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February 12, 2013

Former FDIC Chair Concerned About Use of Internal Risk Models

By Jim Hamilton, J.D., LL.M.

While commending the SEC's proposal to raise the minimum capital required for the very largest broker-dealers that use the alternative net capital requirements, former FDIC Chair Sheila Bair remains concerned that the Commission and other federal financial regulators continue to allow large, complex financial institutions to use their own internal risk models to set and, in some cases, lower their minimum regulatory capital. In a comment letter written in her capacity as Systemic Risk Council Chair, Ms. Bair urged the SEC to revisit the use of models for setting minimum capital requirements.

The independent non-partisan Systemic Risk Council was formed to monitor and encourage regulatory reform of U.S. capital markets focused on systemic risk. The Council members include former SEC Chair William Donaldson and former SEC Commissioner Harvey Goldschmid.

Internal Risk Models. Ms. Bair cautioned that these internal risk models routinely fail in a crisis, which is precisely when loss-absorbing shareholder equity is most needed. In addition, their use for regulatory-capital purposes can create perverse incentives for risk management and real competitive advantages for larger firms relative to smaller firms doing the same activity.

Minimum risk-based capital requirements should be just that, she emphasized: a minimum. If internal models identify additional risks that require higher capital, she continued, firms should be required to raise more equity. Management, boards, examiners, investors and counterparties deserve an objective and clear minimum risk-based capital baseline. To get the necessary capital in place quickly, the Systemic Risk Council encourages the regulators to prioritize getting new higher standards in place for large, internationally active financial institutions, while at the same time strengthening limits against leverage. More broadly, the Council said it is important for the U.S. to exercise global leadership, and strong capital requirements are a competitive strength, not weakness, and essential to system stability.

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