 A nonbank is a financial firm that does not have a bank charter. 

\18 U.S.  unitary thrift holding companies, unlike bank holding
companies, may be owned by, or own, any type of financial services or
other business.  Thrifts also have broader powers than banks in areas
such as insurance and real estate development and are regulated by
the Office of Thrift Supervision. 


      BANK HOLDING COMPANIES ARE
      REGULATED ON A CONSOLIDATED
      BASIS; AND OTHER TYPES OF
      REGULATED ENTITIES ON AN
      INDIVIDUAL BASIS
-------------------------------------------------------- Chapter 1:2.2

As summarized in table 1.1, the regulatory and oversight authorities
of financial regulatory agencies differ.  The Bank Holding Company
Act of 1956 authorized the Federal Reserve Board to regulate bank
holding companies on a consolidated basis.  This gives the Federal
Reserve Board regulatory and examination authority over all
activities of the bank holding company.  Affiliates that are banks
are supervised by one or more of the federal banking agencies listed
in table 1.1.  Among other things, this means that capital standards
apply at the holding company level and bank level.  In addition, FDIC
insures bank depositors and has authority to terminate deposit
insurance for any FDIC-insured institution. 

In contrast to the regulatory authority of the Federal Reserve Board,
SEC and CFTC are authorized to regulate only those entities that
themselves engage in activities involving securities and futures,
respectively, and not the affiliates of those entities.\19

Unlike banks, Congress has not passed legislation authorizing SEC or
CFTC to supervise holding companies of securities broker-dealers or
FCMs, respectively.  However, SEC and CFTC risk assessment rules
promulgated pursuant to the Market Reform Act of 1990 and The Futures
Trading Practices Act of 1992, respectively, enable those agencies to
collect from the regulated entity information about the activities
and financial condition of its affiliates and parent firms to assess
the risks they pose to the regulated entity's financial and
operational condition, including net capital, liquidity, and the
ability to finance operations.\20 These rules do not provide either
agency with the legal regulatory authority to examine or set
regulatory capital requirements over the parent or affiliates of the
SEC-registered broker-dealer or the CFTC-registered FCM, although
they do give both agencies a supervisory role with respect to those
affiliates. 

State insurance departments are authorized to regulate insurance
activities and those firms that sell insurance products.  They are
not authorized to regulate or examine parents or affiliates of the
regulated entities. 



                                    Table 1.1
                     
                        A Comparison of the Regulatory and
                      Oversight Authority Concerning Capital
                       of Federal Regulators of Commercial
                      Banks, Securities Broker-Dealers, and
                        FCMs and State Regulators of Life
                                     Insurers

                           Financial entity subject   Scope of supervisory/
Regulator                  to regulatory authority    oversight authority
-------------------------  -------------------------  --------------------------
Office of the Comptroller  National banks and         National banks; also,
of the Currency (OCC)      federal branches and       under delegated authority
                           federally licensed         of the Federal Reserve,
                           agencies of foreign banks  may participate in
                           with U.S. operations.      examining all activities
                                                      of nonbank affiliates of
                                                      OCC-regulated banks and
                                                      their bank holding
                                                      companies.

Federal Reserve System     State-chartered banks      All activities of
(FRS)                      that are FRS members\a     regulated state-chartered
                           and bank holding           banks that are FRS
                           companies and their        members, bank holding
                           nonbank subsidiaries;      companies, and their non-
                           also, the combined U.S.    bank affiliates.
                           operations of foreign
                           banking organizations.

Federal Deposit Insurance  Federally insured state-   Backup examination
Corporation (FDIC)\b       chartered banks that are   authority for all
                           not members of FRS.\a      federally insured banks.
                                                      Under delegated authority
                                                      of the Federal Reserve,
                                                      may participate in
                                                      examining all activities
                                                      of nonbank affiliates of
                                                      FDIC-regulated banks and
                                                      their bank holding
                                                      companies.

Securities and Exchange    SEC-registered broker-     Only registered broker-
Commission (SEC)           dealers.\c                 dealers--not affiliates or
                                                      parent holding companies.

Commodity Futures Trading  CFTC-registered futures    Only registered FCMs--not
Commission (CFTC)          commission merchants       affiliates or parent
                           (FCM).\d                   holding companies.

State insurance            Insurance companies        Only regulated insurance
departments                domiciled and licensed to  companies--not affiliates
                           operate in the state.      or parent holding
                                                      companies.
--------------------------------------------------------------------------------
Note:  State regulators also oversee state-chartered banks and
securities broker-dealers.  The Office of Thrift Supervision oversees
thrifts; however, we do not focus on thrifts in this report, so they
are not included in this table. 

\a These banks are also overseen by state-level banking authorities. 

\b FDIC administers the Bank Insurance Fund and the Savings
Association Insurance Fund. 

\c Broker-dealers must also comply with requirements of the various
exchanges and industry associations, such as the New York Stock
Exchange and the National Association of Securities Dealers, which
are self-regulatory organizations under the Securities Exchange Act
of 1934. 

\d FCMs must also comply with rules imposed by the various exchanges,
such as the Chicago Mercantile Exchange and the Chicago Board of
Trade, as well as the National Futures Association--all
self-regulatory organizations under the Commodity Exchange Act. 

Source:  GAO analysis of applicable regulations. 


--------------------
\19 For example, the Securities Exchange Act of 1934 requires that
any persons or firms who engage in the business of buying and selling
securities for their own account and/or for customers must register
with SEC as broker-dealers.  Similarly, the Commodity Exchange Act
requires that any persons or firms who engage in the business of
buying or selling contracts for the purchase or sale of any commodity
for future delivery (including commodity options and other
risk-shifting instruments), for their own account and/or for
customers, must register with CFTC as an FCM or Introducing Broker. 
Introducing brokers are firms that solicit and accept commodity
futures and options orders but do not accept customer funds. 

\20 Rules 17h-1T and 17h-2T for SEC and Rules 1.14 and 1.15 for CFTC. 


      CAPITAL REGULATION IS ONE OF
      MANY TOOLS FINANCIAL
      REGULATORS USE TO ENSURE
      STABILITY OF THE FINANCIAL
      SYSTEM AND MARKETS
-------------------------------------------------------- Chapter 1:2.3

Through capital standards and other regulations, regulators of banks,
securities broker-dealers, FCMs, and life insurers seek to help
ensure public confidence in financial institutions and markets by
protecting customers' funds and limiting losses to various deposit
and guarantee funds that further protect customers' funds.  As for
securities broker-dealers and FCMs, regulators seek to ensure that
registered entities will have a pool of liquid assets available on a
daily basis to meet their obligations to customers and other market
participants.  Capital regulation--requirements that firms hold
minimum amounts of capital--is one tool in a kit of many that
financial regulators use to help ensure stability and public
confidence in the financial system and markets.  It is supported by
supervision--the monitoring, inspecting, and examining of regulated
entities--and enforcement.  In some cases, it is also supported by
segregation of customer funds or by insurance protection of those
funds. 

The oversight activities of financial regulators are similar in some
respects and different in others.  Each regulator is to promulgate
rules (including regulatory capital requirements), monitor firms'
financial condition, perform examinations, and take appropriate
actions to enforce relevant regulations and statutes.  The oversight
activities of SEC and CFTC differ most significantly from those of
bank regulators and state insurance regulators because of differing
purposes of the regulation.  SEC and CFTC, with the assistance of
SROs, protect investors and ensure the integrity of the securities
and futures markets; bank regulators and state insurance regulators
ensure the safety and soundness of entities they regulate. 

Supervision of regulated entities in the banking, securities,
futures, and life insurance sectors includes off-site monitoring of
financial reports and on-site examination visits.  In banking,
supervisors are to track the financial condition of their banks on a
continuing basis and between on-site examinations.  A principal
off-site technique banking supervisors use for monitoring the
activities and financial condition of their banks is the review of
detailed financial statements (Call Reports) that the banks submit
quarterly.  In addition, the banking regulators use computerized
monitoring systems that use Call Report data to compute, for example,
financial ratios, growth trends, and peer group comparisons.  Banking
supervisors also meet with bank senior management from time to time
to discuss the current condition of the bank and plans the bank has
for the future.  Monitoring is a complement to on-site examinations,
which lie at the heart of the supervisory process.  The purpose of
bank on-site examinations is for examiners to evaluate the bank's
overall risk exposure with particular emphasis on what is known as
its CAMELS--the adequacy of its capital, and asset quality, the
quality of its management and internal control procedures, the
strength of its earnings, the adequacy of its liquidity, and its
sensitivity to market risk.  Banks are usually examined at least once
during each 12-month period and more frequently if they have serious
problems.  In addition, well-capitalized banks with total assets of
less than $250 million can be examined on an 18-month cycle. 

In contrast to regulation of banks, regulation of the securities and
futures markets is a combination of direct regulation and oversight
by federal agencies and indirect regulation and oversight by SROs
(e.g., the New York Stock Exchange, the National Association of
Securities Dealers).  Securities broker-dealers and FCMs are required
to become members of an SRO and, as SRO members, must comply with SRO
rules and regulations.  SRO rules and regulations are promulgated
under the SEC or CFTC standards and requirements.  Securities SRO
rules and regulations are often more stringent than SEC rules and
require SEC's approval.  SROs must register with SEC or CFTC and are
subject to SEC or CFTC oversight.  SROs establish rules to govern
member conduct and trading, set qualifications for certain market
participants, monitor daily trading activity, examine their members'
financial health and compliance with rules, and investigate alleged
violations of those rules and securities and futures laws.  SEC
oversees the regulatory and supervisory activities of the securities
industry's SROs.  CFTC oversees the compliance activities of the
futures industry's SROs, which include the U.S.  commodity exchanges
and the National Futures Association.  Both SEC and CFTC also
develop, implement, interpret, and enforce statutes and regulations
to protect customer funds, prevent trading and sales practice abuses,
and ensure the financial integrity of firms holding customer funds. 
Additionally, SEC and CFTC conduct direct audits of clearing
organizations and firms handling customer money to ensure compliance
with the capital and segregation rules. 

In contrast to banking, securities, and futures regulation,
regulation of the insurance industry is primarily a state, not
federal, responsibility.  In general, state legislatures set the
rules under which insurance companies are to operate, including
capital standards; and state insurance regulators are to monitor the
health and solvency of the regulated insurance companies.  To help
coordinate their activities, state insurance regulators have
established a central structure--the National Association of
Insurance Commissioners (NAIC), an organization whose members are the
heads of the insurance departments of 50 states, the District of
Columbia, and 4 U.S.  territories and possessions.  NAIC's basic
purpose is to encourage consistency and cooperation among the various
states and territories as they individually regulate the insurance
industry.  To that end, NAIC promulgates model insurance laws and
regulations for state consideration and provides a framework for
multistate examinations of insurance companies. 

State regulators use a number of basic methods to assess the
financial strength of insurance companies, including reviewing and
analyzing annual financial statements, doing periodic on-site
financial examinations, and monitoring key financial ratios. 
Supervision of life insurers is the responsibility of insurance
departments in each state, with the primary responsibility residing
with the "domiciliary" regulator, that is, the regulator in the state
where the company is domiciled.\21 The domiciliary regulator is
responsible for conducting periodic on-site examinations and for
reviewing the required annual and quarterly financial reports. 
Examiners monitor the financial health of the insurer, along with
compliance with rules and regulations, and look for evidence of any
unsafe business practices.  Regulators in states where the company is
licensed and operating, other than the domiciliary state, may
participate in on-site examinations with the domiciliary state if
they choose.  These examinations are called zone examinations.  In
most states, the typical interval between on-site examinations is 3
to 5 years unless regulators have reason to believe problems exist
that could affect the company's viability. 

Financial regulators may take both informal supervisory and/or formal
enforcement actions to ensure that regulated entities undertake
corrective steps for identified problems.  In banking, such informal
actions may include a request that a bank adopt a board resolution or
agree to the provisions of a memorandum of understanding to address
the problems.  If necessary, financial regulators may take formal
enforcement actions to compel the management and directors of
troubled entities to address problems.  Formal enforcement actions in
banking include written agreements, cease and desist orders, prompt
corrective action directives, termination of deposit insurance,
revocation of a bank charter, and closing of the bank.  Other actions
include assessing fines, such as civil money penalties; and removing
an officer or director from office and permanently barring him or her
from the banking industry. 

SEC and CFTC have the authority to take supervisory and enforcement
actions against the entities they regulate.  Their enforcement tools
include court injunctions; temporary restraining orders; and various
administrative proceedings and sanctions, such as assessment of civil
monetary penalties, disgorgement orders, censure, suspension and
revocation of registration, and cease and desist orders. 

Additionally, SEC staff provide informal regulation of broker-dealers
through no-action letters.  In the no-action process, a broker-dealer
requests interpretive relief from SEC staff regarding certain
transactions or activities.  In a typical no-action letter, the staff
states that it will not recommend that SEC take enforcement action if
the requesting party executes transactions or engages in activities
in the limited context stated by the staff.  In SEC's view,
limitations in no-action letters related to risk-management issues
balance regulatory flexibility with the need to avoid undue risk. 
The letters are made available to the public and informally address
regulatory concerns that by necessity are not detailed in securities
statutes. 

As with other financial regulators, insurance regulators have an
array of informal and formal actions that can be employed to correct
problems identified through the supervisory process.  These actions
often begin with informal discussions of regulatory concerns with
company officials.  If problems are not resolved promptly, regulators
have a number of more formal tools available, including
administrative actions; court orders and injunctions; and culminating
with the power to take regulatory control of a company, remove the
officers, and either sell or liquidate it.  Many of the authorities
held by state insurance regulators are enhanced when the Risk-Based
Capital Insurers Model Act has been adopted in a particular state. 
When adopted, this act gives the state's chief insurance regulator
the explicit authority to take regulatory action based on an
insurer's risk-based capital level. 


--------------------
\21 The insurer may or may not be headquartered or even operating in
the state in which it is domiciled for regulatory purposes, although
it usually is. 


   THE FINANCIAL SERVICES INDUSTRY
   IS CHANGING IN RESPONSE TO A
   VARIETY OF DEVELOPMENTS
---------------------------------------------------------- Chapter 1:3

Since the late 1970s, significant changes have been occurring in the
financial services industry due to a number of market shocks,
combined with advances in financial theory and information
technology.  The interaction of these factors has led to significant
expansion of such financial products as derivatives and asset-backed
securities,\22 improved methods to measure and manage risks,
increased competition in financial services, and mergers of financial
firms within and across financial sectors.  In addition, these
factors have encouraged some firms to offer risk management services
to other financial and nonfinancial firms.  This risk management has
often been based on the use of derivatives and asset-backed
securities to repackage risks and returns. 

The creation and growth in derivatives, huge increases in trading
activities, and the development of new secondary markets, along with
the creation of asset-backed securities, have fundamentally changed
the financial landscape.  Derivatives and asset-backed securities
have permitted financial market participants to better manage market
risk by transferring the risk from entities less willing to bear it
to those more willing to do so.  Derivatives have stimulated trading
generally because they gave financial market participants a lower
cost way to hedge investments or to take speculative positions.\23 In
addition, derivatives products markets have grown rapidly.  For
example, the International Swaps and Derivatives Association
estimates that as of December 31, 1996, the combined notional amount
of globally outstanding interest rate swaps and other
over-the-counter (OTC) derivatives had grown to $25.45 trillion from
$3.45 trillion on December 31, 1990.\24

Advances in information technology and financial theory have helped
reduce various barriers to competition.  The increased speed and
lower costs in communicating and transmitting data over large
geographical distances eliminated such distance as an obstacle to
competition.  Moreover, new financial theories and faster computers
helped financial firms handle large amounts of data at low cost and
analyze the risks and returns created by new financial products. 
Swaps and other derivatives, which have been growing rapidly, are an
example of such technology- and theory-dependent products.  Since the
tools and skills underlying them were not unique to any one sector of
the financial services industry, no one sector has a monopoly on
their use; thus, the list of major derivatives dealers includes
banks, securities firms, and insurance companies.\25

Regulators also have acted in ways to promote greater competition in
the financial services industry.  For example, the Federal Reserve
Board has approved a number of additional activities for banks to
offer, including providing investment advice, underwriting insurance
related to the extension of credit, tax planning and preparation,
data processing, and operating a credit bureau or collection agency. 
The Federal Reserve Board also approved bond and stock underwriting
powers for Section 20 subsidiaries of bank holding companies. 
Effective in March 1997, the Federal Reserve Board enhanced these
powers when it increased from 10 to 25 percent the share of total
revenues a bank holding company's Section 20 subsidiary may derive
from corporate equity and debt underwriting.  On the basis of these
decisions, banks have increasingly acquired or created securities
broker-dealer affiliates or subsidiaries.\26

OCC has amended its regulations to permit subsidiaries of national
banks to engage in activities that OCC determines--on a case-by-case
application basis--to be "part of or incidental to the business of
banking."

In addition to banks entering underwriting, an area associated with
securities firms, a number of large securities firms have entered a
traditional province of banks:  commercial loans to corporate
borrowers.  Recently, securities firms have made and traded such
loans, which are commonly linked with securities underwriting.  Such
services enable the firm to provide a customer with a full range of
its financing needs.  In a number of instances, banks and securities
firms have joined together to provide such loan and security
facilities for customers. 

Increasing competition also affects insurance companies and insurance
products.  During the past several years, life insurance companies
increasingly have moved away from traditional whole life and term
insurance products and have focused instead on asset growth or
investment products such as variable annuities.  These products
compete with stocks and bonds, retirement vehicles offered by banks,
and stock mutual funds and are often sold by financial planners and
securities brokers. 

As part of this competition, large, diversified financial firms are
increasingly operating in what once were separate banking, insurance,
and securities sectors, as discussed earlier.  Banks have acquired
investment banks; and many types of firms have acquired thrifts,
which are similar to banks but can be owned by anyone.  For example,
a number of insurance companies have applied for thrift licenses. 
Securities firms have acquired firms that have enabled them to engage
in banking activities.  For example, in 1997, Merrill Lynch &
Company, Inc., and the Travelers Group, Inc., which includes
insurance companies and securities firms, both received federal
thrift charters.  In addition, insurance companies have acquired
securities firms.  For example, the Travelers Group acquired Salomon
Brothers, Inc.  (primarily a securities trading firm) in November
1997, and it already owned Smith Barney and Company (primarily a
retail brokerage firm).  In addition, in April 1998, the Travelers
Group and Citicorp announced their intention to merge and create a
new entity that is to be called Citigroup.  This would be the biggest
corporate merger in history; however, there are questions about the
implications of current banking laws for the merger.  If the laws are
not changed, it is possible the new entity would have to divest
itself of certain operations, either in insurance or banking. 


--------------------
\22 Derivatives are financial contracts whose market value is
determined by the value of an underlying asset, reference rate, or
index.  Asset-backed securities are created from securitized assets,
such as auto loans, credit card receivables, mortgages, equipment
leases, and corporate bonds.  Asset securitization is the process by
which loans and other receivables are pooled, reconstituted into one
or more classes or positions, and then sold. 

\23 To hedge is to reduce risk by taking a position that offsets
existing or anticipated exposure to a change in market prices. 
Position refers to an investor's stake (buying or selling) in a
market or a particular security.  To speculate is to take risk by
taking a position in hope of realizing a profit. 

\24 OTC derivatives are customized contracts that are not traded on
exchanges. 

\25 See GAO/GGD/AIMD-97-8, Nov.  1, 1996, for a list of major
derivatives dealers. 

\26 For example, in 1997, the Bankers Trust New York Corporation
bought Alex Brown & Sons, Inc.  (a stock brokerage firm), and
NationsBank Corporation affiliated with Montgomery Securities. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
---------------------------------------------------------- Chapter 1:4

To help Congress and others better understand current regulatory
capital requirements, developments in those requirements, and
regulatory issues these developments raise, the objectives of this
report are to describe, for the banking, securities, futures, and
life insurance sectors of the financial services industry, (1)
regulatory views of the purpose of capital and current regulatory
requirements; (2) the approaches of some large, diversified financial
firms to risk measurement and capital allocation; and (3) issues in
capital regulation and initiatives being considered for changes to
regulatory capital requirements. 

To achieve these objectives, we interviewed

  -- officials from financial regulators, including OCC, the Federal
     Reserve Board, the Federal Reserve Bank of New York, FDIC, SEC,
     CFTC, and the Office of Thrift Supervision; and the Departments
     of Insurance for New York and Illinois;

  -- academics and consultants who are considered experts in the
     financial services field;

  -- rating agencies' analysts, including A.M.  Best, Standard and
     Poor's, and Moody's Investors Service;

  -- officials of SROs, including the Chicago Board of Trade, the
     Chicago Board of Trade Clearing Corporation, the Chicago
     Mercantile Exchange, the National Futures Association, the New
     York Stock Exchange, and the National Association of Securities
     Dealers;

  -- officials of trade and industry associations, including the
     American Academy of Actuaries, the American Bankers Association,
     the American Council on Life Insurance, the Independent Bankers
     Association of America, the Institute of International Finance,
     NAIC, the New York Clearing House Association, and the
     Securities Industry Association; and

  -- officials of 16 large, diversified firms in the commercial
     banking, securities, futures, and insurance industries (see app. 
     V for a listing of these firms). 

In addition, we reviewed U.S.  government, international
organization, trade association, academic, industry, and private firm
documents, including regulations, annual and other published reports,
papers and articles, industry journals, and information available at
various sites on the world wide web. 

To determine the development of risk measurement and capital
allocation systems in firms, we interviewed and obtained information
from a number of large, diversified firms in the commercial banking,
securities, futures, and insurance sectors (see app.  V for a listing
of these firms).  We did not test the adequacy of any of the risk
measurement and capital allocation systems discussed in this report. 
In selecting firms for this review, on recommendations from SEC, we
chose securities firms that were part of the Derivatives Policy Group
(DPG).\27 We chose commercial banks that appeared likely to be
required to meet the market risk capital requirements that took
effect on January 1, 1998,\28 and life insurance companies that have
been involved in the development of risk-based capital standards for
that industry.  The securities firms we visited are large holding
companies and include both SEC-registered broker-dealers and
CFTC-registered FCMs.\29 We interviewed officials who could speak
about risk management and capital allocation systems for the
consolidated financial firm. 

We developed and used a set of common questions in our discussions
with these firms.  In these interviews, we obtained information about
the following: 

  -- the most important risks faced by these firms,

  -- their risk measurement and capital allocation systems and
     methodologies,

  -- their internal risk management structures and uses of internal
     risk measurement information,

  -- the impact of current capital requirements on their operations,
     and

  -- possible future directions in capital regulation. 

We did our work in Washington, D.C.; New York; and Chicago between
November 1996 and April 1998 in accordance with generally accepted
government auditing standards. 

We obtained written comments on a draft of this report from OCC, the
Federal Reserve Board, FDIC, SEC, and CFTC.  These comments are
reprinted in appendixes VI, VII, VIII, IX, and X.  The agencies
generally believed the report was comprehensive and balanced.  In
their comments, OCC, FDIC, and SEC expand on a number of points made
in the report pertaining to their industries.  On June 2, 1998, the
Washington Counsel of NAIC provided us with oral comments in which he
characterized the report as reasonable.  These organizations also
provided technical comments, which have been incorporated where
appropriate. 


--------------------
\27 DPG was organized in 1994 to address the public policy issues
raised by the OTC derivatives activities of unregistered affiliates
of SEC-registered broker-dealers and CFTC-registered FCMs.  It
comprises the six U.S.  securities firms with the highest volume of
over-the-counter derivatives activities (CS First Boston, Goldman
Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Salomon
Brothers). 

\28 The 5 U.S.  bank holding companies we interviewed are among the
top 10 largest bank holding companies in the United States.  As of
December 31, 1997, the total assets of the 5 bank holding companies
comprised 57 percent of the total assets of the 10 largest bank
holding companies. 

\29 As part of DPG, the securities firms we visited represent five of
the six largest derivatives dealers in the United States. 


REGULATORY CAPITAL REQUIREMENTS
DIFFER BY TYPE OF REGULATED ENTITY
============================================================ Chapter 2

Just as the financial regulators serve differing statutory purposes,
they differ in their views on the purpose of regulatory capital. 
Bank capital standards are focused on maintaining the safety and
soundness of banks, and capital is calculated on a going-concern
basis.  Capital standards for securities broker-dealers and FCMs are
focused on protecting customers in the event of a broker-dealer or
FCM failure and are calculated on a liquidation basis.  Capital
standards for life insurers are to help limit failures and protect
claimants, and capital is calculated on a going-concern basis.\1

In addition to reflecting differences in the regulators' views on the
purpose of capital, regulatory capital requirements also reflect
differences in what have been historically the dominant risks
associated with the regulated entities.  The bank capital
requirements that apply to all banks have emphasized credit risk,
because credit risk has long been the most important and predominant
risk for banks, which traditionally invested the largest part of
their funds in bank loans.  Recently, regulators added a market risk
capital requirement for banks engaged in trading activities that
create market risks.  Capital requirements for securities
broker-dealers and FCMs traditionally focused on liquidity and market
risks and the effect of changing market prices on the value of their
assets, in keeping with the dominant risk in their activities. 
Capital requirements for life insurers focus on traditional risks,
such as actuarial risk which is unique to the insurance industry, as
well as other risks related to their assets and liabilities. 

Current capital requirements reflect a variety of efforts to relate
capital requirements to risks inherent in firms' activities.  These
include efforts to modify current rules to better reflect actual
risks in firm activities as well as efforts to take advantage of new
risk measurement techniques that are more sensitive to correlation
among prices of assets and can more precisely measure risks. 
Industry representatives with whom we spoke, who generally favor
changing regulatory capital requirements to more precisely account
for risks in their activities, see progress in recent changes made to
regulatory capital requirements.  However, they also have concerns
and see needs for additional improvement. 


--------------------
\1 Going-concern value is the value of a company as an operating
business to another company or individual.  The liquidating value of
a company is the value of its assets.  The difference between
going-concern and liquidating value is often termed goodwill. 
Goodwill is generally understood to represent the value of a
well-respected business name or other such factors expected to
translate into greater than normal earning power. 


   THE PURPOSE OF REGULATORY
   CAPITAL DIFFERS BY TYPE OF
   REGULATED ENTITY
---------------------------------------------------------- Chapter 2:1

Although the agencies that oversee banks, securities broker-dealers,
FCMs, and life insurance companies all seek to protect customers and
ensure the smooth functioning of the markets they regulate, their
statutory purposes differ in various ways.  The differences in
regulatory purpose are reflected in the regulators' views of the
purpose of regulatory capital. 


      BANK CAPITAL STANDARDS FOCUS
      ON SAFETY AND SOUNDNESS OF
      BANKS, AND CAPITAL IS
      CALCULATED ON A
      GOING-CONCERN BASIS
-------------------------------------------------------- Chapter 2:1.1

As shown in table 2.1, the regulatory purpose of agencies that
oversee banks is to help ensure the safety and soundness of the
banking and payments systems and minimize losses to the deposit
insurance fund; and the Federal Reserve Board also has responsibility
to help ensure the stability of the U.S.  financial system.  In this
regard, regulators view capital as performing several important
functions.  It is there to absorb losses, thereby allowing banks to
continue to operate as going concerns during periods when operating
losses or other adverse financial results are being experienced. 
Capital also helps to promote public confidence, restrict excessive
asset growth, and provide protection to depositors and the Bank
Insurance Fund administered by FDIC.  Depositors who are protected by
deposit insurance may be less careful in their choice of banks.  This
behavior may, in turn, permit insured banks to operate less
conservatively than they would without deposit insurance to shield
them from depositors' concerns about the banks' safety and soundness. 
The consequences of both the banks' and depositors' behavior is
called "moral hazard." Regulators use capital requirements to
mitigate the moral hazard that arises from deposit insurance
protection. 

In addition, bank regulatory capital requirements are a measure
regulators can use as a starting point in regularly assessing the
financial condition of banks.  A reduction in capital that causes the
institution to approach the minimum required ratio is seen as a
symptom warning regulators that an institution's financial health is
threatened and that regulatory intervention may be needed to protect
depositors and other parties.  Under the Prompt Corrective Action
guidelines enacted as part of the Federal Deposit Insurance
Corporation Improvement Act (FDICIA) of 1991, banking supervisors are
required to increase intervention as a bank's capital ratio falls
through various predetermined ratios before the bank runs out of
capital.  This intervention is meant to reduce the likelihood of bank
failures, reduce the cost of failures that occur, and thus deter or
minimize systemic risk.\2

Minimum capital requirements also help protect the Bank Insurance
Fund, which guarantees depositors will receive par value up to
$100,000 per depositor per insured institution\3 if regulators close
a bank and FDIC must liquidate it.\4 For deposits exceeding the
$100,000 limit, FDIC is to provide reimbursements based on the value
of the assets sold when the bank is closed and liquidated.  Bank
compliance with capital requirements protects the Bank Insurance Fund
because higher capital requirements reduce the likelihood of bank
failure and thus reduce the losses that FDIC is likely to incur in
covering guaranteed deposits from failed banks.  FDICIA imposed a
requirement that a bank whose tangible equity\5

falls to 2 percent (or less) of assets is deemed to be "critically
undercapitalized" and generally is to be placed in conservatorship or
receivership within 90 days of becoming critically undercapitalized. 
Although bank regulation, including capital standards, attempts to
reduce the likelihood of failures, it is not meant to forestall all
failures. 

Bank capital standards are focused on safety and soundness, and
regulatory capital is calculated on a going-concern basis--that is,
with the assumption that the bank will continue operating.  In this
way, bank capital regulation is focused on the continued operation of
the banking system and is meant to ensure that payment services and
the provision of loans to all customers, both large and small, will
not be disrupted. 


--------------------
\2 Systemic risk could occur if the failure of a financial
institution led to the failure of other financial institutions.  In a
worst-case scenario, these subsequent failures could result in a
cascade of failures and impairment of the operations of the financial
system and, ultimately, the overall economy.  Direct regulatory
oversight of bank holding companies is designed to help deter the
failure of a financially weakened large banking institution that
could create systemic problems. 

\3 All accounts owned by an individual in a single banking
institution are aggregated for deposit insurance purposes and covered
up to $100,000 per depositor per insured institution.  If a depositor
has both checking and savings accounts in the same institution, both
accounts taken together would be insured up to $100,000.  However, if
an individual has a joint account with another person in the same
bank, this joint account would be separately insured up to $100,000. 
There is no limit to the number of insured accounts an individual may
have in different banking institutions.  See Deposit Insurance:  A
Strategy for Reform (GAO/GGD-91-26, Mar.  4, 1991). 

\4 The Federal Deposit Insurance Act, as amended by the Federal
Deposit Insurance Corporation Improvement Act of 1991, requires
federal regulators to take specific action against banks and thrifts
that have capital levels below minimum standards.  In an earlier
report, we discuss these requirements and their implementation.  See
app.  I of this report and Bank and Thrift Regulation: 
Implementation of FDICIA's Prompt Regulatory Action Provisions
(GAO/GGD-97-18, Nov.  21, 1996). 

\5 Tangible equity is the sum of common stock, surplus, and retained
earnings, net of Treasury stock and currency translation adjustments,
with intangible assets subtracted. 


      CAPITAL STANDARDS FOR
      BROKER-DEALERS AND FCMS
      FOCUS ON PROTECTING
      CUSTOMERS AND THEIR MARKETS
      AND ARE CALCULATED ON A
      LIQUIDATION BASIS
-------------------------------------------------------- Chapter 2:1.2

As shown in table 2.1, the primary regulatory purposes of the SEC and
CFTC capital standards are to ensure that broker-dealers and FCMs
will have a pool of liquid assets available on a daily basis to meet
their obligations to customers and other market participants.  This
protection of customers does not shield customers from investment
losses if the market value of the investment is less than the
purchase price, and the protection is consistent with SEC's and
CFTC's overall concern with ensuring the integrity of the securities
and futures markets, respectively.  These agencies' regulatory
capital requirements are designed to provide assurance that
broker-dealers and FCMs can fulfill their obligations to customers
and other market participants in the event a broker-dealer or FCM is
closed.  The amounts owed to customers are based on credit balances
(or cash) in customer accounts and the market value of customers'
securities and futures positions at the broker-dealer or FCM. 

Minimum capital requirements also help protect the Securities
Investor Protection Corporation (SIPC), a nonprofit membership
corporation created by Congress under the Securities Investor
Protection Act of 1970.  Within certain limits, SIPC will return to
customers cash and securities held at liquidated SIPC member
broker-dealers.  SIPC protects each customer up to $500,000 for
claims for cash and securities, although claims for cash are limited
to $100,000 per customer.  The cash limit historically has tracked
the bank-insured deposits amount.  SIPC does not protect investors
from declines in the market value of their securities.  Successful
functioning of the net capital rule results in the orderly
liquidation of a failing firm; prevents the need for federal court
intervention; and reduces strains on SIPC's resources, including the
SIPC membership assessment fund from which customers are paid. 


      CAPITAL STANDARDS FOR LIFE
      INSURERS ARE TO HELP LIMIT
      FAILURES AND PROTECT
      CLAIMANTS
-------------------------------------------------------- Chapter 2:1.3

Generally speaking, state insurance regulators are to monitor the
health and solvency of regulated life insurers in order to protect
claimants.  For state insurance regulators, the purposes of capital
are similar to the purposes of capital for bank regulators.  State
insurance regulators impose capital requirements to try to limit life
insurance company failures and thus help ensure the long-run
viability of these insurance companies so that they can meet
policyholders' claims in the future.  However, state regulators
regulate only insurance companies and not the insurance groups or the
often large, diversified financial firms that own insurance
companies.  Generally, however, insurance regulators do have the
responsibility of approving mergers or acquisitions of insurance
companies. 



                               Table 2.1
                
                 Primary Purposes of Regulatory Capital

Entity type             Primary purposes of regulatory capital
----------------------  ----------------------------------------------
Banks and bank holding   To help ensure the safety and soundness of
companies               the banking and payments systems
                         To minimize losses to the deposit insurance
                        funds

Broker-dealers           To protect customers and other market
                        participants from losses due to broker-dealer
                        failure
                         To ensure the integrity of the securities
                        markets

FCMs                     To protect customers and other market
                        participants from losses due to the failure of
                        the FCM
                         To ensure the integrity of the commodities
                        markets

Insurance                To monitor the health and solvency of
companies               regulated insurers to protect claimants
----------------------------------------------------------------------
Source:  GAO analysis of applicable regulations. 


   REGULATORY CAPITAL REQUIREMENTS
   DIFFER BY INDUSTRY SECTOR,
   REFLECTING DIFFERENCES IN
   REGULATORY PURPOSES AND
   DOMINANT ACTIVITIES WITHIN
   SECTORS
---------------------------------------------------------- Chapter 2:2

Current regulatory capital requirements for the banking, securities,
futures, and life insurance sectors vary in how they take into
account the risks of regulated entities in determining minimum
capital standards.  The capital requirements differ, although the
rules for securities broker-dealers and FCMs are similar.  These
differences reflect differing regulatory purposes, as discussed
earlier, or differences in the types of activities and risks that
are, or have been, dominant for the various types of regulated
entities.  To one degree or another, all of the regulators have
adopted some form of "risk-based" capital regulation.  However, due
to differences in their purposes or in the historic risks faced by
the regulated entities, the actual methods for assessing risks and
determining capital levels continue to differ across regulators. 


      BANK REGULATORY CAPITAL
      REQUIREMENTS EMPHASIZE
      CREDIT RISK AND CERTAIN
      MARKET RISKS
-------------------------------------------------------- Chapter 2:2.1

Initial bank risk-based capital requirements primarily emphasized
credit risk, reflecting the predominance of lending activities by
banks.  In 1988, regulators in the United States and other countries
who were part of the Basle Committee on Banking Supervision\6 agreed
to the Basle Accord, an internationally developed capital standards
framework for internationally active banks.  The accord's
requirements were initiated in the United States in March 1990, with
a 2-year phase-in period ending in full implementation in 1992. 
These requirements pertained primarily to credit risk; however, they
were amended in 1996 to incorporate market risk requirements for
specific types of assets that are often traded in internationally
active banks.  In addition to the risk-based requirements, U.S. 
banking regulators also have minimum leverage capital requirements. 
These leverage capital standards were established prior to--and have
been retained even after the implementation of--the risk-based
capital standards.  Also, in 1991, FDICIA created a capital-based
framework for bank oversight and enforcement based on the use of
increasingly stringent forms of prompt corrective action as an
institution's leverage and risk-based capital ratios decline.  (See
app.  I for a more detailed discussion of bank risk-based capital
requirements.)


--------------------
\6 The Bank for International Settlements was established in 1930 in
Basle, Switzerland.  Its objectives are to promote cooperation of
central banks, to provide additional facilities for international
operations, and to act as trustee for international financial
settlements.  The Basle Committee on Banking Supervision meets under
the auspices of the Bank for International Settlements.  It is made
up of the heads of supervision from the central banks and supervisory
authorities of Belgium, Canada, France, Germany, Italy, Japan,
Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom,
and the United States. 


         CREDIT RISK STANDARDS
         UNDER THE BASLE ACCORD
------------------------------------------------------ Chapter 2:2.1.1

The 1988 accord's standards, which bank regulators and others
describe as "risk-based," require banks to hold capital to cushion
against potential losses arising primarily from credit risk.\7

Although the accord pertains to internationally active banks, U.S. 
banking regulators have required all U.S.  banks and bank holding
companies, since 1992, to hold capital equal to at least 8 percent of
the total value of their on-balance sheet assets and off-balance
sheet items,\8 after adjusting this value by a measure of the
relative risk (known as risk-weighting).\9

According to regulatory guidelines on capital adequacy, the final
supervisory judgment of a bank's capital adequacy may differ from the
conclusions that might be drawn solely from the risk-based capital
ratio.  This is because the ratio does not incorporate other factors
that can affect a bank's financial condition, such as interest rate
exposure, liquidity risks, the quality of loans and investments, and
management's overall ability to monitor and control financial and
operating risks.\10 The guidelines establish minimum ratios of
capital to risk-weighted assets; banks are generally expected to
operate well above these minimum ratios. 

Banks are required to meet a total risk-based capital requirement
equal to 8 percent of risk-weighted assets.  At a minimum, a bank's
capital must consist of core capital, also called tier 1 capital, of
at least 4 percent of risk-weighted assets.  Core capital includes
common stockholders' equity, noncumulative perpetual preferred stock,
and minority equity investments in consolidated subsidiaries.\11

The remainder of a bank's total capital can also consist of
supplementary capital, known as tier 2 capital.  This can include
items such as general loan and lease loss allowances, cumulative
preferred stock, certain hybrid (debt/equity) instruments, and
subordinated debt with a maturity of 5 years or more.  The regulation
limits the amount of various items included in tier 1 and tier 2
capital.  For example, the amount of supplementary (tier 2) capital
that is recognized for purposes of the risk-based capital calculation
cannot exceed 100 percent of tier 1 capital. 

These capital standards were developed because regulators in the
United States and in other countries wanted to address more
adequately the credit risks posed by certain bank activities.  By
working with various countries to develop an international standard,
regulators also attempted to encourage banks to strengthen their
capital positions while minimizing any competitive inequality that
might arise if requirements differed across countries.  According to
the original 1987 consultative paper issued by the Basle Committee,
the target ratio of 8 percent capital to risk-adjusted assets
represented a higher level of capital than banks in various countries
were generally holding at the time.\12 Recognizing this, the 1988
Basle Accord allowed 4 years for banks to come into full compliance
with the required amount. 

