Guidance to Emerging Market Regulators Regarding Capital Adequacy Requirements for Financial Intermediaries

1 Guidance to Emerging Market Regulators Regarding Capital Adequacy Requirements for Financial Intermediaries Report of the Emerging Markets Committee of the International Organization of Securities Commissions December 2006 2Table of contents Part I Objectives ---------- -------------------------------------------------------------------- 3 Introduction ----------------------------------------------------------------------------- 3 General Capital Adequacy Practices ------------------------------------------------ 4 Scope and Compilation of Report --------------------------------------------------- 5 Section I Components of Capital Adequacy --------------------------------- 6 Section II. Record Keeping and Reporting requirements -------------------- 18 Section III. Compliance and regulatory issues --------------------------------- 21 General Findings and Recommendations ------------------------------------------ 24 Part II Compilation of Survey respondents -------------------------------------------------- 26 Survey Questionnaire ------------------------------------------------------------- Annex 3 PART I OBJECTIVES OF REPORT: This report was approved by the IOSCO Emerging Markets Committee during its September 2006 meeting and publicly released in December 2006. It was prepared as a result of a mandate given to the EMC Working Group on the Regulation of market Intermediaries (WG3), which was to provide guidance to emerging market regulators regarding capital adequacy requirements for financial intermediaries. The report presents a survey of capital adequacy requirements in twenty four jurisdictions of EMC members and a corresponding analysis that with related recommendations designed to assist EMC members wanting to review and strengthen their existing capital adequacy regulatory framework. IOSCO Principle1 22 has been used as the broad fundamental guideline for the preparation of this report. The report has been divided into two separate parts. The first consists of a comparative analysis and identifies trends, highlights noteworthy items and offers its findings and recommendations. The second contains the detailed responses from all surveyed jurisdictions. INTRODUCTION: Principle 22 of the IOSCO Objectives and Principles of Securities Regulations states that: “There should be initial and ongoing capital and other prudential requirements for market intermediaries that reflect the risks that the intermediaries undertake.” This regulatory principle accurately identifies the purpose of capital adequacy, that as a general guideline, capital must be sufficient to protect a financial organization’s customers and counterparties from various risks, like; market risk, settlement/counterparty risk, credit risk, operational risk, liquidity risks etc. Additionally, an efficient capital adequacy structure can also send timely warning signals to intermediaries to re-focus on their risk management, as a decline in the capital base can expose the intermediary to significantly higher levels of risks. Moreover, in order to ensure efficient functioning of stock markets it is imperative for all participants to have confidence in each other’s stability and the ability to effectively manage risk. The inability of any one intermediary to honor his commitment may call into question the financial solvency of other market intermediaries, leading to serious market disruption and decline in investor confidence. Therefore, there is a dire need to establish adequate capital adequacy 1 IOSCO Objectives and Principles of Securities Regulation endorsed in September 1998 by the IOSCO Presidents Committee 4standards, safeguards and procedures to ensure an intermediary’s financial resources are sufficient to withstand the risk to which its business is subject and reduce potential hazards. General practices with respect to capital adequacy in other jurisdictions: “Capital adequacy” can be described as the minimum capital that financial intermediaries are required to maintain at all times, (in certain jurisdictions this term is also referred to as Regulatory Capital). However, before we proceed to the comparative analysis of various jurisdictions it is important to recognize that practices pertaining to capital adequacy differ worldwide, with jurisdictions having their own specific requirements for addressing capital adequacy. It is interesting to note that the European Union Capital Adequacy Directive, (which is essentially equivalent to the Basel Accord) applies