Background to the study
Securities firms play an important role in stimulating a country’s economic growth. These firms link the supply and demand side of an economy by increasing capital accessibility for individuals who require investment capital. As a result, the securities firms make it possible for securities market to function more efficiently. In addition, it is paramount for the management team of securities firms to ensure that the firm is in a capacity to transact its business successfully. This culminates into an increase in the level of confidence amongst the participants. To achieve this, it is a requirement for security firms to have a certain amount of capital which is referred to as capital adequacy. Capital adequacy refers to a predetermined amount of capital that a security firm must have to protect the stakeholders from risks associated with the institution. Considering the volatile nature of the securities markets, it is important for the securities markets to be regulated. This is made possible by the government through the Capital Market Authority as the securities market regulating agent. The CMA implements a number of standards to ensure that securities firms maintain the required net capital.
Through efficient regulation of the securities firms, CMA is able to minimize the occurrence of market failure. An unregulated market faces a high probability of failure. This would have adverse effects on the country’s economic performance. It is a requirement for securities firms to pass credit adequacy test. In Saudi Arabia, individuals who seeking to venture into securities market by establishing security firms must fulfill all the requirements as set by Saudi Arabia Capital Market Authority. The Authorization and Inspection department is charged with the responsibility of reviewing all such applications. Saudi Arabian securities businesses are categorized into six classes. These include asset management firms, brokerage firms, corporate advisory firms and custody firms. In addition, the department has the responsibility of ensuring that the security firms comply with rules and regulations set by CMA. In relation to securities firms, capital adequacy relates to a number of elements which includes settlement and market risks, liquidity and solvency. For these requirements to be achieved, the capital market authority formulates a number of standards. Liquidity and solvency standards require securities firms to have enough liquid assets to enable the firm meet its obligations to the customers and other Authorized Persons. By having sufficient liquid assets, a firm can be able to meet its financial obligations in the event of its liquidation. This paper entails a report on capital adequacy.
Aim
The aim of the report is to conduct an analysis on capital adequacy in securities markets. The report specifically addresses Saudi Arabian securities firms.
Scope
The definition of net capital in relation to securities firms is given. The report also considers a number of risks faced by the securities firms in their operation. These risks include market risk, liquidity risk, operational risk, credit risk and systematic risk. Some of the market risk elements evaluated relate to changes in price and interest rate. The operational risks identified relate to the firm’s human resource, processes and systems. In addition, external sources of operational risks such as terrorism, natural catastrophes and changes in technology are identified. Increase in the rate of globalization is also identified as one of the factors culminating into an increment in systematic risk in securities firms. This is due to the fact that securities firms are becoming more integrated. The report also analyzes how Saudi Arabia Capital Market Authority has implemented net capital requirement in the operation of securities firms. In addition, the report analyzes the difference between United States and Europe’s net capital requirement. European countries have developed three approaches of computing net capital for securities firms which include standard, intermediate and advanced approaches. On the other hand, US have adopted the standard and alternative method. The report also identifies other methods which are used in tandem with net capital in regulating securities market. Finally a conclusion and a number of recommendations are given.
Definition of Net Capital
In an effort to ensure that securities firms comply with capital adequacy requirement, CMA conducts a computation referred to as net capital. This computation is achieved by utilizing information from the firm’s financial records. The objective of the computation is to determine the amount that would be theoretically available for a firm to pay off all its liabilities. The amount of money which is available after successful liquidation is referred to as net capital or liquid net worth. Sufficient capital is aimed at safeguarding against the effects of systematic risks.
Risks faced by securities firms
Securities firms are faced with a number of risks. These include the following.