The risk-weights for credit risk attempt to account for the relative
riskiness of a transaction on the basis of its broad characteristics,
such as a type of obligor (e.g., government vs.  bank vs.  a private
sector borrower) and whether the transaction is on- or off-balance
sheet.  Assets with a relatively low likelihood of default are
assigned lower risk-weights than assets thought to have a higher
likelihood of default.  Although the amount at risk is often
associated with changing asset prices, the credit risk calculation
does not use market price information to evaluate risks, except in
the case of derivatives contracts.  Because bank loans, which
dominate credit risks, generally are not traded, market price
information cannot be regularly observed and thus used to evaluate
risk.  Instead, the risk-weights for credit risk are broad categories
arrived at through consensus among members of the Basle Committee. 

Under the credit risk rules, the adjustments of asset values to
account for the relative riskiness of a counterparty involve
multiplying the asset values by certain risk weights, which are
percentages ranging from 0 to 100 percent.  A zero risk-weight
reflects little or no credit risk.  For example, if a bank holds a
claim on the U.S.  Treasury, a Federal Reserve Bank, or the central
government or central bank of another qualifying\13 Organization for
Economic Cooperation and Development (OECD) country,\14 this asset is
multiplied by a factor of 0 percent, which results in no capital
being required against the credit risk from this transaction. 

For an obligation owed by another commercial bank in an OECD country,
a bank must multiply the amount of this obligation by 20 percent,
which has the effect of requiring the bank to hold capital equal to
1.6 percent of the value of the claim on the other bank.  Loans fully
secured by a mortgage on a 1-4 family residential property carry a
risk weight of 50 percent, thus requiring the bank to hold capital
equal to 4 percent of the value of the mortgage.  For an unsecured
obligation owed by a private corporation or individual, such as a
loan without collateral, a bank must multiply the amount of the
unsecured obligation by 100 percent, which requires the bank to hold
capital equal to a full 8 percent of the value of the unsecured
obligation. 

The U.S.  regulations place all credit risks into one of four broad
categories and treat each product in a given category as if it
carries equal levels of credit risk--that is, the capital requirement
for each asset in the category is based on the same percentage
risk-weight.  Although these risk-weightings are based primarily on
the type of obligor, qualifying collateral (such as cash and
government securities) and qualifying guarantees (including bank and
government guarantees) are also recognized. 

To adjust for credit risks created by financial positions not
reported on the balance sheet, the regulations provide conversion
factors to express off-balance sheet items as an equivalent
on-balance sheet item, as well as rules for incorporating the credit
risk of interest-rate, exchange-rate, and other off-balance sheet
derivatives.  These positions are converted into a credit equivalent
amount, and then the standard loan risk-weight for the type of
customer is applied.  The risk-weight is applied according to the
type of obligor, except that in the case of derivatives the maximum
risk-weight is 50 percent. 


--------------------
\7 Recently adopted regulatory capital requirements for both banks
and life insurers are often referred to as "risk-based" capital
requirements, a term that is not generally used to describe capital
requirements for securities broker-dealers and FCMs.  However,
current capital requirements for all types of regulated financial
entities variously take account of risks in the entities' business. 

\8 An off-balance sheet item is a financial contract that can create
credit losses for the bank but is not reported on the balance sheet
under standard accounting practices.  An example of such an
off-balance sheet position is a letter of credit or an unused line of
credit, which commits the bank to making a loan in the future that
would be on the balance sheet and thus create a credit risk. 

\9 The risk-based capital guidelines apply on a consolidated basis to
banks and bank holding companies with consolidated assets of $150
million or more.  For bank holding companies with less than $150
million in consolidated assets, the guidelines are to be applied on a
bank-only basis, unless the parent bank holding company is engaged in
nonbanking activity involving significant leverage, or the parent
company has a significant amount of outstanding debt that is held by
the general public. 

\10 Capital Adequacy Guidelines, Reg.  H (12 C.F.R.  pt.  208) App. 
A, Board of Governors of the Federal Reserve System as amended Dec. 
31, 1993.  OCC's regulation is at 12 C.F.R.  pt.  3.10 and 3.11. 
FDIC's regulation is at 12 C.F.R.  pt.  325. 

\11 Perpetual preferred stock means preferred stock that does not
have a maturity date and cannot be redeemed at the option of the
holder.  Cumulative perpetual preferred stock requires all dividends
to be paid on it before payment of any common stock dividends. 
Dividends are not cumulative for noncumulative perpetual preferred
stock.  Banks are allowed to include in their core capital only
noncumulative perpetual preferred stock.  For bank holding company
calculations, both cumulative and noncumulative perpetual preferred
stock qualify for inclusion in tier 1.  However, the aggregate amount
may not exceed 25 percent of the sum of all core capital elements,
including cumulative perpetual preferred stock. 

\12 Consultative Paper:  Proposals for International Convergence of
Capital Measurement and Capital Standards, Committee on Banking
Regulations and Supervisory Practices, BIS (Basle, Switzerland:  Dec. 
1987). 

\13 In July 1994, the Basle Committee amended the accord concerning
the qualification for OECD risk-weighting.  See appendix I for a
further explanation. 

\14 OECD includes members from 29 countries.  Its goals are to
achieve high economic growth, contribute to sound economic expansion,
and contribute to the expansion of world trade. 


         FINAL RULE TO ADDRESS
         MARKET RISK ADOPTED FOR
         DEALER BANKS
------------------------------------------------------ Chapter 2:2.1.2

In September 1996, U.S.  bank regulators issued a final rule based on
the Basle Committee's January 1996 amendment to the Basle Accord
designed to incorporate market risks into the risk-based capital
standards.\15 As applied by U.S.  bank regulators, the purpose of the
amendment was to ensure that banks with significant exposure to
market risk maintain adequate capital to support that exposure. 
Because the market risk rule applies to assets that are commonly
traded in public markets and marked to market,\16 the risk
calculations are based, in part, on measuring expected movements in
prices and the risks in the current financial position of the
institution. 

U.S.  rules apply to any bank or bank holding company whose trading
activity equals 10 percent or more of its total assets or whose
trading activity equals $1 billion or more.  In addition, a bank
regulator can include an institution that does not meet the criteria
if deemed necessary for safety and soundness purposes or can exclude
institutions that meet the applicability criteria.  At the end of
1996, 17 banks and 17 bank holding companies met these criteria.\17
The new rules became mandatory January 1, 1998, but banks could have
begun implementing them as of January 1, 1997. 

The final market risk rule requires that institutions adjust their
risk-based capital ratio to take into account both the general
market\18 and specific risk of all "covered positions" both on- and
off-balance sheet.\19 The rule does not cover all market risks faced
by banks.  For example, interest rate risk on nontrading assets such
as commercial loans and mortgages is not included. 

The rule requires that banks use their own internal models to measure
their daily "value-at-risk" (VAR) for covered positions.\20

VAR reflects changes in prices; price volatility or variability; and
correlation among the prices of financial assets (that is, the extent
to which asset prices move together).  A bank's internal model may
use any generally accepted VAR measurement technique, but the
regulation requires the level of sophistication and accuracy of the
model to be commensurate with the nature and size of the bank's
covered positions.\21

To adapt banks' internal models for regulatory purposes, bank
regulators developed minimum qualitative and quantitative
requirements that all banks subject to the market risk standard are
to use in calculating their VAR estimate for determining their
risk-based capital ratio.  The qualitative requirements reiterate the
basic elements of sound risk management.  For example, banks subject
to the market risk capital requirements are required to have a risk
control unit that reports directly to senior management and is
independent of business trading units. 

According to the final rule, the quantitative requirements are
designed to ensure that an institution has adequate levels of capital
and that capital charges\22 are sufficiently consistent across
institutions with similar exposures.  These requirements call for
each bank to use common parameters when using its internal model for
generating its estimate of VAR.  These common parameters include,
among others:  daily calculation; an assumed holding period of 10
days; a 99 percent confidence level; the use of empirically verified
correlation between risk types; and the use of at least 1 year of
historical data, with the data updated at least once every 3 months. 

The total market risk charge is the sum of the general market and
specific risk charges.  The market risk charge starts from the
estimate of VAR.  Because the VAR models may not capture unusual
market events, the general market risk charge is then the higher of
the previous day's VAR, or the average daily VAR over the last 60
business days multiplied by at least 3.  The specific risk charge can
be determined by a bank's internal model if the model is approved by
the regulator, or by calculations specified in the regulation if the
model is not approved.  The charge for specific risk is added to the
general market risk amount to obtain the total market risk capital
charge. 

For banks subject to the market risk charge, the market risk
regulation includes an additional tier of qualifying capital--tier 3. 
Tier 3 capital is unsecured subordinated debt that is fully paid up,
has an original maturity of at least 2 years, and is redeemable
before maturity only with approval by the regulator.\23

The final rule also requires banks to conduct periodic backtesting
beginning in January 1999.  More specifically, banks will be required
to compare daily VAR estimates generated by internal models against
actual daily trading results to determine how effectively the VAR
measure identified the boundaries of losses, consistent with the
predetermined statistical confidence level.  The regulation will
require bank regulators to use the backtesting results to adjust the
multiplication factor (multiplier) used to determine the bank capital
requirement.\24


--------------------
\15 Amendment to the Capital Accord to Incorporate Market Risk, Basle
Committee on Banking Supervision, Jan.  1996. 

\16 Marking to market means that the value of a financial product on
the books of an institution is regularly expressed in terms of its
fair value.  Some assets, such as stocks and bonds, which are
regularly traded on exchanges, can be marked to market easily on the
basis of current market prices.  Other assets, such as commercial
loans provided by banks, are more difficult to mark to market because
each loan is unique and there is no active secondary market
generating fair prices or values for such loans. 

\17 The Federal Reserve notes that the 17 banks that met the market
risk criteria held 98 percent of the trading positions (assets plus
liabilities) held by all U.S.  commercial banks at the end of 1996. 
Fourteen of the 17 holding companies that met the criteria were
associated with banks that met the criteria. 

\18 General market risk means changes in the market value of covered
positions resulting from broad market movements, such as changes in
the general level of interest rates, equity prices, foreign exchange
rates, or commodity prices.  Specific risk means changes in the
market value of specific positions due to factors other than broad
market movements and includes such risks as the credit risk of an
instrument's issuer. 

\19 Covered positions means all positions (both debt and equity) in a
bank's trading account and all foreign exchange and commodity
positions, whether or not in the trading account. 

\20 Value-at-risk represents an estimate of the maximum amount by
which the value of an institution's positions could decline due to
general market movements during a fixed holding period, measured with
a specified confidence interval. 

\21 The U.S.  market risk approach was based on internal models
produced by each bank.  The Basle Accord permitted two alternative
approaches--a bank could develop its own internal model or apply a
standardized approach written into the accord.  The standardized
approach assigned risk to assets on the basis of their
characteristics, such as interest rates or terms to maturity.  U.S. 
banks are to use only the internal models approach. 

\22 In the market risk amendment, the calculated capital charge is a
conservative estimate of possible losses due to market volatility. 

\23 To be included in the definition of tier 3 capital, the
subordinated debt is to include a lock-in clause precluding payment
of either interest or principal (even at maturity) if the payment
would cause the issuing bank's risk-based capital ratio to fall or
remain below the minimum requirement. 

\24 For example, if a bank exceeds its VAR estimate 10 or more times
in the previous 250 business days, its multiplier could be increased
from 3 to 4. 


         CAPITAL LEVERAGE RATIO
         SUPPLEMENTS CREDIT AND
         MARKET RISK MEASURES
------------------------------------------------------ Chapter 2:2.1.3

In addition to the risk-based capital requirements, U.S.  banks are
subject to a minimum leverage ratio, which is a requirement that tier
1 capital be equal to a certain percentage of total assets,\25

regardless of the type or riskiness of the assets.  Leverage ratios
have been part of bank regulatory requirements since the 1980s.  They
were continued after the introduction of risk-based capital
requirements, as a cushion against risks not explicitly covered in
the risk-based capital requirements, such as operational weaknesses
in internal policies, systems, and controls.  According to FDIC,
leverage standards also help to restrict excessive asset growth and
minimize potential moral hazards by ensuring that any asset growth is
funded by a commensurate amount of owners' equity. 

Since the early 1990s, banks have been specifically required to hold
tier 1 capital equalling between 3 and 5 percent of their total
assets, depending on a regulatory assessment of the strength of their
management and controls.  The amount of capital held by a bank is not
to be less than this leverage ratio.  However, if the risk-based
capital calculation yields a higher capital requirement, the higher
amount is the minimum level required. 


--------------------
\25 For purposes of the leverage ratio, the federal regulators define
"total assets" for banks as the average of total assets reported in
the Call Report, minus any assets that are deducted in determining
tier 1 capital. 


         CAPITAL LEVELS OF
         REGULATED BANKS CURRENTLY
         TEND TO EXCEED REQUIRED
         MINIMUM REQUIREMENTS
------------------------------------------------------ Chapter 2:2.1.4

In 1997, the risk-based capital ratios for the six large banks we
spoke with all exceeded the minimum 8 percent total requirement, as
shown in table 2.2.  In addition, the ratios for tier 1 capital,
which is considered the strongest form of capital, exceeded the 4
percent minimum requirement at all of the banks.  According to
regulatory officials, the risk-based capital ratios of almost all
U.S.  banks exceed the minimum required levels.  According to FDIC,
fewer than 10 percent of U.S.  banks actually report risk-based
capital figures by completing the Call Report Risk-Based Capital
forms.  When calculating their capital ratios, banks are permitted to
perform a simple test that, once passed, negates the need to do the
more complicated calculations.  Over 90 percent of banks pass this de
minimis test, and an algorithm approximates their risk-based capital
level. 

Bank regulators told us they believe prompt corrective action has
been influential in keeping bank capital levels up.\26 In addition,
several years of record-breaking earnings have facilitated financial
firms' capital accumulation. 



                                    Table 2.2
                     
                     Risk-Based Capital Ratios for Six Large
                      Bank Holding Companies, as of December
                                    31, 1997\a

                              (Dollars in billions)

                                         Total risk-based     Tier 1 risk-based
                                              capital              capital
                                        -------------------  -------------------
                                                 Percentage           Percentage
                                                   of total             of total
                                                      risk-                risk-
                                        Dollar     weighted  Dollar     weighted
Bank holding company                    amount       assets  amount       assets
--------------------------------------  ------  -----------  ------  -----------
BankAmerica Corporation                  $26.6        11.6%   $17.3         7.5%
Bankers Trust New York Corp.              11.0         14.1     6.4          8.3
Canadian Imperial Bank of Commerce\a      14.5          9.8    10.2          7.0
The Chase Manhattan Corp.                 33.3         11.6    22.6          7.9
Citicorp                                  31.1         12.3    21.1          8.3
First Chicago NBD Corp.                   12.7         11.7     8.5          7.9
--------------------------------------------------------------------------------
Note:  All figures rounded. 

\a The fiscal year for the Canadian Imperial Bank of Commerce ended
on October 31, 1997.  The capital ratios in the table above for the
Canadian Imperial Bank of Commerce were calculated using regulatory
guidelines for Canadian banks.  Under U.S.  rules, its ratios would
have been 8.8 percent for total capital and 6.4 percent for tier 1
capital. 

Source:  1997 Annual Reports of the bank holding companies in table. 


--------------------
\26 According to FDIC, its risk-based assessment rules provide an
incentive for insured institutions to exceed the minimum required
capital levels.  Insured institutions that are "well capitalized" pay
at a lower premium rate than institutions that are merely adequately
capitalized (meet the minimum requirements), or are less than
adequately capitalized.  To be well capitalized, an institution must
have a total risk-based capital ratio of 10 percent or more, a tier 1
ratio of 6 percent, and a leverage ratio of 5 percent. 


      SECURITIES AND FUTURES
      REGULATORY CAPITAL
      REQUIREMENTS EMPHASIZE
      LIQUID CAPITAL TO MEET
      CUSTOMER OBLIGATIONS IN THE
      EVENT OF FIRM FAILURE
-------------------------------------------------------- Chapter 2:2.2

As discussed earlier, regulators of securities broker-dealers and
FCMs seek to protect customers of the firms they oversee as well as
to protect the integrity of their markets.  The regulatory foundation
of customer protection efforts includes capital requirements in the
form of net capital rules\27 and customer protection and funds
segregation rules,\28 which are designed to protect the regulated
entity's customers and thereby other market participants from
monetary losses and delays that can occur when the regulated entity
fails.\29 The objective of protecting investors does not extend to
the protection of the going concern of broker-dealers or FCMs, nor
does it extend to the protection of investors' holdings against
market losses.  These rules, respectively, require SEC-registered
broker-dealers and CFTC-registered FCMs--the regulated entities--to
continually maintain sufficient liquid assets to protect the interest
of customers and other market participants if the firm ceases doing
business, and as applicable, to keep customer assets segregated from
the regulated entity's assets.  The rules focus specifically on the
regulated entity's financial condition and activities.  As noted
above, SEC and CFTC do not have statutory authority to regulate
holding companies of broker-dealers or FCMs.  The financial condition
of holding companies or other affiliates of the regulated entity are
generally not included in computation of net capital or compliance
with the customer segregation rule.\30


--------------------
\27 SEC Rule 15c3-1 and CFTC Rule 1.17. 

\28 SEC Rule 15c3-3 and CFTC Rules 1.20-1.30. 

\29 CFTC imposes capital requirements on both FCMs and Introducing
Brokers.  Because Introducing Brokers do not hold customer funds and
do not pose a significant risk to the functions of the markets, their
capital regulations are not considered further in this report. 

\30 An exception to this principle is when the registered
broker-dealer guarantees or assumes responsibility for the
liabilities of the related unregistered entity.  In such a situation,
the broker-dealer is required to consolidate into a single
computation the assets and liabilities of both itself and the
guaranteed entity.  See Rule 15c3-1(a)(1)(i) and Appendix C to the
rule. 


         SEC AND CFTC USE SIMILAR
         METHODS TO CALCULATE
         CAPITAL
------------------------------------------------------ Chapter 2:2.2.1

SEC and CFTC calculate broker-dealer and FCM liquid capital,
respectively, in a similar manner.  However, their capital
requirements, which are based on either ratios of capital to assets
or capital to liabilities of the firm, are calculated differently. 


         SEC'S NET CAPITAL RULE
------------------------------------------------------ Chapter 2:2.2.2

Capital standards for brokers and dealers based upon liquidity have
been in effect since 1934 when the Securities Exchange Act was
adopted.  According to SEC, it adopted the SEC Uniform Net Capital
Rule\31 in 1975 in response to congressional concerns arising from
the unprecedented financial and operational crisis in the securities
industry from 1967 to 1970.  It is a conservative liquidity-based
capital standard that requires broker-dealers to maintain a minimum
level of liquid capital sufficient to promptly satisfy all of its
obligations to customers and other market participants, and to
provide a cushion of liquid assets to cover potential market, credit,
and other risks.  The rule focuses generally on the registered
broker-dealer; therefore, the assets and liabilities of a related
entity (e.g., an affiliate or parent) of the broker-dealer are
generally not taken into account in calculation of net capital. 

Net Capital Requirements:  With certain exceptions, the net capital
rule requires a registered broker-dealer to maintain the greater of
an absolute minimum dollar amount of net capital depending on the
nature of the broker-dealer's business,\32 or a specified minimum
ratio of net capital to either its liabilities or its
customer-related receivables. 

Under the SEC regulations, a broker-dealer must satisfy a minimum net
capital ratio based either on a calculated ratio of capital to
indebtedness (liabilities) or capital to customer-related
receivables.  Under the basic (or aggregate indebtedness) method, the
capital a broker-dealer is required to maintain must be the greater
of $250,000 or 6-2/3 percent of aggregate indebtedness (generally all
the liabilities and/or obligations of the broker-dealer).  The basic
method is generally used by smaller broker-dealers.  Under the
alternative method, a broker-dealer is required to maintain capital
equal to the greater of $250,000 or 2 percent of the total amount of
customer-related receivables (money owed by customers and certain
other market participants to the broker-dealer).  If the
broker-dealer is also registered as an FCM with CFTC under the
Commodity Exchange Act (CEA) (i.e., dually-registered), it must
maintain capital equal to the greater of SEC's minimum requirements,
as described above; or 4 percent of the customer funds (money owed to
the customers by the FCM) that the broker-dealer is required to
segregate pursuant to the act and regulations thereunder.  The
alternative method tends to be used by larger broker-dealers. 

The basic and alternative methods are intended to allow a firm to
increase its customer business only to the extent that the firm's net
capital can support such an increase. 

Computing Net Capital:  The process of computing a broker-dealer's
regulatory net capital involves separating its liquid and illiquid
assets.  Liquid assets are assets that can be converted easily into
cash with relatively little loss of value.  Assets that are
considered illiquid are given no value when net capital is computed
(a 100 percent capital charge).  Only liquid assets count in the
calculation of net capital, because a broker-dealer must have
sufficient capital to close its business within a short time frame
and have sufficient liquid assets to meet its liabilities, including
those of customers. 

To begin computing net capital, U.S.  Generally Accepted Accounting
Principles (GAAP)\33 equity must be determined by subtracting the
broker-dealer's GAAP liabilities from its GAAP assets.\34 Certain
subordinated liabilities are added back to GAAP equity because the
net capital rule allows them to count toward capital, subject to
certain conditions.\35 Deductions are taken from GAAP equity for
illiquid assets, such as the value of exchange seats and fixed
assets.  Unsecured receivables are also deducted from GAAP equity. 
The net capital rule further requires prescribed percentage
deductions from GAAP equity, called "haircuts."\36 Haircuts provide a
capital cushion to reflect an expectation about possible losses on
proprietary securities and financial instruments held by a
broker-dealer resulting from adverse events.  The amount of the
haircut on a position is a function of, among other things, the
position's market risk liquidity.  A haircut is taken on a
broker-dealer's proprietary position because the proceeds received
from selling assets during a liquidation depend on the liquidity and
market risk of the assets.  Less liquid assets and assets with
greater price volatility are more likely to take longer to sell and
to be sold at a loss.  Thus, the less liquid the position, the
greater the haircut on the position.  Haircuts generally recognize
limited correlation among prices

that can affect the actual values received when assets are
liquidated.\37 The final figure, after all adjustments are made, is
referred to as net (or liquid) capital.  This figure is then compared
to the minimum requirement to determine capital compliance.  See
appendix II for greater discussion of the SEC net capital rule.


--------------------
\31 SEC Rule 15c3-1 under the Securities Exchange Act of 1934. 

\32 For example, firms that hold customer funds or securities (i.e.,
carrying firms) have a minimum capital requirement of $250,000,
whereas firms that serve as agents for customers and generally do not
hold customer funds and securities (i.e., introducing firms) have a
minimum capital requirement of $5,000.  These levels of minimum
dollar amounts were designed to protect customers against the
riskiness of a particular business conducted by a broker-dealer.  See
appendix II. 

\33 GAAP are accounting rules and conventions defining acceptable
practices in preparing financial statements.  GAAP's aim is to
provide uniformity in financial statements reporting. 

\34 Broker-dealer assets include cash; money owed by customers and
other broker-dealers; securities held in proprietary trading and
investment accounts; and fixed assets like buildings, furniture, and
equipment.  Broker-dealer liabilities include money owed to customers
and other broker-dealers, bank loans, debt securities issued by the
broker-dealer, or funds loaned to it by the parent company. 

\35 The rule permits certain subordinated liabilities to be included
as part of the regulatory net capital of a broker-dealer.  In order
to count toward net capital, among other things, these subordinated
liabilities (1) must be subordinated to the claims of all present and
future creditors, including customers; (2) must be approved for
inclusion as net capital by the broker-dealer's self-regulatory
organization; (3) may not be repaid if the repayment would reduce net
capital below certain required amounts; and (4) must have an initial
term of 1 year or more. 

\36 Haircuts are intended to reflect the inherent risks within a
broker-dealer's trading and investment positions and provide a margin
of safety against losses incurred by a broker-dealer.  Through the
issuance of no-action position letters, SEC officials in the Division
of Market Regulation can reduce the capital charge for a particular
type of transaction.  An approved no-action position can be used by
any market participant for the participant's benefit.  SEC issues
no-action letters in response to requests by broker-dealers, industry
groups, and SROs for its staff members' views on whether they would
recommend enforcement action if the particular set of facts and
circumstances as outlined in the request letter were to occur. 
No-action letters do not make rulings on whether the particular
circumstances are legal or illegal--the letters only state whether
the Division of Market Regulation staff would or would not recommend
an enforcement action to the Commission under those specific
circumstances.  Examination staff use these no-action letters when
calculating a particular broker-dealer's compliance with net capital
requirements.  CFTC also issues no-action positions regarding capital
requirements for FCMs. 

\37 SEC has adopted a risk-based methodology using theoretical option
pricing models to calculate haircuts for listed options and related
hedge positions.  See appendix II. 


         CFTC'S NET CAPITAL RULE
------------------------------------------------------ Chapter 2:2.2.3

Liquid capital for FCMs is generally calculated in the same way that
SEC calculates a broker-dealer's liquid capital.  That is, CFTC
generally makes similar liquidity (illiquid assets deductions) and
risk (haircuts for trading and investment positions)\38

adjustments to GAAP net worth as does SEC in determining the amount
of liquid capital.  (See app.  II for more detail on the
calculation.)

CFTC's capital requirements, like SEC's, are based on the firms'
business activities and apply only to the registered FCMs.  However,
unlike SEC's, CFTC's requirement is based on the amount of required
segregated customer funds,\39 (subject to certain adjustments),\40
rather than aggregate indebtedness or customer-related receivables. 
The amount of required segregated funds is based primarily on margin
requirements for the commodity contracts held by the FCM's customers. 
Margin requirements are set by each exchange for each commodity
contract traded on the exchange and represent the customers'
guarantee of performance.  The amount of margin per commodity varies
depending on the market value of the contract and volatility of the
price of the underlying commodity.  The amount of segregated funds on
deposit is determined primarily by the Standard Portfolio Analysis of
Risk (SPAN) margining system, a VAR based statistical model designed
to evaluate the total risk in a portfolio of related futures and
options positions.  Therefore, the CFTC's capital requirements are,
in large measure, risk-based.  In addition, the deductions or
haircuts for proprietary positions in futures or commodity option
positions are applied to the margin requirement calculated under
SPAN.  All funds held by FCMs but owed to customers are required to
be segregated from the firm's funds and treated as belonging to
customers. 

Under CFTC's net capital rule (Rule 1.17), FCMs must maintain
adjusted net capital in an amount that is no less than the greater of
(a) a prescribed minimum fixed-dollar amount of $250,000; (b) a
variable minimum amount of 4 percent of customer funds required to be
segregated, subject to certain adjustments;\41 (c) the amount of
adjusted net capital required by a registered futures association of
which it is a member; or (d) if the FCM is also a registered
broker-dealer, which is known as being "dually-registered," the
amount required under SEC's net capital rule. 

Under CFTC's capital rule, an FCM calculates adjusted net capital as
the amount by which current assets (cash and other assets that are
reasonably expected to be realized as cash in a year) exceed its
adjusted liabilities (the FCM's total liabilities minus certain
subordinated liabilities) and various regulatory charges or
adjustments--such as percentage reductions in the market value of
certain proprietary positions and undermargined customer accounts.\42

Adjusted net capital is intended to provide a cushion for market and
credit risks and to give a firm with customer accounts time to
transfer accounts and liquidate the accounts of the defaulting
customers in an orderly manner. 


--------------------
\38 CFTC's capital rule defers to SEC's haircuts on proprietary
securities positions to reflect the market risk in such positions. 
SEC's capital rule defers to CFTC's haircuts on proprietary futures
and options positions.  CFTC's capital charges for proprietary
futures and options positions are based on futures exchanges' margin
requirements and are portfolio risk-based. 

\39 Segregated customer funds typically include cash, securities held
for customers or representing investments of customer funds deposited
in segregated funds, bank accounts, margin on deposit with clearing
organizations of contract markets, unrealized gains on futures
contracts, and the market value of long options. 

\40 See intra note 41. 

\41 Pursuant to Rule 1.17(a)(1)(i)(B), this factor is 4 percent of
the customer funds required to be segregated pursuant to CEA and the
rules thereunder, plus the "foreign futures or foreign options
secured amounts" (see Rule 1.3(rr)), less the market value of
commodity options purchased by customers on or subject to the rules
of a contract market or a foreign board of trade. 

\42 An undermargined customer account is a margin account in which
the customer's equity is below its required amount. 


         CAPITAL LEVELS OF
         REGULATED FIRMS CURRENTLY
         TEND TO EXCEED THE
         REGULATORY MINIMUM
         REQUIREMENT
------------------------------------------------------ Chapter 2:2.2.4

Some regulators and firm representatives told us that because a
broker-dealer must cease conducting a securities business if its net
capital falls below the minimum requirement, broker-dealers generally
maintain capital greater than the minimum requirement (a.k.a.  excess
capital).  As shown in table 2.3, the amount of excess net capital
held by the five large securities firms in our study, which are all
dually-registered as FCMs, ranged from $974 million to $1.845
billion.  Some of the firm representatives we interviewed stated that
one reason they held such large amounts of excess capital is that
their counterparties required them to do so in order to be willing to
conduct business with them. 



                                    Table 2.3
                     
                     Capital Information for Five Large U.S.
                         Broker-Dealers and Their Holding
                                    Companies

                              (Dollars in millions)

                                 Total
                            consolidat  Principal
              Parent                ed  U.S. broker-                  Excess net
Date of data  company        capital\a  dealer\b      Net capital\c    capital\d
------------  ------------  ----------  ------------  --------------  ----------
12/26/97      Merrill          $51,419  Merrill           $2,249          $1,845
              Lynch & Co.,              Lynch Pierce
              Inc.                      Fenner &
                                        Smith, Inc.

11/30/97      Lehman            24,784  Lehman            1,484            1,359
              Brothers                  Brothers
              Holdings,                 Inc.
              Inc.

11/30/97      Morgan            38,748  Morgan            2,186            1,753
              Stanley,                  Stanley &
              Dean Witter,              Co. Inc.
              Discover &
              Co.\

11/28/97      The Goldman       21,774  Goldman,          1,770            1,370
              Sachs Group,              Sachs & Co.
              L.P.

12/31/97      Salomon           27,592  Salomon           1,047              974
              Smith Barney              Brothers
              Holdings,                 Inc.
              Inc.\e
--------------------------------------------------------------------------------
\a Total consolidated capital represents the sum of the parent
company's GAAP ownership equity and long-term borrowings.  For the
Goldman Sachs Group, L.P.  (a partnership), it represents the sum of
the parent company's GAAP partners' capital and long-term borrowings. 

\b In terms of total assets.  All of the principal U.S.  registered
broker-dealers are also registered with CFTC as FCMs (i.e.,
dually-registered). 

\c Net capital represents the amount of capital maintained by a U.S. 
registered broker-dealer pursuant to Rule 15c3-1 under the Securities
Exchange Act of 1934 (the Exchange Act). 

\d Excess net capital represents the amount of capital held by a U.S. 
registered broker-dealer that is greater than the amount of capital
that is required to be maintained by a U.S.  registered broker-dealer
pursuant to Rule 15c3-1 under the Exchange Act as of the date
indicated. 

\e Salomon Smith Barney Holdings, Inc.  is a wholly owned subsidiary
of the Travelers Group, Inc. 

Source:  The Goldman Sachs Group L.P.  1997 Annual Review, 1997; the
1997 Annual Reports for the other parent companies; and the 1997 U.S. 
broker-dealers' annual statements of financial condition (audited). 


      EARLY WARNING CAPITAL
      TRIGGERS
-------------------------------------------------------- Chapter 2:2.3

In addition to the minimum base requirements, the regulatory net
capital rules and the rules of the various SROs establish early
warning capital levels that exceed the minimum requirement.  These
capital triggers allow regulators and SROs to identify at early
stages broker-dealers and FCMs that are experiencing financial
difficulties and to take corrective actions to protect customers and
the marketplace.  Broker-dealers and FCMs are required to promptly
notify their regulators when early warning violations occur.  SROs
are required to notify SEC and CFTC and place restrictions on the
activities of regulated entities whose net capital falls to the early
warning levels.\43 For example, under the SEC net capital rule, a
broker-dealer that uses the alternative method of calculating net
capital may not withdraw equity capital in any form to pay
shareholders if its net capital is less than 5 percent of its
customer-related receivables. 

When an FCM's adjusted net capital falls below its early warning
level, which is generally 150 percent of the minimum net capital
amount, it must promptly notify CFTC.\44 In addition, CFTC requires
FCMs to report to CFTC when a series of events, on a net basis,
causes a 20 percent or greater reduction in their net capital. 

As soon as a broker-dealer's or FCM's net capital amount falls below
the minimum net capital level, the firm must immediately cease
conducting business and it must either demonstrate that it has come
back into compliance with net capital requirements or liquidate its
operations.  Closing a broker-dealer or FCM before insolvency makes
the firm a viable merger candidate because of its residual value and
generally allows the regulated entity's customers and other market
participants to be fully compensated when the firm is liquidated. 


--------------------
\43 SEC Rule 17a-11 and Rule 15c3-1(e) under the Securities Exchange
Act of 1934. 

\44 CFTC Rule 1.12.  For dually-registered firms, the CFTC early
warning capital trigger is the greater of (1) 150 percent of the
greatest of the amounts calculated pursuant to CFTC Rule
1.17(a)(1)(i)(A-C) or (2) the amount specified in SEC Rule 17a-11(b). 


         THE SEC NET CAPITAL RULE
         AMENDMENT RELATES CAPITAL
         CHARGES MORE CLOSELY TO
         RISKS IN LISTED OPTIONS
------------------------------------------------------ Chapter 2:2.3.1

After a 2-year test period using the Options Clearing Corporation's
Theoretical Intermarket Margining System (TIMS),\45 SEC amended its
net capital rule in early 1997 to allow broker-dealers to use
theoretical option pricing models\46 (i.e., statistical models) to
calculate required capital charges for exchange-traded (i.e., listed)
equity, index, and currency options and their related hedged
positions.\47 At this time, the only approved vendor and options
pricing model is the Options Clearing Corporation and its TIMS. 
According to SEC, this methodology will relate capital charges
(haircuts) on these instruments more closely to the market risk
inherent in these broker-dealer options positions.  This methodology
permits the risk calculations for listed options to reflect market
prices, price volatility, and correlation among asset prices. 

According to the regulations, this methodology is a two-step process. 
In the first step, third-party source models and vendors approved by
a designated examining authority (i.e., an SRO) are to be used to
estimate the potential gain and loss on the individual portfolios of
the broker-dealers.  In the second step, such approved vendors are to
provide, for a fee, a service by which the broker-dealer may download
the results generated by the option pricing models to allow the
broker-dealers to then compute the required haircut for their
individual portfolios.  (See app.  II for greater discussion of the
salient features of the methodology.) Adoption of this methodology is
the first time SEC has formally permitted the use of statistical
models, which reflect price volatility and correlation, for setting
regulatory capital requirements.  The effective date of the amendment
was September 1, 1997. 

SEC, CFTC, and some SROs are exploring other possible approaches to
more closely relate regulatory capital charges to the actual risks
inherent in a firm's operations.  These initiatives are discussed in
chapter 4. 


--------------------
\45 TIMS is used to measure the market risk associated with
participants' positions and to establish clearing house margin
requirements. 

\46 A broker-dealer may use the Options Clearing Corporation's TIMS
or any other model maintained and operated by any third-party source
and approved by a designated examination authority to determine
theoretical options prices and related haircuts.  See appendix II for
additional discussion. 

\47 See SEC Release No.  34-38248 (Feb.  6, 1997). 


      SEC AND CFTC BOTH HAVE
      CUSTOMER SEGREGATION RULES
      TO PROTECT CUSTOMER ASSETS
-------------------------------------------------------- Chapter 2:2.4

Both SEC and CFTC have rules that require the segregation of customer
funds from firm funds.  The SEC rule complements its net capital rule
and is designed to prevent the misallocation or misuse of customer
funds and securities.  The CFTC rule also complements its net capital
rule and provides for the safeguard of customer funds by requiring
that they are segregated from the FCM's own funds. 


         SEC'S RULE IS DESIGNED TO
         SAFEGUARD CUSTOMER ASSETS
------------------------------------------------------ Chapter 2:2.4.1

The SEC customer protection rule\48 attempts to prevent the
misallocation or misuse of customer funds and customer securities by
broker-dealers.  The rule applies to carrying firms because they hold
customer assets.  The rule, working in conjunction with SEC's net
capital rule, is designed to protect the regulated entity's customers
from monetary losses and delays that can occur when the regulated
entity fails. 

The customer protection rule has two parts:  (1) possession or
control\49 of all customers' fully paid and excess margin
securities,\50 and (2) special reserve bank account.  The first part
is to prevent broker-dealers from using customer securities to
finance the firm's proprietary activities, because all customers'
fully paid and excess margin securities must be in possession or
control of the broker-dealer.  The rule also requires the
broker-dealer to maintain a system capable of tracking fully paid and
excess margin securities daily.  The broker-dealer is required to
keep all customer fully-paid and excess margin securities segregated
from the broker-dealer's assets and maintained free of all claims or
liens. 

The second part of the customer protection rule involves customer
cash kept at broker-dealers.  When customer cash--the amount the firm
owes customers (credits)--exceeds the amount customers owe the firm
(debits), the broker-dealer must keep the difference in a special
reserve bank account.  The broker-dealer is to calculate the amount
of the difference weekly using the reserve formula specified in the
rule.  If debits exceed credits, then no deposit is required. 
Broker-dealers may not use customer margin securities and cash to
finance their operations or proprietary trading activities, except to
finance other customers' transactions.  Also, creditors of a failed
securities broker-dealer cannot claim assets from the broker-dealer's
customer property account. 


--------------------
\48 Rule 15c3-3 under the Securities Exchange Act of 1934. 

\49 "Possession" of securities means the securities are physically
located at the broker-dealer.  "Control" of securities means the
securities are located at one of the approved "control" locations.

Rule 15c3-3 specifies the locations in which a security will be
considered in possession or control of the broker-dealer.  This
includes those securities that are held at a clearing corporation or
depository, free of any lien; carried in a Special Omnibus Account
under the Federal Reserve Board Regulation T with instructions for
segregation; a bona fide item of transfer of up to 40 days; in the
custody of foreign banks or depositories approved by SEC; in a
custodian bank; in transit between offices of the broker-dealer; or
held by certain subsidiaries of the broker-dealer. 

\50 Fully paid securities are securities that are purchased in
transactions for which the customer has made full payment.  Excess
margin securities in a customer account are margin securities with a
market value in excess of 140 percent of the account debit balance
(the amount the customer owes the firm for the purchase of the
securities).  For example, a customer buys $80,000 worth of
securities on 50-percent margin, and the broker-dealer loans the
customer $40,000 (debit balance).  The amount of the customer margin
securities that can be pledged as collateral for a bank loan is
$56,000 (140 percent times $40,000).  Because only $56,000 of the
$80,000 of customer securities can be pledged to the bank as
collateral, the remaining $24,000 of securities are excess-margin
securities that must be segregated and held in safekeeping by the
broker-dealer. 


