Broker-dealers face big compliance challenge, new costs in FINRA stress tests

September 30, 2015

By Richard Satran, Regulatory Intelligence

NEW YORK, Sept. 30, 2015 (Thomson Reuters Regulatory Intelligence) – Broker-dealers who have been largely spared the burden of the painful stress testing that major bank faced after the financial crisis of 2008 will finally taste some of the medicine given to the financial giants.

The Financial Industry Regulatory Authority this week issued guidance on liquidity risk management. The move suggests that five years after the 2008 crash broker-dealers need to upgrade and invest in significant new measures in preparation for the next perfect storm. FINRA will follow up on the new directive with reviews and stress tests on individual firms. 

FINRA based its new guidelines on a review of 43 firms selected from the 4,000 firms it regulates. FINRA did not disclose the names of the firms it studied. The results of the study included in a new directive to firms urging them to pull together their compliance, legal, audit and treasury officers to review their own crisis management systems to conduct computer simulations to gauge their firms’ ability to keep operating through in a major market event.

“We strongly encourage all firms to conduct a self-assessment of their risk and business planning,” FINRA said in a statement this week. A spokesperson for FINRA said the industry-funded agency has not issued specific orders or regulatory mandates but simply offered guidelines on how to manage financial crises.

While the plans were announced with little fanfare, compliance consultants said the message was clear that significant work would be needed, and a FINRA official called the liquidity measures “a very important initiative.” Firms that fail to build safeguards for outsized market ruptures face FINRA reviews “from time to time,” the regulator said, and selected firms will merit closer examinations on whether they “employ effective practices so that they could withstand significant idiosyncratic stresses.”

Major banks have been the main focus of re-regulation and intensive stress testing by U.S. authorities since the financial crisis in 2008. Broker-dealers, for whom FINRA is the primary regulator, have faced a lower level of scrutiny, since they are not seen as posing the same level of systemic threat.

But it was a broker dealer, Lehman Brothers, whose overexposure to toxic mortgage securities triggered Wall Street’s biggest ever bankruptcy and a resulting credit crisis that plunged the markets into the historic 2008 crash.

While broker dealers account for a much smaller share of overall short-term credit than do major banks, regulators see the Lehman debacle as clear evidence they can pose systemic risk. Since they cannot fund operations with deposits as banks can do, the broker dealer firms are more reliant on short term funding vehicles such as repurchase agreements that are among the most susceptible to short-term disruptions when markets turn volatile.

Trading risks continue for broker dealers 

What’s more, the broker dealers are not operating under the proprietary trading limits the Volcker rule placed on big banks. Broker dealer Jefferies Group this week generated losses of $100 million in its distressed energy debt trading, in a fresh reminder that risks, and potential contagious ones, still infect the non-bank sector.

“If firms do not contemplate a sufficiently severe stress environment, they may face problems during the next crisis,” said Bill Wollman, executive vice president FINRA Member Regulation, Risk Oversight and Operational Regulation, who cited the Lehman and MF Global failures as evidence that even the savviest Wall Street brokers pose threats if safeguards are not in place.

In the keynote address at a Federal Reserve conference on broker dealer risk a year ago, Boston Fed chief Eric S. Rosengren called the Lehman collapse “perhaps the defining event of the 2008 financial crisis” along with a series of such mishaps involving Bear Stearns, Merrill Lynch and other broker dealers. But five years after the crash “their reliance on a wholesale funding model that is subject to runs remains surprisingly unchanged.”

Broker dealers reviewed in bank stress tests 

The largest broker dealers, as units of major banks, were already involved in stress testing as subsidiaries of banks under Federal Reserve supervision. The broker dealers under review by FINRA over the past year include those in the $50 billion and below asset range for the first time, bringing heightened regulatory oversight to brokers previously ignored as not posing systemic risk compared with the $1 trillion plus asset banks considered too big too fail.

