2017 EXAMINATION FINDINGS REPORT

December 6, 2017

Net Capital and Credit Risk Assessments

FINRA observed that, in seeking to comply with SEA Rule 15c3-1 (referred to as the SEC’s “Net Capital Rule”) and the interpretations thereunder, some firms faced challenges assessing the creditworthiness of non-convertible debt or money market instruments they held in their inventory for client facilitation or other purposes. These challenges increased following the effective date for compliance with amendments to SEC rules that removed references to credit ratings in order to reduce reliance on credit rating agencies and help ensure that haircut charges for certain securities for purposes of net capital computations are consistent with market data.21 FINRA observed issues principally in six areas:

  • Inadequate Policies and Procedures – In some instances, firms did not adequately design or document their policies and procedures for assessing and monitoring creditworthiness.
  • Inappropriate Use of Thresholds for Conducting Assessments to Determine if Securities Have Minimal Credit Risk – Pursuant to the SEC rule, firms are permitted to apply either a 15 percent haircut to all of their preferred stock, debt securities and money market instruments that have a ready market, or a lower haircut on such securities if it is determined that they have minimal credit risk pursuant to policies and procedures as specified under the Net Capital Rule. FINRA has noted instances where firms first applied the lower haircut to all such securities and then used a threshold to determine for which of those securities they would perform an analysis to determine minimal credit risk. However, the rule makes no allowance for a de minimis threshold below which the required creditworthiness assessment need not be performed.
  • Misapplication of SEC No-Action Letters – FINRA noted instances where firms incorrectly applied the criteria in SEC no-action letters for determining whether a security may be deemed to have a “ready market” to certain securities that are not within the scope of those letters. In particular, FINRA noted instances where firms incorrectly applied guidance for high-yield bonds to asset-backed securities held in their inventory. In other instances, firms did not properly apply the haircut charges prescribed in the no-action letters, and as a result applied lower haircut charges not consistent with the SEC staff’s guidance.
  • Failure to Apply Proper Charges for Open Contractual Commitments – FINRA noted instances where firms applied lower haircut charges to their open contractual commitments without performing the required assessment of creditworthiness as required by SEA Rule 15c3-1(c)(2)(vi)(I).
  • Improper Use of Indices as Benchmarks for Credit Risk Assessments – Some firms incorporated indices or other data into their procedures as benchmarks to assess the credit worthiness of an instrument, but did not reasonably design their use of such benchmarks to be consistent with the Net Capital Rule. For example, some firm procedures used certain benchmarks, but then did not articulate the levels at which the benchmarks would indicate a minimal amount of credit risk.
  • Inappropriate Use of Internal or External Credit Risk Assessments – Firms may incorporate credit ratings developed by an affiliate into their own procedures for assessing creditworthiness, but SEC rules require that procedures informed by such ratings must still be reasonably designed to result in assessments of creditworthiness that typically are consistent with market data. FINRA observed some instances where the use of an affiliate’s credit ratings did not support such procedures, such as one instance where the ratings used in the procedures were not kept current.

End Notes

21 For more information on the SEC's 2013 credit ratings amendments, please see the SEC's Adopting Release.