         CFTC'S RULE IS DESIGNED
         TO SAFEGUARD CUSTOMER
         FUNDS
------------------------------------------------------ Chapter 2:2.4.2

Section 4d(2) of the CEA and CFTC rules 1.20-1.30 provide for the
safeguarding of customer funds\51 by requiring such funds to be
segregated from funds belonging to the FCM.  Similar to the SEC rule,
the CFTC segregation rule complements its net capital rule and exists
to ensure that FCMs do not mix customer funds with theirs.  In the
event of a firm's insolvency, under the rule, customer funds would be
clearly identified as belonging to customers and would not be
available to creditors of the firm. 

The rule requires that funds belonging to an FCM's customers be
separately accounted for; segregated as belonging to commodity
futures or option customers; and, when deposited with any bank, trust
company, clearing organization, or another FCM, deposited under an
account name that clearly identifies them as such and shows that they
are segregated as required by the act and regulations.  Also, each
FCM is required to obtain and retain an acknowledgment from such
bank, trust company, clearing organization, or FCM that it was
informed that the customer funds deposited therein are those of
commodity or option customers and are being held in accordance with
the provisions of the act and regulations. 

On a daily basis, FCMs are to compute the customer funds they are
required to segregate on the basis of funds received from customers
and the daily mark to market of customer positions.  CFTC's
segregation rule requires that 100 percent of each customer's funds
be segregated from FCM's funds.  Unlike securities broker-dealers,
FCMs generally cannot use one customer's funds to finance another
customer's transactions.  Thus, CFTC's segregation requirements serve
to provide protection through the deposit of all customer funds in
segregated accounts.\52

Under SEC requirements, generally the net amount owed to customers is
deposited in a bank account with the assumption that money receivable
from the broker-dealer's customers will be collected and paid to the
customers having credit balances in their accounts, and any shortfall
will be covered by the amount deposited in the bank account set up
for customers.  In addition, SIPC provides insurance protection for
securities customers of broker-dealers in the event there are not
enough funds on deposit in the bank account.  The commodities
industry does not have a customer account government-sponsored
insurance program that protects against losses due to FCM insolvency. 

Together, these customer protection rules are designed to protect (1)
customers and other market participants of broker-dealers and FCMs
from monetary losses and delays that can occur when the regulated
broker-dealer or FCM fails by facilitating the orderly unwinding of a
failed firm through liquidation; and (2) the integrity of the
securities and futures markets. 


--------------------
\51 CFTC Rule 1.3(gg) defines "customer funds" to mean all money,
securities, or property received by an FCM on behalf or owed to
customers used (1) to margin, guarantee, or secure futures contracts;
or (2) as the premium on CFTC-regulated exchange traded options, and
money accruing to customers as a result of such futures and options
contracts. 

\52 According to the Chicago Mercantile Exchange (CME), the customer
segregation requirements are designed to protect customers from the
consequences of an FCM's failure, but they do not always provide
sufficient protection should the default be caused by another
customer of that firm.  In CME's view, protection against
customer-caused defaults rests with the FCM's management and the
importance placed on its internal risk management controls. 


      INSURANCE REGULATORY
      REQUIREMENTS ARE TO ENSURE
      THE LONG-RUN VIABILITY OF
      INSURERS SO POLICYHOLDERS'
      CLAIMS CAN BE HONORED
-------------------------------------------------------- Chapter 2:2.5

According to NAIC, capital requirements have been used as an
important tool in limiting insolvency costs throughout the history of
insurance regulation.  Initially, states enacted statutes that
required a specified minimum amount of capital and surplus for an
insurance company to enter the business or to remain in the
business.\53 In some states, a single dollar amount of minimum
capital and surplus was applicable to all insurers, regardless of the
lines of insurance they wrote.  This requirement was, in effect, an
entrance requirement and generally did not vary with the size of the
insurer or the risks that a company accepted.  Thus, the minimum
amount of required regulatory capital was unlikely to bear any
relationship to the amount of risk on the books of any particular
insurer. 

In the latter half of the 20th century, according to NAIC, changes
within the insurance industry itself and the economic environment in
which it operated raised questions about the long-term viability of
traditional insurance products and led insurers to offer new
products.  These products included variable annuities, variable life
insurance, universal life insurance, single-premium deferred
annuities, and guaranteed investment contracts.\54 In NAIC's view,
competition among sellers of these products led life insurers to seek
higher returns on their investment portfolios, and some of them
sought such returns without sufficient consideration of the
accompanying higher investment risks. 

According to NAIC, an increase in the number and size of life insurer
insolvencies from the 1960s through the 1980s led insurance
regulators to believe they needed new tools to deal with changes in
the industry resulting from new products and investment strategies. 
Because most states required a fixed minimum amount of capital
regardless of the risks undertaken in a company's insurance and
investment operations, regulators believed that the traditional
statutory insurance capital requirements that were in place were not
sufficiently flexible. 

By 1990, according to NAIC, a number of states were experimenting
with risk-based capital formulas for regulatory purposes.  NAIC
became interested in risk-based capital in 1989.  Its working group
and advisory committee developed and tested the life risk-based
capital formula, which was approved by NAIC in December 1992, to be
used for the first time with the 1993 annual statement filed in March
1994. 


--------------------
\53 The life insurance industry designates its capital as capital
stock, which represents funds paid into the company by shareholders;
and as surplus, which is the remaining excess of assets over
liabilities. 

\54 An annuity is a contract written by an insurance company to
provide income benefits for a specified number of years, or for life. 
In a deferred annuity, the premiums are paid currently but benefits
are scheduled to begin at a later date.  A variable annuity is a
contract in which annual units are purchased, often through a
retirement plan account.  The number of units varies with unit cost,
and the benefits vary directly with the experience of assets that
back the contract.  A single-premium deferred annuity is a deferred
annuity contract purchased with a single premium.  Whole life
insurance is a plan that combines protection and a growing cash
value.  Variable life insurance is a form of whole life insurance in
which the cash value varies, depending on the investment performance
in a separate account.  Universal life is a form of life insurance
that combines accumulating cash value with a varying rate of return. 
A guaranteed investment contract is one in which the insurance
company accepts a specified amount of money from a qualified
retirement plan and agrees to refund the money at a fixed date in the
future. 


      APPLICATION OF THE
      RISK-BASED CAPITAL
      REQUIREMENT TO LIFE
      INSURANCE COMPANIES
-------------------------------------------------------- Chapter 2:2.6

According to NAIC, the risk-based capital formula is intended to
determine the minimum amount of capital an insurer needs to avoid
triggering regulatory action.  The amount of capital required varies
with the risk an insurer is assuming in its insurance and investment
operations, as well as the normal risks to which all businesses are
subject.  The formula requires companies to hold minimum percentages
of various assets and liabilities as capital, with these percentages
based on the historical variability of the value of those assets and
liabilities.  Companies are free to make their own capitalization
decisions commensurate with their own level of risk tolerance as long
as the level is above the regulatory minimum risk-based capital
thresholds.  In NAIC's view, its formula, in effect, imposes a
minimum and uniform degree of risk aversion on all companies, but the
formula also allows companies to operate freely at any given level
above the minimum threshold. 

The NAIC life insurance risk-based formula classifies all of the
risks into four major categories:  asset risk, insurance risk,
interest rate risk, and all other business risk.\55 The formula
consists of a series of risk factors that are to be applied, usually
as multipliers, to selected assets, liabilities, or other specific
company financial data to establish the minimum capital needed to
bear the risk arising from that item (similar to risk- weights in
banking). 

  -- The asset risks are the risks of asset defaults and decreases in
     market value.  For example, the risk factor for cash in the
     formula is 0.003, which indicates that an insurer must maintain
     capital equal to three-tenths of 1 percent of its cash holdings
     to absorb the risk of loss in cash in a bank failure.  At the
     other end of the range, the multiplier for publicly traded
     common stocks is 0.300, which indicates a requirement for
     capital equal to 30 percent of the value of the stocks to
     protect against downturns in the market.  The formula also
     includes charges for risks arising from the ownership of
     subsidiaries and affiliates, which vary with the nature of these
     entities.  According to NAIC data, asset risks represent by far
     the largest proportion of risk among the four categories faced
     by the life insurance industry as a whole. 

  -- The insurance risks, which are unique to the insurance industry,
     are the risk of underpricing or unfavorable developments in
     mortality or morbidity.  NAIC developed a series of risk factors
     to determine the capital necessary to absorb those risks that
     are to be applied to the net amount at risk (face amount less
     reserves) for life insurance.  According to NAIC data, insurance
     risks are second in magnitude among the four categories of risks
     for the life insurance industry as a whole.  However, for a
     large number of relatively small companies, this component is
     the dominant risk-based capital risk. 

  -- NAIC defines interest rate risk as the chance that a change in
     interest rates will result in an insurer not earning enough
     return on its investments to meet its interest obligations under
     its various insurance and annuity contracts.  There is also a
     risk that changes in interest rates will spur
     disintermediation.\56 The interest rate risk depends on how
     closely the assets and liabilities are matched in time.  The
     formula is concerned with the risks related to annuity and
     pension business.  Interest rate risk is third in magnitude
     among the four categories of risk for the life insurance
     industry as a whole. 

  -- The all-other-business-risk category encompasses risks not
     included elsewhere in the formula.  In developing the risk-based
     capital formula, the working group recognized that all companies
     are subject to some risks, such as litigation, that are not
     contemplated in the parts of the formula used for other
     categories.  However, the group concluded that the derivation of
     appropriate risk factors for most of these risks was not
     possible.  Also, these risks vary from one company to another. 
     Initially, NAIC decided that the only risk factor to be included
     in the risk-based capital formula would be a charge for the risk
     of guaranty fund assessments. 

In addition, the risk-based capital formula also requires the
performance of sensitivity tests to indicate how sensitive the
formula is to changes in certain risk factors.  These tests require
the company to recalculate its risk-based capital using revised risk
factors for certain specified risks and to report the difference
between the basic calculations and the sensitivity tests.  The
purpose of the tests is to provide additional information for company
management and regulators. 

In NAIC's view, the true impact of the risk-based capital system is
in the Risk-Based Capital for Insurers Model Act (the Model Act),
which NAIC developed and recommended that the states adopt.  When
adopted by a state, this act gives the state's chief insurance
regulator the authority to act on the results generated by the
risk-based capital formula.\57

The act requires each insurer to file a report with NAIC; the
commissioner of the insurer's domiciliary state; and the commissioner
of any state in which the insurer is licensed, if that state's
insurance commissioner requests it in writing.  In their annual
reports, insurers are also required to report their Authorized
Control Level Risk-Based Capital, which is the total risk-based
capital an insurer needs to hold to avoid being taken into
conservatorship.  (See app.  III for additional information on life
risk-based capital regulations.)


--------------------
\55 These risk categories are given the designations of C-0 to C-4,
which are used by the insurance industry.  Asset risk is divided into
risk of default from affiliated investments and all other asset
risks.  These two categories are given the designation C-0 and C-1. 
The other three categories of risk are denoted by C-2, C-3, and C-4,
respectively. 

\56 Disintermediation is the movement of funds from a financial
intermediary (i.e., an insurance company) to a higher yielding
investment in the general market. 

\57 According to NAIC, as of March 1998, of the 51 insurance
jurisdictions, which includes the District of Columbia but excludes
the 4 U.S.  territories, 50 have adopted laws, regulations, or
bulletins that are considered to be substantially similar to the
Model Act.  The remaining jurisdiction, New York, has adopted a
similar law that applies to life insurers. 


   INDUSTRY REPRESENTATIVES SEE
   PROGRESS IN RECENT REVISIONS TO
   CAPITAL STANDARDS BUT CITE
   PROBLEMS WITH THESE AND OTHER
   CAPITAL RULES
---------------------------------------------------------- Chapter 2:3

The interviews we conducted with representatives of large,
diversified firms; industry and rating agency officials; and
regulators indicated generally positive views regarding revisions
made to capital rules in banking and life insurance in the past
several years to more precisely account for their actual risks
("risk-based" capital requirements).  Representatives of banks and
life insurers said that the changes were a step in the right
direction.  However, some of these representatives also said that
further improvements were needed.  Representatives of many of the
large financial firms we interviewed generally said that the current
requirements of the net capital rule did not correlate well with
actual risks.  Several of these representatives said that the net
capital rule affected their decisions about where to conduct certain
activities, such as derivatives. 


      BANK "RISK-BASED" CAPITAL
      REQUIREMENTS ARE SEEN AS A
      REGULATORY IMPROVEMENT BUT
      ALSO RAISE CONCERNS ABOUT
      ACCURACY OF RISK MEASUREMENT
-------------------------------------------------------- Chapter 2:3.1

Bankers, regulators, and industry and rating agency officials we
spoke with generally believe the current risk-based capital standards
for banks are an improvement over the former requirements, but they
still have limitations.  For example, one regulator and one rating
agency commented that although the current credit risk standards are
crude, they are much better than the previous leverage ratio
requirement, which did not vary with any differences in risk levels. 
In the view of the Chairman of the Federal Reserve Board, the
risk-based capital accord of 1988 had shortcomings, but it was a
genuine step forward at the time it was developed.  In the view of
the Comptroller of the Currency, the accord highlighted and
ultimately helped reverse the slippage in bank capital levels
worldwide.  It focused attention on the whole concept of risk as a
tool for both bank managers and bank supervisors and advanced the
effectiveness of bank supervision worldwide.  It gave official
recognition to the growing importance of off-balance sheet activities
in bank operations. 

Some bank officials we spoke with commented that the current credit
risk standards are nonetheless crude and imprecise.  The primary
reason for this is because the risk-weights are not adjusted for
asset quality within each broad class of assets.  Institute of
International Finance officials said that the credit risk rules
offered perverse incentives to banks to take on riskier loans in that
they encourage banks to go up the yield curve in pursuit of a return
on capital.  This means that the bank is making more long-term loans,
which tend to have higher interest rates than do short-term loans,
thus simultaneously increasing interest rate risk and potential
returns.  The Federal Reserve Board Chairman noted a number of
weaknesses in the risk-based capital structure for credit risk,
including its inability to adjust weights for hedging, portfolio
diversification, and management controls.  Such adjustments are based
on changing price volatility and correlation among prices.  Another
weakness noted by regulators is that the current risk-based structure
does not consider all types of risk.  Also, it is not flexible enough
to respond to new market developments and products. 

Officials of one bank told us that they do not manage to regulatory
capital levels, because the credit risk-based capital requirements
provide the wrong incentives by not distinguishing among the quality
of products in the same asset class.  Officials of two banks
commented that they are not constrained by regulatory capital
requirements, because assets can always be securitized so capital
will not have to be held against them, or they can move to riskier
assets in each credit risk category to obtain higher returns.  An
official of another bank felt that the credit risk standards needed
to be realigned to match current credit management practices in the
industry. 

Many bankers we spoke with generally felt the new market risk
requirements, which are based on price volatility and correlation,
were a step in the right direction and represented a recognition of
standard risk management practices and principles.  However, one bank
told us that even this new requirement will require it to hold
unrealistic levels of capital due to the multipliers imposed on the
bank's internal model. 

One regulator commented that a limitation of the new market risk
requirement is that it covers market risk in a bank's trading book,
but not in its banking book, which is where a lot of banks have
exposure to market risk.  Others commented that in practice, managers
adjust their books daily, but the regulatory use of VAR is calculated
with a 10-day holding period; thus, they believe it ignores this
day-by-day adjustment process.  Two rating agencies commented that
even after the inclusion of market risk, other important risks to
banks, such as operational and liquidity risks, are not quantified. 


      REGULATORY CAPITAL
      REQUIREMENTS FOR SECURITIES
      FIRMS RAISE CONCERNS ABOUT
      INEFFICIENCIES IN THESE
      ENTITIES
-------------------------------------------------------- Chapter 2:3.2

SEC believes the current haircut\58 approach of the net capital rule
has several advantages.  First, it requires an amount of capital that
will be sufficient as a provision against losses, even for unusual
events.  Second, it is an objective, although conservative,
measurement of risk in positions that allows the regulator to compare
firms to one another.  Third, the current methodology enables
examiners to readily determine whether a firm is properly calculating
haircuts. 

SEC believes there are also weaknesses associated with determining
capital charges on the basis of fixed percentage haircuts.  For
example, the current method of calculating net capital by deducting
fixed percentages from the market value of securities can allow only
limited types of hedges without becoming unreasonably complicated. 
In this way, the rule does not account for historical price
correlation between foreign securities and U.S.  securities or
between equity securities and debt securities.  By failing to
recognize offsets from these correlations between and within asset
classes, the fixed percentage haircut method may cause firms with
large, diverse portfolios to reserve capital that actually
overcompensates for market risk. 

Representatives of the securities firms, rating agencies, and
industry association officials we spoke with generally felt that the
current net capital rule's requirements do not correlate well with
the actual risks in the activities of firms.  Industry officials told
us that the current net capital rule does not deal well with hedging
or other risk-reducing strategies, which are based on price
volatility and correlation.  Representatives of two firms commented
that regulatory capital rules constrain their business decisions,
because they require the firms to hold what they view as excessive
capital for certain activities.  Three firms told us that the net
capital rule has an impact on where they do certain business
activities, such as derivatives transactions, foreign exchange, and
bridge financing.  Some industry officials said they are forced to
conduct these business activities in unregulated entities due to the
high haircuts imposed by the net capital rule if a broker-dealer were
to conduct these activities.\59

Representatives of another firm said the regulatory structure drives
the holding company structure, which they consider to be an
inefficient and expensive business structure.  Firm representatives
told us they have businesses in many countries, and they are required
to provide information to each country regulator.  No authority
regulates all of the activities of these firms; therefore, even
though firms provide a lot of information to regulators, no regulator
knows the condition of the entire firm.  One rating agency commented
that broker-dealers have shifted risks to other parts of the firm in
response to net capital requirements. 

Representatives of three futures SROs commented that the strengths of
CFTC's net capital rule are that it is easily understood, easily
calculated, and easily verified by regulatory auditors.  Weaknesses
they saw in the rule were that (1) it applies only to funds of
domestic customers on deposit with FCMs, so it misses noncustomers
and foreign customers; (2) it misses coverage of some risks found in
affiliates and internationally; (3) it creates incentives for FCMs to
return excess margin funds to customers because such funds can
increase an FCM's segregation requirement and therefore its capital
requirement; and (4) it does not deal well with the complexities of
exotic instruments. 


--------------------
\58 See footnote 36 for an explanation of haircuts. 

\59 See chapter 4 for a discussion of a recent SEC proposal to create
"limited purpose" broker-dealers that is to address this issue. 


      LIFE INSURANCE RISK-BASED
      CAPITAL REQUIREMENTS ARE
      SEEN AS A STEP FORWARD, BUT
      CONCERNS REMAIN
-------------------------------------------------------- Chapter 2:3.3

Life insurance companies, rating agencies, insurance regulators, and
insurance association officials we spoke with generally felt
risk-based capital requirements were a step forward, but improvements
were needed.  Insurance regulators commented that the main strength
of the requirements is that they permit regulators to close a failing
company.  Similarly, representatives of two firms said that an
advantage of these requirements is that they provided regulators a
tool they could use before a firm had to be closed by allowing for
graduated regulatory action.  Representatives of one firm said that
the effect of the requirements was to get weaker companies to
increase their capital levels.  Representatives of another firm
commented that the most important aspects of risk-based capital
requirements are their objectivity (auditability) and completeness. 
Representatives of one rating agency commented that the insurance
risk-based capital requirements have raised awareness of risk in the
industry.  Representatives of two rating agencies said they saw a
favorable trend in capitalization after the insurance risk-based
capital requirements were adopted.  One regulator commented that the
risk-based capital requirements act as a floor, and firms tend to
hold more capital. 

Life insurance industry officials whom we spoke with generally said
that the current requirements do not cover all risks equally well and
that some changes are needed.  (See ch.  4 for initiatives under
consideration.) These officials saw other limitations in the
risk-based capital standards, including that the model is static, it
is a lagging indicator, it does not address parent/affiliated company
relationships, it has difficulty quantifying risks in new products,
it does not deal well with diversification or with derivatives-based
risks, it is not strong on interest rate risk, and it concentrates
too much on credit risk.  One regulator commented that because the
risk-based capital formula does not address risks evenly, firms have
an incentive to alter their business. 


   CAPITAL RULES FOR LARGE,
   DIVERSIFIED FIRMS UNDERSCORE
   IMPORTANCE OF THESE FIRMS' RISK
   MEASUREMENT PRACTICES
---------------------------------------------------------- Chapter 2:4

As discussed earlier in this chapter, regulators are increasingly
using the results of risk measurement systems of large, diversified
firms in calculations that determine regulatory capital requirements,
thus attempting to better link capital with firms' actual risk. 
Specifically, bank regulators use the market risk measures of large
banks in setting the market risk component of risk-based capital. 
Also, SEC has recently allowed firms to use option pricing models to
calculate some capital charges.  Along with other options, SEC and
CFTC are exploring possible further reliance upon the results of
firms' risk measurement systems in capital regulation.  These
explorations are described in chapter 4. 

Current and possible future use of firms' estimates of risk in
regulatory determination of capital requirements makes the firms'
risk measurement practices an important element of capital regulation
for legislative and regulatory policymakers to understand.  Chapter 3
describes the approaches being used by some large, diversified firms
to measure and manage risk. 


SOME LARGE, DIVERSIFIED FINANCIAL
FIRMS ARE MEASURING RISKS WITH
MATHEMATICAL MODELS
============================================================ Chapter 3

Unlike regulators, whose focus on the capital levels of firms is
driven by regulatory public purposes, firms analyze their use of
capital to help ensure that they can achieve their business
objective--maximizing the value of the capital provided by
stockholders.  To do this they must measure and manage risks,
returns, and capital. 

A number of large, diversified financial firms are measuring some
risks and returns on a firmwide basis.  Among other things, these
measurements are designed to enable them to determine the trade-offs
among risks and returns that would best enable them to maximize the
value of equity capital.  Individual risks are often measured by
means of a variety of complex quantitative and statistical models
that use computer programs to analyze financial data and determine
risks.  Although different firms use similar overall financial
approaches when considering the risks they face, the actual
statistical models that the firms use are firm-specific--that is,
each firm bases its model on its own data and financial activities. 
The extent to which large, diversified firms measure and model each
risk varies according to the risks inherent in their business
activities and their ability to quantify those risks.  Market and
insurance/actuarial risks tend to be most amenable to the use of
statistical models.  Credit and liquidity risks also have
quantifiable elements.  Operational and business/event risks are very
difficult to quantify and are not as readily measured; however, some
firms are developing measurements of these risks. 

Regulators and firms alike recognize that models have limitations;
however, they believe that using such models can improve a firm's
ability to understand, measure, and manage risks, thereby decreasing
the likelihood of some unanticipated risks and losses.  Under widely
circulated general risk management principles, which were developed
in conjunction with financial regulators, firmwide measurement of
risk is an integral part of a unified, firmwide risk management
system.  Such principles include setting limits on trading or other
activities and determining capital requirements for business lines on
the basis of the measured risks, whenever possible. 


   FINANCIAL FIRMS USE CAPITAL TO
   HELP MANAGE THE TRADE-OFF
   BETWEEN RETURN AND RISK
---------------------------------------------------------- Chapter 3:1

Modern finance theory suggests that capital provided by investors
enables financial firms to fund operations, earn profits, and grow. 
It also provides firms with a cushion to absorb unexpected losses. 
Firms need to attract capital from investors by offering a mix of
returns and risks that is competitive with the mix available in other
investments. 

Both equity investors (stockholders) and bondholders consider return
and risk in their decisions to invest in firms.  To attract and keep
equity capital investors, a firm tries to manage the trade-off
between increasing returns and decreasing risks.  The trade-off
exists because increasing returns, at a given level of risk,
generally increases stock values; increasing risks at a given level
of return generally is viewed as lowering stock value. 

Equity stockholders' returns are based on the firm's dividends and
capital gains on the stock.  A firm using a risky but successful
strategy can increase stockholder returns as long as the costs of
borrowed funds are less than the return to equity.  In contrast,
bondholders' returns are based on interest paid by the firm and
capital gains on its bonds.  The returns to bondholders are limited,
and a successful risky strategy does not increase bondholders'
returns. 

Equity stockholders' risks are the volatility of returns and, in the
extreme case, losses in bankruptcy or liquidation when assets are
sold to satisfy the claims of the firm's bond and other debt holders. 
Generally, bondholders' risk is the chance that a firm's risky
strategies will fail and it will not be able to repay interest and
principal.  In the event of a bankruptcy or liquidation, the value of
the assets may not cover the outstanding principal.  Because
stockholders can obtain larger returns from risky and successful
strategies and bondholders cannot obtain added returns from such
strategies, bondholders are less likely to encourage or accept
increased risk-taking by a firm.  Furthermore, if the firm undertakes
risky strategies, bondholders may require a higher interest rate as
compensation for the increased risk.  The higher interest rate
decreases the funding advantage of debt financing and lowers profits
for stockholders. 

Bondholders depend on, among other things, credit rating agencies for
evaluations of the creditworthiness of bonds based, in part, on a
firm's leverage.\1 When a firm receives high ratings, such as an
investment grade rating from credit rating agencies, the market then
allows the firm to pay a lower interest rate on its debt, which
lowers costs.  Consequently, firms often manage their operations to
receive investment grade credit ratings.  Several firms that we spoke
with told us that they manage their firms to a AA investment rating,
which is the second highest investment grade rating.\2

While maximizing stock values, firm management also needs to address
the concerns of regulators and others.  Regulators' concerns are
important, because regulators can limit firms' operating freedom by
forcing them to allocate capital according to the regulators'
concerns over risk and can require firms to cease doing business, if
capital levels fall below the minimum capital requirement.  Managers
also need to take into consideration the interests of many other
parties concerned with the performance of the firm.  Employee
interests are important, because changing compensation packages can
create incentives for excessive risk taking.  In addition, financial
firms undertake many transactions with each other.  It is in each
party's interest to consider the capital levels (relative to risks)
in its trading partner or counterparty, because a poorly capitalized
entity might fail to complete its financial obligations under a
financial contract. 


--------------------
\1 Leverage is the relationship of a firm's debt to equity, as
expressed in the debt-to-equity ratio. 

\2 According to major credit rating agencies, Standard & Poor's and
Moody's, AAA/Aaa through BBB/Baa ratings are investment grade. 
AAA/Aaa are the highest ratings and indicate that the capacity to
repay debt is extremely strong.  AA/Aa ratings indicate a very strong
capacity to repay and differ from AAA only in a small degree.  "A"
ratings indicate a strong capacity to repay, although with somewhat
more susceptibility to adverse effects of changes in circumstances
and economic conditions than in the higher rated categories.  BBB/Baa
ratings indicate an adequate capacity to repay but with somewhat more
susceptibility to adverse effects of changes in circumstances and
economic conditions than in higher rated categories. 


   FIRMS ARE USING MODELS TO
   MEASURE AND LIMIT RISK-TAKING
   AND DETERMINE THEIR CAPITAL
   ALLOCATIONS
---------------------------------------------------------- Chapter 3:2

Advances in financial theory and information technology have enabled
large financial firms to track and evaluate some risks on a more
quantitative basis than they could before.  Some firms are measuring
certain risks on a firmwide basis.  According to the financial
literature we reviewed and several of the firm representatives we
spoke with, large, diversified firms are increasingly doing this
because of heightened competition among firms and increased scrutiny
of risk management practices by regulators. 

Firms can use such tracking and measuring to set limits on
risk-taking, evaluate the return and risks of specific activities,
and allocate capital accordingly--that is, to ensure that the
estimated returns are large enough given the estimated risks.  As
discussed later in this chapter, these activities are embedded in
general risk management principles that lay out a management approach
and in tools that are designed to ensure that a firm is appropriately
addressing its risks.  These principles form the basis of a firm's
risk management system that can, among other things, provide timely
information on trading positions, risks, and risk-adjusted
performance measures.\3 Such principles also encourage firms to
develop risk-adjusted performance measures to track the risk-return
trade-off.  For example, these general principles are embedded in SEC
oversight under the DPG and in bank regulators' capital regulations. 

A general framework for risk-adjusted performance measures that is
used by a number of the larger firms is called the risk-adjusted
return on capital (RAROC) system.\4 RAROC is the risk-adjusted
profitability of a particular business activity per dollar of equity
capital allocated to an activity.  This means that at any given level
of profit and risk, if managers increase capital allocated to an
activity, the RAROC for that activity will tend to decrease. 
Consequently, RAROC directly measures and takes into account the
risk, return, and capital trade-off. 


--------------------
\3 A risk-adjusted performance measure permits a manager to
quantitatively relate the return to the risk associated with a
product or business decision.  One common risk-adjusted performance
measure is the ratio of expected profits over the risk, measured as
volatility of profits.  The measure can improve for one of two
reasons; returns can increase at a given risk level or risk can
decrease for a given return. 

\4 RAROC is discussed in more detail in appendix IV. 


      SOME FIRMS MEASURE MARKET
      RISK WITH STATISTICAL AND
      OTHER FINANCIAL MODELS
-------------------------------------------------------- Chapter 3:2.1

As markets become more competitive, as new financial instruments
create new mixes of risks and return, and as markets remain volatile
and uncertain, managers need improved tools to consider risks and
manage them.  Therefore, the ability to set limits on trading
activity or manage risks is especially important to large financial
firms.  Generally, models can help managers limit risks and are used
to set limits on traders and trading activities.  In addition, models
can be used to determine needed capital levels on the basis of the
measured risks. 

In the banking, securities, futures, and life insurance sectors, some
large firms measure market risk with statistical financial models
supplemented by, or in combination with, other types of models. 
Statistical models apply past data on price changes to determine
losses that might occur in the future; they are often used to measure
market risks, such as trading in securities, derivatives, and foreign
currencies.  Such risks are not equally important for all types of
financial firms.  For example, market risks are important for large
securities firms and banks undertaking trading of financial assets. 
Life insurance companies must often consider interest rate risk (a
type of market risk) when underwriting annuities and other investment
products that they sell.  In contrast, many banks and insurance
companies consider credit risks to be more important.  Basically, the
relative importance of different risks for a firm depends on the
products it offers, the business strategies it uses, and the markets
it serves. 

Models have important limitations; nonetheless, in the views of the
firm representatives and industry experts we spoke with, they improve
a manager's ability to measure and manage risks, thus decreasing the
likelihood of losses due to measured risks that could deplete the
capital cushion provided by management to cover losses. 


         VALUE-AT-RISK (VAR)
         MODELS ARE USED TO
         MEASURE AND MANAGE MARKET
         RISKS
------------------------------------------------------ Chapter 3:2.1.1

A firm's "value-at-risk" (VAR) is an estimate of the maximum amount
that a firm can lose on a particular portfolio a certain percent of
the time over a particular period of time.  Empirically, this loss
can be measured by statistical models as a confidence interval, that
is, the percent of the time a certain loss is not likely to be
exceeded.  This confidence interval implies a corresponding
probability that the certain loss is likely to be exceeded a certain
percentage of the time.  The amount of capital needed to cover this
confidence interval is often called economic capital-at-risk. 

Using the confidence interval approach, a firm might specify a 1- day
time horizon with a 99 percent confidence interval--the percent of
the time that a specified loss is not likely to be exceeded.  This
calculation might yield a $1 million loss that on average would not
be exceeded more than 1 out of every 100 trading days.  To ensure
that this 1-in-100 chance of a $1 million loss would not create a
financial problem, the firm could assign a $1 million capital buffer. 
If the firm wants to lessen the chance that the allocated level of
capital will be exhausted, it could increase the confidence interval,
increase the capital set aside, or change its trading strategy to
create less risk.  In contrast, if the firm wanted to increase the
expected profits, it could decrease the confidence interval, lower
the capital set aside to cover possible losses, or change its trading
strategy to create greater expected profits while accepting the added
risks. 

According to the modeling literature,\5 the four main approaches to
VAR modeling are the correlation or parametric method, the historical
method, the historic simulation method, and Monte Carlo simulation. 
VAR models can be based predominantly on the correlations among asset
prices and the effects of such correlations on the risk in the firm. 
In addition, VAR estimates can be based on historic simulation or
Monte Carlo simulations that show how changes in several fundamental
economic variables or factors would affect the financial condition of
the firm. 


--------------------
\5 "Value at Risk--New Approaches to Risk Management," Katerina
Simons, New England Economic Review, Sept./Oct.  1996. 


         VAR ESTIMATES CAN BE
         BASED ON CORRELATION
         AMONG ASSET PRICES AND
         RETURNS
------------------------------------------------------ Chapter 3:2.1.2

Most VAR models depend on statistical analyses of past price
movements that determine returns on the assets.  The VAR approach
evaluates how prices and price volatility behaved in the past to
determine the range of price movements or risks that might occur in
the future.  This VAR approach is based on price variances and, in
some cases, covariances among the prices that create market risks.\6

This approach uses statistical estimates of the variances of asset
prices and the covariances among asset prices to summarize the
overall market risk faced by the firm. 

The correlation method assumes that the statistical distribution of
asset returns is normally distributed and that the
variance-covariance matrix completely describes the distribution. 
Assuming a normal statistical distribution simplifies the analysis
and the computation of the VAR estimates, because it assumes that
returns are symmetrically distributed around the mean and the
dispersion of returns above and below the mean are similar.\7


--------------------
\6 Variances and covariances are statistical measures of how prices
vary over time.  The variance refers to the variability or volatility
of the price of a specific asset, and the covariance refers to the
variability or volatility of the relative prices of two assets at the
same time. 

\7 In financial theory, the standard deviation is used as a measure
of risk because the theory often assumes that risks are distributed
along a normal probability distribution--often called a bell-shaped
curve.  The standard deviation is a statistical measure of the degree
to which an individual value in a probability distribution varies
from the mean or expected value of the distribution.  In normal
distributions, knowing the standard deviation permits an analyst to
directly determine the confidence interval.  In practice, many
financial risks are not distributed normally.  As a result, the
standard deviation of the distribution does not directly suggest the
probability that a certain loss will be exceeded. 


         VAR ESTIMATES BASED ON
         THE HISTORICAL METHOD USE
         ACTUAL HISTORIC RETURNS
         TO DETERMINE LOSSES
------------------------------------------------------ Chapter 3:2.1.3

The historical method rejects the use of the normal distribution,
because much empirical research on the statistical properties of
asset returns suggests that returns are not normally distributed. 
The evidence suggests that high and low returns are more likely to
occur than would be predicted if a normal curve assumption were used. 
Evidence also suggests that in many cases, the actual returns are
more likely to be negative than would be predicted if a normal curve
assumption were used.  In the historic method, the VAR is calculated
by finding the lowest returns in the historic data.  Using historic
data tends to produce higher VAR estimates.  This occurs because,
empirically, the normal curve assumption underestimates the
likelihood of larger losses.  Implementing the historical approach
requires added historic data that can be expensive to obtain or even
nonexistent. 


         VAR ESTIMATES BASED ON
         THE HISTORIC SIMULATION
         APPROACH USE INFORMATION
         ON RETURNS AND RISK
         FACTORS TO CALCULATE THE
         VAR
------------------------------------------------------ Chapter 3:2.1.4

The returns on particular instruments often cannot be used to
determine the VAR estimate.  If an institution is large and complex,
it may be impractical to maintain historic data on all of its
instruments.  Furthermore, historic data may not be available on new
or innovative instruments that the institution is introducing.  In
such cases, VAR models must include information about the historic
distribution of economic risk factors that will determine the risk
created by new instruments.  Such risk factors are the fundamental
economic creators of risk.  For example, for a bond denominated in a
foreign currency, the risk factors are foreign exchange rates and
interest rates.  For a Standard & Poor's 500 option, the relevant
risk factors are its volatility, the dividend yield on the index, and
the risk-free interest rates.  In the case of banks, when new
instruments are present, the bank can develop a VAR model based on
the statistical distribution of risk factors and the current
composition of the bank's portfolio of activities both on and off the
balance sheet.  However, the use of historic simulation is limited by
the bank's inability to change assumptions about fundamental risk
factors. 


         VAR ESTIMATES BASED ON
         MONTE CARLO SIMULATIONS
         CAN EVALUATE THE EFFECTS
         OF CHANGING NUMEROUS
         FUNDAMENTAL RISK FACTORS
------------------------------------------------------ Chapter 3:2.1.5

Firms often are subject to several risks at one time.  To address the
simultaneous effects of several risks, firms tend to develop Monte
Carlo simulations.  VAR models based on Monte Carlo simulations start
with management identifying a series of changes in several
fundamental risk factors that can simultaneously affect the firm. 
The analysis of the effects of these factors is determined in a
mathematical model in which equations show how changes in the
fundamental risk factors affect the firm's cash flows, financial
condition, and remaining capital. 

On the basis of statistical analyses of how market prices have varied
in the past, the Monte Carlo approach to VAR estimation is designed
to show how the firm will perform in the future by letting managers
evaluate how the firm would perform under thousands of different
economic conditions.  Monte Carlo approaches to VAR estimation also
display the effects of nonlinear risks--risks that grow more than
proportionately with movements in the underlying risk factor.  Such
risks are found in derivatives contracts and in the options embedded
in financial products.\8 Identifying such risks can help the firm to
identify the mix of conditions and strategies that would cause the
greatest harm.  On the basis of the Monte Carlo estimates of VAR, the
firm can adjust trading limits to avoid excessive risks or create a
better risk-return trade-off. 


--------------------
\8 Market risks can vary linearly or nonlinearly with prices. 
Examples of linear or direct risks are losses that can occur if the
price of foreign currencies, a bond, or a stock decreases.  Linear
losses are directly proportional to price movements.  Nonlinear risks
are not proportional in that for some price movements in one
direction, no losses are incurred by the firm; but for larger price
movements in the same direction, large losses can occur.  Nonlinear
risks are generally associated with options contracts or financial
products with options built in.  Mortgages are an example of a
financial product with embedded options.  When interest rates decline
a small amount, mortgage prepayments may not accelerate.  But when
interest rates drop by a large amount, prepayments can accelerate
quite quickly and create financial losses for firms holding mortgages
at rates well above current market rates. 


         BACKTESTING IS USED TO
         DETERMINE THE ACCURACY
         OF VAR MODELS
------------------------------------------------------ Chapter 3:2.1.6

VAR models are commonly backtested to evaluate the accuracy of
assumptions by comparing predictions with actual trading results. 
Backtests determine whether and how well the models' results compare
to a firm's historic daily trading results.  Backtests provide
information retrospectively about the past accuracy of an internal
model by comparing a firm's daily VAR measures with its corresponding
daily trading profits and losses.  Any VAR-set limit that is exceeded
by trading losses at a greater frequency than indicated by the chosen
confidence level indicates that the model is not measuring expected
losses well enough. 


         VAR-BASED MODELS HAVE
         LIMITATIONS
------------------------------------------------------ Chapter 3:2.1.7

According to the financial literature and our interviews, the
limitations of the VAR model include a dependence on past data to
estimate possible future losses and possible errors caused by
simplifying statistical assumptions. 

The VAR calculation and estimated losses from VAR models are based on
the past behavior of prices and price volatility.  If price patterns
are changing now or will change in the future, estimates of potential
losses based on past price changes will be incorrect.  As a result,
the risk managers at the firms told us they must continually update
their statistical estimates and monitor for changing price patterns
that affect losses predicted by VAR models. 

Some VAR calculations are simplified by assuming returns are
distributed normally.  Such simplifications ease data needs, lower
computational costs, and are easier for those less familiar with
advanced statistical modeling techniques to understand.  However,
such assumptions can result in the model underestimating the
probability and extent of large losses.  To avoid this problem,
several of the firm representatives we interviewed said that they use
Monte Carlo simulations when necessary because such simulations take
returns that are not normally distributed into consideration. 