Market risk
This risk relates to a market position which does not turnout to be profitable as the investor expected. This means that market risk results from market fluctuations and takes various forms. One of these risks relates to interest rate risk. Interest rate risk refers to risk in relation to the expected earnings or risk associated with fluctuations in the rate of interest (Comptroller Handbook 1). Interest rate risk also results from difference in timing between rate of change and the cash flow (also called re-pricing risk). According to Monetary Authority of Singapore, changes in interest rate can have adverse effects on the security firm’s capital position and income. It is therefore important for the securities firm to assess the impact the interest rate risk has on its net income (11). In addition, security firms are also faced with foreign exchange risks. This is due to the fact that the value of the investment changes due to fluctuations in exchange rates. It is important for management team of these firms to assess the effect of these changes on its annual income.
Securities firms deal with a variety of assets. Some of these assets include commodities such as grains, gas and electricity. As a result, the securities markets are faced with commodity risks. Commodity risk refers to the uncertainties associated with future market values of the involved commodities and their future income. This is due to the fact that commodity prices vary from time to time. Saudi Arabia is the largest producer of oil in the world. During the financial crisis, there was a significant fluctuation in the world crude oil price. As a result, there was an increment in the degree of commodity risk faced by the security firms. According to Monetary Authority of Singapore, institutions such as securities firms which are involved in commodity trading must account for possible deviations in convenience yields (10). Market risk exposes securities firms to a high probability of its net capital being eroded due to the unfavorable market movements. This has adverse effects on the securities firms’ market to market value of its position. Net capital serves in providing an acceptable margin for capital erosion before the firm becoming totally insolvent.
Liquidity risk
In their operation, the management teams of securities firms intend the institution to have enough funds to cater for their obligations with out selling off their assets.Securities firms are faced by a higher liquidity risks compared to banks. This is due to the fact that securities firms are not deposit taking institutions. In addition, securities firm do not receive financial capital daily from the central bank or as the ‘lender of last resort’. This means that these firms have to depend on their own financial capital. As a result, the securities firms are faced with a high liquidity risk. To be able to meet their financial requirement, self- sufficiency is necessary and hence the importance of managing their liquidity risks (Nerby Frantz, Liu, Choi and Young 4).
Liquidity risk refers to risks which result from inability of a firm to sell its asset with ease in the market in an effort to eliminate chances of a loss occurring. This is due to the fact that the market does not have parties who intend to trade in the particular assets held. As a result, liquidity risk can be defined as the inability of a firm to meet its financial commitments in a cost effective manner. Liquidity risk limits the ability of a firm to pursue business opportunities more effectively. Inability to successfully liquidate a particular asset may also result from the fact that the securities market is not well developed. The liquidity risk faced by a particular securities firm is determined by the complexity of the firm, its nature and scale of operation (Nerby et al 2-3).
Credit risk
Credit risk refers to risk arising from failure by one of the parties to a contract to comply with the contract’s stipulations. Securities firms are faced with a high degree of credit risk. According to Nerby, Frantz, Liu, Choi and Young (1), this results from the fact that these firms greatly depend on balance sheet coverage leverage. Securities firms which are highly rated closely control their credit and market risk by maintaining significant amount of their firm’s asset and funding liquidity. In their operation, these firms experience gains and losses resulting from the liabilities and assets held. As a result, securities firms have a high leverage in their operation. On average, their ratio of net asset to equity capital ranges between fifteen to twenty times. According to Nerby et al (1), securities firms utilize confidence sensitive funding in their operation which is not a stable source. This is due to the fact that this source is characterized by a high degree of volatility. For instance, the source may become expensive or completely dry up. In addition, this source may be negatively impacted by the general perception in the market due to its dynamic nature.
Operational risk
This refers to loss which arises from failure or inadequacy in the firm’s internal processes. These may include the firms systems, people and processes. In the operation of the securities firms it is important for the management team to ensure that the firm has adequate systems to ensure effectiveness and efficiency in its operation. People risk relates to risk that arises from management failures. For instance, the personnel working in the securities firm may not be well trained. This means that there is a high probability of them making ineffective decisions. In addition, the securities firm may not have implemented good control mechanisms. On the other hand, risk from processes relate to breakdown of the processes which are already implemented in the operation of the firm. In addition, the firm’s personnel may not follow the necessary processes and procedures in executing their duties. Operational risk also relates to legal risk arising in the course of the firm’s operation. For example, the firm may fail to comply with the laid down laws and regulations. In addition, the securities firm may not have integrated ethical operating standards such as fulfillment of contractual obligations. From the operational risk, the firm may incur various operational losses.
