In an examination of industry capital standards, global securities regulators highlight the risk of regulatory arbitrage, and the possibility of spillover effects between related companies.
The International Organization of Securities Commissions (IOSCO) Monday published a consultation report that compares the prudential capital frameworks for securities firms in different parts of the world. IOSCO says that it intends to to update its approach to capital standards based on the findings in the report, which aims to highlight similarities, differences and gaps among the different frameworks.
The report highlights several key issues where, it says, that regulators should consider whether their current practices are adequate to oversee and mitigate risk. These include: whether risks in related companies have the potential to spillover and affect the capital adequacy of a regulated affiliate; and, potentially different capital treatments of similar activities in different jurisdictions, which could create an incentive for regulatory arbitrage.
In Canada, the risk of spillover effects has been evident in recent years after several U.S. firms have run into financial trouble, taking down their Canadian subsidiaries in the process.
In terms of Canada’s prudential framework, the report notes that investment dealers in Canada follow a very similar risk-adjusted capital framework to the U.S. The key difference, it says, is that the actual capital requirement is deducted when calculating the risk adjusted capital. “This means that investment dealers have to maintain a risk-adjusted capital amount that is greater than zero,” it notes. Additionally, it says that Canada is one of the jurisdictions that specifically incorporates operational risk into the prudential requirements, along with Australia and Singapore.
Overall, the report finds that many of the key themes it identified are already reflected in IOSCO’s existing approach to capital adequacy, however, it also highlights a couple of areas that might be considered in any update.
In particular, it suggests that any update should identify whether opportunities for regulatory capital arbitrage have materialized; and, it says that the increasing use of internal models should be considered, along with the commensurate increase in infrastructure, systems and controls that are necessary to help ensure that firms are not undercapitalized compared to the risks posed by their positions and activities.
The report poses three questions that IOSCO is seeking public comments on. Specifically, it asks whether the report covers all of the key issues on prudential standards in the securities sector; whether it has successfully identified and properly analyzed the main similarities, differences and gaps between different regimes; and whether any update to IOSCO’s standards are required as a result.