Simplifying assumptions also limits the ability of some VAR models to
measure risks that do not vary directly or linearly with price
changes.  For example, gains or losses on stocks held in portfolios
vary directly or linearly with market prices.  As the market prices
of stocks increase, the value of the stock or foreign currencies held
by a firm increases in direct proportion.  Such direct, linear
relationships also exist in foreign currency trading, a common
activity of many large, diversified financial firms. 

In contrast, losses on options and financial contracts with embedded
options can be nonlinear and need not move proportionately or
linearly with interest rates or other prices.  Options have risks
that are nonlinear; for small price movements there may be no losses
for the firm, but for larger price movements the firm can suffer
large losses.  Similarly, interest rate risks in certain financial
products can be nonlinear.  For example, for small declines in
interest rates, mortgage prepayments will not accelerate.  However,
for large declines in interest rates, prepayments can accelerate
quickly and create large and nonlinear losses for a firm holding
mortgages.  Representatives of several firms told us that nonlinear
effects in certain other types of financial options affect the
accuracy of VAR modeling. 


         STRESS TESTS AND SCENARIO
         ANALYSIS ARE USED TO
         DETERMINE HOW LARGE
         CHANGES IN ECONOMIC
         CONDITIONS COULD LEAD TO
         A FIRM FAILURE
------------------------------------------------------ Chapter 3:2.1.8

Firms use stress tests and scenario analyses to help validate or
cross-check the reliability of VAR models.  Stress tests measure the
potential impact of various large market movements on the value of a
firm's portfolio.  Such tests are a useful tool for identifying
exposures that appear to be relatively small in the current
environment but that grow more than proportionally with changes in
risk factors.  Scenario analysis generates forward-looking "what-if"
simulations for specified changes in market factors that quantify
revenue implications of such scenarios for the firm. 

Stress tests are based on a series of mathematical equations that
show how changes in fundamental economic factors would affect the
financial statements of the firm over time.  Stress tests determine
whether large changes in underlying key factors would lead to losses
that could put the financial firm at risk of failing.  The level of
key economic factors used in the stress test can be based on (1) past
economic situations in which key economic variables have affected a
firm's financial condition or (2) management's judgment.  When using
past economic situations to determine the level of key economic
variables, risk managers may use the results of statistical analyses
to help decide what factors to use in the test and how large the
stress should be.  The values or the risk factors used in the stress
tests can be based on management's judgments and statistical analyses
of the variability of the risk factors in the past.  Some stress
tests apply Monte Carlo simulations to determine how often and how
quickly a firm will fail when subject to stressful economic
environments. 


         ALL MARKET RISK MODELS
         HAVE LIMITS AND BENEFITS
------------------------------------------------------ Chapter 3:2.1.9

The financial literature and our interviews with risk managers told
us that all models are limited to the extent that they rely on
historic data and pricing patterns that may not reflect future
economic conditions and risks.  In addition, all models are limited
by the quality of the data available, the computation power
available, and the ability of analysts to develop mathematical models
to accurately reflect financial risks and returns as economic
conditions change.  Several of the risk managers we met with stressed
the importance of the risk factors used in a firm's internal
modeling.  Because a firm's internal system cannot effectively track
all of the risks the firm is exposed to, risk managers choose those
they believe are the most significant, such as equity and foreign
exchange positions and the yield curve slope.\9

Models also offer benefits.  Managers using models are able to take a
more disciplined approach to the overall operations of the firm. 
Models encourage and permit risk managers to simultaneously consider
the risks and returns in individual assets or portfolios and their
interactions, which, in combination determine the overall risks and
returns of the firm from market risks. 

Our interviews with industry association officials who tend to
represent smaller financial firms suggest that small companies may be
more likely to hold assets until maturity and less likely to realize
the market losses in their portfolios when the market value of assets
decreases.  According to these officials, these companies may not
find it necessary to undertake such market risk modeling, because
their risks and long-run profits are not driven by changes in market
prices and returns.  Instead, their risks may be concentrated in
credit risk, insurance risk, and operational risks, which have not
been quantified or modeled as extensively as market risks. 


--------------------
\9 The yield curve is a graph showing the structure of interest rates
by plotting the yields of all bonds of the same quality with
maturities ranging from the shortest to the longest available.  The
resulting curve shows if short-term interest rates are higher or
lower than long-term rates.  Analysts study the yield curve carefully
in order to make judgments about the direction of interest rates. 


      FIRMS MEASURE CREDIT RISK IN
      A VARIETY OF WAYS
-------------------------------------------------------- Chapter 3:2.2

Traditional credit risk management at banks, securities firms, and
insurance companies has most often been based on analysis of
standardized information reports and judgments by experienced credit
officers of the creditworthiness of borrowers and any collateral
against the loan or bond.  On the basis of such judgments, firm
managers have set limits on financial positions and developed plans
to manage credit risks.  Increasingly at large, diversified firms,
traditional credit risk management approaches have been augmented by
credit-scoring models for certain classes of homogeneous loans, such
as credit card, automobile, and residential mortgages.  In even fewer
firms, models have also been applied to evaluating the credit of
companies with publicly traded stock. 


      TRADITIONAL CREDIT ANALYSIS
-------------------------------------------------------- Chapter 3:2.3

Traditional credit analysis is based on standardized reports and
credit officer judgments.  In most firms, the credit quality of a
particular loan is to be judged by a reviewing officer and placed
into one of several credit categories.  Categories range from
risk-free or low risk to potential or full loss.  In rating
creditworthiness, credit risk is exclusively the risk of a loss on a
loan due to a default and is not the risk due to price volatility. 

A particular loan can be reassessed on the basis of either the
changing condition of the borrower or changes in the economy that may
affect the likelihood that the loan will be repaid on a timely basis. 
When considering the risks from a particular loan or financial
position with a firm, lenders generally consider all the positions
with that firm, because a credit problem in one position with a firm
will usually be associated with credit risks for all positions of the
entire firm.  For example, in a situation where a firm has several
financial interactions with a bank, such as a commercial loan, a
mortgage, and a foreign exchange transaction, if one of these
interactions appears uncreditworthy, it can affect the others. 

Commercial banks, securities firms, and life insurance companies that
we interviewed told us they used the traditional approach to credit
analysis.  Each firm said it applied a consistent evaluation and
rating scheme to all credit decisions.  The firm produced aggregated
results on the overall credit portfolio.  A typical bank might use a
rating system with up to 10 rating categories that are defined from
low to high risk.  Consistent application and updating of the ratings
are part of the process.  In some firms, both the borrower and the
instrument are rated separately.  Part of the rating addresses
covenants or limitations in the contract and collateral used to
secure the contract. 

Given consistent application of the ratings by its credit officers, a
bank can produce a report of the credit risk in its loan portfolio at
any time.  The report changes as loans enter and exit the system and
as ratings of particular loans change over time.  According to one
source, this credit quality report is most meaningful when credits
are monitored and periodically reviewed by a risk management group or
function. 

Insurance companies tend to be very focused on credit risk.  Because
insurance companies' credit risk often appears in bonds and other
traded instruments, rating the instruments is one way to address
credit risk.  Credit ratings needed by the insurance companies are
often performed by the Securities Valuation Office of NAIC.\10

In many financial firms, credit analysis traditionally was done on a
loan-by-loan basis.  Such an approach ignored the fact that all loans
in the same region or industry tended to become less creditworthy at
the same time.  However, given sectoral losses of the 1980s in real
estate and the petroleum industry, firms are increasingly concerned
that many loans concentrated in the same region or industry may
create losses at nearly the same time.  To address these concerns,
some firms are undertaking concentration reports by industry, and
work is under way to improve the industry classification codes needed
to produce concentration reports. 


--------------------
\10 The Securities Valuation Office was established in 1951 to assign
risk ratings to bonds held in investment portfolios of insurance
companies.  At that time, most of the bonds held by insurers were
private placements that were not rated by private rating agencies. 
Currently, however, the Securities Valuation Office uses the private
ratings unless there is a split rating, i.e., conflicting ratings for
the same issue from different private raters.  In these cases, as
well as in the increasingly infrequent cases of private placements
without a public credit rating, the Securities Valuation Office is to
conduct its own analysis and assign a rating. 


         SOME FIRMS ARE USING
         CREDIT SCORING MODELS TO
         DETERMINE CREDIT RISK
------------------------------------------------------ Chapter 3:2.3.1

Credit scoring applies formal statistical procedures to the credit
decision process.  Credit scoring models, based on statistical
analyses, use data on the borrower found in credit reports and loan
application information to determine whether or not a loan is likely
to be repaid.  In addition, credit scoring can be used to adjust
terms on the loan such as downpayments and interest rates.  Such
models are often used in underwriting credit cards and mortgages. 
Credit scoring is most applicable to classes of loans in which there
are numerous loans that are frequently underwritten with similar
terms.  Within each class, the loans are relatively small compared to
the total holdings in the class, made frequently, and easily
statistically analyzed because the loans have relatively homogeneous
characteristics.  This homogeneity occurs because the loans are not
custom-tailored to the borrower or to the collateral asset. 


         SOME FIRMS ARE USING
         STOCK PRICES AND
         PORTFOLIO CREDIT MODELS
         TO MEASURE CREDIT RISK
------------------------------------------------------ Chapter 3:2.3.2

Some banks and consulting firms that we spoke to have developed a
portfolio approach that rates the creditworthiness of loans to larger
corporations whose bonds and stocks are traded regularly in the
financial markets.\11 This approach addresses the correlations among
the creditworthiness ratings of individual assets in the portfolio. 

In the first step, the portfolio approach uses the traditional
approach of rating each loan or financial instrument on a
case-by-case basis to generate its inputs by determining the credit
risk from each obligor (borrower from the bank).  In the next step,
the portfolio approach accounts for the credit risk across the
portfolio based on the correlation of credit quality across obligors. 
In this way, this approach takes into account and quantifies the
benefits of portfolio diversification.  It is similar to the
portfolio approach already used in market risk modeling such as VAR. 

The portfolio approach to credit risk may depend on stock and bond
price information and ratings by credit rating agencies, such as
Standard and Poor's.  Using statistical methods, the portfolio
approach estimates the probability of default on an instrument and
the probable loss from that instrument if a default occurs.  The
approach uses the credit rating from a credit rating agency or the
internal credit rating by a bank evaluating its own loans.  Credit
rating agency ratings and bank loan evaluations are based on reviews
of the financial books and other pertinent information gathered
during the rating or loan application process when a firm is issuing
bonds or applying for a loan.  Such ratings are not driven by market
prices or by the volatility of market prices. 

The portfolio approach also uses market information on stock prices
to estimate the total probability of default on the basis of the
correlations of defaults among the component loans in the portfolio. 
By taking these market prices into account, the portfolio credit
rating can directly take into account the correlation among credit
risks because it can address the correlation among stock prices. 
Such correlation information permits risk managers to develop more
economically efficient portfolios by improving expected profits or
lowering the risk of losses from the total loan portfolio.  As with
market risk modeling, assumptions about the probability distributions
and the correlation among the risks affect the estimated potential
losses due to credit risk embedded in any particular portfolio. 

The portfolio approach to credit risk enables a risk manager to

  -- quantify and control credit concentration risk;

  -- consider concentrations on the basis of industry rating
     category, type of instrument, or other factors;

  -- interpret credit risk in terms of needed capital as is done in
     market risk calculations; and

  -- evaluate investment decisions more precisely in terms of risks,
     returns, and capital. 


--------------------
\11 Both consultants and large banks have developed credit ratings
that are based on stock prices, and some large banks either directly
develop such ratings or use consultants to undertake such ratings. 


      MANY FIRMS USE WORST-CASE
      CASH FLOW SIMULATIONS TO
      MEASURE LIQUIDITY RISK
-------------------------------------------------------- Chapter 3:2.4

Liquidity risk analyses are most concerned with the effect of a
sudden crisis that arises when lines of credit may be closed, assets
can be sold only at a loss, and other new funding sources cannot be
found.  In a liquidity crisis, a firm must be able to sustain itself
and obtain cash as needed when the markets, in general, appear much
less willing to buy assets from the institution or make loans to the
firm experiencing the crisis. 

Many firms develop worst-case simulations (i.e., stress tests) or
models to investigate the implications of a severe loss, which
affects credit ratings, or a systemwide crisis that would affect all
sources of liquidity due to a flight to quality\12 throughout the
economy.  The worst-case "scenarios" are based on simulations of firm
cash flows. 

In each worst-case cash flow analysis, a firm would attempt to
estimate the immediate funding shortfall associated with a severe
loss and a crisis that is systemwide.  In a worst-case analysis, a
firm attempts to measure the speed with which it can acquire needed
liquidity during a crisis.  Such liquidity might be based on
liquidating assets--that is, shrinking its balance sheet--or
estimating sources of funds that would still be available during a
crisis.  The results of such worst-case analyses or simulated crises
are often reported in estimated days of exposure or days of a funding
crisis.  On the basis of the liquidity problems that arise in
worst-case simulations, managers can alter current operations to
forestall liquidity problems in a crisis, adjust the liquidity of
current asset holdings, or create more secure lines of credit. 

Such simulations are not used to forecast future problems but rather
as a planning tool to understand what a liquidity crisis might
entail.  In the view of a number of firm representatives we spoke
with, such simulations or worst-case studies are imprecise but
essential to a firm in the event of a substantial change or
deterioration of its financial condition.  Some firms we spoke with
used such simulations to determine what backup lines of credit, which
cannot be cancelled, are needed to ensure liquidity or funding during
a crisis. 

One large securities firm suggested that financial firms can fail in
a crisis when liquidity is lost even though other fundamental risks
might not be present.  Another large firm emphasized that
broker-dealers depend on liquidity when managing market or trading
risk because, without liquidity--the ability to buy and sell
financial assets without large losses--hedging and other
risk-reducing strategies do not work.  Firms' representatives told us
their firms often maintain an equity cushion above regulatory capital
levels to ensure the constant availability of sufficient cash to deal
with liquidity problems or to undertake a large and potentially
profitable deal.  Another large, diversified firm emphasized that
during crises, investor flights to quality occur and firms without
strong credit ratings may not be able to refinance short-term debt or
fund operations.  Firms that maintain high levels of capital are
generally considered to be more creditworthy. 

Other firms told us that liquidity is an amorphous term and cannot be
addressed by VAR or other mathematical models.  A representative of a
large industry group said that liquidity risk is somewhat
quantifiable but not to the same extent as credit and market risk. 

According to several insurance industry analysts, liquidity is not as
big a concern with many life insurance companies as it is with other
financial institutions because life insurance policy liabilities are
less liquid than life insurers' assets.  Life insurance companies
issue policies that have high surrender charges that tend to limit
redemptions.  A decade ago, when interest rate movements created
options that encouraged early redemptions, illiquidity was more of a
problem for life insurance companies.  New policies are now written
that are designed to bring returns on products into accord with
market rates.  In addition, policy loans are often charged variable
rates that track the market instead of fixed rates in order to
prevent losses.\13


--------------------
\12 Flight to quality occurs in financial markets when investors
rearrange their asset holdings to include only the most creditworthy
or least risky assets.  During such situations, financially weaker
firms may find that they have lost access to credit lines--liquid
funds from creditors or banks--and thus be unable to fund operations. 
Such closing of credit lines can force a firm to fail. 

\13 Many insurance companies use financial consultants specializing
in insurance company risk analysis for their analyses and stress
testing.  The scenario testing includes about 50 to 100 scenarios
that either increase or decrease all interest rates by the same
amount or change short- and long-term interest rates by different
amounts.  Such changes in the interest rates test for interest rate
risk.  A worst-case scenario cash flow test is also undertaken. 


      LIFE INSURERS USE
      STATISTICAL MODELS TO
      MEASURE INSURANCE/ACTUARIAL
      RISK
-------------------------------------------------------- Chapter 3:2.5

In the past, life insurance companies generally used conservative
static assumptions regarding loss distributions and interest rates. 
This approach was ill equipped to deal with the interest rate
volatility of the late 1970s, according to several insurance company
representatives we spoke with.  Life insurance policies are full of
options--settlement options, policy loan options, over-deposit
privileges and surrender or renewal on the part of the insured, and
discretionary dividend options on the part of the insurer.  When
interest rates are volatile, these options increase in value and thus
are more likely to be exercised. 

Traditional actuarial valuation methods that assume interest rate
stability incorrectly value these options when interest rates are
volatile because the companies do not consider or calculate the
economic value of the options.  By assuming stable interest rates,
insurance companies tended to underprice their policies.  Today, the
standard valuation techniques deal explicitly with the interest rate
risk options embedded in policies.  These standard valuation
techniques use statistical modeling approaches such as VAR based on
correlations and Monte Carlo simulations discussed earlier in
connection with market risks. 


      MOST FIRMS SAID THEY DID NOT
      OR COULD NOT MEASURE
      BUSINESS/EVENT AND
      OPERATIONAL RISK
-------------------------------------------------------- Chapter 3:2.6

Although the firms we interviewed emphasized that business risk and
operational risk were crucial concerns, most acknowledged that they
did not or could not effectively measure these risks.  Several firms
described how they were measuring market, credit, and liquidity risks
and explained that their firms did not measure other risks, such as
operational or business risks.  Several suggested that they were not
convinced that operational and business risks could ever be measured
to the same degree that market, credit, and liquidity risks were
measured.  In almost all the interviews we conducted, including all
those with regulators, we were told that because measurement of
business/event and operational risk is difficult, managers' judgments
are crucial to managing these risks. 

A securities-based firm said that most failures in this industry were
not created by market risks; rather, operational problems led to the
failures.  One bank's risk manager suggested that business risk was
an amorphous term and thus could not be measured or placed in a
mathematical or statistical model.  This bank does, however, include
business risk in its Risk-Adjusted-Return on Capital (RAROC) system. 
A manager of a large and complex insurance-based financial firm said
he was not yet comfortable with how his firm measured such risks. 
Another bank, which said it is vigorously trying to model its risks,
told us that it has not yet quantified operational risk.  A major
consultant to the financial services industry concluded that
operational risks are hard to quantify because the risks are embedded
in (1) the operating and accounting systems, (2) the models, (3)
staff behavior, (4) the compensation systems that create incentives
to undertake various activities that affect both firm and employee
risks and returns, and (5) the managers' abilities to foresee the
consequences of the interactions among these factors.  Officials of
one bank we interviewed told us they were quantifying
business/operational risk by using revenue volatility as a proxy for
impact of risk on business results. 


   MEASURING AND MANAGING ALL
   RISKS ON A FIRMWIDE BASIS
---------------------------------------------------------- Chapter 3:3

In practice, risk measurement approaches differ across the risks
faced by firms, and not all risks are quantified to the same extent. 
For example, under widely circulated general risk management
principles, firms are to monitor and manage all risks but are
expected to explicitly measure and manage only market, credit, and
liquidity risks, as discussed above.  Firms monitor and measure other
risks using a more qualitative approach because, to date,
quantification of these other risks has not progressed enough to be
commonly used even at large, diversified firms. 

Because financial firms are as yet unable to quantify and model all
risks, a fully quantified approach to determine needed capital has
not yet been developed.  Nonetheless, the general framework called
RAROC has been developed for such firmwide risk assessments across
all risks and products (see app.  IV for a discussion of this
framework).  However, as long as no common basis exists for measuring
all risks, firms cannot fully integrate their risk measurement and
management systems in a firmwide, cross-risk, and cross-product
analysis.  Thus, given the different approaches and levels of
sophistication currently available for measuring and managing risks,
managers' judgment and effective risk management approaches remain a
crucial determinant of risks, returns, and needed capital levels in
each financial firm. 


   GENERAL PRINCIPLES OF FIRMWIDE
   RISK MANAGEMENT
---------------------------------------------------------- Chapter 3:4

As mentioned earlier, firmwide risk measurement is an integral part
of a unified, firmwide risk management system under widely circulated
general risk management principles.  Our discussions with regulators
and representatives of large, diversified financial firms indicated
that these firms accept the approach of the general risk management
principles and are applying these principles in the design of their
internal risk control function.  However, to date, not all firms we
spoke with have fully implemented the risk and capital measurement
systems laid out by the principles.\14


--------------------
\14 Such general risk management principles have been adopted by bank
regulators in the risk-based capital market risk component discussed
in chapter 2 and appendix I. 


      GENERAL RISK MANAGEMENT
      PRINCIPLES ARE DESIGNED TO
      ENSURE THAT A FIRM IS
      APPROPRIATELY ADDRESSING ITS
      RISKS
-------------------------------------------------------- Chapter 3:4.1

General risk management principles lay out a management approach and
tools that are designed to ensure that a firm is appropriately
addressing its risks.  There is a common set of five broad risk
management principles:\15

1.  A structured framework is to be established to link a firm's
business strategy and operations to its risk management objectives. 

2.  Centralization of the risk management function in one dedicated
staff office is needed. 

3.  Risk measurement, risk reporting, and risk controls are needed to
permit managers and others to evaluate the implications of the risks,
returns, and capital levels in the firm. 

4.  Operations systems are needed to support the risk management
function. 

5.  Risk management systems are needed to provide needed data on a
timely basis. 

Under these principles, the firm's risk management strategy is to be
based on a framework of responsibilities and functions driven by the
board down to operating levels, which covers all aspects of risk. 
The basis for this principle is the view that unless the board is
fully integrated in the risk management approach, the firm's managers
and employees will not be fully committed to risk management.  To
emphasize the importance of risk management, the principles state
that a risk management group composed of senior managers is to be
created. 

In accordance with the principles, the risk management function is to
be fully integrated into a firm's operations.  The day-to-day
responsibility for risk monitoring and risk evaluation is to rest
with the risk management function, which is to report to a risk
management group--a special committee of senior managers.  The role
of the risk management function is to implement policies associated
with specific risks, such as market risk, credit risk, liquidity
risk, operational risk, and business/event risk.  Its purpose is also
to ensure that trading is within approved limits and that risk limits
and policies are properly understood and evaluated before
transactions are undertaken. 

The principles lay out a framework for risk measurement, reporting,
and control of risks; quantification of market, credit, and liquidity
risks; and development of the capability to aggregate and monitor
exposures on a firmwide basis.  The principles require a firm to set
a comprehensive set of limits to ensure that risk exposures remain
within agreed-upon boundaries set by the board or risk management
group.  In addition, the firm needs a mechanism for evaluating firm
performance on a risk-adjusted basis to address the trade-off between
return and risk.  That is, the firm must develop a method to
simultaneously measure and manage the trade-offs that can exist
between return and risk on a firmwide, business-unit, and
product-specific basis. 

The principles call for a risk management system to generate, on a
timely basis, information on the firm's trading positions, risks, and
risk-adjusted performance measures.  Such information is to be
available to the risk management group; risk management function; and
other end users of the information, such as traders, credit risk
departments, or managers of trading units. 

Under the principles, firms are to develop a comprehensive set of
operational controls, because firms engaged in trading activities
often encounter difficulties as a result of operational control
problems rather than measurement problems.  Such operational controls
are meant to ensure that risk limits are set by the board and, once
set, are not violated.  To guard against operational problems, it is
important for firms to rigorously establish controls that limit
risk-taking and unauthorized activities throughout the firm,
according to the principles. 

Firm officials we met with consistently mentioned these principles
and provided firm-specific examples to illustrate their importance. 
For example, many firms and analysts emphasized that although their
approach to risk management is constantly evolving, it is of
paramount importance that senior management determines the level of
risk that the firm will accept and communicates this information
firmwide.  Representatives of several firms commented that a central
committee, which reports to the chief executive officer, monitors
their risks.  Firm representatives stressed that numbers are
important, but good communication, internal controls, and management
judgment are what really matter. 


--------------------
\15 Principles of risk management have been developed by various
industry and regulatory bodies, including the Bank for International
Settlements, the International Organization of Securities
Commissions, DPG, U.S.  bank regulators, and a group assembled by
Coopers & Lybrand.  All of these are broadly similar.  The list here
is from Coopers & Lybrand, termed Generally Accepted Risk Principles. 


ISSUES AND INITIATIVES IN CAPITAL
REGULATION
============================================================ Chapter 4

Through our interviews with industry representatives, regulators, and
others as well as our review of pertinent literature and other
documents, we sought to identify significant issues in capital
regulation.  We group the issues we identified into the following
three categories: 

  -- differences among financial regulators in terms of the risks
     each focuses on and the purposes of its capital rules;

  -- differences between regulators' and firms' estimates of risks
     and needed capital, and in their views of risk and how it should
     be managed, and

  -- concern about how regulatory capital rules are administered. 

The principal issue in the first category is that as firms that have
traditionally been in different sectors of the financial services
industry increasingly offer similar products and take on similar
risks, differences in capital regulation among their regulators may
have unintended competitive implications for these firms. 

Issues in the second category include a concern that current
regulatory capital requirements that are not adequately sensitive to
the risks inherent in a firm's particular products or activities may
create inappropriate risk management incentives for firms and, in
extreme cases, could even lead to increased risk-taking.  A related
issue concerns the possible increased use by regulators of a firm's
internal estimates of risk in setting regulatory capital
requirements, because financial firms and regulators have somewhat
different purposes for capital and tolerances for risk. 

The third category, administrative issues, includes questions about
whether it makes sense to apply the same approach to capital
regulation for firms of all sizes and degrees of complexity.  It also
includes questions, such as how can the regulators properly oversee
the validity of the internal statistical models that firms use to
meet regulatory capital requirements. 

As competition within and among different financial sectors has
increased and as large, diversified firms have improved their ability
to measure and manage risks and capital, financial regulators are
responding by exploring possible changes to capital requirements. 
Many initiatives aim to make capital requirements more sensitive to
the risks firms face in their activities; other initiatives represent
fundamentally different approaches to capital regulation. 


   DIFFERENCES IN REGULATORY
   OBJECTIVES AND APPROACHES MAY
   HAVE UNINTENDED COMPETITIVE
   IMPLICATIONS
---------------------------------------------------------- Chapter 4:1

In an environment of increasing competition across financial sectors
and national borders, large, diversified financial firms increasingly
offer similar products that pose similar risks.  At the same time,
individual firms and their affiliates are regulated by a variety of
domestic and foreign regulators, and some are unregulated. 
Differences in corporate legal systems and markets also contribute to
international differences.  Concern about differing capital
requirements for firms with similar products posing similar risks is
one part of an ongoing "level playing field" debate in financial
modernization.  On a level playing field, firms and markets compete
without advantages that result from government backing (such as
government-backed deposit insurance) or disadvantages that result
from burdensome regulation. 

At the same time, regulators acknowledge that differences in
regulatory purposes have implications for capital requirements that
could limit achievement of a level playing field.  As discussed in
chapter 2, the specific objectives of the various financial
regulators and their approaches to regulation differ.  For example,
bank regulators are concerned with maintaining the safety and
soundness of the banking and payments system and protecting the
deposit insurance funds; and securities and futures regulators are
concerned with investor protection and ensuring the integrity of the
securities and futures markets, respectively. 

Financial regulators and other experts we interviewed discussed the
appropriateness of having similar capital requirements for banks,
which are covered by government-backed insurance funds, and other
firms that are not; or whether it is appropriate for capital
requirements of banks, which are part of the payments system, to be
similar to capital requirements for firms that are not. 
Traditionally, bank regulation has been more concerned with systemic
risk than has regulation of other financial entities.  Some experts
have argued that capital regulation must be stricter on entities that
pose greater systemic risk than on those that do not. 

Also, financial regulators were concerned that different domestic and
foreign capital standards for the various types of financial firms
create incentives for firms to change operations in ways that change
their regulator, such as moving business overseas, to avoid or offset
capital requirements they believe are costly and excessive. 
Different regulators may have different capital standards for the
same product.  In some situations, a firm facing the higher capital
standard has an incentive to move its activities in that product line
into an affiliate that has a different regulator or one that is
unregulated.  However, in banking, all affiliates within the holding
company fall under the holding company capital standards.  If a bank
believes the standards are too high for a certain product, it may
choose to abandon that product line; or it may restructure its
transactions to provide a similar service that carries a lower
capital requirement. 


   DIFFERENCES EXIST BETWEEN
   REGULATORS' AND FIRMS'
   ESTIMATES OF RISK AND NEEDED
   CAPITAL
---------------------------------------------------------- Chapter 4:2

An important issue for regulators is how to establish capital
requirements that meet their purposes without requiring either
excessive or insufficient capital for the risks involved.  To a large
degree, to increase the value of the shareholders' equity in
competitive markets, large, diversified financial firms have
increasingly used statistical and mathematical models to measure and
manage economic risks and to determine their optimum capital levels. 
As firms have been able to apply more sophisticated risk measurement
tools, some said they have become increasingly aware of a discrepancy
between their internal estimates of risk and the capital needed to
support certain activities and the regulatory capital requirements
for those activities.  Even though firms may hold more total capital
than regulatory minimums call for, regulatory capital requirements
may impose higher capital levels for some activities than the firms
believe to be appropriate. 

The difference between amounts of capital allocated by some financial
firms and regulatory capital requirements reflect, in part,
differences between the firms' primary objectives and the purpose of
regulators.  As discussed in chapters 2 and 3, financial firms and
regulators agree that capital serves as a buffer against unexpected
losses.  However, the primary use of capital for firms is to maximize
the value of their shares for stockholders by choosing the best mix
of risk and returns.  Regulators, on the other hand, impose minimum
capital requirements to serve the public interest. 

Currently, financial regulators use a "building block" approach in
setting capital requirements--that is, capital requirements are
determined largely on the basis of broad classes of risk, and the
total capital requirement is the sum of requirements for each risk. 
Many firms and regulators have argued that this building block
approach is inappropriate, because the total risk in the firm is
based on the interactions of all risks in the firm's portfolio, and
risks need not be additive.  We did not identify any firms that were
yet able to hedge across different risks--for example, hedging credit
exposures and market exposures against each other.  However, some
firms said they have developed hedging strategies that allow them to
decrease risks by hedging the same risk within and across
portfolios--for example, hedging interest rate or foreign exchange
risk in different portfolios within the firm.  These risk-reducing
strategies are often not recognized in existing building block
regulatory approaches to setting minimum capital requirements.  Thus,
because these approaches do not recognize the possibility that total
risk may be less than the sum of individual risks if risks offset
each other, they could lead to excessive capital requirements. 

In both the banking and securities/futures sectors, capital
regulations contain formulas that apply single risk-weightings to a
broad range of riskiness within a single category.  For example, in
banking, the same 8 percent capital requirement is imposed on all
unsecured loans to private commercial borrowers regardless of
individual creditworthiness, with the result that a
high-risk/high-return loan carries no more regulatory capital than a
low-risk/low-return loan.  As a result, the regulation might give
firms an incentive to seek the highest returns within a broad class
regardless of underlying risk; or to adjust activities (e.g, develop
new products and/or change operations or corporate structures) in a
way that reduces or escapes capital requirements.  In other words,
firms may adjust business to achieve the lowest regulatory capital
cost rather than an optimal balance of risk and capital.  Also, the
securities net capital rule requires registered broker-dealers to
apply a 100-percent haircut to any portion of the trading profits, to
the extent the profits are unsecured, reflecting SEC's emphasis on
liquidity in its net capital rule. 

Moreover, if capital requirements are not adequately sensitive to
risk, they may require either too much or too little regulatory
capital for the activities being covered.  For example, capital
requirements that require firms to hold more capital than they
believe to be warranted by the risk can cause them to reorganize
their structures, resulting in less regulated financial markets as
firms move operations outside of regulated entities.  Because
securities firms consider the 100-percent haircut for OTC derivatives
transactions excessive, for example, they book much of their OTC
derivatives business in unregulated affiliates to escape capital
requirements and other regulatory oversight for these derivatives
activities.  Some regulators and we have expressed concern about the
lack of regulatory oversight in OTC derivatives activities.\1

On the other hand, capital requirements that are too low to protect
against risk may result in firms holding only the required amount of
capital.  As a result, they may not be sufficiently cushioned against
potential losses.  At the same time, a relatively low capital
requirement may induce some institutions to hold excessive amounts of
the asset, thus increasing their exposure to the risk.  For example,
the calculation of bank capital ratios does not explicitly include
the interest rate risk inherent in mortgages and other
interest-sensitive assets; this may cause banks to hold more of these
assets and fewer assets for which the capital requirement more fully
captures all the risks. 


--------------------
\1 See Financial Derivatives:  Actions Needed to Protect the
Financial System (GAO/GGD-94-133, May 18, 1994); and Financial
Derivatives:  Actions Taken or Proposed Since May 1994
(GAO/GGD/AIMD-97-8 Nov.  1, 1996). 


   INCREASED REGULATORY USE OF
   FIRM ESTIMATES OF RISK RAISES
   ISSUES REGARDING THE
   APPROPRIATENESS OF THESE
   ESTIMATES FOR REGULATORY
   CAPITAL PURPOSES
---------------------------------------------------------- Chapter 4:3

Although financial regulators are already using firms' estimates of
risk in limited ways, concerns about regulatory insensitivity to risk
are leading some regulators to consider increased use of firms' own
estimates of risk for setting regulatory capital requirements. 
Through our interviews and our review of the literature on risk
measurement, we identified a number of concerns with regard to
increased regulatory capital requirements that are based on each
firm's own risk estimates.  First, the current risk measures used by
firms are limited in that they do not measure all risks the firms
face.  Second, some risk measurement systems may measure some risks
incompletely.  Third, models used by specific firms are tailored to
what each firm sees as its risk measurement needs, so they are not
necessarily comparable.  Fourth, increasing regulatory use of firm
risk estimates could cause firms to modify their models to reduce
their regulatory capital requirements. 


      FIRM RISK MEASUREMENTS ARE
      LIMITED IN VARIOUS WAYS
-------------------------------------------------------- Chapter 4:3.1

Both the literature and representatives of all of the firms we
interviewed agreed that a firm's risk measurement systems are limited
in that they do not accurately measure all of the firm's risks.  Many
of the representatives said that because their firms' risk measures
and models address some categories of risks (for example, market and
credit risks) and not others (for example, operational and
business/event risks), their firms continue to use judgments to
determine the overall capital levels they need. 

In addition to limitations resulting from firms not measuring the
same types of risk, some models may not correlate the same type of
risk (such as credit or market risk) across the entire firm.  In this
way, such models may not fully measure all risks within a risk type
included in the model.  However, as discussed earlier, some firms
said they do measure some risks on a consolidated basis--taking into
account correlations of the same type of risk wherever it exists in
the consolidated firm. 

Moreover, models may fail to capture major unique market events of
low probability that could pose considerable risk, such as currency
devaluations in emerging markets.  According to some of the firms'
representatives we interviewed, the firms' risk estimates address
expected losses, but they cannot accurately account for the
unexpected losses the firm may face.  VAR modeling is often based on
day-to-day risks and historical experience and assumes that managers
regularly readjust their portfolios as risks change.  However, the
representatives noted that such models can easily miss
low-probability events that could result in large losses, which could
pose considerable risk.  For this reason, the capital levels
indicated by the models may not cover losses during a major market
event, such as a financial crisis in an emerging market.  Moreover,
even if the models were capable of totally accurate risk measurement,
regulators, who, for example, are likely to be concerned with the
systemic risk posed by a low-probability, high-loss event, may
require more capital for certain risks than the firms would set aside
for that risk.\2


--------------------
\2 This discrepancy between firm-set capital levels and regulatory
minimums need not be unique to firms that use statistical models to
set capital levels. 


      USE OF FIRMS' INTERNAL
      MODELS RAISES QUESTIONS OF
      CONSISTENCY AND
      DEPENDABILITY
-------------------------------------------------------- Chapter 4:3.2

The financial regulators we spoke with are concerned with the
consistency of capital requirements across the firms they regulate. 
When regulators depend on firm-specific models or measures to set
capital levels, however, capital requirements may not be consistent
across firms with similar risk levels.  Each firm that uses internal
models may well reflect in its own model the firm's unique
characteristics, such as the particular risk factors it faces.  Thus,
even when regulators specify the use of common procedures for
developing internal models, such as those in the market risk capital
requirement for banks, the internal models firms produce differ
because each firm designs its model to measure what it sees as its
own risk profile.  Because a firm's model was designed for use with a
specific risk profile, another firm's model applied to the same
profile might produce a different risk estimate.  In addition, both
the consistency and the accuracy of these models depend on the
quality of the raw data used. 

The financial regulators are concerned about the dependability of the
results of firms' risk measurement systems, in terms of the accuracy
of the results and the transparency in the firms' use of internal
models.  To help ensure that the capital set aside for various risks
accurately reflects the firm's risks of possible losses, it is
important for risk measures and models to truly reflect management's
own best judgment about the design and use of the models and for the
model inputs to be complete and accurate. 

With regard to transparency in the use of firm-specific internal
models, regulators and other experts are concerned that their use of
firm-specific risk measures to set minimum capital requirements could
give firms an incentive to adjust the internal models they use to
determine their minimum regulatory capital in such a way as to reduce
their regulatory capital requirements.  Such behavior by firms would
raise questions about the dependability of the risk and capital
measures used by the firms.  Firms might undertake such model
alterations if the regulatory minimums for certain risks exceeded the
capital level managers wished to put aside for such risks, either
because their estimates of risk were lower or their risk tolerances
were greater than those set by the regulators.  The regulators said
that if they could ensure that only one model existed within a firm
for a particular risk, they could be more confident that the firm's
own true risk estimates were being used to set minimum capital
requirements. 


   INCREASING COMPLEXITY OF LARGE
   FIRMS' ACTIVITIES RAISES ISSUES
   REGARDING ADMINISTRATION OF
   CAPITAL REQUIREMENTS
---------------------------------------------------------- Chapter 4:4

Our interviews with industry representatives, regulators, and others
and review of the literature on capital requirements identified
issues in the administration of capital requirements.  One issue
concerns the reasonableness of using the same approach to capital
regulation for firms of a similar type (e.g., banks) but with varying
sizes and degrees of complexity.  That is, as the activities of large
firms diverge from those of small firms, a single standard for all
firms may become increasingly inappropriate. 

As the activities of large firms become more complex, regulators and
firms are concerned about proper regulatory oversight of the use of
statistical models for regulatory purposes.  Regulatory confidence in
the effectiveness of capital standards in accomplishing the
regulatory purpose depends in part on those standards being auditable
and understandable, which is significantly complicated by the use of
sophisticated measures and firm proprietary models.  In the views of
both regulators and other experts, many auditors and regulators may
not yet have the expertise needed to verify the accuracy of the
measures calculated in the models used in determining minimum capital
standards.\3 In addition, depending on their business mix, smaller
firms are less likely to have the resources or the need to develop
sophisticated models. 

Part of this issue concerns the costs to the regulators if they adopt
sophisticated approaches to setting minimum capital requirements. 
Financial regulators understand that their adoption of more
sophisticated regulatory capital requirements (e.g, increased use of
firms' internal models) would mean increased regulatory costs related
to hiring and training regulatory staff. 

Complexities associated with the increasing use of sophisticated
measures and firms' proprietary models in determining capital
requirements could also pose challenges for regulators and industry
representatives in promptly analyzing and addressing policy or
administrative issues in capital standards.  For example,
representatives from a number of firms we spoke with said that as
their internal modeling and capital allocation processes become more
complex, it is more difficult for managers who do not necessarily
have the technical expertise to judge the quality of the models,
processes, and their results. 