Securities firms also face risk from external sources, such as terrorism, vandalism and natural catastrophes. Currently, securities firms are being challenged by emergence of new forms of risks. These risks relate to technological changes and emergence of new and complex investment vehicles.
Systematic risk
Due to an increased rate of globalization, securities firms have been exposed to a high degree of systematic risks. This is due to the fact that the globalization is culminating into more securities firms being integrated in their operation. The increased rate of innovation with the technology environment especially in relation to Information Communication Technology (ICT) has enhanced the rate of securities firms’ integration. This is due to the fact that financial data can easily be transmitted from one location to the other. Efficiency of information flow is important in the operation of securities firms.
However technological development poses a systematic risk to securities firms. Systematic risk means that failure by one of the securities firm can result into failure by the other securities firms in which there is a close link. For instance, the 2007 financial crisis which originated in United States affected Saudi Arabian securities market. This was witnessed through a decline in the market price of securities traded at Saudi Arabian stock market (Hanware and Mustafa Para. 4).
Position risk
Position risk is one of the most key risks that securities firms face. This is due to the fact that these firms deal with a variety of investment vehicles. Securities firms which trade in a principal capacity hold securities with the objective of selling them at a profit in the future. This means that they hold these securities as short term investments. As a result, the security firms must have the capacity to with stand loses which may occur in the course of their operation. This is refers to as position risk.
Saudi Arabia CMA applies net capital
In the recent past, Saudi Arabian government through the Capital Market Authority (CMA) has made tremendous improvement on the operation of its domestic securities firms. This is evident from the fact that the fact that the CMA implemented new capital market laws which are aimed at regulating and supervising the stock market. One of these laws relate to net capital. The laws were drafted by Saudi Arabia Monetary Authority (SAMA) and implemented on 31st July 2003.The securities businesses targeted by these laws includes securities brokers, commodity brokers and other dealers. The law is also aimed at encouraging more investors to venture into the securities business through establishment of brokerage firms and asset management companies (Malki 2).
To able to attain the net capital, the CMA instituted a number of conceptual framework to guide the securities firm in fulfilling net capital requirement. The content of the conceptual framework relates to risk based requirements, amount of capital held and marking of the position of marketable securities. The net capital that securities firms should maintain vary from country to country. Setting a high amount of net capital requirement have the effect of barring potential investors from entering the industry thus impairing competition.For instance, the Saudi Arabia CMA requires securities firm to meet a given minimum net capital amount. According to the requirement, all authorized persons are required to continuously be in a position to have a net amount determined by the CMA. The authorized person should have an amount which is in excess of SR 50 million. The authorized person net capital should be more than 5% of the firm’s revenue during the previous financial year. In addition, net capital should be greater that 10% of the total firm’s indebtedness (Malki 3).
The risk based requirement framework stipulates that the securities firm should be in a position to cover all the potential risks faced by the firm. The framework gives more emphasis on risks related to position and settlement risk requirement. In addition, the CMA applies net capital requirement by ensuring that the securities firms are in a position to cover risks which are not measurable. CMA also ensures that the amount of capital held by a particular securities firm exceeds the total risk b based requirement. Marking the position of marketable securities is aimed at ensuring that securities firms give their true position and to prevent them from disguising losses.
Through the capital market law, Saudi Arabia CMA has been able to effectively ensure soundness and financial strength in the operation of securities firm. This has also been achieved through enforcing professional standards in relation to the operation of securities firms such as security brokers. In addition, CMA periodically reviews the operation of the securities firms to establish their compliance with net capital requirement (Capital Market Authority 9).
