US investment firms march to the Basel II drum
WASHINGTON - Basel II risk-based capital standards are likely to be extended to the world-wide activities of the top five American investment banks under a new rule of the US Securities and Exchange Commission (SEC) that is expected to be approved soon.
The new rule is the SEC's response to a demand by the European Commission in Brussels that all foreign financial firms operating in the European Union's 15 member countries should be supervised on an "equivalent" basis to local firms there.
This requirement stems from the EU's Financial Conglomerate Directive, which takes effect from the beginning of 2005, and obliges conglomerates and multinational firms operating in Europe to be supervised at a consolidated level. As most US banks are already supervised this way by Washington agencies, the main American firms caught in the directive's net are the five bulge bracket investment banks - Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns - who are not yet regulated on a group-wide basis. Under the directive, they have the choice of expensively ring-fencing their European operations, or finding a US regulator to undertake the consolidated supervision.
After much delay, and extended discussion with EU Commission officials and investment bankers, the SEC finally published its proposed rule last October (see that month's GRR). But its approach is generating a fresh round of controversy.
The SEC is, in fact, issuing two new rules. First is the Supervised Investment Bank Holding Company (SIBHC) rule. This puts into effect a section of the Gramm-Leach-Bliley Act of 1999, which ended the historical separation of commercial banking and investment banking in the US. The trouble with the SIBHC rule, however, is that it excludes an investment bank holding company that also owns a bank with deposits insured by the Federal Deposit Insurance Corporation, another Washington agency. As a result, four of the five bulge bracket firms are excluded from this new rule.
So SEC staffers have had to search for an alternative. In an effort to find another way of applying consolidated reporting to international investment banks, they are proposing a second rule that ties this requirement to another proposed change relating to the way that broker-dealers in the US compute their capital.
Holding companies of international investment banks all own broker-dealers that are already supervised, as separate subsidiaries, by the SEC. And many of the more sophisticated broker-dealers have been pressing the SEC to allow them to use models to measure risk and compute capital levels along the lines of those being adopted by the more advanced banks under the new international capital accord (Basel II). At present, broker-dealers are required to meet a net capital requirement set by the SEC.
Under the second proposed rule, broker-dealers can apply to be exempted from the net capital requirement, and instead use a form of the Basel II standard to compute an alternative net capital requirement. But they must also consent to their holding company being supervised on a group-wide basis. That would subject it to additional reporting, record keeping and the examination of all its entities, including the parent and all affiliates, by the SEC. In addition, the holding company (referred to as a "consolidated supervised entity or CSE) would have to apply a risk-based Basel II standard, and obtain approval from the SEC for their risk levels and control systems, explains Michael Macchiaroli, an assistant director in the SEC's market regulations division.
This effectively extends the Basel II provisions through the backdoor to the big five US investment banks, in addition to the roughly 20 commercial banks to which the new capital adequacy accord will apply in America.
The incentive for the holding companies that adopt the second SEC rule - apart from establishing a level of supervision equivalent to that required by the EU - is that their broker-dealer subsidiaries are likely to enjoy a substantial reduction in the level of capital needed when taking market positions.
This second rule is described as the "Alternative Net Capital Requirement" rule. Investment banks applying either of the rules would need to adopt a Basel II-type capital standard. But, under the SIHBC, there would be no capital reduction for a broker-dealer subsidiary, and the minimum liquid capital it would need to qualify would be only $100 million. Under the second rule - offering the capital reduction -- the minimum liquid capital is much larger, at $1 billion.
This convoluted process has been made even more complicated by the need to extend the risk modeling concession to the broker-dealer subsidiaries of US commercial banks and foreign banks operating there. Although this is necessary in order to maintain a level playing field, the banks with significant broker-dealer affiliates are already supervised on a group-wide basis by either a Washington regulator or a regulator in the foreign bank's home country.
This has led to an outcry by US and foreign commercial banks which want their broker-dealers to enjoy the risk-based capital reductions, but fear "duplicative supervision." Concerns about extra costs and burdens were the main theme of the letters sent to the SEC by banks and industry associations during the comment period that ended on February 4. However, Macchiaroli says: "we have no intention of duplicating the supervision already undertaken by the Federal Reserve, or other agencies in the US and abroad." There will be "all possible deference" to these other regulators, he says. "We will not be the consolidated supervisor for these institutions."
In any case, the SEC has only identified around six banks - three US and three foreign -- with broker-dealers that would both qualify for the risk-modeling concession, and maintain a $1 billion of liquid capital. These are thought to be JP Morgan Chase, Citigroup, Bank of America, Deutsche Bank, UBS and Credit Suisse. In addition, the five investment banks are all likely to elect to be supervised under the Alternative Net Capital Requirement rule. Macchiaroli says the final number that may eventually be covered by it will, at most, be 15. Ironically, it is possible that no banks or investment firms will seek to apply the SIBHC rule.