In the view of the Federal Reserve Chairman, no matter how complex
capital requirements become, firms will develop new products to
exploit the remaining inevitable distortions in the regulations to
lower their capital requirements.  As previously discussed, examples
of such distortions are the current credit risk-based capital rules
that treat all commercial loans as if they had equal degrees of
riskiness.  As discussed in the next section, some other experts
argue that trying to address all of the firms' potential activities
through increasingly sophisticated capital regulation is impossible. 
They suggest that the use of simplified regulations, such as an
incentive-based approach or an approach based on strict supervisory
oversight and increased disclosure, would be a better way to
implement capital requirements. 

The importance of these and other issues is apparent in the
initiatives discussed in the next section.  Some of the issues have
more relevance for some of the initiatives than for others.  Some of
the initiatives are actual proposals, and others are still in the
exploratory stage.  Because they are all either proposals or ideas
being explored, we did not evaluate them. 

Most of the initiatives discussed below are attempts to make capital
requirements more sensitive to risks in firm activities, and others
represent new approaches to capital regulation.  Banking regulators
have noted, however, that in consideration of new approaches to
capital regulation, there are both statutory and international
constraints on the changes they can make.  With regard to statutory
constraints, because FDICIA institutionalized regulatory capital
using risk-weights plus leverage as a matter of law, regulatory
capital with a risk-based component will be an integral part of the
overall U.S.  supervisory approach until it is changed by Congress. 
Internationally, U.S.  bank regulators have agreed to coordinate
their capital regulations with those of the other Basle Committee
members, and U.S.  regulators are actively involved in the
committee's work.  Although the Basle Committee is aware of and is
studying many of the initiatives proposed in the United States, none
of the U.S.  regulators we spoke with expected any unilateral new
approaches or any major changes to the Basle Accord or its approach
in the near future. 


--------------------
\3 A firm's management is responsible for meeting capital standards. 
Internal and external auditors, self-regulatory organizations, and
regulatory agency staff are responsible for reviewing firms'
compliance with capital standards. 


   FINANCIAL REGULATORS AND SROS
   ARE EXPLORING WAYS TO MAKE
   CAPITAL REQUIREMENTS MORE
   SENSITIVE TO RISK
---------------------------------------------------------- Chapter 4:5

Regulatory agencies and SROs are exploring or have proposed a number
of initiatives for modifying or changing current capital requirements
in banking, securities, futures, and life insurance that would make
the requirements more sensitive to the actual risks in firm
activities.  The banking initiatives range from a proposal that would
allow banks to use credit ratings from rating agencies to determine
risk-based capital requirements for certain products to taking an
approach to measuring credit risk that is based on statistical
modeling.  SEC and CFTC are monitoring and evaluating the DPG's
voluntary efforts to relate capital to risks.  In addition, SEC
issued (1) a concept release\4 on the extent to which a statistical
modeling approach should be used by broker-dealers to better reflect
market risks in their activities; (2) a proposal that would create a
new class of broker-dealers, called OTC derivatives dealers, that
would be subject to modified capital requirements in connection with
conducting an OTC derivatives business; and (3) proposed amendments
to the net capital rule regarding the method of computing haircuts
applicable to interest rate products.  CFTC is also exploring whether
the regulatory structure should be changed for OTC derivatives
dealers.  Two futures industry exchanges have taken steps to make
minimum capital requirements more risk-based to reflect the total
risks to the FCM.  Although life insurance industry regulators have
no current plans to fundamentally change their formula-based approach
to setting capital requirements, they are working to modify various
components of the current risk-based capital requirements. 


--------------------
\4 A concept release is a paper issued by regulators to elicit
discussion and comment from industry and others on a potential
regulatory change. 


      BANK REGULATORS ARE
      EXPLORING RISK-BASED CAPITAL
      INITIATIVES FOR CREDIT RISK
-------------------------------------------------------- Chapter 4:5.1

Bank regulators have recently proposed revisions to the risk-based
capital standards that, if adopted, would affect the method used to
measure the relative exposure to credit risk for certain products. 
This is in response to the concerns, discussed earlier, about the
imprecise nature of the current credit risk-based capital standards,
which have created conflicts between the regulators and banks.  In
addition, regulators are exploring other modifications to the
standards that would more precisely measure the credit risks firms
face in their activities. 


         BANK REGULATORS HAVE
         PROPOSED USE OF CREDIT
         RATINGS TO MEASURE
         RELATIVE RISK EXPOSURE IN
         CERTAIN PRODUCTS
------------------------------------------------------ Chapter 4:5.1.1

In November 1997, the banking regulators asked for comments on a
proposal that would revise the risk-based capital standards to allow
the use of credit ratings from the nationally recognized statistical
rating agencies (e.g., Moody's Investors Service) to measure relative
exposure to credit risk and to determine the associated risk-based
capital requirement for certain products.  The regulators believe the
use of credit ratings would provide a way for them to use market
determinations of credit quality to identify different loss positions
for capital purposes in an asset securitization structure.\5 Such a
change might open the way for them to determine capital requirements
more precisely across a wide variety of transactions and structures
in administering the risk-based capital system. 

Because credit ratings may not exist for some nontraded positions,
the regulators are also considering some alternative approaches to
the use of credit ratings--the ratings benchmark approach and the
internal information approaches.  Under the first alternative, the
regulators would issue benchmark guidelines that banks would use in
assessing the relative credit risk of nontraded positions in
specified standardized securitization structures.  The second
alternative consists of two different internal information approaches
under which banks would use credit information they have about the
credit quality of assets underlying a position to set the capital
requirement for that position.  The first, the historical loss
approach, would take into account unexpected losses over the life of
the asset pool.  The second, the bank model approach, would base
capital requirements for certain positions on the internal risk
assessments made by banks' "internal models" for measuring credit
risk.  Although regulators have permitted the use of credit ratings
for other purposes, these revisions to the credit risk-based capital
standards, if adopted, would be the first time banks have been
permitted to use credit ratings, benchmarks, or their own internal
risk assessments in determining credit risk-based capital
requirements. 


--------------------
\5 This proposal would cover "recourse" arrangements and "direct
credit substitutes" and other securitized transactions that expose
banks to credit risk.  Recourse refers to any risk of credit loss
that a bank retains in connection with the transfer of its assets. 
Direct credit substitutes, such as a standby letter of credit or
guarantee, refers to arrangements in which a bank assumes all or part
of the risk of loss on an asset or pool of assets owned by another
party, even though the bank had not owned and sold the asset. 


         BANK REGULATORS ARE ALSO
         EXPLORING OTHER POSSIBLE
         MODIFICATIONS TO CREDIT
         RISK CAPITAL REQUIREMENTS
------------------------------------------------------ Chapter 4:5.1.2

According to a 1997 paper by two Federal Reserve officials, there is
increasing discussion in the banking industry as well as the
regulatory community about the possibility for further evolution of
bank capital regulation.\6 This paper was intended to provide the
equivalent of a briefing paper on some of the specific alternative
proposals that have been put forward concerning the future of capital
regulation.  In the view of the authors, the paper was not intended
to pass judgment--positive or negative--on any of these alternatives,
but it sought to raise issues that are likely to be important as the
discussion of the proposals continues. 

In considering the possibility of such evolution, these officials
believe it is helpful to keep in mind several recent changes that
they believe will influence possible future changes.  First, the
overall approach to bank supervision is also undergoing continuing
review.  For example, the bank examination process has been
increasingly focused on risk management and internal controls. 
Second, banks today, especially large internationally active banks,
face a number of different types of risks.  Some of these risks, such
as the market risk of traded instruments, are easier to quantify than
others, such as operational risk.  In addition, the computer systems
and analytical abilities of these banks to measure and manage these
risks are evolving themselves. 

One modification under consideration would be to continue to extend
and revise existing risk-based standards with the goal of improving
the extent to which the risk weights for credit risk reflect the true
economic risk of the underlying positions.  As discussed in chapter
2, many bankers have commented that some of the current risk-weights
do not accurately reflect the risk inherent in particular assets, and
some have argued that the current risk-based capital framework
introduces distortions into the risk-return trade-offs that banks
face.  Such changes may help address the issue of inappropriate
incentives being created for firms by the current risk-weighting
scheme. 

However, in the view of these Federal Reserve officials, it is not
clear that it is possible to better correlate the regulatory risk
calculation with true economic risk.  In order to eliminate
inefficiencies in the risk weights, many believe it would be
necessary to mark loan portfolios to market.  However, there is no
consensus that this is desirable or feasible because there is no
readily available resale market for most loans and, therefore, no
current market value for them. 

Some in the industry are exploring the possibility of using
portfolio-based models of credit risk for regulatory capital
purposes, much as banks' internal models of market risk are now being
used.  According to these Federal Reserve officials, these credit
risk models have yet to be empirically tested.  Such testing appears
to require long periods due to the time period required to observe
changes in credit risks.  One model, called CreditMetrics, was
introduced in 1997 and was accompanied by statements that a primary
goal was to encourage a change in regulatory credit risk capital
calculations.  One problem in the development of credit risk models
noted in the paper is that data for such models are sparse.  Also, it
is not clear what the appropriate holding period is in the case of
credit risk.  Another issue, noted in the paper, is how far to take
this modeling--is there value in attempting to include operational
risk, for example, into such a framework? 


--------------------
\6 "Regulatory Minimum Capital Standards for Banks:  Current Status
and Future Prospects," Darryll Hendricks and Beverly Hirtle, in
Technology:  Policy Implications for the Future of Financial
Services, Proceedings of the 33rd Annual Conference on Bank Structure
and Competition, Federal Reserve Bank of Chicago, May 1997. 


      SEC, CFTC, AND SOME SROS ARE
      EXPLORING APPROACHES TO
      CORRELATE REGULATORY CAPITAL
      REQUIREMENTS MORE CLOSELY TO
      THE RISKS INHERENT IN A
      FIRM'S OPERATIONS
-------------------------------------------------------- Chapter 4:5.2

SEC, CFTC, and some SROs are continuing efforts to revise regulatory
capital charges to (1) reflect the economic risks being undertaken by
broker-dealers and FCMs more precisely and (2) reduce incentives for
some broker-dealers and FCMs to conduct certain activities through
their unregistered affiliates to avoid capital requirements that
apply only to registered broker-dealers and FCMs.  For example, the
current SEC and CFTC capital requirements consider any net interest
payments due a broker-dealer or FCM from interest rate swaps to be
unsecured receivables.  As such, they are deducted from the firm's
GAAP equity (which is the equivalent of a 100 percent capital
charge).  Many broker-dealers and FCMs consider this charge to be an
excessive capital requirement.  However, if these same swaps were to
be conducted in an unregistered affiliate, they would not be subject
to capital requirements. 


         SEC AND CFTC ARE
         EXPLORING THE USE OF
         VALUE-AT-RISK MODELS FOR
         DETERMINING CAPITAL
         REQUIREMENTS FOR MARKET
         RISK
------------------------------------------------------ Chapter 4:5.2.1

Value-at-Risk (VAR), a statistical modeling approach, is increasingly
being used by a few large broker-dealers in varying ways to measure,
control, and report the amount of market risk incurred in their
trading activities.  According to market participants, SEC's current
net capital requirements do not accurately reflect the economic risks
being taken by a broker-dealer's activities, because such
requirements do not incorporate modern finance and risk management
techniques.  Because the current net capital rule generally does not
recognize portfolio diversification, correlation among asset prices,
or the many hedging strategies firms employ to reduce their risk,
these market participants argue that capital requirements and risk do
not always move in the same direction; i.e., if risks increase, then
capital requirements should increase and vice versa.  Accordingly,
certain broker-dealers and their industry associations have been
urging SEC to allow broker-dealers to use their internal models for
determining regulatory capital requirements for market risk (like
banks).  In response to such industry urging, SEC issued a concept
release in December 1997 on the extent to which a firm's statistical
models might be used in setting capital requirements for a
broker-dealer's proprietary positions. 

The statistical modeling approach is intended to more accurately
reflect the risk-return trade-off and the relationship between risks
and regulatory capital.  In the same concept release, SEC discussed
the possibility of adopting a "precommitment" feature similar to that
being considered by banking regulators.\7


--------------------
\7 In the precommitment approach, a bank would commit to manage its
trading portfolio to limit market risk losses over a subsequent
interval to a specified amount; if the bank exceeded its limit, it
would face penalties.  We present more information on this approach
later in this chapter. 


         THE DPG FRAMEWORK
         SUGGESTED HOW TO ESTIMATE
         CAPITAL-AT-RISK BUT DID
         NOT ESTABLISH CAPITAL
         STANDARDS
------------------------------------------------------ Chapter 4:5.2.2

In 1995, DPG member firms, in coordination with SEC and CFTC,
developed a self-regulatory framework to address public policy issues
raised by the OTC derivatives activities of "unregulated affiliates
of SEC-registered broker-dealers and CFTC-registered FCMs." DPG's
voluntary self-regulatory framework\8 includes, among other things, a
provision for evaluating risk in relation to capital.  As noted in
the framework, this initiative is considered part of a process, not a
single event.  As DPG member firms and SEC and CFTC gain insights,
they anticipate further refinements to the framework. 

The "risk in relation to capital" provision of the framework has two
parts.  First, it suggests a way to estimate market and credit
exposures associated with OTC derivatives activities.  The market
risk approach is similar to the approach used by bank regulators in
that it uses internal models; but the credit risk approach is
different in that it is based on rating agency information, not on
regulatory risk-weights.  Second, it advocates an approach for
evaluating those risks in relation to capital.  According to the DPG
framework, capital-at-risk estimates are imperfect measures of
potential losses associated with market and credit risks.\9

However, it noted that managers and supervisors can use them to gauge
capital adequacy, and the firms have agreed to report their estimates
periodically to SEC and CFTC.\10

Although DPG firms' estimates of capital-at-risk are not intended to
be capital standards, the estimates incorporate elements similar to
some of those used in the banks' risk-based capital regulations.  The
DPG capital-at-risk for market risk is to be generated by the DPG
reporting firm's internal model using the same parameters (10-day
price shock, 99 percent confidence interval) required by the bank
regulators.  DPG, however, rejected the use of a multiplier to link
capital-at-risk to capital levels.  Moreover, for credit risk, DPG
adjusts for historical default ratios as published by the rating
agencies.  The DPG firms rejected the bank regulators' method of
estimating potential future credit risk because the bank regulators'
method is based on notional/contract amounts,\11 which the DPG firms
do not consider to be meaningful measures of risk. 

DPG firms consider this to be an interim approach for estimating
current and potential credit risk.  They noted in the framework that
they anticipate cooperating with requests by SEC and CFTC to compute
potential credit risk using other methodologies. 

Because the potential for risk of loss beyond the capital-at-risk
estimate exists, DPG firms agreed to supplement these estimates with
other potential loss estimates resulting from defined stress
scenarios.  The framework also outlines a common approach to audit
and verify technical and performance characteristics because it
allows the DPG firms to use internal models that may be unique.  DPG
member firms developed minimum standards and audit and verification
procedures to ensure that performance characteristics of all models
used to estimate capital-at-risk for market risk are broadly similar
and rigorous. 

SEC and CFTC have received annual reports from the DPG reporting
firms that summarized external auditors' reviews of these models. 
However, because no generally accepted criteria for modeling yet
exist that would allow an external auditor to give an opinion on the
model's adequacy, the independent accountants filed reports regarding
only limited agreed-upon procedures with respect to their reviews of
these models. 

In the second part of the framework's capital-at-risk component, the
DPG firms advocate, for a transitional period, an approach for
evaluating market- and credit-risk estimates in relation to capital
levels.  To evaluate the adequacy of existing capital levels at
DPG-member affiliates, the framework advocates an oversight approach
that encourages regulators and senior managers to take into account
the following factors:  the firm's structure, internal controls, and
risk management systems; quality of management; risk profile and
credit standing; actual daily loss experience; ability to manage
risks as indicated by the firm's ability to perform and document
stress testing; and overall compliance with the framework's policies
and procedures.  The DPG firms anticipate that as experience is
gained with the overall DPG framework, and depending on the evolution
of thinking and policies among regulators internationally, this
approach may require further refinement or modification. 

Concerns remain about using internal models for regulatory purposes
(e.g., validating the accuracy of the results).  However, SEC and
CFTC have been collecting and examining data from broker-dealers'
internal models, via DPG, to gain a better understanding of the
manner in which the models operate and the adequacy of capital
charges derived from them. 


--------------------
\8 Framework For Voluntary Oversight, Derivatives Policy Group, Mar. 
1995. 

\9 "Capital-at-risk" as defined by DPG is conceptually the same as
"value-at-risk" used elsewhere in this report. 

\10 One of the DPG firms, CS First Boston, is not required to submit
information to SEC or CFTC because it has an OTC derivatives
affiliate that is regulated by the Bank of England.  According to
SEC, under its risk assessment rules, it receives copies of quarterly
financial reports that the affiliate files with the Bank of England. 

\11 The notional amount is the amount upon which payments between
parties to certain types of derivatives contracts are based.  In an
earlier report we reported that the amount at risk in a derivatives
transaction is generally about 3 percent of the notional amount.  See
OTC Derivatives:  Additional Oversight Could Reduce Costly Sales
Practice Disputes (GAO/GGD-98-5, Oct.  2, 1997). 


         SEC IS CONSIDERING
         CREATING OTC DERIVATIVES
         DEALERS
------------------------------------------------------ Chapter 4:5.2.3

Current capital and margin requirements applicable to registered
broker-dealers impose substantial costs on the operation of an OTC
derivatives business and make it difficult for U.S.  securities firms
to compete effectively with banks and foreign dealers in the OTC
derivatives markets.  In December 1997, in order to allow
broker-dealers to take better advantage of counterparty netting\12

and to adjust the capital rule to better reflect the risks of OTC
derivatives, SEC proposed the creation of a new class of
broker-dealers called OTC derivatives dealers.  This limited
regulatory structure would be available only to entities acting
primarily as counterparties in privately negotiated over-the-counter
derivatives transactions and would be subject to modified capital,
margin, and other regulatory requirements tailored to the OTC
derivatives business.  For example, under the limited regulatory
structure, OTC derivatives dealers would be required to maintain at
least $100 million in tentative net capital (i.e., capital before
haircuts and undue concentration charges are taken) and at least $20
million in regulatory net capital.  Also, OTC derivatives dealers
would be exempted from certain margin requirements. 

SEC believes the proposed minimum of $100 million in tentative net
capital is necessary to ensure against excessive leverage and risks
other than credit or market risk, all of which are now factored into
the current haircuts, and to provide for a cushion of capital against
severe market disturbances.  Under the proposal, OTC derivatives
dealers would be given the option of either taking haircuts, as
currently required under SEC's net capital rule, or using a rule
proposed to calculate capital charges for credit risk and using a VAR
model to determine capital charges for market risk.  SEC's proposed
rule would require that any VAR models meet certain minimum
qualitative and quantitative requirements. 

In calculating capital charges for market risk, OTC derivatives
dealers could elect one of two methods.  First, OTC derivatives
dealers would be able to use the full VAR method to calculate capital
charges for market risk exposure for transactions in eligible OTC
derivatives instruments and other proprietary positions of the OTC
derivatives dealer.  Under the full VAR method, a market risk capital
charge would be equal to the VAR of its positions multiplied by a
factor specified in the proposed rule.  Second, an OTC derivatives
dealer could use an alternative method of computing the market risk
capital charge for equity instruments and OTC options and use VAR for
its other proprietary positions.  Because OTC derivatives dealers
would be required to obtain authorization from SEC before using VAR
models, this alternative method would also be used by a firm that
does not receive SEC authorization to use a VAR model for equity
instruments. 

In calculating capital charges for credit risk, OTC derivatives
dealers electing to apply the proposed rule would compute a two-part
charge on a counterparty basis.  First, for each counterparty, OTC
derivatives dealers would take a capital charge equal to the net
replacement value in the account of the counterparty multiplied by 8
percent, and further multiplied by a counterparty factor ranging from
20 to 100 percent based on the counterparty's rating by at least two
nationally recognized statistical rating agencies.  The counterparty
factors would link the size of the credit risk capital charge to the
perceived risk that the counterparty may default. 

The second part of the credit risk charge would consist of a
concentration charge that would apply when the net replacement value
in the account of any one counterparty exceeds 25 percent of the OTC
derivatives dealer's tentative net capital and would also be based on
the counterparty's rating by at least two rating agencies.  The
concentration charge would equal 5 percent of the amount of the net
replacement value in excess of 25 percent of the OTC derivatives
dealer's tentative net capital for counterparties that are highly
rated and would increase in relation to the OTC derivatives dealer's
exposure to lower rated counterparties. 


--------------------
\12 Netting is an agreed-upon offsetting of positions or obligations
by trading partners that can reduce a large number of individual
obligations or positions to a smaller number. 


         SEC PROPOSED NEW NET
         CAPITAL RULE TREATMENT
         FOR INTEREST RATE
         PRODUCTS
------------------------------------------------------ Chapter 4:5.2.4

In addition to the OTC derivatives dealers release, in December 1997,
SEC proposed amendments to the net capital rule, Rule 15c3-1,
regarding the method of computing haircuts applicable to interest
rate products.  The proposed amendments would treat most types of
interest rate products as part of a single portfolio and would
recognize various hedges among a portfolio of government securities,
investment grade nonconvertible debt securities (or corporate debt
securities), certain pass-through mortgage-backed securities,
repurchase and reverse repurchase agreements, money market
instruments, futures and forward contracts on these debt instruments,
and other types of debt-related derivatives.  The proposed amendments
are intended to better match capital charges with actual market risk
hedging practices employed by broker-dealers. 


         CFTC IS EXPLORING THE
         REGULATORY STRUCTURE
         APPLICABLE TO OTC
         DERIVATIVES
------------------------------------------------------ Chapter 4:5.2.5

As part of its comprehensive regulatory reform efforts to update its
oversight of both exchange and off-exchange markets, CFTC published a
concept release in May 1998, on issues relating to the OTC
derivatives market.  The concept release requests comments on whether
the regulatory structure applicable to OTC derivatives under CFTC
regulations should be changed in light of the growth in the
derivatives marketplace since CFTC's last major regulatory actions
involving OTC derivatives in 1993. 


         CME AND CBOT ADOPTED
         RISK-BASED CAPITAL
         REQUIREMENTS FOR THEIR
         CLEARING ORGANIZATIONS
------------------------------------------------------ Chapter 4:5.2.6

In 1995, two futures industry SROs, the Chicago Board of Trade (CBOT)
and the Chicago Mercantile Exchange (CME), informally proposed to
CFTC to base minimum capital requirements on "funds at risk" as
opposed to the current "funds required to be segregated." In their
view, the current CFTC net capital requirements (CFTC Rule 1.17) do
not fully reflect all of the risks (e.g., foreign customers trading
in foreign markets) faced by FCMs' trading activities and thus impose
insufficient capital requirements on FCMs.  Funds at risk are
generally defined as the initial margin requirements, which are
themselves risk-based, imposed by the various exchanges on all open
positions held at those exchanges; segregated funds are generally
balances that FCMs owe to customers. 

The CBOT and the CME risk-based capital proposals were positively
received by CFTC, which consulted with the SROs on the parameters of
the risk model.  The SROs' risk-based capital requirements for their
clearing organizations became effective on January 1, 1998.  Under
the newly adopted risk-based capital requirements, all members of the
two SROs are required to maintain adjusted net capital in excess of
the greater of (1) the minimum dollar balances of the respective
clearing organizations, or (2) 10 percent of domestic and foreign
domiciled customer and 4 percent of noncustomer (excluding
proprietary) risk maintenance margin/performance bond requirements
for all domestic and foreign futures and options on futures contract,
or (3) the CFTC/SEC minimum regulatory capital requirements.  CME and
CBOT believe that these new requirements will correlate FCMs' capital
requirements more closely to the total risks they face in their
business. 

To aid in the adoption of an industrywide risk-based capital
standard, CBOT and CME plan to collect and analyze data over several
years to determine the effect of the new requirements on overall
industry capital levels. 


      LIFE INSURANCE REGULATORS
      ARE EXPLORING CHANGES TO
      THEIR RISK-BASED CAPITAL
      REQUIREMENTS
-------------------------------------------------------- Chapter 4:5.3

NAIC has asked the American Academy of Actuaries\13 to study the
possibility of increasing the level of quantification in the interest
rate risk component of the life insurance risk-based capital
requirements.  The reason for changing the interest rate risk
component is due to the difficulty in managing interest rate risk for
life insurance companies.  This difficulty increases as financial
products become more complex, and interest rate risk exists in both
the assets and liabilities of life insurance companies.  The current
risk-based capital formula addresses interest rate risk only in the
asset side. 

Changes to the interest rate risk component of the risk-based capital
requirements are seen by life insurance regulators and companies as a
major change.  Other changes that are being made to the risk-based
capital formula are considered to be minor modifications.  For
example, since the initial formula was adopted, changes have been
made to the mortgage loan factors, and the treatment of insurers'
investments in certain mutual funds have been given different
treatment depending upon what the mutual funds invest in.  Regulators
we spoke with expected further changes similar to these to continue
in the future. 


--------------------
\13 The American Academy of Actuaries is the public policy,
communications, and professional organization for all actuaries. 


   NEW APPROACHES TO CAPITAL
   REGULATION ARE ALSO BEING
   EXPLORED
---------------------------------------------------------- Chapter 4:6

In addition to initiatives that would make regulatory capital
requirements more sensitive to risks in firms' activities, a number
of other ideas are being explored, primarily in banking, that would
take different approaches to simplifying capital regulation.  Three
of them would use various incentives rather than detailed
requirements to deter excessive risk-taking by firms.  The final idea
in this section is motivated by a desire of some in the industry to
keep capital requirements from becoming extremely complex and comes
from the recognition that minimum regulatory capital standards and
banks' own internal capital allocation models serve different
purposes. 


      THE PRECOMMITMENT APPROACH
      WAS PILOT TESTED
-------------------------------------------------------- Chapter 4:6.1

In July 1995, the Federal Reserve Board requested public comment on
the so-called precommitment approach to market risk capital
requirements, which was introduced in a paper by two Federal Reserve
officials.\14 It was developed in response to perceived difficulties
with the internal models approach to market risk capital.  For
example, banks' internal models are not designed to measure risk
exposure over the time horizons of regulatory concern and thus may
not accurately translate to these intervals.  In addition,
model-based capital calculations cannot account for the fact that
some banks will be in a position to reduce their exposure to losses
through investment in superior information systems or other aspects
of risk management. 

Under the precommitment approach, the bank would specify an amount of
capital it believed was adequate to cover its risk exposure over a
fixed subsequent interval and would commit to manage its trading
portfolio to limit losses over the interval to this amount.  If the
bank's losses exceeded the precommitment amount, it would face
penalties that could range from public disclosure to additional
capital requirements or monetary fines.  Under this approach, both
the commitment and the bank's risk management system would be subject
to review by regulatory authorities.  The penalties associated with a
breach of the capital commitment are to provide the incentive for
banks to commit honestly and to manage risk to stay within the
commitment. 

Some industry analysts considered such an approach to be a major
improvement in capital regulation.  However, others believe the
approach raises a number of issues because of its departure from
traditional capital regulation--comparability, interaction with other
supervisory policies, enforceability, and the role of penalties. 

Regarding comparability, on the surface it would seem that
precommitted amounts would be comparable across firms because the
firms are all being asked about the maximum amount they could lose
over the same time interval.  However, the amounts are likely to
differ because they would still be based on subjective estimates of
the quality of internal risk management and differences in firms'
tolerances for risk.  Comparability might also be compromised because
the cost of capital differs across firms. 

With regard to interaction with other supervisory policies, bank
supervisors are already required to focus on bank internal risk
measurement and management systems.  Thus, it is not clear that the
adoption of the precommitment approach would eliminate supervisory
interest in the validation of such systems. 

With regard to enforcement and the role of penalties, there is a
concern not only about the types of penalties that should be used,
but also whether it would be counterproductive to enforce them during
stressful market conditions.  The paper notes that in choosing
penalties, it will be important to determine what the goal of
penalties is--that is, the degree of incentive they are to provide
the bank.  Some experts believe that to reliably achieve regulatory
objectives, the penalties would need to be bank specific and that the
appropriate penalty would depend on a bank's cost of capital and its
individual investment opportunities.  However, these factors are not
ascertainable by regulators.  In addition, recent work by the
original designers of the precommitment approach acknowledges that
the link between after-the-fact penalties and regulatory capital
objectives is tenuous.\15 In the view of a Federal Reserve official,
the appropriate penalty for achieving regulatory capital objectives
for market risks is bank specific and depends on characteristics that
regulators cannot precisely measure.  Moreover, an approach that
relies on after-the-fact penalties to influence bank behavior
implicitly assumes that the bank is forward-looking and takes
potential penalties into account when making current capital
allocation decisions.  This might be a reasonable assumption for
healthy banks, but weak banks may not care about future penalties
that, in the extreme, might not be enforceable if the bank is
insolvent. 

The New York Clearing House Association (Clearing House)\16 conducted
a four-quarter test of the precommitment approach that began in
October 1996.  The pilot was designed to assist the bank regulators
and the participating banks and bank holding companies in evaluating
and assessing the usefulness and viability of the approach for
regulatory capital purposes.  In a comment letter to the Federal
Reserve, the Clearing House suggested that the U.S.  bank regulators
consider adoption of this approach for two reasons:  (1) it might
constitute a way to effectively establish a relationship between an
institution's calculation of value-at-risk for management purposes
and prudent capital requirements for regulatory purposes, and (2) it
would result in capital requirements for market risks tailored to the
particular circumstances of each institution. 

There were 10 participants in the pilot--8 U.S.  and 2 foreign
banking organizations.\17 During the pilot, each participant
precommitted the amount of capital it needed to hold against its
market risk for four 3-month periods.  The pilot was conducted on a
consolidated basis in that participants precommitted capital for the
consolidated trading operation of the holding company, including bank
and Section 20 subsidiaries.  After the end of each period,
participants reported their results to their primary regulators and
provided copies of the reports to the Clearing House.  The
participants conducted the pilot under the assumption that the
penalty would be disclosure, not financial penalties. 

In its report on the pilot's results, the Clearing House said that
the participants believe (1) the precommitment approach is a viable
alternative to the internal models approach for establishing capital
adequacy of a trading business for regulatory purposes; and (2) when
properly structured and refined, steps should be taken to implement
it as an alternative to existing market risk capital standards. 
Further, the participants believe this approach provides strong
incentives for prudent risk management and more efficient allocation
of capital as compared to other existing capital standards.  The
Clearing House believes the pilot contributed to the development and
depth of the participants' thinking about the purpose of capital and
about the distinction between economic capital maintained for the
benefit of shareholders and minimum regulatory capital. 

Pilot results showed that the participants' precommitted capital
amounts were less than the market risk regulatory capital
requirements.  No participant reported a negative change that
exceeded its precommitted capital amount.  Finally, the participants
believe the benefits of the precommitment approach are likely to
apply to other risks of trading businesses, such as operational risk,
as well.  In their view, the approach avoids many of the
complications and inefficiencies that are generated when capital
requirements are set separately for each category of risk. 

One high level regulatory official, reflecting the generally held
regulatory and industry views, said that the pilot demonstrated that
the participants have internal procedures for allocating capital for
market and other risks in their portfolios; but it did not, and
realistically could not, demonstrate that these internal allocations
are sufficiently large to meet regulatory objectives with respect to
minimum capital.  Even though none of the participants reported
losses in excess of their commitments during the pilot, in reality,
none of the participants incurred any cumulative loss over any of the
four quarters.  Hence, no violations would have occurred if no
capital had been committed. 


--------------------
\14 A Precommitment Approach to Capital Requirements for Market Risk,
Paul H.  Kupiec and James M.  O'Brien, FEDS 95-36, Federal Reserve
Board, July 1995. 

\15 Deposit Insurance, Bank Incentives, and the Design of Regulatory
Policy, Paul H.  Kupiec and James M.  O'Brien, Board of Governors of
the Federal Reserve System, Dec.  1997. 

\16 A clearing house is a voluntary association of depository
institutions that facilitates the exchange of payments transactions,
such as checks, and the settlement of participants' net debit or
credit positions. 

\17 The participants in the pilot were BankAmerica Corporation,
Bankers Trust New York Corporation, The Chase Manhattan Corporation,
Citicorp, First Chicago NBD Corporation, First Union Corporation, The
Fuji Bank Limited, J.P.  Morgan & Co., Inc., NationsBank Corporation,
and Swiss Bank Corporation. 


      AN APPROACH THAT EMPHASIZES
      SUPERVISION IS BEING
      EXPLORED
-------------------------------------------------------- Chapter 4:6.2

Another alternative approach to the evolution of bank capital
regulation would be one that emphasizes supervision rather than
minimum standards.  In a 1995 paper, a Federal Reserve official
argued that the distinct uses and characteristics of minimum
regulatory capital requirements and firm internal capital allocations
make it inadvisable to combine them into a single measure.\18 In his
view, they are so naturally contradictory that a hybrid would be much
less informative than two individual measures.  Moreover, he believes
an attempt to bring the two constructs closely in line could
undermine the useful objectivity of minimum capital and deprive firms
of the flexibility they need to determine optimum capital levels. 
Under this approach, the firm would be accountable for determining
its own appropriate level of capital while abiding by sound practices
developed in the context of the business.  Firms engaged in trading
complex instruments would need to apply sophisticated mathematical
techniques; those that focus on, for example, small business lending
would have to apply different techniques (e.g., traditional credit
analysis).  The supervisor would monitor the performance of the firm
in the firm's determination of its appropriate capital level. 

Like the precommitment approach discussed above, this approach also
relies on incentives.  However, in contrast to the precommitment
approach in which penalties are to act as a deterrent to excessive
risk taking, the key to the success of this approach would be the
supervisor.  The supervisor would monitor compliance with minimum
requirements as frequently as feasible and then supplement the
effectiveness of minimum requirements by ensuring that the firm makes
its best efforts to determine an optimum level of capital.  In this
way, the development and determination of the optimum are best left
to the firm, and supervisors would work closely with the firm to
ameliorate the situation if they find capital levels declining toward
the minimums.  The Federal Reserve official also believes this
approach would be consistent with the prompt corrective action rules. 
(See app.  I for more information on prompt corrective action.)


--------------------
\18 "A Prolegomenon to Future Capital Requirements," Arturo Estrella
FRBNY Economic Policy Review, July 1995. 


      AN APPROACH THAT EMPHASIZES
      DISCLOSURE IS ALSO BEING
      EXPLORED
-------------------------------------------------------- Chapter 4:6.3

In their 1997 paper,\19 two Federal Reserve officials noted that a
number of different approaches exist that would emphasize disclosure
rather than minimum standards.  One of these approaches would operate
along the same lines as the approach emphasizing supervision
discussed above.  It would develop a two-pronged capital structure
that would separate minimum standards, which would be set by the
supervisor, from the optimal capital held by the firm, which should
be its own decision.  The first prong could be a minimum capital
calculation in which the method would be chosen to emphasize
comparability across firms; the second prong would be an internal
capital calculation in which the bank would have greater freedom to
use its own methodology.  The bank would publicly disclose the
results of both calculations.  In the authors' view, this approach
would seek to combine public disclosure and the discipline of the
marketplace to ensure that banks had appropriate incentives in the
development of these internal calculations. 


--------------------
\19 See footnote 6. 


      OTHER APPROACHES TO CHANGING
      BANK CAPITAL REGULATION
      EMPHASIZE REDUCING THE
      COMPLEXITY OF THE RULES
-------------------------------------------------------- Chapter 4:6.4

A number of other approaches to capital regulation are being
explored, particularly in the banking area, that would also simplify
capital requirements.  One possible approach discussed by the Federal
Reserve officials in their paper is,\20 in their view, motivated by
the desire of some in the industry to keep the capital rules from
becoming extremely complex and by the recognition that minimum
capital standards serve a different purpose from banks' own internal
capital allocation models.  This approach would develop a capital
framework that would not require ever more complex measures of
portfolio risk.  The hope in developing such a framework is that a
suitable proxy for true economic risk could be found.  This proxy
would not be intended to be extremely precise, but it would need to
roughly capture the bulk of the firm's exposures.  According to the
Federal Reserve officials, the key issue for this alternative
approach is whether it is possible to achieve this goal.  There are
two interpretations for this approach.  In the first, the aim is for
the simple measure of risk to be roughly accurate in that, on
average, it produces a measure of risk that is equivalent to what an
ideally precise measure would produce.  In the second, the goal would
be a simple measure of risk that is good enough to determine whether
the firm has a dangerously low level of capital. 

Another approach discussed by the Federal Reserve officials in their
paper is one that would base capital regulation on observed measures
of volatility, such as earnings volatility.  This approach is also
motivated by a desire to develop a simple but comprehensive approach
to bank capital regulation that would not require the separate
specification of each risk.  One possibility suggested in the paper
would be for minimum capital to equal some multiple of quarterly
earnings volatility.  Such an approach would require almost no
additional calculations by the bank and, in the authors' view, it
would be objective and verifiable; however, they noted a number of
drawbacks to such an approach.  First, it is not clear that earnings
volatility is itself a good proxy for economic risk.  Second, because
it is a transformation of publicly available information, it does not
provide any additional information to the marketplace.  Third, it
would potentially create incentives for bank behavior aimed at
smoothing reported income. 


--------------------
\20 See footnote 19. 


BANK RISK-BASED CAPITAL STANDARDS
=========================================================== Appendix I

The current U.S.  bank risk-based capital regulations implement the
Basle Accord on risk-based capital.\1 In implementing the Basle
Accord each national bank regulator was to make its own regulations
at least as strict as the Accord.  In the United States, U.S.  bank
regulators applied it to all banks, rather than just internationally
active ones, which were targeted by the Accord.  Since 1990, banks
and bank holding companies in the United States have been subject to
risk-based capital standards.  This appendix describes the risk-based
capital standards for banks.  The standards for bank holding
companies are similar. 

Although U.S.  bank risk-based capital guidelines\2 address a number
of types of risk, only credit and market risk are explicitly
quantified.\3 The quantified risk-based capital standard is defined
in terms of a ratio of qualifying capital divided by risk-weighted
assets.  In addition to the quantified risk-based capital ratio for
credit and market risks, bank regulators are required by the Federal
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) to
monitor other risks, such as interest rate risk\4 and concentration
risk.\5


--------------------
\1 The official document referred to as the Basle Accord is entitled
International Convergence of Capital Measurement and Capital
Standards, Committee on Banking Supervision (Basle, Switzerland: 
July 1988). 

\2 Capital Adequacy Guidelines, Reg.  H (12 C.F.R.  pt.  208) App. 
A, Board of Governors of the Federal Reserve System, as amended Dec. 
31, 1993.  OCC's regulation is at 12 C.F.R.  pt.  3.10 and 3.11
FDIC's regulation is at 12 C.F.R.  pt.  325. 

\3 Credit risk is the potential for financial loss resulting from the
failure of a borrower or counterparty to perform on an obligation. 
Market risk is the potential for financial losses due to the increase
or decrease in the value or price of an asset resulting from broad
movements in prices, such as interest rates, commodity prices, stock
prices, or the relative value of currencies (foreign exchange). 

\4 Interest rate risk is the risk of potential loss arising from
changes in interest rates.  It exists in traditional banking
activities, such as deposit-taking and loan provision, as well as in
securities and derivatives activities. 

\5 Concentration risk exists if a bank is heavily exposed to certain
sectors or countries.  It deals with the risks of not diversifying
the assets so that a problem in any one sector or country might
financially affect the bank. 


