However, there are some weaknesses associated with determining capital charges based on 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. Accordingly, the net capital rule recognizes only certain specified hedging activities, and the Rule does not account for historical correlations 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.

To eliminate weaknesses in the current haircut structure, the Commission could modernize the Rule by maintaining the current methodology but changing the haircut percentages and recognizing additional offsetting positions. For example, the proposing release issued simultaneously with this concept release proposes amendments to the Rule that would treat haircuts on certain interest rate products as being part of a single portfolio, similar to the standard approach in the Basle Committee's Capital Accord.¹³ As proposed, the net capital rule would recognize hedges among government securities, investment grade nonconvertible debt securities (or corporate debt securities), pass-through mortgage backed securities, repurchase and reverse repurchase agreements, money market instruments, and futures and forward contracts on these debt instruments. As a next step, the Commission could revise the current haircut percentages and develop methodology to account for more correlations and hedges among other types of securities.

The Commission solicits comment on the following topics. It is not necessary, however, that comments be limited to the specific issues raised in this release. Commenters are encouraged to submit statements with respect to any aspect of the current net capital rule that may be useful to the Commission.

Question 1: Should the Commission retain the current haircut approach but revise the current percentages? If so, which haircut percentages should be modified? How should these percentages be modified? What should be the objective basis for modified haircut percentages? Please provide relevant data to support your response.

Question 2: Do the current haircut percentages adequately account for the market risk, credit risk, and other risks inherent in a particular position?

Question 3: Do the current haircut percentages enable firms to reserve sufficient capital for times of market stress, including one day movements and movements over a period of time? Please provide relevant data to support your response.

Question 4: How can haircut percentages be further adjusted to account for correlations between and within asset classes? Please provide relevant data to support your response.

Question 5: How can the current haircut approach be modified to improve the treatment for specific types of securities, including foreign securities, collateralized mortgage obligations ("CMOs"), and over-the-counter options on interest-rate securities? Please provide relevant data to support your response.

Question 6: Should the Commission include security-specific models, other than the option pricing models, in the Rule? If so, what forms should these models take and what types of minimum requirements should apply to the use of such models?

Question 7: If the Commission includes other security-specific models in the Rule, what types of securities should be covered by such models(i.e., CMOs, over-the-counter options, or treasury securities)?

Footnote:

(13) Securities Exchange Act Rel. No. 39455(December 17, 1997) .