Difference between net capital requirement in US and Europe
In United States, each securities firm is required by law to comply with the net capital requirement as stipulated by the 1934 Securities Act. The capital adequacy rule is conservative in regulating net capital requirement. US have a narrow focus in relation to net capital requirement. The rule requires securities firms to maintain an amount of capital which exceeds the firm’s liabilities. In calculating net capital, the total amount of illiquid assets held by the firm such as in terms of unsecured receivables are subtracted. In addition, the securities firms are required to make additional deductions referred to as haircuts in calculating net capital. In US, net capital rules are designed to ensure that securities firms such as brokers have sufficient funds to meet their financial obligations incase of insolvency without seeking for additional funds from the Securities Investor Protection Corporation (SIPC) fund (Colby Para. 2).
In United States, a comprehensive standard has been formulated by the Securities and Exchange Commission (SEC) to aid securities firms in determining their net capital requirement. This standard is referred to as the aggregate indebtedness standard. SEC allows securities firms to value the assets held at the existing market price in addition a ‘haircut’ is applied to account for market risk. The standard requires net capital to be more than $250, 000 or 2% of the total debt items calculated in relation to the clients’ protection rules. In addition, aggregate indebtedness standard stipulates that the broker-dealers should maintain a certain ratio of the firm’s indebtedness to its liquid capital. The SEC has set this ratio at 15 to 1. In addition, the SEC has formulated the alternative method which is used in determination of net capital. Through the alternative method, the SEC is able to measure the firm’s indebtedness which refers to the total amount owed to the security firm. In addition, this amount also includes commitments made by the firm to purchase securities. In utilizing these methods, the securities firms are required to determine their net capital first while taking into consideration the Generally Accepted Accounting Principles (GAAP).
According to Herring and Schuermann (16), European countries have adopted a consolidated method of control for the financial and the securities firms. This has been achieved through formulation of Capital Adequacy Directives (CAD). Three approaches are used in ensuring effective implementation of net capital requirements for securities firms. These include standard, intermediate and advanced approaches. According to these approaches, the assessment of net capital that a firm should have depends on the risk to which the firm is exposed. According to these directives, securities firms are required to have minimum capital amounting to EUR 125, 000. In addition, securities firms are required to have an amount of funds equal to a quarter of its total fixed assets during its previous financial year. The objective of this requirement is to ensure that the securities firms are in a position to cover all the risks involved in its operation. This means that CAD is designed to ensure that firms have adequate capital to cover potential risks. In addition, securities firms are required to maintain a given amount of its short and long positions in capital form. This is usually done after making a certain amount of allowance for hedging the firm’s operation. European capital adequacy directive has a capital requirement in relation to foreign exchange rate risk exposure (‘Europa’ Para. 3-6).
Effect of financial crisis on net capital
The occurrence of the 2007 financial crisis has distorted the operation of securities firm. This is evident from the fact that the crisis culminated into an increment in the degree of risks faced by securities firms. In an effort to mitigate or completely eliminate the effects of future financial crisis on securities firms, capital market authorities of different countries are considering conducting an adjustment in the regulation of securities firms. This results from the realization of the fact that regulation is a key element in strengthening securities firms. One of the regulatory components being considered in these adjustments is net capital. To ensure that securities firms have sufficient amount of capital to offset their liabilities, Saudi Arabian net capital requirements will be increased. This will serve in increasing liquidity levels in securities firms (‘Capital Market Authority’ 13).
Other methods of regulating securities firms
Saudi Arabian government through the Capital Market Authority has incorporated other methods to net capital in its effort to regulate the operations of the securities firms. The securities firms are required by law to report to conduct continuous and comprehensive reporting of their operations. In their listing process, securities firms are required to exercise transparency. Their periodical reports should entail information related to the firm’s net asset ratio; liability ratios and a ratio of the firm’s account with its associates. The net asset ratio shows the relationship between the firm’s earned and its capital surplus. On the other hand, liability ratio indicates the extent of the firm’s external borrowings and loan guarantees.