   CALCULATING THE RISK-BASED
   CAPITAL RATIO FOR CREDIT RISK
--------------------------------------------------------- Appendix I:1

All banks are required to calculate their credit risk for assets,
such as loans and securities; and off-balance sheet items, such as
derivatives or letters of credit.\6 The credit risk calculation
assigns all assets and off-balance sheet items to one of four broad
categories of relative riskiness (0, 20, 50, or 100 percent)
according to type of borrower/obligor and, where relevant, the nature
of any qualifying collateral or guarantee.  Off-balance sheet items
are converted into credit equivalent amounts.  The assets and credit
equivalent amount of off-balance sheet items in each category are
multiplied by their appropriate risk-weight and then summed to obtain
the total risk-weighted assets for the denominator of the credit
risk-based capital ratio.  Capital, the numerator of the capital
ratio, is long-term funding sources for the bank that are specified
in the regulations.  A bank is to maintain a total risk-based capital
ratio (total capital/risk-weighted assets) of at least 8 percent. 


--------------------
\6 An off-balance sheet item is a financial contract that can create
credit losses for the bank but that is not reported on the balance
sheet under standard accounting practices.  An example of such an
off-balance sheet position is a letter of credit or an unused line of
credit that commits the bank to making a loan in the future that
would be on the balance sheet and thus create a credit risk. 


      MEASURING RISK-WEIGHTED
      ASSETS FOR CREDIT RISK
------------------------------------------------------- Appendix I:1.1

The credit risk regulation requires the use of two sets of
multipliers.  One set of multipliers places each off-balance sheet
item into one of four categories and converts items in each category
into asset equivalents.  These conversion factors are multiplied by
the face or notional amount of the off-balance sheet items to
determine the "credit equivalent" amounts.  In addition, for
derivatives, these credit equivalent amounts are the value of the
bank's claims on the counterparties plus add-on factors to cover the
potential future value of the derivative contracts.\7

Then the other set of multipliers applies the risk-weights to assets
and off-balance sheet credit equivalent amounts according to the type
of borrower/obligor (and, where relevant, the nature of any
qualifying collateral or guarantee).  The sum of the risk-weighted
assets in all categories is the credit risk-weighted assets for the
bank. 

There are four conversion factors that convert off-balance sheet
items into their asset equivalents.  The conversions are based on
multiplying the conversion factors by the face or notional amounts of
the relevant off-balance sheet position. 

  -- The 100 percent credit conversion factor applies to direct
     credit substitutes, such as guarantee-type letters of credit,
     risk participations in bankers acceptances, and asset sales with
     recourse. 

  -- The 50 percent credit conversion factor applies to items such as
     performance bonds, revolving underwriting facilities, or unused
     commitments with an original maturity exceeding 1 year. 

  -- The 20 percent credit conversion factor applies to short-term,
     self-liquidating, trade-related contingencies, including
     commercial letters of credit. 

  -- The 0 percent credit conversion factor applies to unused
     portions of commitments with an original maturity of 1 year or
     less and unused portions of commitments that can be cancelled at
     any time. 

Credit equivalent amounts are also calculated for off-balance sheet
derivatives contracts.  The credit equivalent amounts on such
contracts are the sum of the present positive value (if any) of the
contracts plus estimated potential future exposure.\8

Under the capital regulations, the credit equivalent of the potential
future exposure of derivatives contracts is estimated by multiplying
the notional values of the contracts by specified percentages.  The
multipliers range from 0 to 15 percent; cover 6 types of derivatives
contracts (interest rate, exchange rate, equity, gold, other precious
metals, and other commodities); and include maturity categories of 1
year or less, 1 to 5 years, and over 5 years. 

Although the Basle Accord adopted five risk weight categories, U.S. 
regulations allow only four risk categories.\9

  -- Category 1 has a zero risk-weight and includes items such as
     cash, claims on Organization for Economic Cooperation and
     Development (OECD)\10 central governments and central banks, and
     claims on U.S.  government agencies.\11 The zero weight reflects
     the lack of credit risk associated with such positions. 

  -- Category 2 has a 20-percent risk-weight and includes items such
     as long-term claims on banks in OECD countries, general
     obligations of OECD governments below the national level,
     obligations of government-sponsored enterprises, or cash items
     in the process of collection. 

  -- Category 3 has a risk-weight of 50 percent and includes items
     such as certain loans secured by first liens on 1 to 4 family
     residential real estate and obligations of local governments in
     OECD countries that depend on revenue flows from projects
     financed by the debt. 

  -- Category 4 has a risk-weight of 100 percent and represents the
     presumed bulk of the assets of commercial banks.  It includes,
     among other things, commercial loans and claims on non-OECD
     central governments. 


--------------------
\7 Off-balance sheet derivatives include interest-rate,
exchange-rate, equity-linked derivatives, and commodity derivative
contracts. 

\8 Derivatives are financial products that enable risk to be shifted
from one entity to another.  The value of the derivative is based on
an underlying reference rate, index, or asset, such as stocks, bonds,
commodities, interest rates, foreign currency exchange rates, and
various market indexes. 

\9 These risk-weights for the four categories assume all assets
within each category have the same level of credit risk.  Thus, a
loan to a highly rated corporation generally carries the same
100-percent risk-weight as a start-up loan to a new company or a
small business.  According to the Federal Deposit Insurance
Corporation (FDIC), although this approach in the risk-based
guidelines minimizes government-mandated private sector credit
allocation, applying the same risk-weights to all commercial loans
has been a source of concern to bankers and analysts in the
government and the private sector. 

\10 When the Basle Accord was adopted, OECD included members of 24
developed countries.  Subsequently, other members have joined, and it
currently has 29 members.  Its goals are to achieve high economic
growth, contribute to sound economic expansion, and contribute to the
expansion of world trade. 

\11 In July 1994, the Basle Committee amended the Capital Accord
concerning the qualification for the OECD risk-weighting.  For
purposes of risk-weighting, the OECD group comprises countries that
are full members of OECD (or that have concluded special lending
arrangements with the International Monetary Fund associated with the
Fund's General Arrangements to Borrow), but it excludes any country
within this group that has rescheduled its external sovereign debt in
the previous 5 years. 


      DEFINING CAPITAL IN THE
      CREDIT-RISK CAPITAL RATIO
------------------------------------------------------- Appendix I:1.2

Before the capital ratio can be calculated, capital must be defined
and quantified.  There are two qualifying capital components in the
risk-based credit risk computation--"core capital" (tier 1) and
"supplementary capital" (tier 2).  Tier 1 includes common
stockholders' equity; noncumulative perpetual preferred stock
(including any related surplus); and minority interests in
consolidated subsidiaries, less deductions for certain assets such as
goodwill\12 and core deposit intangibles.  Tier 1 is stockholder
ownership value that cannot be removed if the bank faces financial
difficulties.  Tier 2 includes the allowance for loan loss reserves,
up to a maximum of 1.25 percent of risk-weighted assets; other
preferred stock (subject to limitations); and various long-term debt
instruments, such as subordinated debt, that provide support to the
firm if it is facing financial difficulties because they cannot be
readily liquidated by creditors or bond holders prior to maturity. 
In addition, the regulations limit the amount of tier 2 capital in
total capital and the amount and type of qualifying intangible
assets\13 that can be recognized for tier 1 capital purposes. 

The regulation outlines a number of deductions from the capital base. 
Goodwill and other intangible assets are to be deducted from tier 1
capital as prescribed in the rules.  Other deductions from total
capital include

  -- investments in unconsolidated banking and financial subsidiary
     companies that are deemed to be capital of the subsidiary, and

  -- reciprocal bank holdings of investments in the capital of other
     banks and financial institutions. 

With capital and risk-weighted assets defined, the ratio calculation
is the sum of tier 1 and tier 2 capital divided by total
risk-weighted assets.  Table I.1 summarizes the mechanics of
converting on- and off-balance sheet assets in each category into the
risk-weighted assets and computing the credit risk-based capital
ratio.  The minimum standard risk-based capital ratio is 8 percent,
of which core capital (tier 1) is to be at least 4 percent.\14



                               Table I.1
                
                  The Calculation of the Credit Risk-
                          Based Capital Ratio

Step                    Description
----------------------  ----------------------------------------------
1                       Convert all off-balance sheet items into
                        credit equivalent amounts using a conversion
                        factor from the regulation. The asset
                        equivalent of each off-balance sheet item is
                        the notional or face amount of that item
                        multiplied by a conversion factor. The
                        converted amount of each off-balance sheet
                        item is then placed into one of the four risk
                        categories.

2                       Sum the balance sheet asset values and the
                        credit equivalent amount of off-balance sheet
                        items in each risk category.

3                       Determine the risk-weighted assets in each
                        risk category by multiplying the balance sheet
                        asset values and the credit equivalent amount
                        of off-balance sheet items in each risk
                        category by the appropriate risk-weight
                        percentage for that category found in the
                        regulation.

4                       Calculate risk-weighted assets as the sum of
                        the risk-weighted assets across the four risk
                        categories.

5                       Calculate the credit risk-based capital
                        ratio:

                        tier 1 capital + tier 2 capital
                        risk-weighted assets

6                       Compare the calculated ratio to the standards
                        in the regulation.
----------------------------------------------------------------------

--------------------
\12 Goodwill means the intangible asset that represents the excess of
the purchase price over the fair market value of tangible and
identifiable intangible assets acquired in purchases. 

\13 Qualifying intangible assets include mortgage servicing assets
and purchased credit card relationships.  Other intangible assets,
such as goodwill, favorable leaseholds, and core deposit intangibles,
are deducted in their entirety in calculating tier 1 capital. 

\14 In addition, banks must maintain a minimum leverage ratio of at
least 3 percent tier 1 capital divided by adjusted total assets. 
However, this minimum applies only to banks with the highest
supervisory ratings that are not anticipating or experiencing any
significant growth.  According to FDIC, most banks are subject to a
minimum leverage standard of not less than 4 percent. 


   CALCULATING THE RISK-BASED
   CAPITAL RATIO FOR MARKET RISK
--------------------------------------------------------- Appendix I:2

The risk-based capital regulation requires a bank with a significant
market risk exposure to calculate a risk-based capital ratio that
takes into account market risk as well as credit risk.  The market
risk capital regulation applies to positions in an institution's
trading account such as securities and derivatives; and all foreign
exchange and commodity positions, wherever they are located in the
bank.  Market risk exposure is the gross sum of trading assets and
liabilities on the bank's balance sheet.  To be considered a
significant exposure, this gross exposure must exceed 10 percent of
total assets or exceed $1 billion.  Credit risk determinations are
also made, where necessary, for items included in the market risk
calculation.  Over-the-counter derivatives and foreign exchange
positions outside of the trading account are items subject to both
market and credit risk charges. 

This adjusted risk-based capital ratio requires banks to determine
whether positions are subject to market risk capital requirements,
credit risk capital requirements, or both.  The denominator of the
risk-based capital ratio is the sum of credit risk-weighted assets
for assets with credit risk and market risk-equivalent assets.  To
determine market risk-equivalent assets, the bank is required to use
its own internal model to calculate its daily value-at-risk (VAR).\15
The numerator of the risk-based capital ratio expands the definition
of capital to include a tier 3, which is a special form of
subordinated debt as defined in the regulations.  The market risk
regulation imposes qualitative requirements on the banks and
specifies quantitative parameters to be used with the banks' internal
models. 


--------------------
\15 VAR models use statistical analyses to estimate the maximum
amount that the value of all covered positions (trading account, all
foreign exchange, and commodities) could decline during a fixed
holding period within a stated confidence level.  For example, a
value-at-risk estimate might be the dollar loss that could occur 1
out of every 100 days based on statistical analyses. 


      MEASURING MARKET RISK AND
      MARKET RISK-EQUIVALENT
      ASSETS
------------------------------------------------------- Appendix I:2.1

Market risk consists of general market and specific risk components. 
To determine the market risk-equivalent assets, the risk or capital
charges must be calculated for both components. 

Market risk capital charges are based on general market and specific
risks.  Examples of general market risk factors are interest rate
movements and other general price movements.  Capital charges for
general market risks are to be based on internal models developed by
each bank to calculate a VAR estimate, i.e., potential loss that
capital will need to absorb.  The internal VAR estimate for general
market risks is to be based on statistical analyses that determine
the probability of a given loss, based on at least 1 year of
historical data.  This VAR estimate is to be calculated daily using a
99 percent one-tailed confidence interval with a price shock
equivalent to a 10-business day movement in rates and prices; i.e.,
99 percent of the time the calculated VAR would not be exceeded in a
10-day period. 

Specific risk arises from factors relating to the characteristics of
specific issuers of instruments.  Specific risk factors reflect both
idiosyncratic price movements of individual securities and "event
risk" from incidents, such as defaults or credit downgrades, which
are unique to the issuer and not related to market factors.  If a
bank's internal model does not capture all aspects of specific risk,
an add-on to the capital charge is required for specific risk. 
Specific risk estimates based on internal models are subject to
adjustments based on the precision of the model. 

The total market risk capital charge is the sum of the capital
charges for general market and specific risk.\16 The total market
risk capital charge is based on the larger of the previous day's VAR
estimate and the average of the daily VAR estimates for the past 60
days times the multiplier.  The multiplier ranges from 3 up to a
maximum of 4 depending on the results of backtesting.\17 Market
risk-equivalent assets are the total market risk capital charges
multiplied by 12.5.\18


--------------------
\16 In this discussion, de minimis risks are subsumed in the specific
risk discussion.  De minimis risks are those risks that the regulator
permits the bank to calculate in an alternative manner. 

\17 Backtests provide information about the accuracy of an internal
model by comparing a bank's daily VAR measures to its corresponding
daily trading profits and losses. 

\18 The multiplier (12.5) is related to the 8-percent minimum
risk-based capital ratio in the regulation and is used in order to
generate a denominator for the capital requirement that is comparable
to the denominator used for credit risk.  An 8-percent requirement
means that asset values can be, at most, 12.5 times capital values
because 8 x 12.5 = 100.  If the multiplier were any larger, the 8
percent capital requirement could not be met for market risk. 


      DEFINING CAPITAL IN THE
      MARKET RISK CAPITAL RATIO
------------------------------------------------------- Appendix I:2.2

The market risk capital ratio augments the definitions of qualifying
capital in the credit risk requirement by adding an additional
capital component (tier 3).  Tier 3 capital is unsecured subordinated
debt that is fully paid up, has an original maturity of at least 2
years, and is redeemable before maturity only with approval by the
regulator.  To be included in the definition of tier 3 capital, the
subordinated debt is to include a lock-in clause precluding payment
of either interest or principal (even at maturity) if the payment
would cause the issuing bank's risk-based capital ratio to fall or
remain below the minimum requirement.  Tier 3 capital provides
another capital cushion against losses due to market risk. 


      CALCULATING THE MARKET
      RISK-BASED CAPITAL RATIO
------------------------------------------------------- Appendix I:2.3

Application of the market risk capital ratio requires the use of a
two-part test.  The sum of tiers 1, 2, and 3 capital must equal at
least 8 percent of total adjusted risk-weighted assets.  The tier 3
capital in this sum is only to be allocated to cover market risk.  In
addition, the sum of tier 2 and tier 3 capital for market risk may
not exceed 250 percent of tier 1 capital allocated for market risk. 
The regulation includes other restrictions on the use of tier 2 and 3
capital. 

Table I.2 shows the mechanisms by which the risk-based capital ratio
is calculated for credit and market risk. 



                               Table I.2
                
                   The Calculation of the Risk-Based
                Capital Ratio for Market and Credit Risk

Step                    Description
----------------------  ----------------------------------------------
1                       Determine whether positions are subject to
                        market risk capital requirements, credit risk
                        capital requirements, or both.

2                       For the credit risk assets and off-balance
                        sheet items, calculate the credit risk-
                        weighted assets as described in table I.1.

3                       Quantify general market risks using the bank's
                        VAR model to estimate the volatility of the
                        prices of market risk assets and items using a
                        VAR model. The estimated VAR is the higher of
                        the previous VAR or the average of the daily
                        VAR estimates for the past 60 days multiplied
                        by a factor between 3 and 4 depending on the
                        accuracy of the VAR model.

4                       Quantify specific risks using risk add-ons or
                        estimates based on the bank's internal model,
                        or some combination of both.

5                       Determine the total risk-weighted assets for
                        market risk by summing the measures of general
                        market and specific risks and multiply this
                        sum by 12.5.

6                       Calculate the total risk-weighted assets for
                        market risk by summing the credit risk-
                        weighted and market risk-equivalent assets.

7                       Determine tier 3 capital and the total capital
                        for the numerator. The mix of the capital
                        tiers in the numerator of the combined credit
                        and market risk-based capital ratio is limited
                        by the regulation.

8                       Calculate the total risk capital ratio subject
                        to the capital restrictions in step 7.

                        (tier 1 + tier 2 + tier 3 capital)
                        (credit risk-based assets + market risk-
                        equivalent assets)

9                       Compare the calculated ratio to the standards
                        in the regulation.
----------------------------------------------------------------------

      INTERNAL MODEL
      SPECIFICATIONS AND
      REQUIREMENTS
------------------------------------------------------- Appendix I:2.4

The regulation requires the bank's internal model to address all
major market risk categories\19 using factors sufficient to measure
market risks in all covered positions.\20 The regulation specifies
certain requirements for the bank's internal model.  In developing
its internal model, the bank may use any generally accepted
measurement technique, such as variance-covariance models, historical
simulations, or Monte Carlo simulations.  However, the level of
sophistication and accuracy of the model must be commensurate with
the nature and size of the bank's covered positions. 


--------------------
\19 The market risk model does not cover all market risks.  For
example, it does not cover interest rate risk on mortgages that are
not held in the trading book. 

\20 Covered positions means all positions in a bank's trading account
and all foreign exchange and commodity positions, whether or not in
the trading account. 


      QUANTITATIVE REQUIREMENTS
      FOR GENERAL MARKET RISK
------------------------------------------------------- Appendix I:2.5

For regulatory capital purposes, the VAR measures must meet the
following quantitative requirements: 

1.  The VAR measure or maximum likely loss is to be calculated on a
daily basis with a 99 percent one-tailed confidence level with a
price shock equivalent to a 10-business day holding period.  This
10-day shock can be calculated directly or be based on the 1-day VAR
figures. 

2.  The VAR calculation is to be based on historical data of at least
1 year. 

3.  The VAR calculation is to account for nonlinear price
characteristics of options positions and the sensitivity of the
market value of the positions to changes in the volatility of the
underlying rates or prices.  That is, the calculation must take into
account the fact that certain financial positions imply minimal risk
for certain market price movements and much larger risks for other
market price movements. 

4.  The VAR measures may incorporate quantified empirical
correlations\21 within and across risk categories, provided that the
bank's process for measuring correlations is sound. 

5.  Beginning 1 year after adoption of the rules, backtesting will be
required and it is to be based on the most recent 250 days of
trading.  The testing is to be done on a 1-day holding period and a
99 percent one-tailed confidence level. 


--------------------
\21 Correlation is a measure of the degree of association between two
variables.  The empirical correlation can be either positive,
negative, or nonexistent. 


      QUANTITATIVE REQUIREMENTS
      FOR SPECIFIC RISK
------------------------------------------------------- Appendix I:2.6

An institution whose internal model does not adequately measure
specific risk must continue to calculate standard specific risk
capital charges or add-ons to the VAR-based capital charge to
determine market risk capital requirements.  An institution whose
internal model adequately captures specific risk may base its
specific risk capital charge on the model's estimates. 

Specific risk means the changes in the market value of specific
positions due to factors other than broad market movements, including
idiosyncratic variations as well as event and default risk.  In order
to capture specific risk, the internal model is to explain the
historic price variation in the portfolio and be sensitive to changes
in portfolio concentrations--the extent to which one type of asset
dominates the portfolio--requiring additional capital for greater
concentrations.  The internal model is required to be robust to
adverse environments.  The model's ability to capture specific risks
is to be validated through backtesting.  Institutions with models
that are not validated with backtesting are to continue to use
specific risk add-ons as defined in the regulations. 


      QUALITATIVE RESTRICTIONS IN
      APPLYING THE MARKET
      RISK-BASED CAPITAL
      REGULATION
------------------------------------------------------- Appendix I:2.7

The risk management system of any bank subject to the market risk
requirement is required to meet the following minimum qualitative
requirements.  It is to have

  -- a risk control unit that reports directly to senior management
     and is independent from business trading units,

  -- an internal risk management model that is integrated into daily
     management processes,

  -- policies and procedures to identify and conduct appropriate
     stress tests and backtests of the model,\22

  -- independent annual reviews of its risk measurement and risk
     management systems. 


--------------------
\22 Stress testing provides information about the impact of adverse
market events on a bank's covered positions. 


   FDICIA REQUIRED REVISIONS TO
   U.S.  RISK-BASED CAPITAL
   STANDARDS
--------------------------------------------------------- Appendix I:3

FDICIA was enacted to make fundamental changes in federal oversight
of depository institutions in response to the thrift and banking
crisis of the 1980s, which resulted in large federal deposit
insurance fund losses.  Section 305 of FDICIA required, among other
things, that bank regulators revise their risk-based capital
standards to include concentration of credit risk, risks of
nontraditional activities, and interest rate risk.  Inadequate
management of these risks had created problems for the bank and
thrift deposit insurance funds. 

In response, on December 13, 1994, bank regulators amended risk-based
capital standards for depository institutions to "ensure that those
standards take adequate account of concentration of credit risk and
the risks of nontraditional activities," which include derivatives
activities.  Regulators are to consider the risks from nontraditional
activities and management's ability to monitor and control these
risks when assessing the adequacy of a bank's capital.  Similarly,
institutions identified through the examination process as having
exposure to concentration of credit risk or as not adequately
managing their concentration of risk are required to hold capital
above the regulatory minimums.  Because no generally accepted
approach exists for identifying and quantifying the magnitude of risk
associated with concentrations of credit, bank regulators determined
that including a formula-based calculation to quantify the related
risk was not feasible. 

U.S.  bank regulators addressed the interest rate risk portion of
section 305 through a two-step process.  Step one consisted of a
final rule issued on August 2, 1995, that amended the capital
standards to specify that bank regulators will include in their
evaluations of a bank's capital adequacy an assessment of the
exposure to declines in the economic value of the bank's capital due
to changes in interest rates.  The final rules specify that examiners
will also consider the adequacy of the bank's internal interest rate
risk management.  Step one also included a proposed joint policy
statement that was issued concurrently with the final rule.  This
joint policy statement described how bank regulators would measure
and assess a bank's exposure to interest rate risk. 

Originally, bank regulators intended that step two would be the
issuance of a proposed rule based on the August 2, 1995, joint policy
statement that would have established an explicit minimum capital
requirement for interest rate risk.  Subsequently, bank regulators
elected not to pursue a standardized measure and explicit capital
charge for interest rate risk. 

According to the bank regulators' June 26, 1996, joint policy
statement on interest rate risk, the decision not to pursue an
explicit measure reflects concerns about the burden, accuracy, and
complexity of developing a standardized model and the realization
that interest rate risk measurement techniques continue to evolve. 
Nonetheless, bank regulators said they will continue to place
significant emphasis on the level of a bank's interest rate risk
exposure and the quality of its risk-management process when they are
evaluating its capital adequacy. 

The regulators concluded that interest rate risks were too difficult
for many institutions to quantify, and concentration risk was too
difficult to quantify in a manner that could be used in a risk-based
capital calculation.  Therefore, instead of developing a quantitative
standard for each of these risks, the regulators decided that both
risks need to be carefully monitored by examiners and that regulators
could increase capital requirements for any institution on a
case-by-case basis. 


   FDICIA USES CAPITAL RATIOS TO
   DETERMINE BANK CAPITAL ADEQUACY
--------------------------------------------------------- Appendix I:4

FDICIA contains several provisions that were intended to collectively
improve supervision of federally insured depository institutions. 
FDICIA's Prompt Regulatory Action provisions created two new sections
in the Federal Deposit Insurance Act--sections 38 and 39--which
mandate that regulators establish a two-part regulatory framework to
improve safeguards for the deposit insurance fund.  Section 38
creates a capital-based framework for bank and thrift oversight that
is based on the placement of financial institutions into one of five
capital categories.  FDICIA requires that banks meet both a
risk-based and a leverage requirement. 

Capital was made the centerpiece of the framework because it
represents funds invested by an institution's owners, such as common
and preferred stock, that can be used to absorb unexpected losses
before the institution becomes insolvent.  Thus, capital was seen as
serving a vital role as a buffer between bank losses and the deposit
insurance system.  Although section 38 does not in any way limit
regulators' ability to take additional supervisory action, it
requires federal regulators to take specific actions against banks
and thrifts that have capital levels below minimum standards.  The
specified regulatory actions are made increasingly severe as an
institution's capital drops to lower levels.\23 By focusing on
capital, which absorbs losses, and requiring regulators to take
actions when capital levels fall below predetermined thresholds,
including requiring closure if capital levels become too low, FDICIA
was meant to curb failures and deposit insurance losses if regulators
had to close an institution. 

Section 38 of FDICIA requires regulators to establish criteria for
classifying depository institutions into the following five capital
categories:  well-capitalized, adequately capitalized,
undercapitalized, significantly undercapitalized, and critically
undercapitalized.  The section does not place restrictions on
institutions that meet or exceed the minimum capital standards--that
is, those that are well-capitalized or adequately capitalized--other
than prohibiting the institution from paying dividends or management
fees that would drop them into the undercapitalized category. 

The regulators jointly developed the implementing regulations for
section 38 and based the criteria for four of the five capital
categories on the international risk-based capital calculation and
the leverage capital ratio.  The fifth category--critically
undercapitalized--is based on a tangible equity-to-total assets
ratio. 

The four regulators specifically based the benchmarks for an
adequately capitalized institution on the Basle Committee's
risk-based capital requirement, which stipulates that an
internationally active bank must have at least 8 percent total
risk-based capital and 4 percent tier 1 risk-based capital.  The
benchmarks are also based on the U.S.  leverage capital standard,
which generally requires U.S.  banks to have tier 1 capital equal to
at least 4 percent of total assets.  For the definition of a
critically undercapitalized institution, the regulators adopted
section 38's requirement of a tangible equity ratio of 2 percent or
less. 

As shown in figure I.1, three capital ratios are used to determine if
an institution is well-capitalized, adequately capitalized,
undercapitalized, or significantly undercapitalized.  A
well-capitalized or adequately capitalized institution must meet or
exceed all three capital ratios for its capital category.  To be
deemed undercapitalized or significantly undercapitalized, an
institution need fall below only one of the ratios listed for its
capital category.  Although not shown in the figure, a fourth
ratio--tangible equity--is used to categorize an institution as
critically undercapitalized.\24 Any institution that has a 2 percent
or less tangible equity ratio is considered critically
undercapitalized, regardless of its other capital ratios. 

   Figure I.1:  Summary of Four
   Section 38 Capital Categories
   and Ratio Requirements

   (See figure in printed
   edition.)

Note:  Only the tangible equity ratio is used to determine whether an
institution is critically undercapitalized.  Institutions with a
tangible equity ratio of 2 percent or less are considered to be
critically undercapitalized. 

\a The leverage ratio can be as low as 3 percent if the institution
has a regulator-assigned composite rating of 1.  Regulators are to
assign a composite rating of 1 only to institutions considered to be
sound in almost every respect of operations, condition, and
performance. 

\b An institution cannot be considered to be well-capitalized if it
is subject to a formal regulatory enforcement action that requires
the institution to meet and maintain a specific capital level. 

Source:  Interagency regulations issued on September 29, 1992 (57
Fed.  Reg.  44866). 


--------------------
\23 In November 1996, we reported that inherent limitations of
section 38 requirements and the regulatory implementation of section
39 raise questions about their effectiveness in ensuring that
regulators will act early and forcefully enough to prevent or
minimize losses to the insurance funds.  See Bank and Thrift
Regulation:  Implementation of FDICIA's Prompt Regulatory Action
Provisions (GAO/GGD-97-18, Nov.  21, 1996). 

\24 The tangible equity ratio is the sum of common stock, surplus,
and retained earnings, net of Treasury stock and currency translation
adjustments, with intangible assets subtracted from both the
numerator and denominator. 


KEY SEC FINANCIAL RESPONSIBILITY
RULES
========================================================== Appendix II

The Securities and Exchange Commission's (SEC)\1 uniform net capital
rule (15c3-1) and customer protection rule (15c3-3) form the
foundation of the securities industry's financial responsibility
framework.\2 The net capital rule focuses on liquidity and is
designed to protect securities customers, counterparties, and
creditors by requiring that broker-dealers have sufficient liquid
resources on hand at all times to satisfy claims promptly.  Rule
15c3-3, or the customer protection rule, which complements rule
15c3-1, is designed to ensure that customer property (securities and
funds) in the custody of broker-dealers is adequately safeguarded. 
By law, both of these rules apply to the activities of registered
broker-dealers, but not to unregistered affiliates. 


--------------------
\1 SEC is the federal agency responsible for administering the
Federal Securities Laws.  One objective of the Federal Securities
Laws is to protect investors. 

\2 Other financial responsibility rules include the records
maintenance and preservation rules (17a-3 and 17a-4); the financial
reporting rule (17a-5); the early warning or "telegraphic" notice
rule (17a-11); the quarterly security counts rule (17a-13); the
hypothecation rules (8c-1 and 15c2-1); the initial margin
requirements of the Board of Governors of the Federal Reserve System
(12 C.F.R.  Section 220.3(b)); and the maintenance margin rules of
the self-regulatory organizations (e.g., New York Stock Exchange rule
431).

Note:  SEC and Commodity Futures Trading Commission (CFTC) officials
stated that the futures industry capital adequacy and customer assets
protection requirements (CFTC Rules 1.17, and 1.20-1.30,
respectively) generally mirror the requirements in SEC rules 15c3-1
and 15c3-3. 


   THE SEC NET CAPITAL RULE (RULE
   15C3-1)
-------------------------------------------------------- Appendix II:1


      BACKGROUND
------------------------------------------------------ Appendix II:1.1

SEC amended the net capital rule (Rule 15c3-1) in 1975 to establish
uniform net capital standards for brokers and dealers\3 registered
with SEC under Section 15(b) of the Securities Exchange Act of 1934
(Exchange Act).  With few exceptions, all broker-dealers registered
with SEC must comply with this liquidity standard.\4 The primary
purpose of this rule is to ensure that registered broker-dealers
maintain at all times sufficient liquid assets\5 to (1) promptly
satisfy their liabilities--the claims of customers, creditors, and
other broker-dealers; and (2) to provide a cushion of liquid assets
in excess of liabilities to cover potential market, credit, and other
risks if they should be required to liquidate.  The rule achieves its
purpose by prescribing a liquidity test that requires a broker-dealer
to maintain the greater of a specified minimum dollar amount or
specified percentage of net capital in relation to either aggregate
indebtedness (generally all liabilities of the broker-dealer) or
customer-related receivables (money owed to the broker-dealer by
customers) as computed by the reserve requirements of Rule 15c3-3. 
The net capital rule thus enhances investor/customer\6 confidence in
the financial integrity of broker-dealers and the securities market. 
The net capital rule applies only to the registered broker-dealer and
does not apply to the broker-dealer's holding company or unregulated
subsidiaries or affiliates.\7


--------------------
\3 A broker is any person that engages in the business of effecting
transactions in securities for the account of others, but does not
include a bank.  A dealer is any person that engages in the business
of buying and selling securities for his own account, through a
broker or otherwise, but does not include a bank, or any person
insofar as he buys or sells securities for his own account, either
individually or in some fiduciary capacity, but not as part of a
regular business.  Broker-dealers combine the functions of brokers
and dealers. 

\4 The sole market maker (a dealer that makes bids and offers at
which he/she will trade) and sole specialist (a member designated by
an exchange to be the sole market maker for a particular stock) on
the options floor are exempted from the SEC net capital rule; and
floor brokers on an exchange, under certain circumstances are
exempted from the rule.  Also, SEC may exempt certain broker-dealers
from the rule upon a determination that it is "not necessary in the
public interest or for the protection of investors" to subject the
particular broker-dealer to the rule.  See Rule 15c3-1(b). 

\5 Liquid assets are assets that can be converted easily into cash
with relatively little loss of value.  Broker-dealers must have at
all times at least $1 of liquid assets for each $1 of liabilities
(except for subordinated liabilities that are treated as part of the
broker-dealer's capital) in addition to the minimum requirements of
the net capital rule in case they fail the net capital test or
voluntarily cease operations.  Once liquidation is decided upon, a
broker-dealer's operations are generally liquidated in an orderly
manner within a short time frame without the use of a formal
bankruptcy proceeding. 

\6 Generally, a customer is defined as any person from whom or on
whose behalf a broker or dealer has received or acquired or holds
funds or securities for the account of such person. 

\7 An exception to this principle is where the registered
broker-dealer guarantees or assumes responsibility for the
liabilities of the related unregistered entity.  In such a situation,
the broker-dealer is required to consolidate into a single
computation the assets and liabilities of both itself and the
guaranteed entity.  See Rule 15c3-1(a) and Appendix C to the rule. 


      NET CAPITAL COMPUTATION
------------------------------------------------------ Appendix II:1.2

To comply with SEC's net capital rule, broker-dealers must perform
two computations:  one computation determines the broker-dealer's net
capital (liquid capital), and another computation determines the
broker-dealer's appropriate minimum net capital requirement (base
capital requirement). 

Net capital is defined as U.S.  Generally Accepted Accounting
Principles (GAAP) equity plus qualified subordinated liabilities\8

and credits less nonallowable assets,\9 certain operational charges
(e.g., fail-to-deliver),\10 and prescribed percentages of the market
value (otherwise known as haircuts)\11 of securities and commodities
that constitute the broker-dealer's trading and investment positions. 
See figure II.1 below. 

   Figure II.1:  SEC Net Capital
   Formulation

   (See figure in printed
   edition.)

Source:  GAO analysis of SEC's net capital rule. 

The process of computing a broker-dealer's regulatory net capital is
really a process of separating its liquid and illiquid assets.  In
computing net capital, under either the basic or alternative method
(discussed below), the broker-dealer must first determine its equity
in accordance with GAAP.  GAAP liabilities deducted from GAAP assets
result in GAAP equity.  GAAP requires that the broker-dealer mark to
market all securities and commodities positions daily, thereby
reflecting unrealized gains (which add to equity) and losses (which
subtract from equity)--the current market value--and making it
difficult to forbear market losses beyond a day. 

Once GAAP equity is computed, a number of adjustments are made to
reflect the estimated value of the broker-dealer if it was liquidated
in a hurry.  Liabilities that are properly subordinated to the claims
of creditors, including customers, are then added back to GAAP equity
as well as certain deferred income tax liabilities and accrued
liabilities.  Assets considered not readily convertible into cash are
deducted from GAAP equity.  This includes intangible assets
(goodwill); fixed assets (furniture, fixtures, and buildings);
prepaid items (rent and insurance); and the value of exchange
memberships.  The broker-dealer also deducts most unsecured
receivables, including unsecured customer debits and bridge loans;
and charges for delays in processing securities transactions beyond
the normal settlement date.  These collective additions and
subtractions to GAAP equity result in an amount called tentative net
capital.  Tentative net capital is then reduced by certain percentage
deductions, called haircuts, of the current market value of a
broker-dealer's securities and commodities positions and an undue
concentration charge, which reflects the risk of a large,
concentrated holding in one security, to arrive at the
broker-dealer's net capital.  Then, the net capital base requirement
(required net capital amount) is subtracted from the net capital
amount to determine the amount of excess net capital held by the
broker-dealer. 


--------------------
\8 To be counted as capital in the net capital computation, the
subordinated liabilities, among other things:  (1) must have an
initial term of 1 year or more; (2) must be subordinated to the
claims of all present and future creditors, including customers; (3)
may not be repaid if the repayment would reduce regulatory net
capital below certain required amounts; and (4) must be approved for
inclusion as net capital by the broker-dealer's self-regulatory
organization (SRO). 

\9 Nonallowable assets are considered illiquid assets (assets that
cannot be immediately or quickly converted into cash) by the net
capital rule.  Such assets decrease a broker-dealer's net capital,
because they are deducted from GAAP equity in the net capital
computation. 

\10 A fail-to-deliver is a situation in which the selling
broker-dealer does not receive securities from the client in time to
make delivery with the buying broker-dealer. 

\11 The haircut is based on the risk characteristics (i.e., market
risk, price volatility, and liquidity) of a particular security.  For
example, securities perceived as risky typically receive a large
haircut (e.g., 100 percent for nonmarketable securities); those
perceived as less risky generally receive a small haircut (e.g., 0
percent for short-term government securities).  This means that for a
100-percent haircut the broker-dealer must finance 100 percent of the
security's value with firm capital.  Reduced haircuts are allowed
when risk is reduced through utilization of hedging strategies. 
Hedging is a strategy designed to protect a position in securities or
commodities against price movements by taking an offsetting
investment position.  A haircut serves as a safety margin for market
fluctuations and delays encountered in liquidating securities and
commodities positions.  See pages 140-145 for greater detail on
haircuts. 


      METHODS AVAILABLE FOR
      BROKER-DEALERS TO COMPUTE
      REQUIRED NET CAPITAL
------------------------------------------------------ Appendix II:1.3

A broker-dealer may compute its net capital requirement by one of two
methods.  The first method, called the basic or aggregate
indebtedness method, requires that the net capital of a broker-dealer
conducting a general securities business (i.e., a firm that clears
securities transactions and carries customer accounts) be equal to
the greater of $250,000 or 6-2/3 percent of its aggregate
indebtedness.  The 6-2/3 percent requirement says a broker-dealer
must have at least $1 of net capital for every $15 of its
indebtedness (i.e., a leverage constraint).  In the broker-dealer's
first year of operation, its net capital must exceed 12.5 percent of
its aggregate indebtedness.  Most of the smaller broker-dealers
typically use the basic method to compute their net capital
requirements because of the nature of their business.  Typically,
smaller broker-dealers either do not hold customer or broker-dealer
accounts and therefore need less than the $250,000 required for
broker-dealers that carry customer accounts; or they want to be
subject to the less stringent requirements of Rule 15c3-3. 

Under the second method, the so-called alternative method, the
broker-dealer is required to have net capital equal to the greater of
$250,000 or 2 percent of its customer-related receivables from the
reserve calculation of Rule 15c3-3 or, if registered as a futures
commission merchant (FCM),\12 4 percent of the customer funds
required to be segregated pursuant to the Commodity Exchange Act
(CEA) and the regulations thereunder (less the market value of
commodity options purchased by option customers on or subject to the
rules of a contract market, each such deduction not to exceed the
amount of funds in the customer's account).  When a firm is
registered both as a securities broker-dealer with SEC and an FCM
with CFTC,\13 known as being "dually-registered," it must comply with
both agencies' regulations.  However, a dually-registered firm is
required to meet only the capital standard that would cause it to
hold the most capital.  SEC offers this method to broker-dealers as a
voluntary alternative (with self-regulatory organization approval) to
the basic net capital requirement.  This method is based on the
broker-dealers' responsibilities to customers rather than aggregate
indebtedness.  Reversion to the basic method by the broker-dealer
requires SEC's approval.  This option (most commonly used by large
broker-dealers because it can result in a lower net capital
requirement than under the basic method), in conjunction with Rule
15c3-3 (discussed below), is designed to ensure that sufficient
liquid capital exists to return all property (assets--funds and
securities) to customers, repay all creditors, and have a sufficient
amount of capital remaining to pay the administrative costs of a
liquidation if the broker-dealer fails.  The broker-dealer's ability
to return customer property is addressed by Rule 15c3-3.  The
repayment of creditors and the payment of the broker-dealer's
liquidation expenses is addressed by the 2 percent of
customer-related receivables net capital requirement and the
deductions from net worth for illiquid assets and risk in securities
and commodities positions.  See pages 148-151 for an example of a
hypothetical simplified net capital computation under the alternative
method. 