While big banks have been the main focus of regulators in the post-crash era, regulators have been looking at ways to safeguard the broker dealer sector, which accounts for $4.7 trillion in total assets, according to the Federal Reserve. The failure of a broker dealer, Lehman Brothers, has long been viewed as tipping point in the market instability that led to the 2008 market crisis.

The smaller firms pose a different set of problems for regulators. With less capital to invest in upgrades they are reluctant to take on the cost of creating risk protection, said Julian Fisher, a veteran of bank stress tests who heads financial services consultancy, Crest Rider.

Legal fees, technology investment, compliance implementation and other costs could run into the millions of dollars for a single firm. Indirect costs of building capital reserves could add further stress to profit margins for smaller broker already struggling to survive, he said.

“FINRA is coming to town with liquidity stress tests no matter what size your firm is,” said Fisher. “It’s not just the province of the big boys in New York, anymore. But smaller firms have less resources to invest in technology and expertise to do what’s required, and it can be incredibly costly.”

Nudging firms to do their own stress tests 

FINRA and the Securities and Exchange have been signaling the need for changes for some time now, said Mitch Avnet of Compliance Risk Concepts. The firms have held off on making big investments to comply with the regulators’ concerns because they have preferred putting capital to work on building their businesses in a highly competitive marketplace.

“Historically they thought that if they had excess capital they were fine, but FINRA is working proactively now and trying to head off a situation where the small firms are really hit by a major event,” Avnet said.

FINRA’s low key approach has been aimed at building cooperation and avoiding sending off alarms at a time of recent stress in markets. People close to FINRA say the regulator is pushing best practices and guidelines that are not rules, mindful of the vast differences in the makeup and capital structure of its diverse membership, and the cost constraints many operate under. The cost of regulation has pushed small firms to consolidate in an effort to build scale – and firms have been disappearing at a rate of 300 per year.

The regulator said its study over the past year found many brokers making strides toward account management automation needed to generate daily updates on capital positions. The ability to respond quickly to a funding crisis is critical in heading off a contagion, FINRA said. Some of the firms the regulator studied would have difficulty acting quickly enough in a crisis.

While FINRA found some firms had the capacity to respond quickly, “we also observed firms that included performing daily computations in their mitigation plans, but had not done the preparation necessary to assure that the process would work.”

Some of the broker dealers’ covered only a portion of the inventory of securities and could not do the rapid reporting that is necessary in fast markets. Some firms “had not identified which manual computations it ordinarily performs weekly that it would have to perform on a daily basis.”

The broker dealers need to have action plans in place for dealing with a funding crisis. Even small firms have complex assets that can be difficult to liquidate when markets are under stress. But the cost of these “hair cuts” needs to be factored into the overall liquidity plan, raising concerns over firms’ capital levels.

In some cases, FINRA said, the firms already tested were able to satisfy the regulator’s concerns by describing mitigating actions the firm would take or demonstrating the resources available to offset the stressed outflows of cash. FINRA said the resulting picture provides a balanced view of the ability of firms to withstand a funding crisis.

“Understanding how firms plan for and manage liquidity risk has been a priority for FINRA and other regulators since the financial crisis in 2008,” said Wollman.

But while the FINRA strategy of nudging firms toward compliance by guiding them in “best practices,” FINRA has also made it clear it will take stronger steps to make sure safeguards are in place and in cases it will impose solutions for firms that have not done so on their own.

When nudging fails to result in viable plans, the regulator said, “FINRA intends to review firm liquidity risk planning and will use stress tests with various designs from time to time in the future, either with a group of firms or as part of the examination of individual firms where appropriate.”

FINRA said it will continue to guide firms to create contingency plans to prepare for future scenarios and avoid being caught out as they were in 2008. “If firms do not contemplate a sufficiently severe stress environment,” Wollman said, “they may face problems during the next crisis.”

(This article was produced by Thomson Reuters Regulatory Intelligence. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @RiskMgment)

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yes i agree Trading risks continue for broker dealers but there are few trading stratagies here
Trading strategies

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