In addition, securities firms are regulated by the stock market which has set a number of clearance and settlement rules through the Security Depository Center (SDC) (‘ Capital Market Authority’ 9).
Conclusion
Efficient operation of securities firms can culminate into increased rate of economic growth. However, the securities market is characterized by a high degree of volatility. This makes its necessary for them to be regulated by the government through the CMA. To attain this, CMA has formulated a number of rules which the securities firms are required to comply with. One of the most important rules relates to capital adequacy or net capital. This refers to the amount of capital that a firm should theoretically have at any one given time. Capital adequacy results into an increment in the degree of confidence in the securities firm amongst the investors. Sufficient net capital enables securities firms to meet their financial obligations efficiently in the event of insolvency. By having sufficient capital, investors increase their level of confidence on securities firms. Individual governments are charged with the responsibility of setting the amount of net capital requirements for their domestic country securities firms. Saudi Arabian government has managed to effectively set the net capital amount for securities firms. In their operation, securities firms are faced with numerous risks. Some of these risks relate to market risk, liquidity risks, credit risk, systematic risk, operational risk and position risk. Market risk results from fluctuation in market price of securities, foreign exchange rate and the interest rates. On the other hand liquidity risks results from inability of securities firms to liquidate their assets in a more cost effective manager to alleviate possibility of the firm incurring a loss. Increase in the rate of globalization has also culminated into an increase in the rate of integration between securities firms culminating into an increment in systematic risk. This is due to the fact that failure by one security firm can result into failure by other firms.
In its operation, Saudi Arabia capital market authority has instituted net capital requirement through formulation of capital market law. The net capital requirement has played a significant role in ensuring financial strength and soundness in the operation of the securities firms. The capital market law also entails a number of conceptual frameworks aimed at regulating potential risks.
United States and European countries have incorporated different approaches in the determination of net capital. The standards and alternative methods are used in United States while standard, intermediate and advanced approaches are incorporated in European countries. In addition, the United States has adopted a specific focus in determination of net capital while a consolidated approach is used in European countries. This is evident from the fact that financial institutions and securities firm have similar net capital requirements.
Other methods are used incorporated with net capital in ensuring effective operation of the securities firm. These include liability, net asset ratios and a ratio of the firm’s account with its associates.
Recommendations
- Saudi Arabia government through the CMA should design capital adequacy rules which are specific to the country’s financial system. This will enable the country to have a strong securities market. For instance, net capital should not be set too high. This will ensure that more investors venture the sector.
- The CMA should ensure that it conducts continuous review of the securities firms operation. The review should be aimed at establishing whether the securities firms are complying with the net capital requirements.
- The net capital set should be in a position to offset possible financial loss resulting from various risks.
- Securities firms should make an effort to mitigate or eliminate some of the risks they face. Some of the risks that these firms can eliminate are those related to operational risk.
Works Cited
Capital Market Authority. “Kingdom of Saudi Arabia: capital market law.” n.d. 2010. Web.
Colby, Roberts. “Prudential supervision of US securities firms.” New York: US Securities and Exchange Commission. 2006. Web.
Comptroller Handbook. “Interest rate.” 1998. Web.
Europa. “Capital adequacy of investment firms and credit institutions.” 2007. Web.
Hanware, Khalis and Mustafa, Abdul. “ Financial crisis pummels stocks” Arab news. 2008. Web.
Herring, Richard and Schuermann, Til. “Capital regulations for position risk in banks, securities firms and insurance companies.” Philadelphia.Wharton School University of Pennsylvania. 2003. Web.
Malki, Fahad. “The development of commercial laws in Saudi Arabia.” 2010. Web.
Monetary Authority of Singapore. “Market risk: guidelines on risk management practices.” Feb. 2006. Web.
Nerby, Peter, Frantz, Blaine, Liu, Maryann, Choi, Benjamin and Young, David. “Rating methodology: credit risks of securities firm. 2003. Web.