There are some differences between the two methods of computation. 
For example: 

  -- The alternative method ties required net capital to
     customer-related assets (receivables) rather than all
     liabilities like the basic method. 

  -- The alternative method requires a broker-dealer to provide a bad
     debt reserve of 3 percent of its customer-related receivables
     versus 1 percent under the basic method. 

  -- Under the alternative method, stock record differences and
     suspense account items (prospective losses due to recordkeeping
     problems) must be included in the calculation of net capital
     after 7 business days versus the 30 calendar days required under
     the basic method. 

However, both methods limit a broker-dealer's ability to increase its
customer commitments only to the extent that net capital supports
such an increase. 

Also, the type of securities business a broker-dealer conducts
determines its minimum net capital requirements.  For example, for
broker-dealers engaging in all facets of a securities business
(involves clearing securities transactions and holding customer and
broker-dealer accounts),\14 the minimum dollar net capital
requirement is $250,000; for broker-dealers that generally do not
carry customer or broker-dealer accounts (introducing brokers), the
minimum dollar amount is $5,000.  See pages 152-153 for more detail
on the SEC minimum net capital requirements for specialized types of
business. 


--------------------
\12 An FCM is an individual, association, partnership, corporation,
or trust that solicits or accepts orders for the purchase or sale of
any commodity for future delivery on or subject to the rules of any
contract market and that accepts payment from or extends credit to
those whose orders are accepted. 

\13 CFTC is the federal agency responsible for administering the CEA
and overseeing the futures and commodity options industry to protect
the public from fraud and manipulation in the marketplace. 

\14 A more detailed description is a broker-dealer who buys and sells
stocks, bonds, options, or municipal securities, and/or engages in
firm commitment underwritings as underwriter or selling group member. 


      EARLY WARNING CAPITAL LEVELS
------------------------------------------------------ Appendix II:1.4

In addition to the minimum base net capital requirements, SEC and
SROs (such as the National Association of Securities Dealers and the
national exchanges)\15 have established "early warning" levels\16

of capital that exceed the broker-dealer's minimum capital
requirement.  This advance warning alerts SEC and the SROs to the
fact that a broker-dealer is experiencing financial difficulty (i.e.,
broker-dealer's net capital is dropping toward its minimum
requirement) and allows time for initiation of corrective action. 
Broker-dealers that violate the early warning levels must immediately
notify SEC and their designated SRO\17 and are thereby subject to
closer regulatory scrutiny by SEC and the SRO.\18 SROs may also
impose additional operating restrictions or warning requirements on
their members, which can be more stringent than SEC's.  For example,
the New York Stock Exchange's rule 326 restricts the business
activities of member broker-dealers that are approaching financial or
operational difficulties.  When a broker-dealer's net capital drops
below its minimum net capital requirements, SEC requires the
broker-dealer to cease operations immediately and get additional
capital to come into capital compliance or liquidate its operations. 

The early warning notice levels are as follows: 

  -- Under the basic method, the broker-dealer's ratio of aggregate
     indebtedness to net capital is greater than 1,200 percent. 

  -- Under the alternative method, the broker-dealer's net capital is
     less than 5 percent of customer-related receivables or, if an
     FCM, net capital is less than 6 percent of CEA customer
     segregated funds. 

  -- The broker-dealer's net capital is less than 120 percent of its
     required minimum dollar net capital. 

Market participants indicated that prudent broker-dealers maintain
capital levels far in excess of their required minimum net capital
amount.  They told us that the largest broker-dealers typically hold
$1 billion or more in excess of their required capital levels
because, among other reasons, their counterparties require it for
conducting business with them. 


--------------------
\15 Securities SROs set rules (with oversight by SEC) for fair
conduct, license or approve firms engaged in market making
activities, and supervise the activities of market participants. 

\16 This early warning system also includes other criteria for
notification to SEC and the designated SRO by broker-dealers:  when
the broker-dealer fails to keep books or records current, when the
broker-dealer's independent accountant notifies it of a material
inadequacy in financial statements, or upon occurrence of other
specified events.  See Rule 17a-11. 

\17 If a broker-dealer is a member of more than one SRO, one of them
will be designated as the SRO responsible for overseeing the
broker-dealer's activities and its compliance with the financial
responsibility rules. 

\18 A broker-dealer is prohibited from withdrawing equity capital if
such withdrawal would cause the broker-dealer's aggregate
indebtedness to net capital to exceed 10 times its net capital; its
net capital to fall below 120 percent of its minimum dollar
requirement; its net capital to fall to less than 5 percent of
customer-related receivables under the alternative method; or, if an
FCM, less than 7 percent of CEA-segregated funds; or subordinated
debt to exceed 70 percent of total capital, or net capital to be less
than 25 percent of haircuts used in calculating net capital.  This
limitation includes withdrawals in the form of redemption or
repurchase of stock, dividends, or other distributions as well as
unsecured loans or advances to stockholders, partners, sole
proprietors, employees, or affiliates (i.e., related persons).  Under
certain conditions, a broker-dealer is required to notify (written
form) SEC and the designated SRO when capital is transferred out of
the broker-dealer to related persons.  For example, the broker-dealer
is required to notify SEC and the designated SRO 2 business days
before any withdrawals of equity capital greater than 30 percent of
the broker-dealer's excess net capital. 


      FINANCIAL REPORTING
      REQUIREMENTS
------------------------------------------------------ Appendix II:1.5

SEC has delegated to the SROs primary responsibility for enforcing
broker-dealer compliance with the net capital and customer protection
rules.  SEC and the SROs have established a uniform system of
reporting by broker-dealers and inspection schedules and procedures
to routinely monitor broker-dealers' compliance with such rules. 
Registered broker-dealers, depending on their type of business, are
required to file either monthly or quarterly reports with their
designated SROs.  FOCUS (an acronym for Financial and Operational
Combined Uniform Single Report (SEC Form X-17A-5)), the report
broker-dealers are required to file, contains confidential key
financial and operational information of a broker-dealer's
operations.  If a broker-dealer has financial or operational
difficulties, SEC or the SRO may require it to accelerate its reports
filing at any time as specified in Rule 17a-5(a)(2)(iv).  FOCUS is an
integral part of the SRO's early warning system and provides the SRO
with a substantial amount of information to detect existing or
potential financial and operational problems.  Additionally, Rule
17a-5 requires broker-dealers to file annual audited financial
statements supplemented by an accountant's report setting forth any
material inadequacies. 


   THE SEC CUSTOMER PROTECTION
   RULE RESTRICTS BROKER-DEALER
   USE OF CUSTOMER SECURITIES AND
   FUNDS
-------------------------------------------------------- Appendix II:2

SEC Rule 15c3-3, adopted in 1972, provides regulatory safeguards
regarding the custody and use of customer securities and free credit
balances (funds)\19 held by broker-dealers.  The rule, with limited
exceptions,\20 requires compliance by all registered broker-dealers. 
The purpose of Rule 15c3-3 is to protect customer funds and
securities held by the broker-dealer. 

Rule 15c3-3 has two parts.  The first part requires broker-dealers to
promptly obtain and maintain the physical possession or control of
all fully paid and excess margin customer securities.\21 The second
part requires broker-dealers to segregate all customer cash or money
obtained from the use of customer property that has not been used to
finance transactions of other customers. 


--------------------
\19 Free credit balances are a broker-dealer's liabilities to
customers and are subject to immediate cash payment to customers on
demand, whether resulting from sales of securities, dividends,
interest, deposits, or otherwise.  However, they exclude funds in
commodity accounts that are segregated in accordance with the CEA or
in a similar manner. 

\20 Certain types of broker-dealers are exempted from the
requirements of the customer protection rule.  See Rule 15c3-3(k)(2)
for more detail. 

\21 Fully paid securities are securities that are purchased in
transactions for which the customer has made full payment.  Margin
securities in a customer account are those securities with a market
value equal to or less than 140 percent of the customer's debit
balance (the amount the customer owes the broker-dealer for the
purchase of the securities).  Excess margin securities in a customer
account are those securities with a market value greater than 140
percent of the customer's debit balance.  An example of excess margin
securities:  A customer buys $80,000 worth of securities on 50
percent margin.  The broker-dealer loans the customer $40,000 (debit
balance).  The amount of the customer margin securities that can be
pledged as collateral for a bank loan is $56,000 (140 percent x
$40,000 debit = $56,000 available as collateral).  Because only
$56,000 of the $80,000 of customer securities can be pledged to the
bank, the remaining $24,000 of securities are excess margin
securities that must be segregated and held in safekeeping by the
broker-dealer. 


      PART 1:  PHYSICAL POSSESSION
      OR CONTROL OF CUSTOMER
      SECURITIES
------------------------------------------------------ Appendix II:2.1

SEC's requirement that broker-dealers maintain possession or control
of all customer fully paid and excess margin securities substantially
limits broker-dealers' abilities to use customer securities.  Rule
15c3-3 requires broker-dealers to determine, each business day, the
number of customer fully paid and excess margin securities in their
possession or control and the number of fully paid and excess margin
securities that are not in the broker-dealer's possession or control. 
Should a broker-dealer determine that fewer securities are in its
possession or control than is required (a deficit position in
security), Rule 15c3-3 requires the broker-dealer to initiate action
and specifies time frames by which these securities must be placed in
the broker-dealer's possession or control.  For example, for
securities that are subject to a bank loan,\22 the broker-dealer must
issue a recall instruction within 1 business day of a deficit
position determination, and the securities must be returned to the
broker-dealer's possession or control within 2 business days of the
recall instruction.  Once a broker-dealer obtains possession or
control of customer fully paid or excess margin securities, the
broker-dealer must thereafter maintain possession or control of those
securities. 

Rule 15c3-3 also specifies where a security must be located to be
considered "in possession or control" of the broker-dealer. 
"Possession" of securities means the securities are physically
located at the broker-dealer.  "Control" of securities means the
securities are located at one of the approved "control" locations
discussed below.  "Control" locations include a clearing corporation
or depository, free of any lien; a Special Omnibus Account in
compliance with Federal Reserve System Regulation T\23 with
instructions for segregation; a bona fide item of transfer of up to
40 calendar days (longer with written permission from the transfer
agent); foreign banks or depositories approved by SEC; a bank (as
defined by the Exchange Act) supervised by a federal banking
authority, provided the securities are being held free of any lien;
in transit between offices of the broker-dealer (for no more than 5
business days) or held by a majority-owned corporate subsidiary of
the broker-dealer if the broker-dealer assumes or guarantees all of
the subsidiary's obligations or liabilities; or in any other location
designated by SEC (e.g., a mutual fund or its agent in the case of a
registered open-ended investment company). 


--------------------
\22 Securities that have been pledged to a bank as collateral are an
example of securities that are subject to a bank loan. 

\23 Federal Reserve System Regulation T (12 C.F.R.  220) regulates
the extension of credit by and to broker-dealers.  For the purposes
of SEC Rule 15c3-3, it deals primarily with broker-dealer margin
accounts.  In securities industry parlance, margin is credit extended
by a broker-dealer to a purchaser of a security to fund part of the
purchase price.  Interest is charged on the balance amount, and
ownership of the stock certificate passes immediately to the
purchaser.  Regulation T currently allows a purchaser of securities
to borrow up to 50 percent of a security's purchase price. 


      PART 2:  SEGREGATION OF
      CUSTOMER FUNDS AND THE
      RESERVE FORMULA
------------------------------------------------------ Appendix II:2.2

The second requirement of Rule 15c3-3 dictates how broker-dealers may
use customer cash credit balances and cash obtained from the
permitted uses of customer securities,\24 including from the pledging
of customer margin securities.  Essentially, the customer protection
rule restricts the use of customer cash or margin securities to
activities directly related to financing customer securities
purchases.  That is, the broker-dealer may not use customer property
as a source of working capital for its operations. 

The rule requires a broker-dealer to periodically (weekly for most
broker-dealers)\25 compute the amount of funds obtained from
customers or through the use of customer securities (credits) and
compare it to the total amount it has extended to finance customer
transactions (debits).  If credits exceed debits, the broker-dealer
is required to have on deposit in an account for the exclusive
benefit of customers\26 at least an equal amount of cash or
cash-equivalent securities (e.g., U.S.  treasuries).  Consequently,
the rule serves to protect any required deposit in a secured location
from creditors of the broker-dealer in an insolvency.  For most
broker-dealers, the calculation must be made as of the close of
business every Friday, and any required deposit must be made by the
following Tuesday morning.  If the required deposit is not made by
the broker-dealer, the broker-dealer must immediately notify its SRO
and SEC by telegram and promptly confirm such notice in writing. 
Such notice must be given even if a broker-dealer is presently in
compliance with the reserve portion of the rule but discovers that it
was previously out of compliance due to a computational error or
otherwise.  If a broker-dealer fails to make a deposit to the special
reserve account when required to do so, it is a criminal violation,
and the broker-dealer must cease doing business.  If the debits
exceed the credits, no deposit is required. 


--------------------
\24 Permissible uses of customer funds by broker-dealers include,
among others:  financing customers' margin accounts (i.e., an account
in which a customer uses credit from a broker-dealer to take security
positions); borrowing of securities to effect customers' short sales
(i.e., securities sold but not owned at time of sale by
broker-dealer); and delivery on customers' fail-to-deliver (i.e.,
selling broker-dealer does not receive securities from client in time
to make delivery to buying broker-dealer). 

\25 A broker-dealer with customer credits (funds) of less than $1
million and aggregate indebtedness of less than 800 percent of net
capital can compute the reserve requirement on a monthly basis as of
the month's close of business.  The broker-dealer is required to make
a deposit of 105 percent of the excess credits on the second business
day following the computation date.  See Rule 15c3-3(e)(3). 

\26 Rule 15c3-3(e)(1) requires that a broker-dealer maintain a bank
account that is separate from any other account of the broker-dealer
and specified as a "Special Reserve Bank Account for the Exclusive
Benefit of Customers" (reserve account).  The broker-dealer must also
obtain written notification from the bank that all cash or qualified
securities within the reserve account are being held for the
exclusive benefit of customers; are being kept separate from any
other accounts maintained by the broker-dealer with the bank; cannot
be used directly or indirectly as security for any loan to the
broker-dealer by the bank; and shall be subject to no right, charge,
security interest, lien, or claim of any kind in favor of the bank or
any person claiming through the bank. 


   U.S.  SECURITIES HAIRCUTS
-------------------------------------------------------- Appendix II:3

The haircuts described below are from SEC Rule
15c3-1(c)(2)(vi)(A)-(M). 


      SECURITIES HAIRCUTS
------------------------------------------------------ Appendix II:3.1

The percentage amount of the haircut varies depending on the type of
security, the maturity date, the quality, and the marketability. 
Generally, the haircut is deducted from the market value of the
greater of the long or short position in each security; however, in
some cases haircuts apply to the lesser position as well.  The
haircuts are designed to discount the firm's own positions to account
for adverse market movements and other risks faced by the firms,
including liquidity and operational risks. 


      U.S.  AND CANADIAN
      GOVERNMENT AND AGENCY DEBT
      SECURITIES
------------------------------------------------------ Appendix II:3.2

This refers to securities issued (or guaranteed as to principal and
interest) by the U.S.  or Canadian government or agency.  A haircut
is applied to aggregate net long or short positions in 4 main
categories (and 12 subcategories) of maturity dates ranging from less
than 3 months to 25 years or more.  The haircuts range from 0 percent
for the short-term securities (0-3 months) to 6 percent for
securities with later maturities. 

For the most part, government securities haircuts are also applied to
quasi-agency debt securities, such as those issued by the
Export-Import Bank, Tennessee Valley Authority, and the Government
National Mortgage Association (Ginnie Mae). 


      MUNICIPAL DEBT SECURITIES
------------------------------------------------------ Appendix II:3.3

These are securities that are direct obligations of, or guaranteed as
to principal and interest by, a state or any political subdivision
thereof as well as agencies and other state and local
instrumentalities.  Haircut percentages are applied to the market
value of the greater of the long or short position according to
maturity date.  For municipal securities issued with stated
maturities of 2 years or less, haircuts range from 0 percent for
securities maturing under 30 days to 1 percent for those maturing in
456 days but less than 732 days. 

For longer term securities with stated maturities of 2 years or
longer, haircuts range from 3 percent to 7 percent. 


      CERTAIN MUNICIPAL BOND
      TRUSTS AND LIQUID ASSET
      FUNDS
------------------------------------------------------ Appendix II:3.4

These funds are redeemable securities issued by investment companies
whose assets consist of cash, securities, or money market
instruments.  The haircut ranges from 2 percent to 9 percent based
upon the types of assets held by the fund. 


      COMMERCIAL PAPER, BANKERS
      ACCEPTANCES, AND
      CERTIFICATES OF DEPOSIT
------------------------------------------------------ Appendix II:3.5

The percentage deductions for highly rated corporate short-term debt
instruments (money market instruments) that (1) have a fixed rate of
interest or (2) are sold at a discount and that have maturity dates
not exceeding 9 months range from 0 percent to 0.5 percent in five
maturity categories ranging from less than 30 days to less than 1
year. 

Bankers acceptances and certificates of deposit guaranteed by a bank
and with maturity dates over 1 year have the same haircuts as U.S. 
government securities. 


      NONCONVERTIBLE DEBT
      SECURITIES
------------------------------------------------------ Appendix II:3.6

These securities are corporate bonds that cannot be exchanged for a
specified amount of another security, (e.g., equity securities), at a
stated price.  Highly rated bonds are assigned haircuts ranging from
2 percent to 9 percent for maturity dates ranging from less than 1
year to over 25 years.  Certain positions in nonconvertible
securities can be excluded from the foregoing haircuts if hedged with
U.S.  government securities. 

Also included in this category are foreign debt securities for which
a ready market exists.  For purposes of foreign securities, a ready
market is deemed to exist if such securities (1) are issued as a
general obligation of a sovereign government; (2) have a fixed
maturity date; (3) are not traded flat or in default as to principal
or interest; and (4) are highly rated (implicitly or explicitly) by
at least two nationally recognized statistical rating organizations,
such as Standard & Poor's and Moody's Investors Service. 

For positions hedged with U.S.  government securities, haircuts on
the hedged positions range from 1.5 percent for maturities of less
than 5 years to 3 percent for maturities of 15 years or more.  For
positions hedged with nonconvertible debt, haircuts on the hedged
positions range from 1.75 percent for a maturity of less than 5 years
to 3.5 percent for a maturity of 15 years or more.  In either case,
no haircut is taken on the hedging position (i.e., the U.S. 
government securities or the nonconvertible debt). 


      CONVERTIBLE DEBT SECURITIES
------------------------------------------------------ Appendix II:3.7

The treatment of debt securities that can be converted into equities
and have fixed rates of interest and maturity dates is based on the
securities' market value.  If the market value is 100 percent or more
of the principal amount, the haircut is the same as that applied to
"all other securities," or 15 percent of the market value of the
greater of the long or short positions, plus 15 percent of the market
value of the lesser position, but only to the extent that this lesser
position exceeds 25 percent of the greater position.  If the market
value is less than the principal amount, the haircut is the same as
for nonconvertible debt securities. 


      PREFERRED STOCK
------------------------------------------------------ Appendix II:3.8

This stock is cumulative, nonconvertible, highly rated, and ranked
prior to all other classes of stock.  The stock is not in arrears as
to dividends and carries a haircut of 10 percent of the market value
of the greater of the long or short position. 


      OPEN CONTRACTUAL COMMITMENTS
------------------------------------------------------ Appendix II:3.9

These commitments are haircut at 30 percent of the market value of
the greater of the net long or net short position (minus unrealized
profits), unless the class and issue of securities are listed on a
national securities exchange or are designated as NASDAQ National
Market System Securities.  If the securities are listed or
designated, the haircut is then 15 percent (unless the security is an
initial public offering whereupon the percentage deduction reverts to
30 percent). 


      ALL OTHER SECURITIES
----------------------------------------------------- Appendix II:3.10

These securities include corporate equities and certain foreign
securities (other than preferred stock discussed above).  They are
assigned haircuts of 15 percent of the market value of the greater of
the long or short positions, plus 15 percent of the market value of
the lesser position, but only to the extent that this lesser position
exceeds 25 percent of the greater position (i.e., the first 25
percent of the lesser position incurs no haircut). 


      SECURITIES WITH A LIMITED
      MARKET
----------------------------------------------------- Appendix II:3.11

In cases where there are only one or two independent market makers
submitting regular quotations in an interdealer quotation system for
the securities, the haircut is 40 percent on both the long and short
positions.  In cases where there are three or more independent market
makers submitting regular quotations, the haircut is the same as for
the "all other securities" category above. 


      UNDUE CONCENTRATION
----------------------------------------------------- Appendix II:3.12

This refers to a situation where a broker-dealer has a securities
position for which the market value is more than 10 percent of the
broker-dealer's net capital before haircuts (i.e., "tentative net
capital").  For the charge to apply to equities, the market value of
the position must exceed the greater of $10,000 or the market value
of 500 shares.  For debt securities, the provision applies to
positions valued over $25,000.  The haircut is an extra percentage of
the usual haircut applied, and it is applied only to the excess
portion of the total position (over 10 percent).  The additional
haircut for concentrated positions in equity securities is 15
percent.  For other securities, it is 50 percent of the normal
haircut on the concentrated securities. 


      NONMARKETABLE SECURITIES
----------------------------------------------------- Appendix II:3.13

These are securities for which there is no ready market, and they
carry a 100-percent haircut.  Such securities have no independent
market makers, have no quotations, and are not accepted as collateral
for bank loans. 


   U.S.  OPTIONS AND COMMODITIES
   HAIRCUTS
-------------------------------------------------------- Appendix II:4

The net capital rule also includes deductions for hedged positions,
including futures and options contracts.  Options to buy and sell
securities and commodities are subject to haircuts because their
market values change.  See Appendix A to Rule 15c3-1 for options
contracts and Appendix B to Rule 15c3-1 for relevant haircuts for
futures contracts.  CFTC generally has jurisdiction over the
regulation of futures and options markets, including their relevant
haircuts.  Since securities broker-dealers hold futures and options
positions in their portfolios, SEC incorporates CFTC's haircuts for
commodities futures and options into its net capital rule.  CFTC also
incorporates SEC's securities haircuts into its net capital rule
(Rule 1.17). 


      APPENDIX A TO SEC RULE
      15C3-1 (OPTIONS HAIRCUTS)
------------------------------------------------------ Appendix II:4.1

Appendix A to SEC Rule 15c3-1 prescribes haircut methodologies for
listed and unlisted options. 


         RISK-BASED HAIRCUT
         METHODOLOGY FOR LISTED
         OPTIONS
---------------------------------------------------- Appendix II:4.1.1

Recently, to better reflect the market risk in broker-dealers'
options positions and to simplify the net capital rule's treatment of
options for capital purposes, SEC adopted a risk-based methodology
using theoretical option pricing models to calculate required capital
charges (haircuts) for listed options and related hedged positions. 
A simple, strategy-based methodology, similar to the old haircut
methodology, remains for those firms that do not transact enough
options business to warrant the expense of using option pricing
models.  This is the first time SEC has approved the use of modeling
techniques for computing regulatory capital charges.  The effective
date of the new rule was September 1, 1997. 

Third-party source models (and vendors) approved by a designated
examining authority (i.e., self-regulatory organization) are used to
perform the actual theoretical gain and loss calculations on the
individual portfolios of the broker-dealers.  Such approved vendors
provide, for a fee, a service by which the broker-dealers may
download the results generated by the option pricing models to allow
broker-dealers to then compute the required haircut for their
individual portfolios.  The greatest loss at any one valuation point
would be the haircut.  At this time, the only approved vendor/model
is the Options Clearing Corporation's Theoretical Intermarket
Margining System (TIMS). 


         UNDERLYING PRICE MOVEMENT
         ASSUMPTIONS
---------------------------------------------------- Appendix II:4.1.2

Specified underlying price movement assumptions designed to provide
for the maintenance of capital sufficient to withstand potential
adverse market moves are included.  The underlying price movement
assumptions were established to be consistent with the volatility
assumptions currently incorporated into the net capital rule.\27

Specifically, the models calculate the theoretical gains and losses
for a portfolio containing proprietary or market maker options
positions at 10 equidistant valuation points using specified
increases and decreases in the price of the underlying instrument. 
The greatest loss at any valuation point becomes the haircut for the
entire portfolio. 


--------------------
\27 The option pricing model, for each option series, would calculate
theoretical prices at 10 equidistant valuation points within a range
consisting of an increase or decrease of the following percentages of
the daily market price of the underlying instrument:  (i) +(-)15
percent for equity securities with a ready market, narrow-based
indexes (as defined), and non-high-capitalization diversified indexes
(as defined); (ii) +(-)6 percent for major market currencies (e.g.,
European Currency Unit, Japanese Yen, and Deutsche Mark); (iii)
+(-)10 percent for high-capitalization diversified indexes (as
defined); and (iv) +(-)20 percent for currencies other than major
market currencies.  For nonclearing specialists and market makers,
there is a reduction in the underlying price movements:  +(-)4-1/2
percent for major market currencies positions, +(-)10 percent for
non-high-capitalization diversified indexes, and +6(-8) percent for
high-capitalization diversified indexes.  The maximum loss at any one
valuation point would be the haircut for the portfolio.  An option
series includes option contracts of the same type (a call or a put)
and exercise style covering the same underlying instrument with the
same exercise price, expiration date, and number of underlying units. 


         PERMISSIBLE OFFSETS
---------------------------------------------------- Appendix II:4.1.3

A percentage of a position's gain at any one valuation point is
allowed to offset another position's loss at the same valuation
point.\28 For example, options covering the same underlying
instrument are afforded a 100-percent offset.  Other offsets are
permitted between qualified stock baskets and index options, futures,
or futures options on the same underlying index.  Broker-dealers are
permitted to offset 95 percent of gains with losses (i.e., a 5
percent capital charge). 


--------------------
\28 A valuation point refers to the repricing of an option in
relation to assumed changes in the value of the underlying
instrument. 


         MINIMUM CHARGE
---------------------------------------------------- Appendix II:4.1.4

In addition, broker-dealers must take certain minimum deductions to
address decay and liquidity risk if the option pricing model
calculated an insignificant or no capital charge for a portfolio. 
This minimum charge is generally one-quarter of a point, or $25 per
option contract, unless the basic equity option contract covers more
than 100 shares.  In this case, the charge is proportionately
increased. 

SEC rules also require a deduction of 7.5 percent of the market value
for each qualified stock basket of non-high-capitalization
diversified indexes.  The rules also require 5 percent of the market
value for each qualified stock basket of high-capitalization
diversified and narrow indexes used to hedge options or futures
positions that are subject to the minimum charge. 


         ALTERNATIVE
         STRATEGY-BASED HAIRCUT
         METHODOLOGY FOR LISTED
         AND UNLISTED OPTIONS
---------------------------------------------------- Appendix II:4.1.5

SEC also permits firms with limited options business to use an
alternative strategy-based haircut methodology that generally follows
the haircut approach in the previous version of Appendix A to the net
capital rule.  See Table II.1.  This rule was designed for firms
whose options business would not make it cost effective to use an
option pricing model.  A similar strategy-based methodology is also
employed for broker-dealers that engage in buying and writing
unlisted over-the-counter options.  See Table II.2. 



                                    Table II.1
                     
                        Alternative Strategy-Based Haircut
                          Methodology for Listed Options

                           Adjustments to net
Type of option\a/          worth:
definition\b               listed options only        Haircuts on listed options
-------------------------  -------------------------  --------------------------
Uncovered short: Short     Add market value of        Appropriate percentage of
put or call with no        option.                    the current market value
related stock or option                               of the securities
position.                  Add time value\c of short  underlying the option
                           option position.           security less the out-of-
                                                      the-money amount, but
                                                      reduction cannot serve to
                                                      increase net capital.
                                                      Minimum haircut is the
                                                      greater of $250 per 100
                                                      share option contract or
                                                      50 percent of
                                                      aforementioned percentage.

Long options (calls or     None                       50 percent of the current
puts): No offsetting                                  market value of the
securities or options                                 option.
position.

Hedged call: Long call     Deduct time value on long  Take applicable haircut on
option vs. short           call.                      the short stock position
underlying stock.                                     not to exceed the out-of-
                                                      the-money amount on the
                                                      call option. Minimum
                                                      haircut of $25 for each
                                                      100 share option contract,
                                                      but minimum charge need
                                                      not exceed intrinsic
                                                      value\d of the option.

Hedged put: Long put       Deduct time value on long  Take applicable haircut on
option vs. long            put.                       the long stock position
underlying stock.                                     not to exceed the out-of-
                                                      the-money amount on the
                                                      call option. Minimum
                                                      haircut of $25 for each
                                                      100 share option contract,
                                                      but minimum charge need
                                                      not exceed intrinsic value
                                                      of the option.

Hedged call: Short call    Add time value of short    Take applicable haircut on
option vs. long            option.                    the long stock position
underlying stock.                                     reduced by the call's
                                                      intrinsic value. The
                                                      minimum charge here is $25
                                                      per each 100 share option
                                                      contract.

Spread: Long put options   Add net short market       Call spread: excess of
vs. short put options and  value or deduct net long   exercise value\e of long
long call options vs.      market value of options.   call over short call. If
short call options.                                   exercise value of long
                                                      call is less than or equal
                                                      to the exercise value of
                                                      the short call, no haircut
                                                      is required.
                                                      Put spread: excess of
                                                      exercise value of short
                                                      put over long put. If
                                                      exercise value of long put
                                                      is greater than or equal
                                                      to exercise value of short
                                                      put, no haircut is
                                                      required.
--------------------------------------------------------------------------------
\a A listed option is any option traded on a registered national
securities exchange or automated facility of a registered national
securities association. 

\b Uncovered means an option that is written without any
corresponding security or option position as protection in seller's
account.  A call is an option giving its holder (buyer) the right to
demand the purchase of a certain number of shares of stock at a fixed
price any time within a specified period.  A put is an option giving
its holder (seller) the right to demand acceptance of delivery of a
certain number of shares of stock at a fixed price any time within a
specified period.  Short means the investor sells the option.  Long
means the investor buys the option.  Hedge means any combination of
long and/or short positions taken in securities, options, or
commodities in which one position tends to reduce the risk of the
other.  A spread is the simultaneous purchase and sale of the same
class of options at different prices. 

\c Time value is the amount by which the current market value of an
option exceeds its intrinsic value. 

\d Intrinsic value (or "in-the-money amount") is the amount by which
the exercise value, if a call option, is less than the current market
value of the instrument underlying the call; and if a put option, the
amount by which the exercise value of the option is greater than the
current market value of the instrument underlying the put. 
"Out-of-the-money" is the amount by which the exercise value, if a
call, is greater than the current market value of the underlying
instrument; and, if a put, the amount by which the exercise value is
less than the current market value of the underlying instrument. 

\e Exercise value is the price at which an option can be exercised. 

Source:  The SEC Division of Market Regulation, Appendix A to SEC
Rule 15c3-1, and SEC Release No.  34-38248. 



                               Table II.2
                
                   Alternative Strategy-Based Haircut
                    Methodology for Unlisted Options

Type of option\a        Haircuts on unlisted options
----------------------  ----------------------------------------------
Uncovered calls and     15 percent, if equities, (or appropriate other
puts                    percentage) of the current market value of the
                        underlying security less any out-of-the-money
                        amount. Minimum haircut of $250 per 100 share
                        option contract.

Covered calls and puts  15 percent, if equities, (or appropriate other
                        percentage) of the current market value of the
                        underlying security less any in-the-money
                        amount. Net capital cannot be increased
                        because of haircut.

Conversion accounts\b   5 percent, if equities, (or 1/2 the
                        appropriate other percentage for other
                        securities as set forth in the rule) of the
                        current market value of the underlying
                        security.

Long options            15 percent, if equities, (or appropriate other
                        percentage for other securities as set forth
                        in the rule) of the current market value of
                        the underlying security. Limited to allowable
                        asset value of the option.
----------------------------------------------------------------------
\a An unlisted option is any option that is not traded on a
registered national securities exchange or automated facility of a
registered national securities association. 

\b A conversion is a call option created from a put option when a
long position in the underlying equity is taken. 

Source:  The SEC Division of Market Regulation, Appendix A to SEC
Rule 15c3-1 under the Exchange Act, and SEC Release No.  34-38248. 


      APPENDIX B TO SEC RULE
      15C3-1 (COMMODITIES AND
      COMMODITIES FUTURES
      HAIRCUTS)
------------------------------------------------------ Appendix II:4.2

As for securities, the net capital rule imposes a series of
deductions from the market values of commodities.  The amount of the
deductions varies depending on whether the commodities are part of a
hedged or spread position; whether the commodities stand alone as a
long or short position; and what types of commodities accounts
(inventory accounts, customer accounts) are at issue.  These haircuts
generally conform with similar provisions in CFTC's net capital rule
and are dependent on the margin requirements set by the commodities
boards of trade and clearing organizations.  See Table II.3. 



                               Table II.3
                
                  Commodities and Commodities Futures
                                Haircuts

Commodities transaction:            Haircut:
----------------------------------  ----------------------------------
1. Inventory registered as          No charge
deliverable and covered by a
futures or option

2. Covered inventory                5 percent charge of market value

3. Uncovered inventory              20 percent charge of market value

4. Covered commitments and          10 percent charge of market value
forwards

5. Uncovered commitments and        20 percent charge of market value
forwards

6. Futures and short and long       Applicable margin requirement\a
options
                                    150 percent of applicable
                                    maintenance requirement\b

                                    200 percent of applicable
                                    maintenance requirement\c
----------------------------------------------------------------------
\a If broker-dealer is a clearing member of a contract market with
respect to applicable transactions. 

\b If broker-dealer is a member of an SRO. 

\c All other broker-dealers. 

Source:  The SEC Division of Market Regulation and Appendix B to Rule
15c3-1. 


      HYPOTHETICAL EXAMPLE OF A
      BROKER-DEALER'S NET CAPITAL
      CALCULATION UNDER THE
      ALTERNATIVE METHOD
------------------------------------------------------ Appendix II:4.3

Tables II.4 and II.5 and II.6 provide information for calculating net
capital.  Table II.4, a trial balance, provides a starting point for
our simplified hypothetical example of a broker-dealer's net capital
calculation under SEC's alternative method.  A trial balance is a
list of all open accounts in the general ledger and their balances. 
A general ledger is a collection of all assets, liabilities, capital,
revenue, and expense accounts.  Accounts are the means by which
differing effects on business elements (e.g., revenues) are
categorized and collected.  In table II.5, we converted the trial
balance into a balance sheet of assets, liabilities, and capital.  In
table II.6, we compute the broker-dealer's net capital, including
haircuts, using information contained in table II.5.  The result of
the computation shows that the broker-dealer is in capital compliance
and has $352.6 million in excess net capital. 



                               Table II.4
                
                  Broker-Dealer's Trial Balance as of
                           December 31, 1997

Account title                                     Debits       Credits
Cash in banks                               $400,000,000
Customer debits\a                             40,000,000
Customer credits                                          $115,000,000
Dividends payable                                            8,000,000
Syndicate payable                                           30,000,000
Furniture and fixtures (net)                  12,000,000
Advances and loans\b                          20,000,000
Good faith deposits\c                         13,000,000
Subordinated loans\d                                        40,000,000
Loans payable                                               30,000,000
Accrued expenses payable                                     7,000,000
Commission income                                           40,000,000
Trading account\e                            130,000,000
Investment account\e                         100,000,000
Real estate                                   50,000,000
Mortgage payable\f                                          35,000,000
Interest receivables\g                         5,000,000
Capital account                                            465,000,000
======================================================================
Total                                       $770,000,000  $770,000,000
----------------------------------------------------------------------
Notes to financial statements: 

\a Customer debits are in cash account and are outstanding for less
than 7 days. 

\b Advances and loans to employees are unsecured. 

\c Good faith deposits with utility companies. 

\d Subordinated loan from firm's president, not approved by American
Stock Exchange. 

\e All securities are listed on the American Stock Exchange and are
of long equity positions.  As of 12/31/97, the market value of the
Investment account is $99,000,000; and the market value of the
Trading account is $105,000,000. 

\f Mortgage payable is for business condo. 

\g Interest receivable less than 30 calendar days from payable date. 

Source:  GAO. 



                Table II.5 Broker-Dealer's Balance Sheet
                        as of December 31, 1997

Assets
Allowable assets
----------------------------------------------------------------------
Cash                                                      $400,000,000
Customer debits                                             40,000,000
Trading account                                            105,000,000
Investment account                                          99,000,000
Interest receivables                                         5,000,000
Total allowable assets                                    $649,000,000


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

Non-allowable assets
----------------------------------------------------------------------
Real estate                                               $ 50,000,000
Furniture & fixtures (net)                                  12,000,000
Advances & loans                                            20,000,000
Good faith deposits                                         13,000,000
Total non-allowable assets                                $ 95,000,000
Total assets                                              $744,000,000


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

Liabilities
----------------------------------------------------------------------

Aggregate indebtedness
----------------------------------------------------------------------
Customer credits                                          $115,000,000
Dividends payable                                            8,000,000
Accrued expenses payable                                     7,000,000
Loan payable                                                30,000,000
Mortgage payable                                            35,000,000
Syndicate payable                                           30,000,000
Total aggregate indebtedness                              $225,000,000


Other liabilities
----------------------------------------------------------------------
Subordinated loan                                         $ 40,000,000
Total liabilities                                         $265,000,000


Owners' equity
----------------------------------------------------------------------
Capital account                                           $465,000,000
Commission income                                           40,000,000
Mark to market (investment)                                (1,000,000)
Mark to market (trading)                                  (25,000,000)
Total capital                                             $479,000,000
======================================================================
Total liabilities and capital                             $744,000,000
----------------------------------------------------------------------
Source:  GAO. 



                               Table II.6
                
                Broker-Dealer's Net Capital Computation
                        as of December 31, 1997

Accounting steps:            Description                   Computation
---------------------------  ---------------------------  ------------
                             Total assets
 minus                        Total liabilities           $744,000,000
 equals                       Net worth                    265,000,000
 minus                        Deductions:
                              Non-allowable assets        $479,000,000
 equals                       Net capital before
 minus                        haircuts                      95,000,000
 equals                       Total haircut charges\a     $384,000,000
 minus                        Net capital                   30,600,000
 equals                       Required minimum net
                              capital                     $353,400,000
                              Excess net capital               776,000
                                                          $352,624,000
----------------------------------------------------------------------
\a Haircut computation:
The haircut for equity securities is equal to 15 percent of the
market value of the greater of the long or short positions, plus 15
percent of the lesser positions, but only to the extent that these
positions exceed 25 percent of the market value of the greater
position. 

15% of trading account:  15% x $105,000,000 = $15,750,000
15% of investment account:  15% x $99,000,000 = $14,850,000
Total haircuts $30,600,000

Computation of Alternative Net Capital Compliance: 

Base requirement:  broker-dealer's net capital must be the greater of
$250,000 or 2 percent of aggregate customer debits (i.e.,
customer-related receivables) as computed per Rule 15c3-3's reserve
formula. 

