5.2 Different prudential standards in the securities sector

199. In February 2015 IOSCO published a report1 analysing the way in which various jurisdictions implemented the 1989 IOSCO Report containing the capital adequacy standards for investment firms. In this report IOSCO sought to “highlight similarities, differences and gaps among the different frameworks for securities [regulations]”. As such the report is a valuable starting point for the analysis of prudential requirements for investment firms. The frameworks most widely used by prudential supervisors to regulate investment firms as identified by the 2015 IOSCO report2 are the CRD 2013 and CRR framework and the “Net Capital Rule”, or NCR. The NCR framework or an equivalent framework is primarily applied in the United States,3 but also in Canada, Hong Kong, Singapore, China and Australia.4 The CRD 2013 and CRR framework is applied in the European Union and has effect in the European Economic Area.

200. IOSCO concluded that both the CRD approach and the NCR approach share a common objective: “to ensure that an [investment firm] holds sufficient capital to protect customers and creditors from losses if it were to fail. This means the [investment firm] must hold enough capital to absorb any losses on liquidating its position or from closing customer’s defaulting positions that are guaranteed to clearing organizations.”5 There is, however, a mayor difference between the two approaches in that “the NCR is primarily directed towards ensuring that [investment firms] have sufficient liquid balance sheet assets, whereas the CRD is primarily about solvency of the firm”.6 Although the CRR contains a framework for liquidity requirements, this framework is not fully applicable to investment firms.7 Furthermore, the CRD approach is based on the Basel Capital Accords, which are designed for internationally active banks. As such, whereas the capital requirements in the NCR approach are designed for an orderly wind-down or ‘gone-concern’ principle, the capital approach in the CRD is focused more on a ‘going-concern’ principle. The CRD approach does contain, however, certain elements of the gone-concern principle8 for certain investment firms. Such firms are subject to the CRD approach of the ‘fixed overhead requirement’,9 which is a capital requirement based on a three-month survival period and thus “trying to capture the costs of winding-down the firm within three months”.

201. The CRD approach measures balance sheet risks and off-balance sheet risks and calculates capital requirements based on the overall concepts of credit risk, market risk, operational risk, counterparty credit risk, settlement risk and large exposure risk.10 The NCR approach is different in that it is solely focused on providing the authority entrusted with the winding down process with ‘enough’ liquid assets to “liquidate the [investment firm] in an orderly fashion without causing mutualized losses to customers resulting from that failure”.11 Under the NCR approach, Net Capital is determined where certain illiquid assets are deducted and ‘haircuts’ are made to reflect market risk positions.12 This Net Capital gives an indication of the available net or liquid capital of the investment firm and is then compared with a Required Net Capital. This deviates from the CRD approach, where the capital requirement is based on unexpected losses13 in the investment firm’s balance sheet and not on the ability of the investment firm to fulfil its short-term financial obligations or liabilities.

202. This highlights a significant difference in the way both approaches try to achieve the goals mentioned above. Under the CRD approach, an investment firm should be able to withstand any balance sheet losses and thereby prevent a situation where liquidation is required. The CRD approach thus provides a capital charge for unexpected losses14 to try to prevent failures. The NCR approach work[s] in a fundamentally different way in that it does not impose capital requirements for unexpected losses in the balance sheet. The NCR approach ensures that when a failure does happen, the investment firm has enough liquid assets to be able to fulfil all its liabilities. Although the approaches differ significantly, the intentions are the same: the losses for customers, counterparties and markets caused by the failure of an investment firm should be minimized.

203. Both the NCR approach and, in certain cases, the CRD approach, through the specific capital requirement of the fixed overhead requirement for certain investment firms, are established along the lines of the “gone-concern” principle.15 The approaches require the investment firm to have sufficient capital to “survive” a minimum period of time,16 in which authorities entrusted with the winding down process can wind-down the business and transfer the clients to other investment firms in a controlled manner. The basis of the CRD approach, however, is a “going-concern” principle. As discussed, the CRD approach capitalizes unexpected losses, which should result in a firm that has enough capital to “survive” all expected and unexpected losses and thereby avoiding a wind-down situation. The appropriateness of this “gone” concern principle for (certain) investment firms will be discussed further in Chapter 8. The following sections will briefly discuss the Net Capital Rule and the Basel Accords.