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Methodologies for Determining Capital Standards for Internationally Active Securities Firms

Role of Capital and Controls

The acceptance of risk and its management is an integral part of a securities firm's business. Firms develop systems of control designed to keep losses at a manageable level, (i.e. absorbable by current earnings, ideally without jeopardising overall goals for return on assets or capital). On top of this, firms will keep some capital to act as "internal insurance" in the event that losses are higher than expected. If a firm gets this capital / risk ratio wrong, it runs the risk of insolvency.

The supervisor's involvement is motivated by two key considerations. First, the need to protect investors and preserve the integrity of the market. Second, the reduction of systemic risk. The purpose of regulatory capital is therefore to reduce the probability of insolvency to an acceptable level and provide for an orderly wind-down of a firm.

Capital is not the only tool available to a supervisor. It is however an attractive tool because it is relatively non-intrusive. The supervisor can set capital requirements without getting involved in assessing a firm's day-to-day business decisions. Nevertheless, the level of capital should be proportional to the risks being run by the firm. If not, the supervisor will be giving firms the wrong incentives as the charges shape the way firms undertake their business. Gaps or anomalies in capital requirements may lead to damaging insolvencies as firms look to reducing the capital charge at the expense of managing the risks.

Of equal importance to capital are effective controls. The Technical Committee has published 12 benchmarks by which supervisors and securities firms can measure the adequacy of control systems. 2 Adequate systems and controls reduce the risks being run by a firm and hence implicitly increase the capital / risk ratio and reduce the probability of insolvency. Whether supervisors prefer to increase the capital / risk ratio by focusing on capital rather than controls will to some extent depend on the type of risk being examined. The following section examines particular risks in turn with a view to identifying the role of capital and controls in relation to each risk.


2. Risk management and control guidance for securities firms and their supervisors. A report by the Technical Committee of IOSCO - May 1998

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