Aggregate customer debits equal (customer debits - (customer debits x
3%)).  In our example, aggregate customer debits equal $38,800,000
($40,000,000 - ($40,000,000 x 3%)).  The 3 percent is analogous to
the broker-dealer's loss reserve for the loans made to customers. 
Our base requirement is $776,000 (2% x $38,800,000). 

Because the $776,000 is more than the $250,000 minimum dollar
requirement, the broker-dealer must hold at least a minimum of
$776,000 in net capital.  The broker-dealer is in compliance with
this requirement because it has $353,400,000 in net capital. 

Another requirement is that the broker-dealer's subordinated debt to
total debt-equity ratio may generally not exceed 70 percent for 90
days.  The ratio is calculated by dividing a broker-dealer's total
net worth into its subordinated debt ($40,000,000/$479,000,000). 
With a ratio of only 8.35 percent, the broker-dealer meets this
requirement. 

Source:  GAO. 



                                    Table II.7
                     
                     SEC Minimum Net Capital Requirements For
                               Brokers and Dealers

Type of broker or dealer                 Minimum requirement
---------------------------------------  ---------------------------------------
Brokers or dealers that carry accounts
--------------------------------------------------------------------------------
1. Firms that carry customer accounts
or broker or dealer accounts and
receive or hold funds or securities for
those persons (known as general
securities brokers or dealers).

i. Basic or aggregate indebtedness (AI)  Greater of $250,000 or 6-2/3% of AI
method

ii. Alternative method                   Greater of $250,000 or 2% of Rule 15c3-
                                         3 Reserve Formula debits

2. Firms that carry customer accounts,   Greater of $100,000 or 6-2/3% of AI
receive but do not hold customer funds
or securities, and operate under the
paragraph (k)(2)(i) exemption of Rule
15c3-3.


Introducing brokers*
--------------------------------------------------------------------------------
1. Firms that introduce accounts on a    Greater of $5,000 or 6-2/3% of AI
fully disclosed basis to another broker
or dealer and do not receive funds or
securities.

2. Firms that introduce accounts on a    Greater of $50,000 or 6-2/3% of AI
fully disclosed basis to another broker
or dealer and receive, but do not hold,
customer or other broker-dealer
securities and do not receive funds.


Dealers*
--------------------------------------------------------------------------------
1. Brokers or dealers that trade solely  Greater of $100,000 or 6-2/3% of AI
for their own accounts, endorse or
write options, or effect more than 10
transactions for their investment
account in any 1 calendar year.


Mutual fund brokers or dealers*
--------------------------------------------------------------------------------
1. Brokers or dealers transacting a
business in redeemable shares of
registered investment companies and
certain other share accounts.

i. Wire orders (or telephone calls)      Greater of $25,000 or 6-2/3% of AI

ii. Application (or subscription)        Greater of $5,000 or 6-2/3% of AI
method and do not otherwise receive or
hold funds or securities


Market makers*
--------------------------------------------------------------------------------
1. Brokers or dealers engaged in         Greater of $100,000 or 6-2/3% of AI or
activities as a market maker             $2,500 per security for securities with
                                         a market value greater than $5 per
                                         share, and $1,000 per security for
                                         securities with a market value of $5 or
                                         less with a maximum requirement of $1
                                         million


Other brokers or dealers*
--------------------------------------------------------------------------------
1. Firms that deal only in Direct        Greater of $5,000 or 6-2/3% of AI
Participation Programs (i.e., real
estate syndications).


2. Firms that do not take customer       Greater of $5,000 or 6-2/3% of AI
orders, hold customer funds or
securities or execute customer trades,
because of the nature of their
activities (e.g., mergers and
acquisitions).


Futures commission merchants
--------------------------------------------------------------------------------
1. Brokers or dealers registered with    Greater of $250,000 or 4% of customer
CFTC.                                    funds required to be segregated
                                         pursuant to the CEA and regulations
                                         thereunder


ALTERNATIVE METHOD\a
--------------------------------------------------------------------------------
1. Any firm may elect this method;       Greater of $250,000 or 2% of Rule 15c3-
however, the firm will be subject to     3 Reserve Formula debits
the $250,000 minimum net capital
requirement.
--------------------------------------------------------------------------------
\a A broker or dealer electing this method to calculate its net
capital levels must notify its examining authority in writing and may
not thereafter revert to the Aggregate Indebtedness Method (unless
approved by SEC.)

* The minimum capital requirements opposite the type of
broker-dealers are under the Basic (or Aggregate Indebtedness)
Method. 

Source:  The SEC Division of Market Regulation and Rule 15c3-1 under
the Securities Exchange Act of 1934. 


REGULATORY ACTIONS AND OTHER
PROVISIONS OF THE LIFE RISK-BASED
CAPITAL MODEL ACT
========================================================= Appendix III

Nearly all life insurers are required to calculate both their total
capital and their required risk-based capital and file a risk-based
capital report.\1 In the view of the National Association of
Insurance Commissioners (NAIC), however, the true impact of the
risk-based capital system occurs when the Risk-Based Capital for
Insurers Model Act (the act), developed by NAIC, is adopted by the
states.  When adopted, as it has been in 50 of 51 insurance
jurisdictions, this act gives the state's chief insurance regulator
the authority to act on the results generated by the risk-based
capital formula.\2

When the act is adopted by a state, all insurers in that state become
subject to its provisions.  For example, the act requires each
insurer to file a report with NAIC; the commissioner of the insurer's
domiciliary state; and the commissioner of any state in which the
insurer is licensed, if that state's insurance commissioner requests
it in writing.  In their annual regulatory financial reports,
insurers are also required to report their Authorized Control Level
Risk-Based Capital (ACLRBC), which is the total risk-based capital an
insurer needs to hold to avoid being taken into conservatorship.\3

The general approach NAIC has taken has been to estimate the expected
loss an insurer would suffer in the face of a catastrophic financial
event.  The size of that expected loss represents the risk-based
capital required to deal with it.  Each insurer determines the amount
of risk-based capital that it is required to set aside by multiplying
its holdings of each category of assets and/or liabilities by a
factor.  The factors are estimates of the potential for a
catastrophic loss to the insurer, or, in other words, an estimate of
the risk attached to that particular category of assets or
liabilities.  In addition to risk-based capital, insurers are
required to set aside an Asset Valuation Reserve (AVR).  The AVR is a
prospective reserve that is related to the likelihood that an asset
will lose value, and its calculation and value are closely related to
the insurer's risk-based capital. 

Conceptually, the risks facing insurers are divided into four risk
categories (asset, insurance, interest rate, and all other business
risks).  These are designated as C-0 through C-4 (asset risk is
divided into two parts).  After the calculation of risk-based capital
for each of the risk categories, the total is adjusted for
covariance.  The covariance adjustment is meant to take into account
that problems in all four risk categories are not likely to occur at
the same time. 

In order to calculate risk-based capital without requiring life
insurers to collect additional data on the assets and liabilities
reported by life insurers on their regulatory reporting forms, the
NAIC risk-based capital formula divided assets and liabilities
already reported among the risk categories C-0 through C-4.  Table
III.1 summarizes the specific items that are assigned to each risk
category. 



                              Table III.1
                
                 Summary of the Components of the Life
                Insurance Risk-Based Capital Formula and
                Their Relationship to Risk Categories C-
                             0 through C-4

Risk Factors            Items included
----------------------  ----------------------------------------------
C-0                      Affiliated U.S. Property and Casualty
Asset risk -            Insurers
affiliated amounts       Affiliated U.S. Life Insurers
                         Affiliated Alien Life Insurers
                         Investment Subsidiaries
                         Investments in Upstream Affiliates
                        (Parents)
                         Off-balance Sheet Items

C-1                      Bonds
Asset risk -All Other    Mortgages
                         Preferred Stock and Common Stock
                         Separate Accounts
                         Real Estate
                         Other Long-term Assets
                         Concentration Factor
                         Miscellaneous
                         Reinsurance

C-2                      Individual and Industrial Life Insurance
Insurance Risk           Group and Credit Life Insurance
                         Health Insurance Claim Reserves
                         Premium Stabilization Reserve Credit

C-3                      Low-Risk Category
Interest Rate Risk       Medium-Risk Category
                         High-Risk Category

C-4                      Based on guaranty fund assessments
Business Risk
----------------------------------------------------------------------
Source:  1997 NAIC Life Risk-Based Capital Report Including Overview
and Instructions for Companies. 


--------------------
\1 All states have adopted a law requiring most insurers in their
states to file an annual NAIC form containing information on their
assets, liabilities, and capital, including risk-based capital. 

\2 New York has adopted a similar law that applies to life insurers. 

\3 The material in this appendix has been largely taken from the 1997
NAIC Life Risk-Based Capital Report Including Overview and
Instructions for Companies. 


   C-0:  ASSET RISK FROM
   AFFILIATED INVESTMENTS
------------------------------------------------------- Appendix III:1

The insurance subsidiaries risk (C-0) is essentially the risk-based
capital requirement of the downstream insurance subsidiaries owned by
an insurer.  The risk-based capital requirement is the best estimate
of the overall risk of an insurance company, so NAIC believes it is
appropriate to require the parent to hold an equivalent amount of
risk-based capital to protect against financial downturns of the
affiliate.  The C-0 component is assumed to be wholly correlated with
the parent's total risk-based capital on the assumption that
financial problems in the parent will have a contagion effect in the
subsidiaries, and vice versa. 

The risk-based capital for affiliated investments of U.S.  life
insurance companies, property and casualty insurance companies, and
investment subsidiaries is calculated on a "see through" basis
(multiplied by the percent of ownership).  This requires "looking
through" all holding and subsidiary companies to the lowest level of
ownership for each affiliated stock investment.  The advantage of
this approach is that where there is a choice of whether to have
ownership of an asset in either the parent or the subsidiary, risk-
based capital results are unlikely to affect that decision. 

Some insurance affiliates are themselves subject to risk-based
capital requirements.  Others are not.  The risk-based capital
requirement of the reporting life insurer for those insurance
subsidiaries that are subject to a risk-based capital requirement is
based on the Total Risk-Based Capital After Covariance of the
subsidiary, prorated for the percent of ownership of that subsidiary. 
For affiliates that are not subject to insurance risk- based capital
requirements, the risk factors vary from 30 to 100 percent, prorated
by the percentage of the reporting company's holdings. 

Off-balance sheet items are included in C-0, even though they may or
may not have any affiliate relationship with the life insurer.  The
potential for risk exists in off-balance sheet items.  For items
other than derivative instruments, a factor of 1 percent was chosen
on a judgment basis.  The 1-percent factor will differentiate between
the companies that have small and large exposures to this risk. 
Since there is no firm actuarial basis for assigning the 1-percent
factor to these risks, off-balance sheet items are included in the
sensitivity analysis (described later) using a factor of 3 percent;
and leases are added as an additional off-balance sheet item. 


   C-1:  ASSET RISKS FOR ALL
   NONAFFILIATED ASSETS
------------------------------------------------------- Appendix III:2

Life insurance companies hold several types of assets.  The major
categories are bonds, stocks, mortgages, and real estate.  They also
hold other assets that do not fit neatly into these categories. 


      BONDS
----------------------------------------------------- Appendix III:2.1

The bond holdings of insurers are split into seven different risk
classifications or categories based on bond quality.  Class 1 bonds
are those of the highest quality, while Class 6 bonds are those bonds
that are in or near default.  The seventh bond classification is for
U.S.  government securities. 

Each bond classification has a different risk factor by which bond
holdings in that category are multiplied.  The risk-based capital
requirement for a U.S.  government security is zero because there is
no default risk for those bonds.  The risk factors for other bonds
range from 0.003 ($3 per $1000 of value) for Class 1 bonds to 0.300
($300 per $1000 of value) for high risk bonds in Class 6.  As the
risk gets higher, the risk-based capital requirement increases.  In
addition, there are other statutory limitations on the amount of junk
bonds that insurers are permitted to carry on their books. 

There is also an adjustment, called the bond size factor, that
increases the nominal risk factors for insurers that have less
diversification in their bond portfolio, after excluding U.S. 
government issues and certain U.S.  agency issues.  For insurers with
relatively few different issuers (that is, little diversification),
the bond size factor increases the risk-based capital factor by 2.5
times.  Only a handful of insurers with at least 1,300 issuers in
their bond portfolio can use the nominal factors. 


      MORTGAGES
----------------------------------------------------- Appendix III:2.2

The risk-based capital formula treatment of mortgages differs by the
type of mortgage and the mortgage status.  Mortgages are generally
broken down into three main categories--farm, residential, and
commercial.  These categories are also further subdivided as to
whether the mortgage is insured/guaranteed or not.  The risk-based
capital factors also differ for current mortgages, those 90 days
overdue, and those in the process of foreclosure.  There is also a
company-specific experience adjustment to the risk-based capital
factors for farm and commercial mortgages, based on the experience of
the insurer relative to the industry as a whole. 

Beginning in 1997, the risk-based capital calculation for troubled
mortgages is made on a mortgage-by-mortgage basis in order to
recognize the extent to which the statement value of each of those
troubled mortgages has already been marked to market or otherwise
written down. 


      UNAFFILIATED PREFERRED AND
      COMMON STOCKS
----------------------------------------------------- Appendix III:2.3

In contrast to banks, insurance companies are permitted to hold
stocks as investments. 


         UNAFFILIATED PREFERRED
         STOCK
--------------------------------------------------- Appendix III:2.3.1

Experience data to develop preferred stock factors are not readily
available; however, it is believed that preferred stocks are somewhat
more likely to default than bonds, and the loss or default would be
somewhat higher than that experienced on bonds.  Formula factors are
equal to bond factors plus 2 percent (but not more than 30 percent). 
This is consistent with the approach adopted for preferred stock
factors for AVR purposes. 


         UNAFFILIATED COMMON STOCK
--------------------------------------------------- Appendix III:2.3.2

The factor for unaffiliated common stock is based on studies
conducted at two large life insurance companies.  Both of these
studies indicated that a 30-percent factor is needed to provide
capital to cover approximately 95 percent of the greatest losses in
common stock value over a 2-year period.  This factor assumes capital
losses are unrealized and not subject to favorable tax treatment at
the time loss in market value occurs.  Two other classes of common
stock receive a different treatment.  Nongovernment money market
mutual funds are more like cash than common stock; therefore, the
factor used is 0.3 percent, the same factor used for cash.  Federal
Home Loan Bank stock has characteristics more like a fixed income
instrument rather than common stock.  A 2.3-percent factor was
chosen. 


      SEPARATE ACCOUNTS
----------------------------------------------------- Appendix III:2.4

Separate accounts are investment pools held separately from all other
assets of the insurer.  The primary purpose of separate accounts is
to allow the insurer to make investments exempt from the usual
investment restrictions imposed by state law.  Separate accounts are
authorized by states to permit insurers to offer customers investment
strategies that would not otherwise conform to insurance regulations. 
Because of the nature of separate accounts, losses cannot exceed the
funds held in the separate account and thus are insulated from the
general accounts of the insurer.  The customer, rather than the
insurer, is responsible for all investment gains and losses. 
Separate accounts are maintained primarily for pension funds and
variable life and annuity products.  Although separate accounts
represent a large segment of the aggregate assets and liabilities of
the life insurance industry, they have considerably less of a
risk-based capital requirement than other investment assets used to
fund general account obligations. 


      REAL ESTATE
----------------------------------------------------- Appendix III:2.5

Life insurance risk-based capital makes a distinction between
company-occupied real estate, real estate acquired by foreclosure,
and investment real estate.  Furthermore, real estate may be owned
directly, in which case it is reported as "real estate," or it may be
owned through a partnership.  Partnerships and joint ventures are
referred to as "Schedule BA" assets and are discussed separately. 
Like mortgage risk, the real estate risk for real estate directly
owned is calculated separately for each property.  There is a charge
for the statement value of the property as well as a charge for the
amount of encumbrances. 

Companies that have developed their own risk-based capital factors
have used factors ranging from 5 percent to 20 percent.  One study
indicated real estate volatility is about 60 percent of common stock,
suggesting a factor in the range of 18 percent.  Assuming some tax
effect for losses, a factor of 10 percent was chosen.  Foreclosed
real estate would carry a somewhat higher risk at 15 percent.  The
foreclosed real estate factor is lower than the factor for mortgages
in foreclosure (20 percent) because mortgages in foreclosure have
already been written down when they are moved to the foreclosed real
estate category.  Because a surplus reduction has already been taken,
the factor is lower. 


      OTHER LONG-TERM ASSETS
----------------------------------------------------- Appendix III:2.6

Schedule BA on the life insurers' regulatory financial report (known
as the Annual Statement) includes those long-term assets that,
because of their peculiar nature, are not included elsewhere on the
report.  These include assets owned by the insurer through
partnership arrangements as well as other unusual assets.  In
recognition of the diverse nature of Schedule BA assets, the
risk-based capital is calculated by assigning different risk factors
according to the different type of assets.  Assets with underlying
characteristics of bonds and preferred stocks rated by the NAIC
Securities Valuation Office have different factors according to the
Office's assigned classification.  Unrated fixed-income securities
are treated the same as Other Schedule BA Assets and assessed a
30-percent charge.  Rated surplus and capital notes have the same
factors applied as Schedule BA assets with the characteristics of
preferred stock.  Schedule BA real estate also has a 15-percent
factor because of the additional risks inherent in owning real estate
through a partnership.  The factors used for Schedule BA mortgages
are the same as for commercial mortgages.  Where it is not possible
to determine the risk-based capital classification of an asset
reported on Schedule BA, a 30-percent factor is applied. 


      ASSET CONCENTRATION FACTOR
----------------------------------------------------- Appendix III:2.7

The purpose of the concentration factor is to reflect the additional
risk of high concentrations in single exposures (represented by an
individual issuer of a security or a holder of a mortgage, etc.). 
The concentration factor doubles the risk-based capital factor (with
a maximum of 30 percent) of the 10 largest asset exposures, excluding
various low-risk categories or categories that already have a
30-percent factor.  Because the risk-based capital of the assets
included in the concentration factor has already been counted once in
the basic formula, this factor itself serves only to add in the
additional risk-based capital required.  The calculation is completed
on a consolidated basis; however, the concentration factor is reduced
by amounts already included in the concentration factors of
subsidiaries to avoid double counting. 


      MISCELLANEOUS ASSETS:  CASH,
      SHORT-TERM INVESTMENTS, AND
      DERIVATIVES
----------------------------------------------------- Appendix III:2.8

The factor for cash is 0.3 percent.  It is recognized that there is a
small risk related to possible insolvency of the bank where cash
deposits are held.  The 0.3 percent, equivalent to a class 1 bond,
reflects the short-term nature of this risk. 

The short-term investments to be included here are those that are not
reflected elsewhere in the formula.  Commercial paper, negotiable
certificates of deposit, repurchase agreements, collateralized
mortgage obligations, mortgage participation certificates, interest
only and principal only certificates, and equipment trust
certificates, should be included in appropriate bond classifications
(class 1 through class 6) and should be excluded from short-term
investments.  The 0.3-percent factor is equal to the factor for cash. 

For derivative instruments, the statement value exposure net of
collateral (the balance sheet exposure) is included under
miscellaneous C-1 risks.  Because collars, swaps, forwards, and
futures can have statement values that are positive, zero, or
negative, the potential exposure to default by the counterparty for
these instruments cannot be measured by the statement values and must
be calculated.  The factors applied to the derivative's off-balance
sheet exposure are the same as those applied to bonds and reflect the
insurer's exposure to loss upon default of the counterparty. 


      REINSURANCE
----------------------------------------------------- Appendix III:2.9

Insurance companies often lay off part of their risk by purchasing
reinsurance.  There is a risk associated with recoverability of
amounts from reinsurers.  The risk is deemed comparable to that
represented by bonds rated as risk classes 1 and 2 and is assigned a
factor of 0.5 percent.  Some types of reinsurance such as reinsurance
with nonauthorized companies, reinsurance among affiliated companies,
reinsurance with funds withheld, and reinsurance involving policy
loans, are subject to a separate surplus charge.  To avoid an
overstatement of risk-based capital, the formula gives a 0.5-percent
credit for these types of reinsurance. 


   C-2:  INSURANCE RISK
------------------------------------------------------- Appendix III:3

Life insurance and health insurance are often underwritten and sold
by the same companies.  Each carries its own unique set of risks. 


      LIFE INSURANCE
----------------------------------------------------- Appendix III:3.1

Life insurers establish reserves to cover expected claims costs from
their outstanding insurance-in-force.  The life insurance risk-based
capital factors chosen represent the surplus needed to provide for
excess claims over expected claims, both from random fluctuations and
from inaccurate pricing, for future levels of claims.  For a large
number of trials, each insured either lives or dies according to a
"roll of the dice" reflecting the probability of death.  The present
value of the claims generated by this process, less expected claims,
will be the amount of surplus needed under that trial.  The factors
chosen under the formula produce a level of surplus at least as much
as needed in 95 percent of the trials. 

The model was developed for portfolios of 10,000, 100,000, and 1
million lives; and it was found that the surplus needs decreased with
larger portfolios, consistent with the law of large numbers. 

One set of factors is applied to individual and industrial
insurance-in-force and another set for group and credit insurance. 



                              Table III.2
                
                Risk Factors for Life Insurance In Force

                                               Factors for     Factors
                                                individual         for
                                                       and   group and
                                                industrial      credit
Amount of insurance-in-force (in dollars)        insurance   insurance
--------------------------------------------  ------------  ----------
First 500 million                                   0.150%       0.12%
Next 4,500 million                                  0.100%       0.10%
Next 20,000 million                                 0.075%       0.06%
Over 25,000 million                                 0.060%       0.05%
----------------------------------------------------------------------
Source:  GAO analysis of 1997 NAIC Life Risk-Based Capital Report
Including Overview and Instructions for Companies. 


      PREMIUM STABILIZATION
      RESERVES
----------------------------------------------------- Appendix III:3.2

Premium stabilization reserves are funds held by the company in order
to stabilize the premium a group policyholder must pay from year to
year.  Usually experience rating refunds are accumulated in such a
reserve so that they can be drawn upon in the event of poor future
experience.  This reduces the insurer's risk.  For group life and
health insurance, 50 percent of premium stabilization reserves held
in the Annual Statement as a liability (not as appropriated surplus)
are permitted as an offset up to the amount of risk-based capital. 


      HEALTH INSURANCE
----------------------------------------------------- Appendix III:3.3

Risk-based capital factors for health insurance are applied to
medical and disability income premiums and claim reserves with an
offset for health premium stabilization reserves. 


   C-3:  INTEREST RATE RISK
------------------------------------------------------- Appendix III:4

Interest rate risk is the risk of losses due to changes in interest
rate levels.  The factors chosen represent the surplus necessary to
provide for a lack of synchronization of asset and liability cash
flows. 

The impact of interest rate changes will be greatest on those
products for which the guarantees are most in favor of the
policyholder and for which the policyholder is most likely to be
responsive to changes in interest rates.  Therefore, the risk varies
by withdrawal provision.  The risk-based capital calculation defines
three risk categories:  low, medium, and high.  Factors for each risk
category were developed based on the assumption of well-matched asset
and liability durations.  A loading of 50 percent was then added on
to represent the extra risk of less well-matched portfolios. 
Companies with well-matched books may be eligible for a reduction in
their risk-based capital required for interest rate risk. 


   C-4:  BUSINESS RISK
------------------------------------------------------- Appendix III:5

General business risk is based on premium income and annuity
considerations.  No good proxies for business risk exist in the
information usually reported by life insurers.  As a result, the
formula factors were based on a company's reported guaranty fund
assessments.  Guaranty funds are the mechanism set up in the
insurance industry to indemnify policyholders in the event of an
insurance company failure.  In all states except New York, the funds
are post-assessment; that is, the remaining insurance companies are
assessed by the guaranty fund after a company has failed.  The
assessments reflect each company's share of the cost of failures. 


   DETERMINING WHETHER A LIFE
   INSURER HAS ADEQUATE RISK-BASED
   CAPITAL
------------------------------------------------------- Appendix III:6

Regulatory capital adequacy is determined by calculating a value
called the Authorized Control Level Risk-Based Capital (ACLRBC). 
This value is then compared with the insurer's Total Adjusted Capital
(TAC) by computing the ratio (that is, ACLRBC divided by TAC).  The
value of this ratio determines the regulatory actions to be taken by
regulators that are in states that have adopted the Risk-Based
Capital for Insurers Model Act. 


      CALCULATING THE AUTHORIZED
      CONTROL LEVEL RISK-BASED
      CAPITAL
----------------------------------------------------- Appendix III:6.1

The purpose of the life insurance risk-based capital formula is to
estimate the risk-based capital levels required to manage losses that
can result from a series of catastrophic financial events.  These are
the C-0 through C-4 calculations described above.  However, chances
are remote that all such losses will occur simultaneously.  The
covariance adjustment states that the combined effect of the C-1,
C-2, and C-3 risks are not equal to their sum but are equal to the
square root calculation described below.  It is statistically assumed
that the C-1 risk and C-3 risk are correlated, and the C-2 risk is
independent of both.  This assumption provides what is considered by
NAIC to be a reasonable approximation of the capital requirements
needed at any particular level of risks. 

ACLRBC is 50 percent of the sum of the C-0 plus the C-4 risk-based
capital and the square root of the sum of the C-1 and C-3 risk-based
capital squared and the C-2 risk-based capital squared. 


      TOTAL ADJUSTED CAPITAL
----------------------------------------------------- Appendix III:6.2

In order to calculate their TAC capital for risk-based capital
purposes, insurers are allowed to make several adjustments to their
reported total capital.  These include adding to total capital their
AVR, part of the provision for future dividends, and an adjustment to
avoid double counting for some subsidiary amounts. 


      RISK-BASED CAPITAL LEVEL OF
      ACTION
----------------------------------------------------- Appendix III:6.3

Under the Life Risk-Based Capital Model Act, a comparison of the
ACLRBC with the level of TAC determines the level of regulatory
attention, if any, applicable to the company. 

Under the act, the following levels of risk-based capital require
specific regulatory actions as detailed in Table III.3: 

  -- No Action

  -- Company Action Level

  -- Regulatory Action Level

  -- Authorized Control Level

  -- Mandatory Control Level



                              Table III.3
                
                    Regulatory Actions Triggered by
                Different Total Adjusted Capital Levels
                    Under the Risk-Based Capital for
                           Insurers Model Act

Action level or indicator           Total adjusted capital level
----------------------------------  ----------------------------------
No Action\a                         2 times ACLRBC or more

Company Action Level\b              1.5 to 2 times ACLRBC

Regulatory Action Level\c           1 to 1.5 times ACLRBC

Authorized Control Level\d          0.7 to 1 times ACLRBC

Mandatory Control Level\e           0.7 times ACLRBC or less
----------------------------------------------------------------------
\a The No Action level means, basically, that the insurer has passed
the risk-based capital test and can go on about its business. 

\b In a Company Action Level event, the company is required to
prepare a detailed business plan, including a discussion of
corrective action to eliminate the event.  The plan is to be
submitted to the insurance commissioner of the state of domicile for
approval.  If the commissioner approves the plan, the state insurance
department is to monitor the company's progress until its TAC exceeds
its Company Action Level.  If the company cannot or will not prepare
a recovery plan that is satisfactory to the commissioner, or the
company fails to adhere to its plan, under some circumstances it will
drop into the Regulatory Action Level. 

\c At the Regulatory Action Level, the commissioner of the state of
domicile is to (1) require the company to submit a plan for
corrective action or, if applicable, a revised plan; (2) perform such
examinations as are deemed necessary; and (3) issue a corrective
order. 

\d At ACLRBC, the commissioner of the state of domicile is authorized
to take all regulatory action considered necessary to protect the
best interest of the policyholders and creditors of the insurer. 

\e In a Mandatory Control Level event, the commissioner of the state
of domicile is authorized to take the necessary steps to place the
company under regulatory control (i.e., rehabilitation or
liquidation).  The commissioner may delay action up to 90 days if
there is a reasonable expectation that the Mandatory Control Level
event may be eliminated. 

Source:  GAO analysis of 1997 NAIC Life Risk-Based Capital Report
Including Overview and Instructions for Companies. 


      TREND TEST
----------------------------------------------------- Appendix III:6.4

Companies whose TAC is between 2.0 and 2.5 times the ACLRBC are
subject to a trend test.  The trend test calculates the greater of
the decrease in the margin between the current year and the prior
year and the average of the past 3 years.  It assumes that the
decrease could occur again in the coming year.  Any company with a
trend below 1.9 times ACLRBC would trigger Company Action Level
risk-based capital regulatory action. 


      SENSITIVITY TESTS
----------------------------------------------------- Appendix III:6.5

The sensitivity tests provide a "what if" scenario to the calculation
of risk-based capital by recalculating ACLRBC or TAC using a
specified alternative for a particular factor in the formula. 

The amounts reported in the sensitivity tests are an actual
recalculation of ACLRBC and TAC.  If a company does not have any of
the assets or liabilities specified by the sensitivity tests,
including affiliates, noncontrolled assets, guarantees for
affiliates, contingent liabilities, long-term leases, and interest
swaps, the amounts reported after the tests are the same ACLRBC and
TAC as originally calculated. 


   OTHER PROVISIONS OF THE MODEL
   ACT
------------------------------------------------------- Appendix III:7

The Model Act extends confidentiality to any information contained in
a company's risk-based capital report, except that information the
company publishes in a publicly available annual statement.  The act
also prohibits any person or organization engaged in the insurance
business from publishing a company's risk-based capital figures. 
However, a company may publish its correct level if a materially
misleading level has been published by others.  According to NAIC,
the purpose of this provision is to prevent insurers or their agents
and brokers from using risk-based capital levels for marketing
purposes.  In NAIC's view, risk-based capital levels were not
designed for marketing purposes, and their publication could be
misleading to consumers.\4 Moreover, NAIC states that (1) risk-based
capital levels determined under its formula are still minimum capital
levels, (2) the ratio indicates whether or not a company is subject
to regulatory action because it fell below the minimum standard, and
(3) any attempt to rank companies by their levels indicates a lack of
understanding of the risk-based capital system. 


--------------------
\4 A number of state insurance department representatives and
insurance company officials told us that risk-based capital figures
have been used as a "beauty contest" for marketing and competition
purposes. 


RISK-ADJUSTED RETURN ON CAPITAL
========================================================== Appendix IV

To maximize value for stockholders, firms try to maximize returns for
a given risk or minimize risk for a given return.  To evaluate
whether they are maximizing stockholder value, firms develop ratios
of returns to risks.  These ratios permit them to simultaneously
consider how changes in risks and returns are related.  In general,
if the ratio of return to risk is increasing, stockholder value has
increased.  The general risk management principles discussed in
chapter 3 require firms to develop measures of risk-adjusted returns,
whenever possible.  In the large firms that we interviewed, measures
of risk-adjusted returns have been developed most commonly for market
and credit risks. 

Among the firms we visited, this tracking, measuring, and managing is
often done via Risk-Adjusted Return on Capital (RAROC), a term first
used by Bankers Trust.  RAROC permits a firm to evaluate the return,
risk, and capital trade-off.  Each line of business or instrument in
a fully developed RAROC system can be evaluated to determine if its
returns are high enough to warrant the risks undertaken and if the
capital allocated to cover the risks is adequate. 

In RAROC, risk is measured as a variability in returns and is based
on probability or frequency distributions of returns observed in
historical data.  By putting all risks in terms of loss distributions
and allocating capital according to profit variability, risk is
aggregated and priced all in one exercise.  That is, the trade-off
between risk and return can be done for the whole firm at once across
all risks.  The RAROC approach is based on economic theory and is
consistent with statistical models, such as VAR, Monte Carlo, and the
portfolio model approach to credit risk. 

According to our interviews and our review of relevant literature,
RAROC or equivalent processes are in use or are under development in
large banks, securities firms, and life insurance companies.  RAROC
is used to help firm management determine the capital required to
protect the firm against most, but not all, potential losses.  Firm
representatives stressed to us that in practice, they used RAROC
along with judgment for their decisions on firmwide capital needs. 

In conjunction with the determination of the amount of capital needed
to protect the firm, RAROC generates a determination of returns from
each investment for the firm.  The firm's return depends on the
returns from each particular investment and how the investment's
return correlates with returns from other investments or products. 
That is, a RAROC system takes into account the consequences of
diversifying a firm's investments so that losses and gains on a
diversified portfolio of investments can cancel each other out. 
RAROC also takes into account how hedges affect returns and risks. 

The basic steps in a RAROC system are: 

1.  The firm analyzes each activity and product in the firm and
determines the basic risk categories embedded in the investment or
product.  This unbundling of risks in each product permits the firm
to analyze the level of risks in each risk category on a firmwide
basis. 

2.  The firm quantifies firmwide the amount of risk and return in
each basic risk category and for each product.  The firm measures
each risk category and product using standardized measures of return;
and, when possible, the returns on risk measures are based on widely
traded instruments with readily available market prices.  When such
prices are not available, firms can use internal models.  The
measurement is based on weekly or daily measures of returns and
risks.  This time period is consistent with day-to-day use of VAR
modeling--setting limits and allocating capital to current risks in
the trading book. 

3.  On the basis of the risk measures determined in step two, the
firm determines the risk levels for all risk categories consistent
with its planning horizon.  (For the assets that are commonly traded,
the planning period may be less than 1 year.)

4.  The firm computes the amount of capital required for each risk
category to reduce the probability of a loss to the agreed upon
capital limit.  For example, the amount of capital required might be
the amount needed to protect a bank against losses 99 percent of the
time over the next year. 

Given that capital is to be set aside to cover risks at a 1 percent
confidence interval, the ratio of returns to such risks can be used
as a measure of relative profitability, hence the name risk-adjusted
return on capital. 

RAROC has several uses in addition to the basic use of determining
the amount of capital to set aside to cover risk.  It can also be
used to

  -- evaluate the extent to which a firm has diversified its risks so
     that losses on one product are not positively correlated over
     time with losses on another product;

  -- determine, on a risk-adjusted basis, the performance of
     different products or lines of business;

  -- allocate resources in order to earn a satisfactory return for
     shareholders;

  -- evaluate the accuracy of product pricing in order to affect
     risks, return, and capital; and

  -- help determine employee compensation and rewards on the basis of
     the risk-adjusted returns generated. 


FINANCIAL FIRMS INTEVIEWED BY GAO
=========================================================== Appendix V


      BANK HOLDING COMPANIES
------------------------------------------------------- Appendix V:0.1

BankAmerica Corporation\1
Bankers Trust New York Corporation
Canadian Imperial Bank of Commerce
The Chase Manhattan Corporation
Citicorp\2
First Chicago NBD Corporation\3


--------------------
\1 In 1998, BankAmerica Corp.  and NationsBank Corp.  announced plans
to merge and to create a new holding company called BankAmerica Corp. 

\2 In 1998, Citicorp and Travelers Group, Inc.  announced their
intention to merge and form a new entity called Citigroup. 

\3 In 1998, Bank One Corp.  and First Chicago NBD Corp.  announced
their intention to merge.  The new entity is to be called Bank One
Corp. 


      SECURITIES/FUTURES FIRMS
------------------------------------------------------- Appendix V:0.2

ED&F Man International, Inc.
Goldman, Sachs & Co.
Lehman Brothers, Inc.
Merrill Lynch & Co., Inc.
Morgan Stanley & Co., Inc.\4
Salomon Brothers, Inc.\5


--------------------
\4 In 1997, Morgan Stanley Group, Inc.  merged with Dean Witter
Discover & Co.  to form Morgan Stanley, Dean Witter, Discover & Co. 
Morgan Stanley & Co., Inc.  and Dean Witter Reynolds, Inc.  remain as
separately registered broker-dealers. 

\5 In 1997, Travelers Group, Inc.  bought Salomon Inc.  and merged it
with Smith Barney Holdings, Inc.  to create a new company called
Salomon Smith Barney Holdings, Inc.  Salomon Brothers, Inc.  and
Smith Barney, Inc.  remain as separately registered broker-dealers. 


      INSURANCE COMPANIES
------------------------------------------------------- Appendix V:0.3

Hartford Life Insurance Companies
Lincoln-National Corporation
The Prudential Insurance Company of America
Swiss Re Financial Products Corporation




(See figure in printed edition.)Appendix VI
COMMENTS FROM THE OFFICE OF THE
COMPTROLLER OF THE CURRENCY
=========================================================== Appendix V



(See figure in printed edition.)



(See figure in printed edition.)


The following are GAO's comments on the Office of the Comptroller of
the Currency's letter dated June 16, 1998. 


   GAO COMMENTS
--------------------------------------------------------- Appendix V:1

1.  OCC commented that the report fails to recognize how capital
regulations change bank behavior and also how they influence overall
economic activity.  In OCC's view, to ignore these issues is to
assume either that capital regulations have no impact, or that the
impact is invariant to changes in capital regulations.  Our purpose
in presenting issues in capital regulation was to discuss the
potential effects of capital regulation on behavior.  It was not our
purpose, however, to analyze in detail the extent or interaction of
those effects. 




(See figure in printed edition.)Appendix VII
COMMENTS FROM THE FEDERAL RESERVE
BOARD
=========================================================== Appendix V




(See figure in printed edition.)Appendix VIII
COMMENTS FROM THE FEDERAL DEPOSIT
INSURANCE CORPORATION
=========================================================== Appendix V



(See figure in printed edition.)


The following are GAO's comments on the Federal Deposit Insurance
Corporation's letter dated June 17, 1998. 


   GAO COMMENTS
--------------------------------------------------------- Appendix V:2

1.  FDIC commented that the report's focus on economic risk means
that it underemphasizes FDIC's concern with bank failures.  Our
intent in chapters 2 and 3 was to describe the difference in the
purpose of regulatory capital as seen by financial regulators and
economic capital as seen by financial firms.  We did not intend to
underemphasize FDIC's concern with bank failures but, rather, place
FDIC's concern in the context of both other regulators and firms
themselves.  In chapter 4, we explicitly point out that regulators
have different views from firms and this, in part, reflects concerns
about protecting the bank insurance fund. 

2.  FDIC commented that the report notes that capital requirements
are only one method of controlling risk, but that it does not analyze
the interaction between the regulatory tools meant to mitigate risk. 
Our purpose in discussing the other regulatory tools was to place
capital requirements in their context within the bank regulatory
system.  Our purpose was not to evaluate capital requirements and
their interaction with other regulatory tools. 




(See figure in printed edition.)Appendix IX
COMMENTS FROM THE SECURITIES AND
EXCHANGE COMMISSION
=========================================================== Appendix V



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)




(See figure in printed edition.)Appendix X
COMMENTS FROM THE COMMODITY
FUTURES TRADING COMMISSION
=========================================================== Appendix V


The following are GAO's comments on the Commodity Futures Trading
Commission's letter dated June 24, 1998. 


   GAO COMMENTS
--------------------------------------------------------- Appendix V:3

1.  CFTC commented that the report correctly recognized its concern
with protecting both customers and the markets in one place, but that
this dual concern was not reflected elsewhere in the report.  We have
made this correction throughout the report. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix XI

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Lawrence D.  Cluff, Assistant Director
Barbara I.  Keller, Project Manager
Mitchell B.  Rachlis, Senior Economist
Joe E.  Hunter, Senior Evaluator
John H.  Treanor, Banking Advisor
Desiree W.  Whipple, Communications Analyst


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